Monday, June 6, 2016

Community Question: Understanding Cost

Many business owners (and even some accountants) struggle with the concept of cost – and rightly so. A simple Google search on ‘cost’ yields thousands of results, and all of them growing increasingly technical.

My intention with this blog is to provide clarity on these matters, with a focus on some of the most common questions I have received from the community regarding costing.

What does it mean when an accountant refers to “Cost”?

When an accountant refers to “cost” or “cost of goods sold” – they are referring to the direct-variable cost of providing goods and services. Now, the keyword to this is direct and variable.

For example:

Suppose you’ve manufactured a door - the wood materials, the labor, and the machinery used are all directly related because they are used in the process of manufacturing the door. Furthermore, these costs are considered variable because you could do it faster or slower depending upon your operation.

More stable (fixed) costs - rent, utilities, and insurance - typically don’t fluctuate and you incur these costs regardless of if you are making a product or providing a service. Since they are not variable, they are not considered a cost. That being said, keep in mind this is just one example and rent/utilities can easily be considered a cost in a service industry.

Moving forward, let me break it down even more so it’s easier to understand. When you are confronted with determining what to consider cost versus overhead – apply this simple rule:

If you are willing to calculate it and it is relevant to your industry - it is a cost

Why do accountants make a distinction between my expenses? Aren’t all my expenses considered the cost of doing business?

Yes, all of your expenses (hopefully) are for the sake of your business. However, a distinction between “costs” and “expenses/overhead” has to be made for the sake of managerial purposes. Not only is it easier to identify areas that could use improvements – it also allows you to compare the financial side of your business against your competitors and see how you stack up.

The other reason why this distinction is needed is because cost can be managed (note that I use the word managed, not cut – read further to know why). This management process can be done by finding better suppliers, improving processes, better technology, automation, and so on.

Suffice to say, a distinction has to be made in order to identify areas that can benefit from better management. Keep in mind, these areas will vary from industry to industry, and is almost solely dependent upon your willingness to track certain expenses separately.

How do I determine my cost?

The easiest way to determine what items to consider as costs is to use established industry standards.  Keep in mind, those are more guidelines than actual standards.

In my opinion, the best way to determine your cost is to ask yourself - “What does it take for me to provide this particular goods/service?”

It’s tempting to lump everything into this question, but think of it objectively: you want to provide a good/service – what are the additional expenses associated with it?

That, would be your cost.

Why is understanding my cost important?

Cost is by far, the most underappreciated and important subject any business owner needs to master. By understanding your cost, you can determine your pricing, which, in turn determines your competitiveness in the industry and ultimately – the value you provide your customers.

It is also important to understand cost because it is an ever-changing picture. What was cost last year, could go up or down this year. So, it is important to stay on top of your costs and to always have a good handle on any changes in the industry you’re in.

The last reason to understand cost is because many business owners forget that cost is the cornerstone to profit margin. If your costs are not revisited on a regular basis and changes to pricing are not done regularly – you could end up in a situation where you compete yourself out of business.

What do you mean when you say “Competing yourself out of business”? That seems like a paradox.

When I refer to a company as competing itself out of business, I am referring to a very gradual and seemingly innocent process that, could and will often take years to occur. It is also absolutely irreversible if caught too late.

Competing yourself out of business means, to have a lot of customers, orders, and demands, but not the cash flow to reflect your success.

Now, how is that even possible? Simple, it happens all the time and in most cases, companies don’t even realize it.

For example:

Suppose a restaurant creates a menu price when it opens, and for three years its popularity soars, attracting more customers. This is a great situation to be in – but say they forget to look at their food costs, or they never revise their menu prices… this leads to a lower profit margin and less cash flow. The ultimate predicament created then, is that the popularity of the restaurant is based solely on them never raising their prices – which means, when this mistake is caught and corrected, the popularity of the restaurant will likely suffer with it.

On a manufacturing/retail side, it could be that the cost of labor has increased over the years. This increase in labor has a direct impact on the profit margin of the products – which, if left unevaluated, would ultimately reduce the cash flow of the company (on every item/product that you sell).
This reduction in cash flow can lead to a number of problems – some of the worst being lack of innovations, inability to replace inefficient machinery, lower employee morale, and lack of quality control.

However, during this period, production would be skyrocketing because unchanged prices would make the company’s product the lowest priced in the industry. This deceptive illusion is difficult to catch without a trained eye, but can be easily avoided with proper cost management and tracking.

In conclusion, cost is a difficult subject to comprehend because it changes from industry to industry. That is why it is always recommended to hire an expert, like Tran Nguyen, who can work directly with you and your business to analyze and manage your cost.

Thank you for reading, and as always, your questions are appreciated.
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