Income Statement Sequencing Explained and How to Allocate Your Income in the Most Efficient Way
When it comes to a healthy diet plan, the smartest way is to eat first the low calorie and nutritious food and then when you move to the unhealthy food you are almost full, and this leaves less chance for you to eat high-calorie food. The concept of sequencing your income allocation is similar to this where you allocate money first towards the profit and the owner’s compensation and then you move to other categories. This article explains how Sequencing the Income Statement items can help make sure you earn more profits and spend the least on the unnecessary items.
Why Sequencing is Important
Sequence by its definition means arranging items in a particular order. When you look at your Google calendar and notice that your tasks are not sequenced in chronological order then it is of no use. But if it ordered chronologically then your job is made much easier by just arranging your tasks in a proper sequence. Similarly, when you receive any income in your business, and you do not fix an order to utilize the money then it may happen that all the money received is used to meet your operational expenses. Instead, if you decide a sequence in which you will allocate your money whenever you receive then this will make sure you get the desired profit margin and that too just by following a sequence.
One may argue that we allocate and get the desired profit at the end but without sequencing. This is indeed possible as once you decide your allocation it will not change whether you do it since the beginning or at the end. Ultimately, it is just a percentage that you use to allocate to different categories. However, just by maintaining a sequence since the very first amount you receive will not only make sure you get your expected profit margin but allow you to eliminate all the dispensable expenses which you may not be doing while allocating in the end as the money is already spent. It may also happen when you allocate at the end you end up falling short of money and you may have to compromise on either your profit or the owner’s remuneration.
There is one more argument where you might think that ‘but why is it important to maintain all accounts such as owner’s compensation and profit separately. Isn’t it enough to just have one excel sheet and all details as a part of one document itself? Is it necessary to maintain all the categories of the accounts?’ The answer here is yes, it is of the utmost importance to maintain a separate category of the accounts. Let me explain this with the help of an example. You have a bank statement and just by looking at it, you cannot segregate where you have spent your money and in which category you have received the money. But if you maintain separate accounts of each category then you get a clear picture of where all your money goes and from where you receive them.
How to Sequence – The Pay Yourself First Concept
Some people suggest spending money towards meeting the entity’s operating expenses first and then at the end they allocate money to profits and owner’s compensation. The best way is to maintain a sequence where you will first allocate your money towards your profit and then towards the owner’s compensation. This is called the Reverse Engineering of Profits. Once you have allocated the money towards these two items you should go ahead and allocate money to the statutory obligations such as taxes and other government dues. The operating expenses should be allocated lastly. The reason why the profit and owner’s remuneration should be allocated first is that the owner of the business puts in a lot of effort to run the business and it is the owner who has started the business and hence, he should be rewarded first whenever he receives any income.
While allocating the receipt of an income, it may happen that you are falling short of money by the time you reach to allocate money towards the expenses. When this happens, you should thoroughly analyse your expense side of your income statement and see if you can cut down any item which you think is unnecessary. You may also negotiate terms with your vendors and suppliers if you can get more credit period or any discount or can allow you to pay through instalments. This will help you make sure you get the desired profit, and it will be maintained throughout the year. Needless to say, the Sequence matters and it can lead you to maximize your profits and minimize your expenses.
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