It is important that your business keeps an effective costing system to ensure your prices (and cost management) are accurate. Even simple records can make your costing system more efficient and easy to run.
Your costing process also involves regularly evaluating your system to ensure prices adequately cover all your costs (direct costs and most importantly, your overhead costs), enabling you to make a profit.
This is one of the most common methods used by manufacturers, retailers and service industries to cost or quote on jobs. The direct cost and an allocation of overhead for each individual job is estimated and how much the job actually costs (the “actuals”) is then recorded against that job.
Typically the job estimate and the actual cost should match and if the variance exceeds say, 10 percent, you should investigate the cost ‘blow out’. Ideally you should remedy the situation in future quotes.
Standard Costing Systems
To accurately price a service or product, you need to be aware of what the actual costs are for the item supplied. It isn’t, however, always possible to obtain exact figures on what a service or product will cost. In such circumstances, where you don’t know what they will cost, you can use what is called a ‘standard cost’.
With standard costing, you take a pre-determined “standard” for each of the following areas – material, labour and overheads – and you can then control the actual costs against these standards.
To determine your costs, you measure against:
- Material – standard quantity and price, if applicable
- Labour – standard rate and amount of time
- Overheads – standard fixed and variable overheads.
Many businesses will develop standard costs for certain types of goods and services and use these to quote and then price services.
For example service/retail businesses, such as hairdressers, they must focus on the true cost of providing a service. The cost of keeping and stocking products, such as hair care ranges, must be considered as well as the hourly rate of all the staff in determining a price for a service.
In addition to these costs, if you are thinking of adding staff in order to increase your capabilities to deliver services, you must consider the full cost of all employees in determining your rates or “charge-out” cost, and ultimately the prices you will charge for services.
This sort of cost information should not be difficult to obtain if you have a properly designed costing and accounting system.
The ideal costing system should incorporate individual costs under appropriate headings (direct labour, materials, overheads, distribution costs, selling costs, financing costs, etc.). You can then group the costs together to obtain a costing for any service or product.
This will also help you in planning budgets, analysing your profits and making any other business decisions, such as adding new services or products.
You should also be aware of the limitations of standard costing:
- Standard cost variances are often reported to managers too late for them to take timely corrective action.
- Labour has become less significant and tends to be more fixed than variable. A focus on labour efficiency variances tends to encourage production of excess inventories.
- Increasing quality should be a key objective. An over-emphasis on costs may result in lower quality. For example, focusing on the materials price variance may result in the purchase of low quality materials.
- Competitive conditions often require continuous improvement; attaining preset standards isn’t sufficient.
Understand the benchmarks you are using, as well as their limitations. Needless to say, few good service/retail businesses operate without adopting the principles of standard costing.
Good costing practices
To ensure you remain price-competitive on your services and products, here are some steps you can keep in mind each time you have to cost one of them:
- Prepare a detailed cost estimate for the service or product. Don’t overlook some of the less obvious costs, such as any work sent outside, delivery costs, employees’ sick leave and other absences, costs of support staff, minor material costs.
- Check your accounting system to make sure it records the actual amount of time and materials spent on each service or product.
- Calculate the profit needed on each service and product, depending on your usual profit margin.
- Calculate the actual costs of each service and product. Compare your estimated cost against the actual cost for each service and product. Price your services and products accordingly.
Costing your goods or services correctly is vital. Obviously if you under-cost your products or services, whatever income you derive, it is unlikely to cover costs.
Businesses old and new do fail, so despite the fact you may now have a mature business, the basic principles on costing still hold true.
Benchmarking your costs and performance
In order to assess the performance and costs of your business, you need to take the following steps. Firstly, look at your expenditure figures for the last couple of years and using this information, plus the knowledge of your own business, estimate the costs for the next period.
When you are preparing these figures, think back over any changes (actual or planned) in your business and adjust for these. No business is static and the same applies for any planning. Initially, estimate your fixed costs, such as property expenses, insurance, equipment costs, management wages etc.
Next, compile your variable costs, which are concerned with the functioning of the business, such as materials (if applicable) casual wages, superannuation, electricity, telephone and vehicle operating costs. With both these costs, you can compile and analyse your own business.
Check your costs against those of your competitors (benchmarking associates) to see whether you fall into the high, low or average category. This will help you decide whether you then need to reduce your costs to maintain your profitability.
For instance, if your costs are high, you may want to think about reducing them to increase your gross profit margin. Look at your fixed costs first – can these be lowered by say, leasing cheaper premises, reducing management staff, sale of excess machinery etc.
Check your variable costs. Can they be reduced and if so, where and how? Examples may include reducing casual staff, ensuring settlement discounts are taken, reducing excess expenditure on stationery, consolidating mobile phone accounts, etc. If cost reduction is difficult, consider whether you need to raise prices in order to increase profit and cover your increasing costs.
If your costs are low, check your competitors’ (benchmarking associates) figures to see where their costs are higher and if this has made an appreciable difference to profits. Having lower costs is generally a positive outcome, but not if it is at the expense of reduced capacity, service etc. (and perhaps profitability). For example, could more staff lead to significant increases in sales?
Once you have worked out your costs accurately, you then have a better idea of whether you have costed your products or services correctly and if they need to be adjusted. The benchmarking process will lead you to a more profitable outcome.