Know Your Costs

If you want to have a profitable business you must know your costs.

An owner-manager should know costs in detail. Then, you can compare your cost figures as a percentage of sales (operating ratio). Be certain that your costs are itemized so that you can put your fingers on those that seem to be rising or falling according to your experience and the cost figures of your industry. When costs are itemized, you can spot the culprit when the overall figure is higher than what you had budgeted. Take advertising costs for example. You can catch the offender if you break out your advertising expenditures by product lines and by media. In addition, a thorough check of inquiry returns from advertising will help to avoid unproductive publications.

In knowing your costs, keep in mind that the formula for profit is: Profit equals Sales minus Costs.

A Few Words on Determining Costs

Many businesses fail or have poor results because they don't take into account all the costs associated with producing their product or service.

In most businesses, costs can be broken down into two categories:

1. Fixed costs: These are overhead costs that don't change, regardless of production levels. They are sometimes referred to as overhead costs or indirect costs.

2. Variable costs: These are direct labor and material costs that increase or decrease in direct proportion to the amount of goods or services produced. They are sometimes referred to as direct costs.

Determining the total costs of producing your product or service, and deciding which costs are variable and which are fixed, will have important implications for your overall financial planning and decision making. This will have implications for the price you charge and the volume of product or service you produce.

Sometimes it's difficult to determine if a certain cost is fixed or variable. For example, in most small businesses some employee costs are fixed and others are variable. Direct labor costs associated with the actual production of your product or service are considered variable costs. On the other hand, the wages paid to staff who work in areas such as administration or sales are usually considered fixed overhead costs.

Your accountant or bookkeeper can help you identify which of your costs are fixed and which are variable.

Sometimes your total fixed and variable costs do not add up to the true costs of producing your goods and services. This is because intangible costs, such as machine set-up time, idle time, and time for estimating and bidding on jobs, cannot always be calculated. If you cannot accurately calculate these factors, a miscellaneous expense element must be added to your cost calculations.

Know Your Product Markup.

Be certain that the pricing of your products provides a markup adequate for the kind of profit you expect to achieve. You must keep constantly informed on pricing because you have to adjust for rising costs and at the same time keep prices competitive. Knowledge about your markup also helps you to run close outs with your eyes open. Continuing to make a product that only a few customers want is an effective merchandising tool only when you use it on purpose - for example, to hold or attract buyers for other high markup products. Don't hesitate to drop a loser from your line.