What Does It Cost?
Most small businesses (and big businesses too) understand their costs much better than their revenues. This is understandable since costs are something businesses generate whereas revenues are generated by that inconvenient entity called the customer. However, costs are usually more complicated than they appear.
First of all it is important that costs be collected and recorded in some orderly fashion. Some very small businesses use nothing more than a checkbook. This may provide a rough estimate of your cash position but provides no visibility on which products or services are profitable. Even the smallest business should be using some type of software so that critical management information can be retrieved quickly. Programs like QuickBooks and others are worth using. Even the powerful spreadsheet program, Excel, can be used to record and analyze business data. Others have invoicing and check writing features that make keeping track of costs easy.
You should hire a bookkeeper unless you are one of those business owners who like to keep their own books (and are good at it). The bookkeeper will record your data and keep each item of cost or revenue in the right category. This data can then be turned over to a CPA to analyze further, as needed, especially for taxes and filing the proper forms with the many necessary government agencies.
I recommend that you set up an analytical model of your business as a spreadsheet. This involves treating all your costs and all your revenues as variables. After you have set up this overall business spreadsheet, you can ask yourself “what if” questions. What will the impact on your profit be if fuel prices go up 50%? What if one customer wants a price reduction of 15% but would increase his order quantity by 30%? What if you could by a new piece of equipment for $2,000 that would reduce the cost of one product by 35%? The questions are (and should be) endless.
A second important feature of costs is understanding whether they are they fixed or variable. Fixed costs are those costs that don’t change if you produce more or less goods or services. Variable costs do change directly with output. If you produce 20% more, the variable costs go up 20%.
Variable costs are the direct costs that go into producing your product or service. For example, let’s say you make a toy. There is the wood, plastic, glue, paint, and rope that go into the toy. These are direct materials. You employ someone to make the toy and he makes 3 per hour. You have one-third of an hour of direct labor (plus employee benefits and other direct employee costs) in each toy. You have to package and ship the toy. All these are direct, variable costs. Make more toys, have more costs.
Fixed costs are a bit fuzzier. If you bought a machine to make part of the toy, the depreciation and interest you pay on the loan are fixed costs. A specific annual insurance policy covering painting hazards would be fixed.
The distinction between fixed and variable cost is critical in understanding how to price your products or services. Let’s assume your toy has $20 of variable cost (each toy) and $2000 of fixed costs per year. If you sell 100 toys per year your total cost is $20 x 100 plus $2000 =$4000 or $40 per toy. From a cost standpoint you probably need to price your toy at about $80. However if you sell 1000 toys per year your cost will be $20 x 1000 plus $2000 = $22,000 or $22 per toy. Now if the market price for your toy (ah the market, remember my previous column?) is about $40-45 you are probably OK if you can sell 1000 toys per year.
All your overhead costs such as rent, liability insurance, most utilities, owner’s salary, etc are another type of fixed costs. These overhead type costs must be allocated based on some philosophy. Work this out with your accountant.
So, make sure your costs are well recorded and understood. Have your accountant help you with your business spreadsheet and your fixed and variable costs. Then like the comedian says, you can make it up on volume
This article was written by Seattle SCORE Chapter member Fred Parkinson for the Kitsap Sun in Bremerton.