Whether a business is large or small, the same basic principles and practices of internal control apply. One of the key components of internal control is the accounts payable cycle.
Large or Small, the Control Concepts are the Same
Whether a business is large or small, whether it is operated from a separate facility or you operate it from your home, the same basic principles and practices of internal control apply. One of the key components of internal control is the accounts payable cycle, encompassing the purchasing and cash disbursement functions. Even though the internal control steps involved in the process may be concentrated in just one person, in the case of a home-based business, or in a just a few people in a small business, these steps will be inherent in the decisions that are made and the actions that are taken. Segregation of duties, as would apply in a larger business, may not be practical or possible in a small business, but being aware of the different aspects of internal control will help to more clearly define the decision-making process, keep your small business on track, avoid unnecessary expenses or losses, and make the most efficient use of your resources.
Making Focused Decisions
In a home-based business or a sole proprietorship, accounts payable controls will probably come down to the decision of whether you should spend a certain amount of money on a certain item. This decision will actually involve a process of control in the sense that you have some basis for making the decision. A cash disbursement shouldn’t be perceived as a decision that is made at the moment of purchasing goods or paying for services. The origin really goes back to your business plan. All disbursements made in your small business should ultimately be justified based on your business plan – your goals and objectives, and the course you set for achieving them.
Staying on Course
Direction is key – in what direction are you going, and where does your direction come from. In the case of a sole proprietorship or home-based business, for example, you are the source of your own direction. You decide where you are going and how you want to get there. Maintaining a clear focus on your direction will help you avoid making unnecessary or unproductive expenditures, and veering off the course you have set. Your focus will be on making those disbursements that are necessary and reasonable in order to help you achieve your goals.
Flexibility with a Solid Base
Of course a certain amount of flexibility needs to be built into any system, in order to take advantage of opportunities as they present themselves, to respond to changes in the marketplace, and to adapt and adjust as your business evolves and grows. But having a framework in which to evaluate decisions regarding disbursements will once again take you back to your original plan. If your plan needs to be changed or adjusted, then that becomes your new plan and your new focus for direction, and your framework for decision-making. This is a dynamic and ongoing process, but it is nevertheless a process that requires careful thought and planning, and not spontaneous decisions.
Timing is often critical in a fast-paced business or marketplace, where delaying a decision can mean losing out on an opportunity. Your whole cycle therefore needs to be just as dynamic. With some forethought, you can build flexibility into your system, without sacrificing the control element. And when you are clear about your objectives and direction, the time it takes to evaluate a decision regarding disbursements is reduced. You know how that disbursement fits into your overall business strategy. And, as you gain experience and knowledge in your business, you will develop an instinct about what disbursements are necessary and reasonable. An instinctive decision is actually based on an accumulation of knowledge and experience, and is not the same as an uninformed decision. Instinctive decision-making takes on added importance in a fast-paced environment, but you need the inherent framework provided by an internal control system, together with your knowledge and experience, in order to make these decisions.
The Business Plan as the Starting Point
Clarity as to your goals, objectives, and direction comes from going through the process of developing your business plan. It is here where you think through the product or service you will offer on the market, what it will take to produce the product or provide the service, the resources you will need in order to do so, and the efficiencies you hope to utilize in your favor.
The business plan could be thought of as a description of the destination (the goals and objectives of the business), and the business strategy as the means to get there. This leads to the preparation of a budget, which could be thought of as a map, leading to the destination.
In determining the resources you will need, you will inherently make a distinction between capital expenditures, start-up costs, and operating expenses. Some items, the expenditures for capital goods, will contribute to your business over a sustained period of time, while other items, the operating expenses, will be necessary to maintain ongoing operations, will have a shorter turnover time, and will be recurring.
The Budget as a Tool
A budget should not be so rigid as to restrict or limit a business, or prevent it from taking advantage of opportunities as they arise. But if it is not realistic and definitive, a budget loses meaning and purpose. Changes to a budget should be made within the broader context of changes in strategy or direction. New roads may be built that lead to the same destination, shortcuts may be found, or additional destinations may be added as the business grows and expands. This leads to budgetary changes aligned with changes in the plan and strategy.
The budget represents in concrete terms (but not set in concrete) how the plan will be carried out – what income should be expected and what expenditures should be made to generate that income. The budget transforms the business plan into terms that can be put into practice in the day-to-day operations of the business. In this sense, the budget should be seen as a practical tool to be utilized to move the business forward on the right path, and not thought of as a deterrent, intended to limit the capacity to make decisions and run the business.
Budgets, Forecasts and Projections
A budget for capital expenditures and start-up costs is generally prepared once, when a business is commencing operations. An operating budget is often prepared on an annual basis. Many changes can occur during the year. While some changes can be foreseen and programmed into the budget, there will undoubtedly be other fluctuations that cannot be easily predicted, such as variations in the prices of materials and supplies, the cost of fuel, and other expenses. And selling prices may need to be adjusted according to fluctuations in market conditions.
Many businesses have an annual budget, and then prepare quarterly or monthly forecasts to take into account these fluctuations during the year. In a home-based business or a small business, the time and effort involved in preparing such forecasts may or may not always be justifed. The important thing is to be aware of these changes during the year and how they affect the business overall. For example, increases in the cost of materials and supplies may need to be offset by adjustments in selling prices in order to achieve the same bottom line goal.
If a business plan that was presented to lenders or investors contains a budget, that budget should not be altered, since the lenders and investors will probably want a report comparing actual results to budgeted results at some point in the future, depending on how financing for the business was negotiated. In this case, fluctuations during the year can be managed more efficiently by preparing updated forecasts.
Likewise, cash flow projections will be directly affected by price changes and other fluctuations during the year, and the business decisions that are made in response to these changes. A cash flow projection therefore needs to be kept as up-to-date as possible. Here again, if the business plan contains a base cash flow projection, this can be maintained for comparative reporting purposes, with updated cash flow projections added as business conditions dictate.
Flow of Control
The steps involved in an accounts payable control system, or the thought process involved in decision-making, can be seen in terms of a logical flow, that starts with the business plan and ends with the disbursement. This flow is as follows:
1. Business plan
2. Business strategy
4. Forecasts and cash flow projections
6. Quotes and bids
7. Competitive comparison
8. Purchase order
9. Proof of delivery
10. Invoice verification
Within the context of overall internal controls, the controls that apply to the accounts payable cycle affect, or form a part of other, more general internal controls, such as variance analyses of budgeted versus actual expenses, or forecasted or projected expenses versus actual expenses. The controls inherent in the accounts payable process will also form part of cash flow comparisons and analyses. Variance analysis should lead to productive information and practical steps and measures that can be taken to improve the entire accounts payable process, always in line with the original intent expressed in the plan, and leading to more effective decision-making and ultimately, greater success in running the business and achieving goals and objectives, and improvements in the bottom line.