Why Hourly Job Costing Analysis?

Preface: Whatever your line of business services, to ensure your business is managed effectively, you need Bob Cratchit’s math skills to calculate your  costs accurately as frequently as every month.

Why Hourly Job Costing Analysis?

Donald J. Sauder, CPA | CVA   (2015)

Do know your hourly job costs? Maybe you need an Excel document from Bob Cratchit ? Costs count, and accurate hourly job costing is a easy component when analyzing if your business is making a profit on an hourly basis.

If you have a team of service technicians who service computer networks, how do you know how much to bid on a new server install or client network upgrade? How do you calculate what to charge per service hour? If one technician works on three projects in a day, how do you begin to calculate your cost for upgrading a hard drive, repairing a server power supply, and resolving malware concerns?

So when you calculate costs of your technician wages at $40 per hour, you can see that your true cost for your business per billable tech hour is closer to $114 per hour to upgrade the hard drive, repair the server power supply, and resolve malware concerns.

With thanks to Bob Cratchit, here is a simplified method to figure hourly costs for your projects. For example, your service technicians costs $40 per hour including employee benefits, employer taxes, and perks. If a hard drive upgrade takes 3 hours, your cost is $40 x 3 = $120 for labor. So what should you charge? Let’s say you have five technicians who work a combined 420 billable hours per month. Your cost for employee wages is approximately $1,600 per week (40 hours x $40 per hour), and $6,400 for the month ($1,600 x 4 = $6,400 per technician, per month). Overhead for the five technicians is $175,000 a year in rent, utilities, office supplies, advertising, office staff, and sales reps. Your fixed cost for the service technicians’ salaries plus overhead is approximately $575,000 per year. At 420 hours per month average your five technicians would work 5,040 hours a year. $575,000/5040 = $114 per hour of labor costs per hour to break even. For an 8% net profit margin, you should charge at least $123 per hour ($123 x 5040 = $619,920 of yearly sales).

So when you calculate costs of your technician wages at $40 per hour, you can see that your true cost for your business per billable tech hour is closer to $114 per hour to upgrade the hard drive, repair the server power supply, and resolve malware concerns.

If you didn’t accurately figure the cost of your operating expenses in the above example, and billed $95 per hour, your business would have a loss of $96,200 for the year based on the 5,040 billable hours. However, if you can optimize efficiency from you technicians and have only 4 technicians working 1,260 billable hours per year (vs. five technicians working 1,080 billable hours individually) you could decrease service wages $76,800, and decrease operating expenses and service wages to $482,200 per year to an average of $95 per hour.

Perhaps you have a good sales rep and have five efficient techs working 1,500 billable hours per year, which would be 7,500 billable hours yearly. With an overhead cost of $175,000 and technician wages of $384,000 your total costs of $575,000 would result in a cost of $77 per tech hour at 7,500 billable hours. So if you billed $95 per hour you would net $18 per technician hour, or $135,000 with five billable service technicians.

In summary, accurate costing is key to profitability in any service businesses be it plumbing, cleaning, electric, snow plowing or mowing yards. If you are unsure or need your confidence boosted when calculating cost, contact your trusted advisor.

Whatever your line of business services, to ensure your business team’s costs are managed effectively, you likely need Bob Cratchit’s math skills to calculate your updated hourly costs accurately as frequently as every month.

 

A Monthly Business “Vacation Hour”

Preface: The Traction EOS Process™ provides a proven way to successful manage your business. The entrepreneurial operating systems (EOS) incorporates EOS Tools in the right order to best strengthen each key component of your business. One of those key tools is the Clarity Break. Try it. Scheduling your “vacation hour” monthly will likely be more challenging than you think. Read about it here….

EOS-Clarity-Break

Bitcoins in Business

Preface: Bitcoin is as much a speculative asset as a medium of exchange in today’s economy. While the Federal Reserve has no governance over the BitCoin exchange as such, as a digital cryptocurrency, its exchange value rises and falls on marketplace whims and traders.

Bitcoins in Business

Credit: Donald J. Sauder, CPA | CVA

Money or cash in the early days of Colonial America was denominated mostly in pounds, shillings, and pence, with values of exchange varying from colony to colony. For instance, a Pennsylvania pound value was not the same trade exchange value as a Massachusetts pound.

While paper money began circulating circa 1690 in early American, it initially financed ventures like King William’s War and other sovereign conflicts. In 1776 Adam Smith futilely criticized paper bills of credit in his famous work, The Wealth of Nations.

We’ve advanced past sophisticated plastic cards of credits of the 1990s to the developing world of Bitcoin and the cryptocurrency world.

Although the paper currency has historically been driven from a perspective of financing government defense departments, today the history of the Quaker faiths short-term opposition from at least one Yearly Meeting towards the Continentals currency for reasons of its purpose associated with taxes to pay for the war, has long been forgotten by pacifists. And, so today, the world of America is entirely bought into the “Dollar.”

The business community in American and the World, today transactions solely in dollars, accounting is in dollars even though a few businesses have foreign exchange considerations. We’ve advanced past sophisticated plastic cards of credits of the 1990s to the developing world of Bitcoin and the cryptocurrency world. Transactions in physical coin(s) are facing the final curtain, let’s say “Beam me up Scotty!”

 BitCoin was the early invention of cryptocurrency introduced to around 2009 to the business community.

For those who vaguely familiar with Bitcoin, it is a cryptocurrency. That is a decentralized digital currency without a central bank or single administrator that transacts on a peer-to-peer network with no need for intermediaries. Transactions with cryptocurrencies are verified with network nodes through cryptography and listed in public ledgers called blockchain. BitCoin was the early invention of cryptocurrency introduced to around 2009 to the business community. Bitcoin is name for a brand of cryptocurrency like US Dollar, Canadian Dollar, Euro, etc.

Bitcoins are not printed or minted as is typical legal tender. Bitcoins are developed from a process called mining. Mining is essentially a process of computer solving mathematical questions to earn “grams of Bitcoin.” The mining process requires substantial computer capacity, hence high electric consumption. The known and planned and charted course concludes the Bitcoin mine at 21,000,000 BitCoins. Today computers have mined around 17m of those Bitcoins and math equations required are consuming “a lot” of electricity.

Like many exciting stories in early currency developments, the developer of Bitcoin Satoshi Nakamoto mined about a million Bitcoins himself in the early days before handing the network to Gavin Andresen.

Like many exciting stories in early currency developments, the developer of BitCoin Satoshi Nakamoto mined about a million BitCoins himself in the early days before handing the network to Gavin Andresen. Nakamoto claims his Bitcoin wallet disappeared when he had his computer repaired one day, and his wallet in the laptop went with a 1,000,000+ of Bitcoins.

Warren Buffet, one of the world’s richer men, is quoted as saying “Bitcoin has no unique value at all. It doesn’t produce anything. You can stare at it all day, and no little bitcoins come out. It’s a delusion.” He goes on to say, “Cryptocurrencies will come to bad endings… If you buy something like bitcoin or some cryptocurrency, you don’t have anything that has produced anything. You’re just hoping the next guy pays more.” Everyone is entitled to an opinion, and Buffet admits, “I was too dumb to realize. I did not think [Bezos] could succeed on the scale he has… [We] miss a lot of things, and we’ll keep doing it.”

Bitcoin is as much a speculative asset as a medium of exchange in today’s economy. While the Federal Reserve has no governance over the BitCoin exchange as such, as a digital cryptocurrency, its exchange value rises and falls on marketplace whims and traders. With a price in 2013 of $13.30 per coin and $770 in 2014, Bitcoin today is above $10,000 per coin exchange value to the US Dollar. On December 17, 2017, the price was an all-time high of $19,783.06 per coin.

Whether Bitcoin was named after a carefully saved hard-bitten coin for purposes of a purchasing a future meal, or more likely “digital coins,” every business person should have an opinion on the future of the cryptocurrency developments. Why? Because as economic trends continue they too will need make a serious decision on how they will transact when buying and selling products or services with the world. the decision to crypto or not to crypto may not be as easy it seemed in the early days.

You’re Invited to an Exclusive Building Your “Dream Team” Workshop on October 3

You’re Invited to an Exclusive Building Your “Dream Team” Workshop

October 3, 2019

Develop Your People, Build a Positive Corporate Culture And Take Your Business To The Next Level

As leaders, we want our organizations to be high-performing, and in order for that to be a reality, our people need to perform at a high-level. When our people perform at a high-level, and they do it together, your organization will have your own “Dream Team”.

This workshop is for business leaders that aspire for their organizations to perform better, and in the process, produce better results. This workshop will address important questions:

 Join us on October 3, when Steve Erb, of True Edge Performance Solutions, will walk us through the following:

•  How can we make the positive changes to Build Our Dream Team and take our organizations to the next level?

Company Culture -> Why does it matter? How can I impact?

• We’ll work toward evaluating your organization and identifying positive culture development strategies

• Your Greatest Asset -> How can I develop my team? What tools can I use to assist?

• We’ll work on processes and tools to help you build your “Dream Team” • Recognition -> Why is this so hard?

• We’ll work on recognition strategies that will enable sustainable change

Develop Your People, Build a Positive Corporate Culture And Take Your Business To The Next Level

As a workshop, you will develop and clarify your “Next Steps” for your business after each session; and you will have the opportunity to learn from others in a collaborative environment in the process.

Register Here: Building Your Dream Team Workshop

(A buffet breakfast is included.)

For more information, please contact:

Presenter: Steve Erb, MBA

True Edge Performance Solutions

SErb@TrueEdgeLLC.com

717-509-9177, ext. 106

“Grow With Traction” – An EOS (Work)shop August 28th

“Grow With Traction” – An EOS (Work)shop to help you achieve your vision!

If you are the owner, leader or manager of an entrepreneurial organization who wants to see your business consistently run better and grow faster, Brian White and EOS can help you and your team simplify, clarify and achieve your vision.

Even the most successful entrepreneurs occasionally find running a business more challenging than they expected. Many work longer hours and get less return on their investment of time and money than they would like. Most entrepreneurs regularly grapple with one or more of the following challenges:

  • Lack of control – over time, the market, or the company
  • People – don’t listen, understand or follow-through
  • Profit – there’s not enough of it
  • Growth – is okay, but they just can’t seem to break through to the next level
  • Magic Pills – Lots of remedies and quick fixes have come and gone, but the wheels are still spinning

If these problems seem all too familiar, you’re not alone. It doesn’t have to be that way. For over 15 years, Brian has been helping entrepreneurs and their leadership teams succeed. In this interactive workshop, Brian will introduce you to the Six Key Components™ of successful businesses. He’ll arm you with a set of simple, practical tools you and your leadership team can begin using right away to get more done and realize better results.

Read More Details on Eventbrite:

Clarify | Simplify | Achieve your Vision

Companies who should attend:

  • A company that has 10+ people
  • A company that is more afraid of the status quo than making change
  • A company who is self-implementing EOS (read Traction, Get A Grip, have been implementing with no facilitator and/or downloaded some EOS tools)
  • Companies who want to get to the next level (would like to see what EOS is and get some tools)

Brian is excited to share his expertise to help you run a better business.

Tax Credit for Research or Development (Segment II of II)

Preface: Researching and developing can be hard work, and proper documentation can be hard work too. When applicable, hopefully, the research and development projects yield improvements to your products or processes, and the documentation yields a tax credit.

Tax Credit for Research or Development (Segment II of II)

Credit: Jacob M. Dietz, CPA

Sufficiently document in the records what the original problem was to solve, the steps in the process, and what was finally created. The IRS wants documentation, although it does not specify in exactly how to document. This article gives some ideas. Consider grouping records by project for recordkeeping. Examples of this documentation could be: notes from meetings, drawings, blue prints, notes of tests, etc.

There are some exclusions for activities. Below is a partial list of the excluded activities that do not qualify for the credit:

  1. Research after the product is being produced commercially
  2. Adapting a product for a specific customer
  3. Duplicating (reverse engineering)
  4. Studies and surveys
  5. Funded by others.

If the project is not a qualifying project, then do not include expenses for that project for a research credit.

If, however, the project does qualify, then make sure you have substantiated by documentation how it qualified, and then track the expenses and indicate how they are qualifying expenses.

For each period, track how many hours of each employee was for each activity. Keep records that show the employee name, the employee hours, the day, and the activity

Track and Document Expenditures

Labor

Labor is likely a significant amount of the research expense. Carefully substantiate labor costs. For each period, track how many hours of each employee was for each activity. Keep records that show the employee name, the employee hours, the day, and the activity. Also, indicate what the employee did for the project. For example, was the employee creating drawings, or sawing, or testing, etc. Include labor for the actual research, and first-line management supervision of those employees.

At the end of the project, be prepared to substantiate how many hours each employee put into the project. At the end of the year, be prepared to substantiate the ratio of qualified research hours to nonqualified hours for each employee.

 If you are buying supplies, and you know they will all be used for research and development, code them immediately to that research and development supplies account.

Supplies

Track the supplies that are used in research and development. Consider creating a separate general ledger account, and record your supplies expense in that account. If you are buying supplies, and you know they will all be used for research and development, code them immediately to that research and development supplies account.

Alternatively, some supplies that you buy may be used for both qualified research expenses, as well as other expenses. In this situation, consider keeping a usage log that tracks how many of each supply is used in a specific project. Every month, this log can be entered in your books and records, and the expense can be taken from the account that the supply was originally purchased in and moved to the research and development supplies expense account.

If you have multiple projects, then try to document which project consumed the supplies.

If using the usage log to move expenses from their original expense account to a research and development supplies account, document how the price per each is computed. For example, perhaps it is pulled periodically from a catalog or an invoice.

Save documentation that shows how the supplies are being used. For example, suppose that you are using metal to create a piece, and subjecting it to tests to see if it will break. Try to have some documentation that would indicate why all this metal is being used, such as notes from the tests or some other substantiation. If you have multiple projects, then try to document which project consumed the supplies.

Subcontract Labor

If subcontractors are paid to do any research, consider creating a separate general ledger account for subcontractor research expense. Keep copies of the contract on file. It should be clearly documented how they fit into the overall project. There are various qualifications for the subcontract expense to qualify. Here are some of them:

  1. The work is of a nature that would qualify if it were performed in-house by an employee.
  2. There should be an agreement with the subcontractor before the subcontracted work was accomplished.
  3. The agreement should explain that the work is being done for your company
  4. The agreement should indicate that you must pay for the research even if the project fails
  5. The agreement should indicate that your company should own the rights, although not necessarily exclusively, to the research being subcontracted.

Before taking the tax credit, however, consider if you have qualifying activities and qualifying expenses. Also, make sure you have documentation to prove them.

If your business is spending significant money to research and develop, smile and consider the tax credit. Before taking the tax credit, however, consider if you have qualifying activities and qualifying expenses. Also, make sure you have documentation to prove them. Researching and developing can be hard work, and proper documentation can be hard work. Hopefully, the research and development yields improvements to your products or processes, and the documentation yields a tax credit. Taking the credit can be complex, so consult with your tax advisor if you are interested in applying to your business research or development activities.

 

Tax Credit for Research or Development (Segment I)

Preface: If your business is spending significant money to research or develop, smile and consider the research or development tax credit. Before taking the tax credit, however,  consult with appropriate tax counsel.

Tax Credit for Research or Development

By Jacob M. Dietz, CPA

The IRS allows a tax credit for increasing research or development activities. If you are a business owner spending on research and development, then you may have felt pain watching money flow out the door to develop a product before you can even sell the product.

If you find yourself grimacing as you pay to research or develop, consider if the research credit will put a smile on your face with a tax credit.

Furthermore, you may even doubt if the product you are researching and developing will ever succeed. If you find yourself grimacing as you pay to research or develop, consider if the research credit will put a smile on your face with a tax credit.

Different industries can qualify for the research credit, and manufacturing is a prime industry for this credit. For example, suppose you are a small equipment manufacturer. You want to create a much larger version of your current equipment, but when you do that the axle tends to break. You therefore try a larger diameter for the axle, but then another part of the machine hits the axle. Then you try a second material for the axle, but one of your shop machines has trouble with it. Too much of the second material gets destroyed in the manufacturing process. Next you try a third material, which works well. Does that scenario sound familiar? If so, keep reading.

Another industry that can qualify is construction. Suppose a construction company wants to move into the energy efficient market. They may incur some qualifying research and development costs along the way.

If you are interested in this credit:

  1. Determine if you have qualifying activities
  2. If yes, then track your qualifying expenses and
  3. Document both your qualifying activities and your qualifying expenses.

What type of activities qualify?

Not all expenses qualify. For an expense to qualify, it must be a qualifying expense of a qualifying activity. Also, you should document how the activity qualifies.

Make sure the tax documentation for a project indicates what uncertainty is trying to be researched and overcome.

In determining which activities qualify for the credit, check for these qualifications:

  1. There should be uncertainty to overcome. For example, perhaps the project is to make a larger piece of equipment, but it is uncertain how to make an axle to withstand the additional stress. Make sure the documentation for a project indicates what uncertainty is trying to be researched and overcome.
  2. The research should be technological in nature. If it relies on engineering or some type of physical science, that helps. The documentation that shows what the problem is may make it clear that it is technological, and that physical science or engineering should help. For example, maybe the research is to make something stronger, more powerful, larger, etc. Maybe the research is to make a new kind of equipment. This type of research would rely on physical science, and possibly engineering.
  3. There should be a process of experimentation, in which the company strives to solve a problem. The problem should somehow relate to quality, reliability or similar features and not merely be cosmetic. Ideally, there should be records indicating what the problem is, and what steps are being taken to improve it. If one attempt at improving ends up failing, that can be documented. Documenting a failure in the process helps to demonstrate that experimentation occurred.
  4. The research and development should be to either create an improve a new product, invention, technique etc.

To be continued….

Surviving a Debt Euroclydon (Segment VI)

Preface: Now you have a financial target, and now you know when you “don’t have enough (working capital or equity).” We omit the “when you have too much” because that’s usually not the problem.

Surviving a Debt Euroclydon (Segment VI)

Credit: Donald J. Sauder, CPA | CVA

Typically, as an entrepreneur builds equity with profitable earnings, liabilities decrease as they are paid-off, and investment increases. Therefore, the measurements and grades improve with time. Startup business ventures should appreciate that their most substantial risk is liquidity, i.e., measured as working capital.

Diligent financial managers will measure this monthly, and possible graph the trends on comparable actual working capital to the 100% level

The above working capital tool is advisedly applicable to businesses in almost every industry. Diligent financial managers will measure this monthly, and possible graph the trends on comparable actual working capital to the 100% level.

Preparing for a Debt Euroclydon can begin with two easy tools. Tool one is working on optimizing the analytical ratio of equity to total assets or total liabilities and equity.  Tool two is tracking trends with working capital levels and grades. These are quantitative financials to bring a mathematical approach to what some advisors say is too much…debt, payables, etc. Now you have a target, and now you know when you “don’t have enough (working capital or equity).” We omit the “when you have too much” because that’s usually not the problem.

…..while financial tools and weather forecasts may be helpful, always keep the following (Questions) top of mind, because that’s what your financials reflect.

If your business has all the necessary financial reporting to begin these steps towards diligent financial preparedness, then your also advised starting to be your own business “financial weatherman.” You can achieve this following these two easy tools. If you don’t know where to start, then all you need to do is ask for help.

Above all, when preparing for any business risks or pressures, i.e., a Debt Euroclydon, while financial tools and weather forecasts may be helpful, always keep the following questions top of mind, because that’s what your financials reflect.

1)    What is our enterprises’ purpose?
a.     Are we achieving that purpose effectively?
2)    What is our enterprises’ vision?
a.    Are we working successfully towards the vision?
3)    What are our enterprises’ core values?
a.    Do we commendably exemplify those values?
4)    What is our enterprise core focus?
a.    What do our customers appreciate most about our core focus?
5)    What does our business contribute to the community?
a.    Are our products or services, adding the most exceptional         value possible?

Finally, many business successes and opportunity are a matter of “time and chance.” They are not necessarily indications of superior strength, wisdom, understanding, or skill, so as an entrepreneur give thanks daily, and live with gratitude.

Surviving a Debt Euroclydon (Segment V)

Preface: Numerous business owners have an intuitive feeling on working capital levels, but quantifiably grading working capital provides an understandable and mathematical measurement where your business is at now, and where your business working capital could and should be.

Surviving a Debt Euroclydon (Segment V)

Credit: Donald J. Sauder, CPA |CVA

Measuring working capital is the second easy tool to help maintain a well-oiled enterprise. Working capital is a balance sheet calculation, or current assets minus current liabilities equals your business working capital. Working capital measures the operational liquidity level of a business.

So what are currents assets? They are often your cash and equivalents accounts, accounts receivable, vendor prepayments, and inventory. Assets that are easily convertible into cash with a year. Current liabilities are often your accounts payable, credit cards, line of credit, tax liabilities, accrued expenses, customer prepayments, and deposits, and don’t forget the current portions of debt.

To precisely measure an enterprise’s working capital, it is necessary to have accurate accounting with appropriate accountant oversight for proper classifications of both current and noncurrent assets and liabilities.

The current ratio applies for the same financial numbers as working capital, yet instead of subtracting current liabilities from current assets, the current ratio divides current assets by current liabilities. Typically, a current ratio should be higher than two and likely two and a half, to be solidly established from an analytical measurement metric.

….the working capital grading tool is to help clients measure optimal working capital levels, i.e., how much is enough when discussing working capital? Let’s call it the working capital grade. It requires analysis of both the balance sheet and profit and loss statement.

Working capital measurement is an analytical approach to monitor a business’ capacity to continue operations with sufficient cash flows and to pay operating expenses and satisfy current liabilities cash uses.

Sauder and Stoltzfus, as an entrepreneurs CPA firm, has developed a working capital grading tool to help clients measure optimal working capital levels, i.e., how much is enough when discussing working capital? Let’s call it the working capital grade. It requires analysis of both the balance sheet and profit and loss statement.

Tracking the working capital balance from consecutive period to period will provide a data map, but you need to know, “Do you have enough yet?”

Working capital seems easy enough to calculate. You look at your financial statements and subtract current liabilities from current assets. If you should have the financial accuracy to calculate the balance, the numbers independently, do not provide much analytical guidance. Tracking the balance from consecutive period to period will provide a data map, but you need to know, “Do you have enough yet?”

Numerous business owners have an intuitive feeling on working capital levels, but quantifiably grading working capital provides understandable and mathematical measurement where your business is at now, and where your business working capital could and should be.

Here’s how we grade working capital. You can do math or follow along with current assets minus current liabilities as the formula.) Let’s say the cash $5,000 + accounts receivables $45,000+ inventory $70,000 is $120,000. Now subtracting accounts payable $30,000 + accrued wages $15,000 + current portion of debt $25,000 is $70,000. Now the working capital calculation is $120,000 – $70,000 = $50,000.

In our example, the working capital was $50,000, so the business is not yet solidly positioned or fully prepared for a debt Euroclydon.

Next, we compare that working capital level of the balance sheet to the profit and loss statement, measuring both direct labor expenses, and operational or general and administrative costs on a quarterly basis, e.g., what do you pay indirect labor expense or general and administrative expense, on average, every three months? This example can include multiplying a year of data with .25 for 1/4th of the annual costs or merely looking at quarterly data. This number is an estimate only, like a professor grading essay papers, the difference between the grade of a B+ or A is discretionary.

Now following with a business that has a direct labor expense in cost of sales of $300,000 per year, you would multiply the twelve-month fiscal year number by 0.25; that calculates to $75,000 per quarterly 300,000 * 0.25). If your operating expenses or general and administrative expenses are $250,000 for the twelve-month fiscal year, then you would multiply that balance by 0.25 to arrive at a calculated $62,5000 ($250,000* 0.25).

The greater of those two numbers is your optimized working capital. That is the $75,000 or $62,500. The greater is the direct labor of $75,000. Do you make the grade? Your business is solidly pillared if you have the greater of these two numbers in the working capital formula, i.e., $75,000.

In our example, the working capital was $50,000, so the business is not yet solidly positioned or fully prepared for a debt Euroclydon. If you have working capital above the calculation, your business can take on additional risk to safely develop the expansion of operational activity, as long as you continue to maintain or monitor appropriate working capital levels in your business.

In the above-calculated working capital scenario, the $50,000 of working capital measurement divided by $75,000 is a 66% ($50,000 balance sheet working capital / $75,000 profit and loss measurement)  Making the grade? Yes, it’s that simple.

The working capital grading tool works like this:
1.    35% equals one month of working capital
2.    70% equals two months of working capital
3.    100% equals three months of working capital.
4.    You can score well above 100% in a firmly positioned business, and you’re ready for the debt Euroclydon.

If your business working capital grade is below 15% to 25%, your business likely needs immediate help from an expert financial advisor. On the other hand, the $25,000 increase required from $50,000 to achieve $75,000 can be obtained with steady additional earnings and profits retained in the business, i.e., you can earn your way out of the problem, or maybe a long-term amortization of say a line of credit, i.e., reducing current liabilities.

To be continued.

Did I Purchase What You Sold?

Preface: Buyers are well-advised to give appropriate attention to asset allocations for tax purposes with transactions to avoid being pressured by uncooperative sellers after signing.

Did I Purchase What You Sold?

By Jacob M. Dietz, CPA

Sometimes a hardworking entrepreneur decides to move on to new adventures. The new adventure could be another enterprise, it could be mission work, or it could be a slower lifestyle and grandchildren. When this happens, there may be a sale of the business. When selling a business, make the allocation of the price a part of the agreement of the sale.

The Case of the Missing Allocation

Imagine if a custom chopping business owner named Reuben decided to sell his business, ABC Custom Chopping, LLC to another custom operator, Henry. He is selling the entire business including the equipment, the customer list, the employees, etc.

They agree to sell it for $750,000. In June, Henry writes a check (with the help of a bank loan) and takes over the business. Everything seems great until February.

In February, Reuben goes to his accountant and says he sold the business for $750,000. His accountant asks for an allocation schedule showing how much was paid for different asset categories. Unfortunately, no such allocation was ever created.

Purchase Price Allocation to Assets

What is an asset allocation, and why does it matter? IRS Form 8594, Asset Acquisition Statement, lists 7 classes of assets. A full treatment of this form is beyond the scope of this blog, but in certain cases when a business sells both the buyer and seller must fill out form 8594, which shows how the price of the business is allocated among asset classes.

Ignoring most of the classes, let’s look at class V and class VII. Class V includes various items, including equipment. Class VII includes goodwill. Goodwill has also been referred to as “blue sky” and can be the amount of the purchase price not allocated to other items.

Back to Reuben and Henry. How should they allocate the purchase price? Henry hopes to allocate as much as possible to the equipment, which is class V. Why? Equipment can be depreciated quicker than goodwill is amortized, and with accelerated depreciation Henry may even be able to deduct it all in year 1. Goodwill (class VII) on the other hand, is amortized (expensed) over 15 years.

Reuben, however, may want to allocate more to goodwill. Why? All or part of the sales price allocated to equipment will be subject to ordinary income treatment. The price allocated to goodwill can be subject to capital gain treatment. Ordinary income is often taxed at a higher rate than capital gain income.

Unfortunately, Reuben and Henry are motivated in opposite ways on how to allocate the purchase price, and they lack a business incentive to compromise. Henry has the business. Reuben has the money.

Agree when Negotiating

What could have been done differently? They could have agreed on an allocation before the deal was signed. When they were still negotiating the price, then they would have had a business incentive to compromise.

For example, assume Henry wants to allocate $700,000 of the purchase price to equipment, and Reuben wants to allocate $600,000 to equipment. They could perhaps meet in the middle, and agree to $650,000.   Alternatively, perhaps Reuben could agree to Henry’s number, $700,000 for the equipment, but negotiate an additional $10,000 or so to the sales price.

Although it may seem like one extra hurdle to selling the business, make sure your purchase agreement includes an asset allocation. What is purchased should be the same as what is sold. If there is disagreement, it is better to compromise at the time of the sale instead of trying to agree months later when the business incentive to compromise is no longer present. Months after the sale is a good time to enjoy the new adventure, but it is not a good time to argue over the allocation.