Is your profit figure lying to you? Allocating costs for your business's accounts
When you’re thinking about which business costs to include in your profit and loss account and gross and net profit margin, are you allocating your costs correctly?
Don’t just think about when you paid the bill
If you’re just putting costs into the month that you paid for them, you could be getting the wrong idea about your profit margin and costs. Instead, you should match your costs to the time period that the cost actually relates to.
Here’s a simple example: if you pay for a magazine ad in January but the magazine doesn’t hit the shelves until August, the benefit to your business happened in August, not January. Therefore, you should allocate that advertising cost to August, and not January.
When you’re managing your books, there are two ways that you can allocate costs to get more accurate accounts:
Costs that you pay in advance - prepayments
If you pay in advance for a cost, you should wait to account for that cost until the time that it relates to. This is called a prepayment. To see how a prepayment works, this video explains it in less than a minute:
Costs that you pay afterwards - accruals
If you’re billed for a cost after the time that the cost relates to, you should bring the cost back and account for it at the time it relates to. This is called an accrual. To see how accruals work in less than a minute, check out this video:
When to review your costs
Many small businesses make it an annual exercise to review their costs and add any prepayments or accruals, but ideally, you should do this review every month. If you only review these costs annually, you won’t have an accurate picture of your business’s true profit and loss throughout the year.
When you review your costs, don’t forget to think about years as well as months that the cost may have been relevant for - if a cost relates to income that you’ve invoiced in a certain year, then you need to include the cost in that year too, even if you didn’t pay for the cost until later.
Allocating your costs ensures that your accounts reflect what happened in your business, not just when money may or may not have come out of your bank account. Having accurately allocated costs will help you make better decisions when you’re looking at your business’s performance, and when you’re planning for the future.