A Crash Course in Accounting Basics
by Linda Carlson
How do I know if I’m making money? Established publishing companies have finance experts who are responsible for answering that question in various ways at regular intervals. But micropublishers and self-publishers—including those starting out without a background in accounting or finance—may need to provide periodic answers to the question themselves.
To determine its financial health, every profit or not-for-profit organization must start by determining what’s been invested and what’s being spent on a continuing basis. This means that you have to track what you spend. Recent articles in the Independent have focused on options for accounting. (See “Measuring Profitability,” May 2008; “Three Good Ways to See How Your Business Is Doing,” December 2009; and “Publishers’ Favorite Tools for Assessing Company Health,” January 2010; all available at ibpa-online.org via “Independent Articles” in the navigation bar on the left of the Home page. And find the current installment of our Building a Better Budget series in this issue.)
This article explains major concepts and terms involved in assessing your financial well-being. “Numbers That Matter to Members of IBPA,” below, shows how some independent publishers track income and expenses and how they use the information they collect.
“Making money” can be defined as being cash-flow-positive—in other words, as having more cash coming in than going out. That’s the most basic kind of accounting. Some businesses use more formal accounting to look at monthly or quarterly income statements, also known as P&Ls, or profit -and-loss statements. These include figures for sales you’ve billed for (“recognized,” in accountant-speak) but have not yet been paid for (accounts receivable), and figures for bills you know you have to pay but have not yet written checks for (accounts payable).
As you’ll see, some IBPA members talk about “breakeven” as well as about cash flow and income statements. They figure they “break even” if what they spend is at least matched by income they generate.
Breakeven is most appropriately used for specific projects, titles, or imprints rather than for a business as a whole, while ROI—return on investment—is best for measuring the income generated by an imprint or by the business as a whole, to facilitate comparisons with return (income) from investments in that imprint or in the business with return from other kinds of investments.
To illustrate the differences between these kinds of measurements, let’s assume that you spend $15,000 on editing, designing, and printing 5,000 copies of a book that you sell for $10 a copy.
On a cash-flow basis, you’d be in a negative position until you’ve sold enough books (and actually received the payments) to pay back the $15,000. To stay cash-flow-positive, you’d have to continue to sell enough copies to cover the monthly expenses of running your business.
It’s important for publishers to understand cash flow because so much of our business is usually through distributors and wholesalers, who typically pay after they sell our books. And that is not only months after we have delivered the books to them; it’s also months after we have counted those books as sold.
Ideally, you’ll have at least a simple spreadsheet that shows when you expect to receive payments for the books you’ve shipped and when you have to make certain payments. This cash-flow projection could be called a financial timeline.
Most businesses that have inventory are required by the Internal Revenue Service to use accrual accounting rather than cash accounting for federal tax reporting.
In its income section, an income statement will show what revenue—in this case, book sales—you have accrued (recognized or earned) for the accounting period and often for the year to date.
The expenses section of the income statement will show the bills you have to pay: salaries, office and warehouse rent, utilities, Web site hosting and maintenance, office equipment, postage, advertising, taxes, and so on.
Unless you borrowed the $15,000 and are making regular payments on the loan, that figure will not show up on an income statement. And figures that do appear there show what you expect to receive—what you’ve billed for—which may not be what you actually do receive, in large part because of returns. (That’s why the cash-flow projections mentioned above are important.)
To account for bills that may never be paid (and net them out of your income), you need a “doubtful receivables” category. If you use Schedule C with your federal income tax return to report business income, you have seen this line item.
Breakeven calculations tell you how you’re doing on a single part of your business—a book, for example, or a promotional campaign. They do not involve your ongoing, or “fixed,” costs.
To assess breakeven, you add up the expenses specific to a project. For a book, you determine direct costs—for items such as editing, artwork and photography, design, typesetting, manufacturing, and freight. Then you divide this total by the money you actually make on each copy.
Using the example from the “Cash Flow” section above, if you’re selling your book for $10 and have no incremental (per-book) costs such as postage and royalties, you divide the $15,000 by $10. That tells you that you’ll break even on the project—cover its direct costs—when you’ve sold 1,500 books. If you sell the book for $10, but must pay $1 in royalties and $2.38 for Media Mail per copy, you’ll actually net $6.62 per sale, so your breakeven calculation is $15,000 divided by $6.62, or 2,266 copies.
This means that the most you can earn on sales of the 5,000 initial press run is about $18,000, since you’ll have 2,734 copies that can be sold after breakeven, with the profit per book being $10 minus the $3.38 in royalties and postage. Of course, there also will be copies that you can’t sell: those sent to the Library of Congress with your copyright filing, the author’s free copies, and those sent to reviewers and potential vendors.
What about costs that aren’t “direct”? Indirect costs, also called fixed costs or overhead, comprise what it costs you to at least figuratively open the door to your business every day. They include payments for rent, office equipment, utilities, Web hosting, wages, and the like. Different businesses handle overhead in different ways. What’s important for you is knowing what your overhead or fixed costs are, and how you can control them before sales start and when sales are slow.
Although analyzing fixed costs in depth is usually not worth the time until a company is up and running, it’s good to understand from the start how they can be allocated.
If you publish only one book and have no other business activities, all your overhead expenses can be allocated to that single title because they result from it. Including overhead in a breakeven calculation is difficult, however, because overhead expenses are not incremental to the cost of each book. In other words, you cannot accurately assign a certain percentage of your fixed costs to the sale of each book, and you can’t treat them as one-time expenses either, except when you do a single short-term project.
Suppose you spend a year creating and selling a book. To find out if you made money on the project, you need to factor in your overhead expenses for that year. Sticking with our example, let’s assume it cost you $500 a month, or $6,000 a year, for office and other general expenses. Add the $6,000 to the $15,000 for book creation for a total of $21,000. Now divide that by the $6.62 you net from each book sale, and you’ll see that you’ll finish the project in the black if you sell at least 3,200 copies.
Any allocation of overhead is arbitrary, in any business. Publishers with multiple titles sometimes allocate the expense of a print catalog by apportioning its total cost according to the number of square inches of catalog space devoted to each book. With this method, if your catalog cost $5,000 to design, print, and mail, and each of your 25 titles got the same amount of space, you would allocate $200 of catalog costs to each title.
Another method calls for allocating overhead based on sales. For example, if you publish three titles, one earning you $5,000 this year, another $10,000, and the third $15,000, then 17 percent of your overhead expenses would be charged to the first title, 33 percent to the second, and 50 percent to the bestseller. This is also unrelated to the actual indirect costs of each book and takes no account of the time required for selling a particular title. Perhaps one title is usually purchased in bulk with credit cards, so you process one order and have no collection problems, while another title sells a couple of copies a time on consignment.
Even for very small or very new businesses, allocating overhead can be worthwhile when changes in pricing or outsourcing are contemplated. If you carefully determine how much time is spent on each kind of order, for example, and then look at the contribution from each kind, you might be able to decide whether it makes sense to offer a discount on online orders because they’re easier to process, or to encourage phone orders because they let you upsell.
Make vs. Buy
“Make vs. buy” refers to in-house vs. outsourcing. This often involves the cost of staff time as well as quality issues. For example:
Is it better to design a book yourself, or to outsource the job to an experienced book designer who will also handle any issues with your printer? You won’t know unless you record all the time you spend on such a project and then compare the value of your time and the quality of the finished project to the cost and quality of a similar project done by an outsider.
Is it better to input names and addresses into a database yourself, or use a mailing service’s list, and its addressing and sorting service, to reduce your per-piece postage costs? To answer this question, you must know how many entries you or your staff can make in an hour and how the accuracy and comprehensiveness of your in-house list compare to the accuracy and comprehensiveness of the list a vendor would provide.
Return on Investment
What all the accounting methods discussed so far miss is how well your entire investment is working for you. This is the information that lets you determine whether your money might be better invested elsewhere, an especially important factor if you’re considering expansion through acquisition of new titles, of another company, or even of an expensive piece of equipment.
ROI is also important if you need to borrow funds, or if you’re deciding whether to continue in business, sell your operation, or close up shop.
The accounting formula that provides a figure for return on investment is, in very simple terms, the ratio of income produced by an asset (your company) divided by its investment cost (everything permanent that you’ve sunk into it).
Again using our book example, assume that in a year’s time, you sell 2,000 copies at $10 each, generating $20,000. Before you calculate your return on the invested $15,000, you subtract (“net out”) each month’s $500 of overhead expenses. This means your net income for the year from the book is $14,000. Divide that $14,000 by $15,000 and you have an ROI of 0.93:1—in other words, a negative return on your investment.
Taking our example a little further, let’s assume that in the second year of this book’s life, you sell an additional 2,500 copies as well as paperback rights, and you license some content for $5,000, all of which yields a gross income from the book for this year of $30,000. Subtract the average monthly expenses of $500, and your net income is $24,000. With the first year’s income of $14,000, you have a total of $38,000 return on your initial investment of $15,000. So your ROI for two years is 2.53:1. Averaged over the entire period, the return is positive. (But is it better than a bank’s certificate of deposit or a Treasury bond, especially given that your entire investment was at risk? That’s one of the nonquantifiable factors that only you can determine.)
Linda Carlson (lindacarlson.com), who has an MBA, consults to publishers on marketing and tries to ensure that both she and her clients avoid relying on gut feelings.
Numbers That Matter to Members of IBPA
How important is accounting? Aside from the obvious need to complete state and federal income forms and sales and business tax forms, accounting is what determines whether your publishing company is a personal passion or a business.
“If you do not track sales and expenses, you do not know where your time or money can be most beneficial,” asserts Ken Beller, an engineer by training, who runs the single-title LTS Press in Sedona, AZ. “Running on gut feelings is gambling, not business.”
Ken Weiler, at Ostfront Publications in Hanover, PA, put out his first book in September of this year; he uses two Excel spreadsheets to “track every dime of expense.” They tell him what he spent on company start-up and what he spent on book production.
He discovered that the book—Why Normandy Was Won: Operation Bagration and the War in the East 1941–1945—was “an expensive endeavor,” costing almost double what he initially anticipated.
But the increased costs were due to changes he decided to make in content and format. If these changes make his 488-page $24.95 paperback easier to sell from his Web site (where he doesn’t share revenue with a distributor), and/or make it sell faster overall and without significant returns, they will improve his cash flow and income statement, let him break even faster, and contribute to a positive ROI. But because he didn’t try to sell an edition without the refinements and extras, he’ll never know exactly how much they all contribute.
At Midnight Marquee Press in Baltimore, Susan Svehla uses MYOB software to track book costs, shipping expenses, and discounts—and to tell her how much she’s making on each sale. With MYOB, she reports, “I can pull up the exact profit margin for individual orders as I’m doing the invoice.”
This means that when she’s invoicing a bookstore, she may see the retail price, a trade discount, the shipping cost to that location, the royalty, and possibly even the cost of the packing materials as well as the cost of producing the book. When she’s invoicing an individual, the software might show the retail price, any promotional discount, sales tax, and the royalty, shipping, and packing costs.
At Hoopla Press in Las Cruces, NM, Samira Made is also tracking all expenses. As a start-up with sales just beginning, she doesn’t have much else to track except hits on the Web site after a promotion and which promotions generate the most sales (as indicated by the different discount codes on each piece of promotional material).
“I’m not sure how we will analyze the value of IBPA promotions at bookseller conferences and in book buyers’ catalogs,” she adds. “We hope we receive several review requests after our ‘books for review’ ad is sent out.”
What Makes Exhibiting Work
A more experienced publisher offers some tips on determining whether conferences pay off. Says Georgette Baker of Cantemos—Bilingual Books and Music in Chino Hills, CA: “I track all conference and travel expenses. I know where books are sold and how many are purchased by bookstores, through online sales, and by individuals at conferences. At the end of each year I know which conferences generated sales. I don’t return to those that cost more to attend than they produce in sales.”
In other words, Baker is calculating breakeven on each of the conferences she attends.
Many organizations that regularly attend conferences and trade shows do so because of the industry visibility their exhibits provide. They expect sales at the shows—and also follow-up sales and licensing deals. The decision whether to return is based on total revenue that can reasonably be attributed to the exhibit. Seattle publisher Parenting Press spent thousands of dollars each year for its staff to exhibit at the National Association for the Education of Young Children, and sales at the show never matched the total cost. But the contacts made at the NAEYC exhibit have resulted in licensing deals, one of which has generated as much as $58,000 in a single year, and over the past eight years, a total of hundreds of thousands of dollars.
Allen Anderson of Fifteen Ways in McLean, VA, cautions publishers who make decisions based on breakeven to ensure they’re using “contribution” in their calculations.
“Often, businesspeople use net profit or gross profit to determine cost and benefit,” he says. “Both these figures include lots of costs that should not be included in breakeven.” For example, office rent, copy machine rental, utilities, Web hosting, wages and benefits, and other fixed costs of doing business are considered “overhead” and not ordinarily included in breakeven calculations.
Another common mistake is using the dollar figure generated by sales without considering the cost of producing the items sold.
Pursuing Other Kinds of Goals
Although many IBPA members are well aware of what accounting can do for them, and are careful to take advantage of financial analysis, some others echo this comment: “Our profit margin on each item rarely determines what we do next. That’s mostly on instinct.”
And at least a few, I’m sure, share the views of Angie McKinsey at Martin Pearl Publishing in Dixon, CA: “My company was created to help others make their dreams come true. Being rich is not my goal. I strive to make enough to pay the bills, and I expect it will take anywhere from three to seven years to make a profit.”
A Starter Set of Accounting Terms
If you’re not a numbers person, you may be confused by the many different terms that are used for the same function, asset, or expense. This short glossary includes general accounting terms rather than those specific to publishing.
Sunk costs: Money you’ve spent that you cannot recover. Examples: payments for research for a book that is never published, or remodeling space for your office.
Fixed costs: Recurring expenses, or costs, such as rent, insurance, utilities, Web site hosting, and salaries that are seldom affected by sales or production levels; costs that are incurred whether or not your business is producing anything.
Overhead: Ongoing expenses that are necessary for your operation but cannot be attributed to any specific project; similar to fixed costs in that overhead expenses continue even if your business is not making sales. In many operations, overhead is allocated to different projects or business units using some formula. In publishing, besides expenses such as rent and Web site hosting, overhead expenses would include costs of advertising and public relations activities that promote the company as a whole rather than specific titles.
Incremental cost: The cost associated with manufacturing an additional unit (which in publishing might be the cost of printing an additional 1,000 copies after a certain minimum). Also called marginal cost.
Variable costs: Costs that can be measured per unit and vary with the level of manufacturing or sales, such as commissions and royalties. In publishing, the unit manufacturing cost of a book is a variable cost.
Breakeven: The number of units (such as books) that must be sold to cover the cost of the project. To calculate breakeven, the total cost of the project is divided by the contribution per unit, with contribution being sales price minus the variable costs. Anything above breakeven is usually considered profit on that project, but this ignores overhead costs, such as editorial work.
Cost of goods sold (COGS): Includes parts and labor you have paid for but not shipping, advertising, or other indirect costs. If you use Schedule C for your federal income tax return, you calculate COGS by starting with the cost of starting inventory, adding sales over the given period, and then subtracting the cost of ending inventory.
Contribution: Sometimes called contribution margin or margin, this is the sales price minus the variable costs (such as the unit printing cost).
Gross revenue: Total revenue before expenses are deducted. Also called gross income.
Net income: What you have earned in a given period, usually a quarter or year; calculated by subtracting your total expenses from total income (gross revenue or gross income). Also called net earnings, net profit, or, casually, the bottom line.
Sales: The total dollar value of your sales in a given period; with accrual accounting, the value of the invoices you have issued rather than the cash you have collected.
Recognize: What you record as the dollar value of your sales in a given period. With accrual accounting, you recognize a sale when you fulfill the order and bill the customer. With cash-basis accounting, you recognize a sale when you receive the funds.
Receivables: What you’re owed for your sales. With accrual accounting, if you invoice customers when you fulfill their orders, the total they owe you is a receivable.
Net sales: The dollar value of your sales in a given period minus returns and unpaid invoices (doubtful receivables)
Figures for New Formats
It’s increasingly important for publishers to track costs and sales today because of switches to print-on-demand and electronic formats. But this is much too complex a subject to explore here.
For publishers with deep backlists, cult followings, or very specialized topics, and with customers who expect to buy online, POD reduces “sunk costs” (the upfront expenses of a typical press run) and warehouse costs; and if printing and distribution are outsourced to CreateSpace, Lightning Source, or a similar vendor, it also eliminates most packing and invoicing labor. However, per-copy printing costs are higher, so the potential profit per book may be reduced.
E-books also eliminate printing costs, and if your electronic edition is an add-on to a print title, you may be able to allocate such fixed costs as design between the two editions. With no standard format for all e-readers today, your e-book design and preparation for publication may be costly and time-consuming. In addition, e-book buyers are changing fast, and what they want is changing so fast that publishers must monitor developments constantly and carefully.
Tracking sales and expenses involved in print, POD, and electronic formats can help you decide what makes sense for your business.