Purpose of Class Accounting
Accounting refers to a system of recording economic activity. The common person thinks of this in terms of revenue, costs and expenses to determine a net profit. Naturally, there is a lot more to this. Many business operations do more than just one function or sell one product or they may serve multiple locations. Class accounting was developed to help the accountant sort the economic activities into distinct groups or departments. Thus, an alternative way to think of class accounting is as departmental accounting. It can also be looked at as location accounting, i.e. separate stores. Another option is to think of class accounting as function based accounting. Here are several different types of business operations and possible classes (groups) or lines of business:
- Construction – Residential, Commercial; or New Home, Remodeling and Additions
- Convenience Store – Alcohol Sales, Fuel and Groceries; another option could be Licensed (alcohol, cigarettes), Groceries, Prepared Foods, Drinks, Auto
- Jeweler – Watches, Stones, Ornaments
- Law Firm – Real Estate, Consulting, Courtroom, Estate Work
- Restoration Company – Fire, Water, Mitigation
- Retail Clothing – Men’s, Women’s, Children or Clothing, Shoes, Accessories and Coats
- Restaurant – Drinks, Main Courses, Deserts
- Electrician – Installs, Service, Commercial
- Flooring Outlet – Tile, Laminates, Carpet
- Bakery – Pastries, Breads, Cakes/Pies
The key to understanding class accounting is that the particular group has a defined function, location or product line. Each one of the classes has both revenue from sales and corresponding costs. The idea is to track these sales and associated costs in order to delineate financial performance with each class. This is the end purpose, to gain an understanding of how well that respective function, location or product line does in comparison to the other classes of the company or over time.
An important rule or principle to use with class accounting is don’t create classes just because you may think its beneficial. The guiding rule is that the respective function, location or product should produce at least 20% of the company’s sales. If it isn’t at this level, you will do a lot of work for very little value from the information it returns. As an example, with the restaurant above, if deserts are not 20% of the revenue stream, then combine it with the main courses and call it meals instead. Now the restaurant has two main classes, drinks and meals. This is OK. Never, ever have more than five classes with accounting. It will create a lot of heartache and questions than solutions. Combine items that are close in the form of function, location or product line.
For example, I had a client once that had more than 12 locations, so instead of having 12 classes, we used zip codes as the class. One zip code had six of his locations, only one zip code had one location. We were able to reduce the number of classes down to four total. This allowed him to evaluate based on the respective areas and not at the store level.
To use classes based on locations, each of the locations should be selling the same product or providing the same service, i.e. the product sold is homogeneous among the locations. It is preferable to use class accounting based on separate functions or product lines.
Below is an example of how a bowling alley was able to discern the better performing departments based on the results over a period of one year. To help you understand class accounting, think of the five major sections of a bowling alley. First is the primary function of bowling, this should be the class that has the greatest revenue and overall contribution to the company. The other four are the bar, amusements, retail shop and of course the snack bar. Below is an illustration of this bowling alley’s financial performance by class and as a whole:
Let’s Go Bowling
Year Ending December 31, 2018
Bowling Snack Bar Pub Retail Amusements Totals
Net Receipts $1,685,700 $341,200 $280,700 $127,100 $56,000 $2,490,700
Cost of Sales:
Labor 365,000 84,500 71,200 37,000 6,200 563,900
Equipment 281,500 7,400 1,200 -0- 10,500 300,600
Product -0- 97,800 132,600 63,200 2,400 296,000
Other 14,800 6,300 13,800 2,100 900 37,900
Sub-Total COS 661,300 196,000 218,800 102,300 20,000 1,198,400
Gross Profit $1,024,400 $145,200 $61,900 $24,800 $36,000 1,292,300
Expenses (Facilities, Management, Office, Compliance, Insurance etc.) 777,500
Operating Profit $514,800
The end results vouch the business concept that the bowling function does indeed generate the bulk of the gross profit for this business operation. The snack bar comes in second overall for value. Look at the formatting of the report, it clearly informs management how well each of the respective departments perform. Furthermore, it breaks out the respective costs into understandable groups for future budgeting purposes and analysis. Without class accounting, the only column on the income statement would be the total column which doesn’t help management understand how they are earning their money; they can only use subjective information to discern profitability among the departments.
Now, how do you implement class accounting?
Implementing Class Accounting With QuickBooks
Most accounting software use the term ‘department’ to create function based accounting. QuickBooks uses the term ‘class’ to separate the accounting into functional, location or product groups. Without classes, all sales and corresponding costs would be in a cumulative group assigned to a particular account name. There are some basic rules the reader should adhere to before using class accounting. Let’s cover the basic rules:
- Class accounting as with any form of departmental accounting is limited to sales and cost of sales accounts. It is not for use with general overhead types of expenses. The reason for this is that these two types of ledgers are directly associated with function, location or product/service sold. General overhead expenses are difficult to class due to their general nature. As an example, rent is very difficult to allocate among the respective classes. It can be done, but a well designed formula must be created and this requires formal education and advanced understanding of the principles to develop a formula. With small business, it really doesn’t provide a lot of value and the associated cost doesn’t warrant the value it may generate. Simply stated, don’t use classes with expenses, only use class assignment with sales and cost of sales types of entries.
- Class accounting is never used with balance sheet accounts. This is because the balance sheet by class will never balance. This is a very advanced level of accounting and is only used in big organizations; it requires several accountants and complicates then entire accounting process; so don’t do class balance sheet information.
- Start class accounting at the beginning of an accounting year; if started other than at the beginning, it requires all entries year to date to be modified for class accounting. This is a lot of work if the company has hundreds of entries per day.
With QuickBooks, you must first turn on class accounting. This is done in preferences under EDIT, go to the bottom of EDIT and you’ll find PREFERENCES. Under PREFERENCES, select ACCOUNTING and then select COMPANY PREFERENCES. There you will see a checkbox under CLASS to turn on class accounting. You do not need to turn on the prompt or assign to an account function. Trust me, it will just overwhelm you every time you make an entry, it actually drives me crazy; you’ll get use to assigning classes. If you turn on either of these two functions, you’ll want them off within a few days.
Once turned on, go to LISTS and select CLASSES and create your departments. Now you are ready to enter data with classes. With a typical entry, the CLASS column is now available. Look at this bill entry screen:
Over to the right, the last column is the class identifier. This column exists with all entries, it has a drop-down list of the classes generated at the master entry point.
For all entries involving sales or associated costs, the bookkeeper selects the class and the system will record the values to that class.
Now the accountant can pull reports based on classes including detail reports. If data is not classed, the reports will have a ‘Other’ column with data located in it for sales and cost of sales. Here, you simply click on the value to break it down to the original source entry and set the classes for those entries. Ultimately, that ‘Other’ column will disappear.
Congratulations, you have enacted class accounting with QuickBooks. It is that simple.
Interpretation of Information
None of this is going to do management any good unless they can interpret the results appropriately. Remember the primary goal of class accounting, it helps to delineate sales and the associated costs into the respective functional groups, or based on location or a product line. Therefore it is important to interpret the information accordingly.
Another important point about information is that it is easy to jump to rash conclusions. Time is the key to properly interpreting information. The more time given, the more likely the trend noted will be true. For example, I saw one Limited Partner jump to a conclusion for a location based class accounting report that the particular restaurant was suddenly doing poorly and therefore it was a good idea to terminate that location. I was taken aback; I explained that the sudden decrease in sales was directly related to road construction being done right out in front of the store and that this road work will be done in about two months. If anything, sales would jump over historical amounts because additional parking was being added on that road right in front of the store.
The above illustrates the importance of taking into consideration subjective criteria in determining the underlying causes of results. Use the information over time to develop a true understanding of what is happening or causing the financial results for that particular class.
In addition, look at each class separately and compare that class’s performance against its historical results. If one compares one class against another, it becomes too easy to create a negative image of the one class. Go back to the bowling alley results from above. You would think that the amusements class wasn’t performing well. The reality is that amusements makes the bowling alley money and unless the owner can develop a better substitute it isn’t worth making changes. Again, don’t jump to conclusions.
One last note, make sure management defines what a class is; don’t let the accountant or bookkeeper define the respective classes. Without a clear definition, the data entered is often misclassified and the results are greatly distorted in the reports. This leads to poor decisions made as a result of the reports. Define the class appropriately, inform all parties as to the definition and verify that the data is entered correctly via testing.
Go back to the bowling alley case above, how would the bowling alley classify the beer sales generated at the snack bar? Should those sales be classed as snack bar or bar? Again, management makes this decision, not the accountant or bookkeeper. ACT ON KNOWLEDGE.
Do you want to learn how to get returns like this?
Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.
There are four key principles used with value investing. Each is required. They are:
- Risk Reduction – Buy only high quality stocks;
- Intrinsic Value – The underlying assets and operations are of good quality and performance;
- Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
- Patience – Allow time to work for the investor.
If you are interested in learning more, go to the Membership Program page under Value Investing section in the header above.
Join the value investing club and learn about value investing and how you can easily acquire similar results with your investment fund. Upon joining, you’ll receive the book Value Investing with Business Ratios, a reference guide used with all the decision models you build. Each member goes through three distinct phases:
- Education – Introduction to value investing along with terminology used are explained. Key principles of value investing are covered via a series of lessons and tutorials.
- Development – Members are taught how pools of investments are developed by first learning about financial metrics and how to read financial statements. The member then uses existing models to grasp the core understanding of developing buy/sell triggers for high quality stocks.
- Sophistication – Most members reach this phase of understanding after about six months. Many members create their own pools of investments and share with others their knowledge. Members are introduced to more sophisticated types of investments and how to use them to reduce risk and improve, via leverage, overall returns for their value investment pools.
Each week, you receive an e-mail with a full update on the pools. Follow along as the Investment Fund grows. Start investing with confidence from what you learn. Create your own fund and over time, accumulate wealth. Joining entitles you to the following:
- Lessons about value investing and the principles involved;
- Free webinars from the author following up the lessons;
- Charts, graphs, tutorials, templates and resources to use when you create your own pool;
- Access to existing pools and their respective data models along with buy/sell triggers;
- Follow along with the investment fund and its weekly updates;
- White papers addressing financial principles and proper interpretation methods; AND
- Some simple good advice.