In order to preserve the competitive vitality of your small business it is essential that you’re aware of all your costs, that you control them, and that you know as well as they compare with those of competitors who product the same product or provide the same service.
Costs are a measurement of the resources, or input required to produce a product or service and bring it to the customers or clients. It is important to consider all costs, from the creation of a new product or service through the service after the sale. By understanding all the costs, you can set the price you need to charge for the product or service, in order to meet the all your costs and generate a reasonable margin or profit for your company.
Cost Accounting Conundrum
Non-Manufacturing Costs-Period and product costs are the two types of expenditure under this classification. Period costs are those that are measurable through time intervals like rent on a monthly basis. Product costs are those expenses related to the sale of such products.
Costs Related to Function and Control-These are costs that are variable, fixed, direct, indirect, controllable, non-controllable, avoidable, unavoidable, relevant and irrelevant. Variable costs are those that will change in accordance with the level of business activity. Examples are direct materials, direct labor, cost of goods sold, etc. since they tend to fluctuate in relation to the result of the goods, both in the production and sales.
Fixed costs remain constant irrespective of the change in the standard of business operations. Direct costs are those that are specifically identified to every processes, products or departments. Indirect costs are the opposite, on the other hand. The types of costs that weren’t given some explanations are almost synonymous to their names and self-explanatory. Hence, no further explanations were attempted.
In overall terms, net operating income is calculated as follows: Sales revenues minus the expenses of sales equals gross margin. The gross margin minus selling and administrative expenses equals net operating income.
From operating income you subtract other general expenses that aren’t directly allocable to sales but that still form part of the expenses of running your business. These expenses include interest and bank charges, non, and taxes-operating losses.
Cost of sales consists of all costs that are clearly allocable to the products sold or the services rendered. Some of these expenses are easily identified, such as the price of materials and labor that enter directly into manufacturing a product. Other costs may be harder to allocate directly to a specific product or service. However, it is important to identify them as precisely as possible.
In a merchandising company that buys articles for resale, direct costs include the amount paid for the ware, transportation costs, and the shipping, and storage or storage costs. When you buy and sell more than 1 type of product, it is important to assign the costs that correspond to more than 1 type of product, for example the costs of shipping an order that includes several types of products, and the cost of warehousing various types of products.
In manufacturing companies, direct costs include raw materials, labor, and supplies. What is important is to be in a position to measure the cost and to allocate it to specific products. In this type of business, cost accounting takes on added importance, to be able to calculate a unit cost that can serve to set the proper selling price and calculate the margin earned on each type of product.
In a services business, direct costs are the hours each person spends providing the service, multiplied by the compensation each person receives. It is important to consider all costs, including salaries and wages, benefits, and bonuses and awards when calculating the hourly cost. There could be materials that are employed in providing the service and these also form part of the direct cost. And when the services of contractors or other third parties are used, the amount paid for their services is also contained in the direct cost.
Indirect costs are those that cannot be allocated to a specific product or service but that nevertheless form part of operating costs. These costs can include utilities such as water, electricity, and gas, and insurance. They also include repairs and maintenance of machinery and equipment, and depreciation and amortization.
Indirect costs can be assigned to products and services according to a predetermined method. This may appear on a prorated basis.
In a merchandising company you could divide the purchase cost of the merchandise by the number of items purchased during a month. Then you can allocate part of the indirect costs for the month on a prorated basis to the items sold during the month to calculate the cost of sales. The remaining part of the indirect costs would remain as part of the expenses of inventory, for the items purchased but not sold during the month.
In a manufacturing company, you could allocate the indirect costs that are measured based on the adoption of time, such as rent, the base cost of utilities, insurance, and depreciation, based on the number of products manufactured in the same period, such as a month. These allocated indirect costs would then form part of the expenses of the product. The cost associated with products sold during the month would be booked as cost of sales. The cost associated with products manufactured but not sold during the month would be booked as part of the inventory cost.
In a services business, the total indirect costs incurred in the month could be divided by the total number of hours worked during the month. These costs would then be prorated and allocated to cost of sales based on the percentage of hours worked during the month that can be billed to clients. The portion of indirect costs allocated to hours that cannot be billed would constitute an administrative or general expense.
There are more precise ways to allocate indirect costs. For example, in a manufacturing company where machinery is used to produce a product, if you can calculate how much machine time is needed to produce one unit, or a certain quantity of units, and you can determine all the costs involved in operating the machinery (electricity, fuel, lubricants, repairs, maintenance, depreciation), and water you can calculate an indirect cost per unit. This involves more effort in accounting for the costs, but when these expenses are significant, it may be beneficial and even necessary.
Depreciation is the method used to disseminate the cost of investments in buildings, machinery, equipment, and installations over their useful life. There are specific rules that are relevant for the depreciation that can be requested as a business expense, and therefore a deduction for tax purposes. It could be that the same method used for tax purposes may be used to calculate depreciation expense in your business, for financial accounting purposes. But if you wanna have a more precise identification of the cost that your fixed assets involve, you’ll need to make the most accurate estimate possible of their useful life.
Depreciation is either of the accounting terms that many people find hard to understand and it is easy to understand why. Depreciation is the decline in value of a fixed asset as it is ‘used up’ in the day to day operation of the business. Depreciation is a non-monetary business expense, I.e. there is no cash outflow, although it isn’t a tax allowable deduction. Amortization is like depreciation. As such it’s another one of the accounting terms that many people struggle to get to grips with.
Depreciation deals with the decline in value of a tangible fixed asset, I.e. one that can be observed and touched. On the other hand, amortization deals with the reduction value of an intangible fixed asset, I.e. one that has no physical substance, such as goodwill, patents and licences.
Useful life depends on many factors including whether the asset is purchased new or used, the manufacturer’s indications, the use that is made of the asset, the operators’ know-how, the share of its capacity during which the equipment or machinery is operated, scheduled maintenance, the exposure of the asset to wear factors such as conditions, and the company’s policy with regard to scheduled replacements.
To calculate depreciation you take the invested amount, it’s the initial acquisition cost, and subtract the salvage value. This is the value you plan to recover from the asset when you no longer use it. This gives you the depreciable value. The depreciable value divided by the number of periods during which you expect to utilize the asset (its useful life) provides you with the depreciation charge per period.
In addition to being direct or indirect, costs can also be fixed or variable. Variable costs fluctuate according to the amount produced or the amount of activity, while fixed costs remain constant, regardless of the degree of production or activity. Rent and insurance are fixed costs-they’re the same every month. Raw materials and supplies are generally considered variable costs.
Salaries and wages can be fixed costs and also variable costs. Wages that are paid depending on the amount of work performed, or the number of units produced, are considered variable costs. The salaries of administrative personnel are generally fixed costs. In a manufacturing company, the number of workers may conform to production requirements, and in the present case salaries and wages could serve as a fixed cost in the short run, but variable over the long term.
The depreciation of machinery, equipment, and other installations used in manufacturing can represent a variable cost if depreciation is calculated on the basis of machine hours, for example. The depreciation of other assets, when calculated based on equal periods, would represent a fixed cost.
It is important to consider costs on a total as well as unit basis. A total cost may seem reasonable, and may leave a profit in one month, when a certain number of units are produced. But the same total cost in a month when fewer units are produced may be excessive.
For example, if you had revenues of $50, 000 one month, with a total manufacturing cost of $40, 000, you were left with a gross margin of $10, 000. In that month, you manufactured and sold 100 units at a price of $500 per unit, and a unit cost of $400. The next month, the manufacturing cost stayed the same at $40, 000. But instead of manufacturing 100 units, you only manufactured 50. Now the unit cost is $800 ($40, 000 / 50). If you sell the 50 units during the same price of $500, your total sales revenue would be $25, 000 (50 units x $500), as well as with the total cost of $40, 000 you ‘d have a loss of $15, 000.
This system is oriented to the activities carried out under the company, with the calculation of the value that each activity in each process adds. The activities are the set of elemental jobs and tasks whose realization determines the final products. The basic idea behind this method is that it’s the activities and not the products that generate costs. It is the products that consume the activities. And in this model, the indirect costs of supporting activities take on greater importance.
According to this method: (1) the different supporting activities (indirect expenses) are identified and analyzed. (2) The corresponding costs are allocated to each activity, creating cost groupings. (3) Activity measures are found, that serve as a link between the activities and the corresponding indirect costs. These can be linked to the finished product. These activity measures must be set in activity units that can be clearly identified.
The activity measures, or "cost drivers" could include the number of production orders filled and the number of deliveries made, for example. A higher cost is allocated to those products that have demanded more cost drivers and therefore many of the company’s resources.
The activity based cost method is particularly relevant for an operation in which indirect expenses make up a significant part of the expenses of manufacturing a product. In an operation in which raw materials, labor, and supplies are the most important costs, and indirect expenses make up a less significant component, the traditional method of costing may provide a sufficiently precise cost determination.
But it should be pointed out that the activity based cost system is designed to identify the set of activities whose goal is to create value for the business. It is a system that generates the cost of such products, but is also served to analyze a company’s value chain. The sets of activities that make up the overall productive processes are kept in sequential order to identify the cost that is accumulating in the chain, and the value that is added in each process.
Once all the fees are identified, you can use this information to plan, prognosis, and budget. Information on costs can be used to determine the prices to be required for the products and services your business offers. In a business that operates on the basis of jobs or projects, this information will allow you to quote a price that covers all your costs and leaves you with an adequate profit margin.
You need systems to record your actual costs. With these records you can compare your estimated and budgeted costs to the real costs and perform a variance analysis. You can take the necessary measures in managing your operation based on this.