Why do we need accounting? Some might think, that accounting is only a boring and unnecessary redundancy and that it exists only due to regulations and legal requirements. But the opposite is true. Accounting exists because it plays an extremely important role in running a business.
Let’s illustrate this with a simple example:
Meet Adam. He lives in a small village where there is no convenience store, and its residents have to travel to a nearby town to go shopping for most basic goods, which is a few miles away. Adam came up with the idea that he could open his own small store, where he would sell the most necessary products. He rented and renovated a garage in his neighbour’s house and built several shelves and a counter, with the materials he had on hand. Then he went to the wholesaler and bought goods for a total amount of $1,000. He knew the prices of items from the store in town, and he set his prices at the same level. He expected that his potential customers will be more willing to buy from him, than to drive a few miles, since the prices are the same. Of course, these prices were higher than the prices at which he bought his merchandise. Adam bought the same goods every week and sold them at the same prices. However, after a month, when he checked his account, it turned out that he had $500 less than a month earlier. “It’s impossible, I must have been robbed!” Adam thought. However, all account activity was in order, and nobody attacked him in the store either. So what went wrong?
In the evening, Adam sat down and took his bills and notes he had kept during work. He wrote down all the expenses on one side, adding up 4 bills from the warehouse for $1,000 each. Then he took bills from gas stations, there were five of them for the amount of $100. At the end, he added the amount for the monthly rental of the premises, i.e. $500. The total was $5000. On the other side, he wrote down his total sales by week.
Adam realised, that even though he was getting more money for the goods than he had paid for them, the store had brought him a loss. He began to wonder what to do: “Not only do I have to break even, but I also have to make a living from this business” he thought.
We can see that if someone wants to run a business without even the simplest of calculations, he will be at the mercy of fate. It might as well turn out that Adam gained a lot from his company, but without any calculations, he would not be able to analyse and optimize his business. Also, when in a crisis, he would have a problem finding the reason why he suddenly stopped earning money.
So Adam started counting. As we saw, he learned that his business took losses, but he didn’t yet know why, so he started to look for a reason. At the very beginning, he checked how individual products were selling. It turned out that every three days he was selling all the bread he bought, every four days – all the vegetables, and every five days – all the fruit. He also realized that some of cleaning products didn’t sell, because they are longer-lasting products, so people don’t buy them every week. At the same time, some products, such as juices, went bad rather quickly, which caused Adam to throw away half of them every week. After counting everything up, Adam made a shopping list, but this time he decided he would buy more pre-packaged bread, vegetables and fruit so he wouldn’t run out so quickly. He also bought half as many juices and did not buy cleaning products at all, because he still had a supply from previous purchases. He decided that he would only buy it, when he would have a week’s supply of cleaning products left. This time, he paid only $750 to the wholesaler.
After a week, when people saw that Adam’s store was better stocked and had more products actually needed on a daily basis, they started to buy there more willingly. After all, Adam’s well stocked store saved them time and fuel money. Sales became higher and more stable. Adam’s clients spent in his store $1500 every week. And every week Adam would go to the wholesaler and buy best-selling products, and once every four weeks he would also buy cleaning products. This meant that he bought products for $750, three times a month, and once a month he bought for $1000. At the end of the month, Adam calculated his sales and expenses again:
So this time, thanks to Adam’s analysis, he earned $1,750, which covered last month’s loss and generated profit. However, it would not be possible if it were not for the calculations he made.
10 years have passed. During this time Adam expanded his business and his profits grew. After a while, he opened a second store in the town nearby, and after that, finally expanded his business to a whole network of small shops. Simple calculations made on a piece of paper are no longer sufficient for Adam’s needs. Now, his accountant prepares a complete report for him every month, to give him an overall view of the operation of the entire company. On the basis of this report and comparing it with the reports from previous periods, Adam is able to initially assess whether the business is going well or badly: whether the company is profitable, whether it has adequate financial liquidity, etc. If the company would underperform, the reports would help Adam to determine why or at least where to look for a problem. If, for example, the company would be no longer profitable or its profitability would decline, Adam could request reports for individual stores, look at their performance, and see which one is profitable and which one is losing money. Then he will look for reasons why this store is not profitable, analyse its income and costs. There can be various reasons for a store to underperform. For example, Adam can find out that sales have dropped significantly. To find out why it dropped, he will need to talk to the store manager. However, thanks to his analysis, he knows what the problem is and what to ask about.
To sum up, Adam from 10 years ago, who did everything by himself in his small convenience store, needed only the simplest calculations. He certainly didn’t need complicated reports, because he personally knew about everything that was happening in his store. However, with the growth of business, when Adam stopped personally participating in most of the processes in his company, efficient management of the company is possible thanks to accounting, which provides him with the crucial knowledge.