What is the true cost of your products or services?
There is one area that is often neglected, or perhaps not given the attention that it requires, in a lot of businesses and that is the correct costing of products or services. (Where I refer to product below I mean both products and services).
There are two main reasons why this is so important.
- The obvious one is that you need to know the cost so you can set the selling price. However in a lot of instances the market is the real determining factor of the selling price and not the cost.
- That being the case then it is vital that the cost is know so that the profit for each product can be measured.
If the real profit for each product is not know then you will not know which products you should sell more of and you may be focussing on products that have a lower profit but which you falsely believe to be more profitable. While this may not lead you to making a loss it will certainly lead to you making a lower profit than you potentially could.
So how do you go about working out the real cost of a product?
Costs can be split into two broad categories, namely Variable and Fixed Costs.
Variable costs are those that vary directly in relation to the sale of the product. These will include raw materials (or the finished good if you but and sell complete products), labour used directly in the product, cost of delivery, etc. In other words, any cost, which, if you stopped selling that product the cost would also stop completely.
Fixed Costs are those that you will continue to incur even if you stop selling the product or stop selling altogether. These will include costs such as rent, wages and salaries of admin and indirect staff, electricity, security, telephones etc.
There are some costs that are semi variable, i.e. which will decrease if you stop selling a product but for the purpose of costing treat those as fixed, as we are talking about an ongoing business where you are looking to change your sales mix and not one where you are decreasing total sales.
This may seem straight forward and obvious and in principle it is, but the important issue is to be identify the variable and fixed costs properly. One of the easiest ways to do this is to ask the question – “What expenses will I not incur if I stop selling this product?”
The next, and more tricky issue, is to allocate the fixed expenses to each product. While this may, in some cases, seem to be very difficult it is just as important and well worth you spending time on. This is particularly important if some products use more of a resource than others. For example space, where rent or storage is a significant cost and one product requires more space than another, even though they have similar others costs. Or one requires a greater selling effort.
There is not an exact science for this allocation of costs and the only way is to sit down and decide what drives each cost and how to allocate to each product. This could be on a percentage, or cost of material of a product, or even equally. The more accurate you can do this the better.
Simple way is to allocate fixed costs as a percentage of variable costs or equally pert product. There are many cases when this may work accurately enough but be aware that this may also be way off and could affect your total calculated cost. This in turn may affect your selling price and ultimately your profits.
The time taken to think carefully about how you allocate your costs will be well worth it. The situation to avoid is selling something too cheap because you think it cost less and then not understanding why you are losing money.
The product costing template gives the outline of how to go about costing your products or service.
Make better decisions
When you have a more accurate costing system you can better decisions about selling prices and which products to concentrate on.