Sunday, August 22, 2010

Budgeting: Part 21: The Profitable Business Fallacy

"It's not hard to meet expenses. They're everywhere."
- Unknown

(In this post and subsequent posts, I am walking though 12 different examples of household budgeting mistakes and how they can all be corrected with accrual accounting techniques. Accrual accounting recognizes income when it is earned and expenses when they are incurred. An alternate definition is that accrual accounting records events that change your net worth.)

The symptom:
Your business appears to make good profits except when expenses spike.

The example:
Your small business seems to be doing well. You have plenty of steady work and you keep meticulous records of all your receipts. For most months, your customer payments (inflows) exceed your expenses for parts, rent, gasoline, telephone and other things (outflows) by $4,000 or $5,000. However, a few months out of each year are ruining things for you. Last month, it was the quarterly tax payment of $3,000. Five months ago, you had to buy a couple of new computers for $3,000, and replace some special construction tools for $5,000. Last year was mostly fine except for July, when you had to buy a new work van for $25,000. You feel that if only you could make every month what you make during the good months, you would be completely satisfied with your business.

If you've been reading this series, you may have already recognized that there is nothing new in the setup of this article. We've already covered the basic accrual issues and techniques, and the above symptom is suspiciously like the last article. The only real difference is that this article deals with unexpected business expenses, while the last one dealt with unexpected personal expenses.

So why even bother to break this out into a separate post? Mainly I've done that for emphasis. Unfortunately, over the years I've seen a number of small businesses that didn't make money, but yet the owner continued to insist that it was "making money most of the time". I don't bring any of this up to poke fun. Indeed, if you personally knew these people, I'm sure you would also find the situation very sad.

There are probably not a lot of small business owners out there that will come across this post, but if I can help even one person, this article will be a success. So if you are a struggling proprietor, do the words at the top of this article ring true? Do you feel that you are making money "most of the time", but a continual stream of unlucky "one-time expenses" are ruining your profitability?

I urge you to level with yourself. Most business owners have some familiarity with cyclical expenses, accrual techniques, and profit margins. But what's often lacking is realism. Sometimes entrepreneurs want things to work out so badly that they delude themselves into thinking things are working out when they are not.

Cash-based accounting can be one of your most delusional tools if you want to pretend things about your finances. Try evaluating your business differently. If you accrue your revenue and expenses, is your business really in the red? If so, take action! Decide to run your company differently or find a different line of business. Don't let years go by while you blame "unexpected costs" and "surprise expenses" for your business problems.

Recognition of a problem is the first step in solving it. If fact, you might even be halfway there...

Sunday, August 15, 2010

Budgeting: Part 20: The Unexpected Costs Fallacy

"There are known knowns. These are things that we know we know. There are known unknowns. That is to say, there are things that we now know we don't know. But there are also unknown unknowns. These are things we do not know we don't know."
- Donald Rumsfeld

(In this post and subsequent posts, I am walking though 12 different examples of household budgeting mistakes and how they can all be corrected with accrual accounting techniques. Accrual accounting recognizes income when it is earned and expenses when they are incurred. An alternate definition is that accrual accounting records events that change your net worth.)

The symptom:
You appear to be saving money except for unexpected costs.

The example:
Your finances seem fine most of the time. However, every once in a while you get clobbered by an unexpected expense, like a huge car repair bill or a furnace replacement. You feel like these unexpected items are killing you! Every time you get a few thousand dollars saved up, another unexpected expense comes along. You feel that you must the unluckiest person in the whole world. If only you could somehow stop these one-time expenses long enough, you could really get somewhere financially.

The quote at the beginning of this article was spoken at a press briefing by a former U.S. Defense Secretary, and the words immediately created a firestorm of controversy. His supporters called the statement a brilliant bridge between epistemology and battlefield strategy, while his critics said the statement merely reflected arrogance, evasiveness, and bad English. I'm an apolitical person and this is an apolitical blog, so I'll leave the judgment of Mr. Rumsfeld to others. But the interesting aspect of this incident is that most of the press described the categorization system as if it were a novel idea, rather than discussing whether the military had correctly categorized the matters at hand. This leads me to believe that this categorization scheme is not widely understood.

Three Categories of Risk

The field of project management has long categorized obstacles into three buckets: known knowns, known unknowns, and unknown unknowns. When I took a graduate course in project management in the early 90's, the professor was fond of saying, "It's the unk-unks that will kill your project." The known knowns are dispatched in a straightforward manner. The known unknowns are handled by various statistical and risk reduction techniques. And the unknown unknowns, being by definition completely unexpected, are typically mitigated by a simple buffer of money or resources.

For example, suppose you had a small painting company and someone had contracted a job to you to repaint the interior of a house. How do you arrive at a proper estimate? The known knowns consist of straightforward things like the cost of your paint, your equipment, your labor costs for the painting crew, and your taxes.

The known unknowns can be trickier. Some rooms will probably have some surprises; others may not. Some painters might call in sick, but not all of them. The local paint store might possibly be out of that paint today, but you will be able to get it at another store by spending some extra money. If you've been doing this kind of work for a while, you probably intuitively know the likelihood of the problems and how much extra to charge so that you cover these problems over time. But the unknown unknowns come out of nowhere, like a competitor hiring away your whole crew or a new environmental regulation that disrupts your whole pricing paradigm.

Our personal spending items can also be categorized by this same system. We have known knowns (perhaps a fixed monthly mortgage payment), known unknowns (perhaps a variable heating bill), and unknown unknowns (something truly unexpected).

Avoiding Surprises

Now the key insight I would like to suggest in this article is that in many cases, the costs that people treat as unexpected are actually quite predictable. Or to put it another way, many financial unknown unknowns ought to be brought into the realm of known unknowns.

To be sure, there certainly are completely unexpected events in life. There are people who are struck with debilitating diseases, victimized by crime, or forced to flee a war zone. I really don't have much to offer these people except my prayers and help.

But for many of us in many situations, what we categorize as a financial surprise is really nothing of the sort. Certainly the car repair bill and the furnace replacement fall into that category. You didn't really think the car and the furnace were going to last forever, did you? No. You knew they would eventually fail. You just didn't know when it would happen. This means the event is a known unknown and can be planned for in your budget.

Planning for Three Kinds of Costs

I'd like to suggest three kinds of "surprise costs" that can be handled reasonably well.

  1. Replacement costs. Unexpected costs are often replacement costs for big ticket items. If you read my earlier article on depreciation, then you already know why depreciation is important and how to account for it in your budget.
  2. Repair costs. I also mentioned in the depreciation article that repair costs are not depreciation costs, and in fact depreciation is sometimes specifically defined as not including repair costs. Nonetheless, repair costs for big ticket items can be substantial; they just don't fall under the depreciation bucket.
  3. Inflation costs. You might think inflation is so slow moving that you don't need to budget for it. However, a 5% or 10% yearly jump in college tuition rates or mortgage payments can easily kill a tight budget. Additionally, if you are budgeting for an item in the distant future, such as a retirement house or a health insurance policy, it's critical to factor in inflation or you will be struggling to hit a moving target.
So how do we handle these costs in an accrual context in your household budget? Depreciation should generally be handled by marking down the value of the depreciating asset in one account and budgeting for it in another account. If you do that, then the replacement of cars, furnaces, and other items will not be a surprise or a problem on either a cash or accrual basis. Repairs seem to be most easily budgeted through insurance costs. You can buy insurance on almost anything these days. On some items, it can make sense to actually purchase insurance because you may not be able to absorb the risk if a repair occurs soon after the purchase. For other items, you may want to "self-insure", but make sure you are using a reasonable insurance amount for a reasonable period of time. For example, perhaps you don't want to buy a bumper-to-bumper insurance policy on a vehicle. Instead, you can find out what such a policy would cost and then budget for that cost for as long as you own the vehicle. This will give you a reasonable basis for your budget. A lot of people peg these numbers way too low, so it is helpful to have a conservative rationale for your estimate. Inflation is perhaps the most complex of the three items because it's the most unpredictable and it compounds over time. People often assume they are powerless to fight inflation and they feel that they can only mitigate it by saving a lot of extra money to prepare for the unexpected. This is not entirely the case, but to understand how we can control inflation, we have to understand exactly what it is first.

Handling Unexpected Inflation

In extremely general terms, inflation is an increase in value of one item relative to another. When the comparison is to money, inflation simply becomes an increase in the price of the item. These definitions should give us an intuitive understanding of how inflation can be controlled. The one surefire way to combat inflation is to purchase the item in question now. Then the comparison is no longer relative to money or anything else. Any other method will not be completely foolproof in terms of inflation risk. For example, the normal strategy to combat inflation is to invest your money in something that you feel will grow faster than the cost of the thing you ultimately want to purchase. Hence, you might invest your money in stocks for 15 years in the hope of paying for college tuition, or you might park the money in bonds for 5 years while you are saving for a down payment on a house. Often this will work out, but sometimes it doesn't - tuition might rise faster than stocks, and house prices might rise faster than bonds. The two things to understand about prepurchasing are: (a) You truly do eliminate the inflation risk for that item, but (b) you increase your risk in other areas. For example, instead of trying to combat the risk of inflation in college tuition through investing, you could purchase a prepaid tuition plan. Many states have these plans available and some individual colleges do as well. By purchasing prepaid tuition, you eliminate the inflation risk of the tuition. However, you have increased your risk position in other areas. First, by putting the money in the tuition contract now, you've lost the opportunity to make money elsewhere. It's possible that the opportunity cost will be high, but unfortunately you won't know that ahead of time. Second, you might later wish you hadn't purchased the tuition contract. Perhaps your child doesn't end up going to college or receives a full scholarship or you have a financial crisis. Staying liquid gives you options you won't have if you purchase something with the money now. Third, if you had to borrow money to prepurchase a large item (which is often the case for many people), then you incur interest costs and the risk that you won't be able to make the payments. Additionally, some items will not make any sense to purchase before their intended use. This would include items that depreciate or have sizable carrying costs. For example, you wouldn't buy a car 2 years before you need it just to lock in today's car prices. The car will be worth must less in 2 years even if you don't use it.

Using Accrual Techniques Properly

Some people intuitively know that they should be planning for irregular costs. They budget for car repair costs based on averages they read in a book or perhaps the amount they spent on repairs last year. For example, they might budget $100 per month for such repairs. They might actually transfer money to a savings account for this purpose, or if they don't have cash flow problems, they might simply note that $100 needs to be budgeted for repairs each month as part of their overall spending plan. If you're already doing that for some items, then you're way ahead of most people in avoiding financial surprises. Nonetheless, people who budget that way sometimes make one crucial mistake that ruins the entire system. If you have a reasonable basis for picking $1200 a year for car repairs, then you can budget $100 per month for it. You should realize, however, that the $100 repair expense is accruing each month whether or not you have any repairs. This means that you cannot "zero out" the repair budget for any months where you have no cash expenses. For example, if you had only $50 total in car repairs for the first 6 months of the year, you shouldn't zero out the other $550 that was budgeted and spend it on something else. This will lead to the exact kind of surprise you were trying to avoid in the first place. If you start raiding that money, then you don't really understand what that $100 per month represents. It's certainly not the amount you actually spent, and it's not just a planning convenience to arrive at a fixed number each month. If you drove the car around for another month, it's quite likely that you incurred wear and tear on the car such that an additional $100 of repairs will eventually be needed to correct it. However, you may or may not have those repairs done that month. So on an accrual basis, you actually have a $100 expense each month whether or not the car is in the shop. Thus, you can't start reducing your repair budget every time you go a month without a cash repair. The cash and accrued expenses will likely all even out in the end if you don't meddle with it prematurely.