How to Calculate the True Cost of Your Products and Services

As we continue this series on how to price your products and services, we look at understanding their costs.

Actually, it is about more than just determining the prices. It’s also about securing the longevity and profitability of your business.

Misinterpreting costs that lead to pricing mistakes can cause a drop in sales or reduced profit margins.

As a small business owner, having a grasp of cost analysis and communicating it effectively can make all the difference between a flourishing business and one facing survival challenges.

Key Takeaways:

  1. Recognizing the significance of understanding costs in decision-making processes is crucial.
  2. Direct (variable) costs such as materials, labor, and manufacturing expenses are directly related to product development or service delivery.
  3. Indirect costs are essential for business operations and cannot be specifically attributed to products or projects.
  4. Indirect costs are generally fixed and do not vary directly with production or sales.
  5. The cost-plus pricing strategy involves calculating costs and adding a desired profit margin to determine the selling price of goods or services.

Importance of Understanding Costs

Every decision made in a business is either the cause of or influenced by the associated costs. This underscores the importance and relevance of cost analysis in your decision-making process.

Whether it’s setting prices or planning budgets and projections, having an accurate grasp of costs empowers business owners to make informed choices. This knowledge plays a role in:

  1. Establishing Competitive Prices: Being aware of the costs related to your products and services allows you to set prices that are both competitive and profitable.
  2. Spotting Opportunities for Cost Savings: Through cost analysis, you can pinpoint areas where expenses can be trimmed without compromising on quality.
  3. Forecasting and Budgeting: Accurate cost information is essential for developing budgets and forecasts, which are vital for planning and decision-making.
  4. Enhancing Profitability: Understanding costs helps identify products or services that are underperforming and take steps to boost profitability.

Cost management

Direct Costs

Direct costs are expenses directly linked to creating a product or providing a service. These costs encompass materials, labor, and manufacturing and change based on production levels.

In a retail business where products are purchased from a supplier and then on-sold, direct costs are the cost of the purchased items and associated freight to get them into the store.

Materials

Calculating the cost of materials is relatively easy as it involves adding up all the materials and components needed for product creation. In the case of service-oriented businesses, this could encompass the supplies and tools required to provide the service.

Example: The cost of ingredients (flour, sugar, eggs) in a bakery.

Labor

Labor costs incorporate the wages and benefits paid to employees directly involved in producing goods or delivering services. This includes the base salary and additional expenses like health insurance, retirement benefits, and payroll taxes.

Example: The hourly wages of bakers and decorators in the bakery.

Manufacturing

The expenses related to manufacturing encompass costs that are directly associated with the production process. These can involve the depreciation of machinery, upkeep, and other expenses linked to production.

For instance, this could refer to the expenses incurred in running and upkeeping ovens and mixers in a bakery.

Indirect Costs

Costs not directly connected to producing goods or services in a business are known as indirect costs. These expenses play a role in the functioning of the business but cannot be specifically attributed to a particular product or project.

Here are some typical examples of costs:

  1. Rental expenses: Payments for office or factory spaces.
  2. Utility bills: Electricity, water, internet and phone services costs.
  3. Salaries and Wages: Payments to staff not directly involved in production, such as management, administration, and support staff.
  4. Asset depreciation: The decrease in the value of assets such as furniture, equipment and machinery over time.
  5. Office supplies: Items like paper, pens, and other consumables for operations.
  6. Insurance coverage: Protection against property damage, liability issues, and other business risks.
  7. Maintenance and repair costs: Expenses incurred to keep equipment and facilities maintained.
  8. Professional services fees: Legal advice, accounting services, and consulting assistance charges.
  9. Marketing and advertising expenses: Costs associated with promoting the business.
  10. IT services and software expenditures: Costs related to technology infrastructure and software supporting business activities.

In financial statements, indirect costs are often referred to as ‘Overheads’ or ‘Other Expenses’ but are sometimes grouped according to the type of expenditure, such as Administration Expenses, Utilities, Marketing and Sales, to give more clarity and analysis.

This helps to not only analyze individual expenses but also categories of expenses as a percentage of sales.

For example, dividing the total marketing and sales costs by sales shows what percentage of sales is spent on marketing and sales. This percentage can then be compared to industry averages to give you a better understanding of how your business is performing.

Application: Cost-plus Pricing

Coffee shop owner checking costs to set prices

As discussed in our previous article (link below), the cost-plus pricing method is one approach businesses use to establish the selling price of their goods or services. Here’s a basic breakdown:

  1. Calculate Total Costs: First, the business needs to add up all the costs involved in producing the product or service. This includes direct costs (like materials and labor directly used in production) and indirect costs (like rent and utilities).
  2. Add Desired Profit Margin: After determining the costs, the business then adds a desired profit margin on top. This profit margin represents the money the company aims to earn from each sale.
  3. Set Selling Price: The price for its product or service is set by combining the profit margin and costs. This price ensures that all expenses are covered while allowing for a profit.

Essentially, the cost-plus method involves summing up all expenditures associated with producing goods or offering services and then adding an amount as profit. It serves as a transparent mechanism for businesses to ensure they cover their costs while earning profits on each sale.

However, the question arises about how to allocate fixed indirect costs when you may have different products and don’t know what your sales will be.

Without wanting to overcomplicate things, this involves identifying the factors that drive the costs, such as the number of machine hours used or the number of employee hours, and using that to apportion the fixed costs.

Obviously, this isn’t very easy, and you need the expertise of a cost accountant to assist you.

Conclusion

Self-employed business owners need to have a reasonable grasp of costs and how they influence their business’s success and longevity. Understanding the costs linked to their products and services helps them set prices, ensure profitability, and stay competitive in the market.

By analyzing costs, owners can pinpoint areas where costs can be reduced, optimize resource distribution, and make informed decisions that enhance efficiency and financial security.

Knowing the distinction between direct and indirect expenses facilitates financial planning, forecasting, and overall financial administration, resulting in increased profitability expansion opportunities and sustainable long-term business development.

 


Other articles in this series:
The Beginners Guide to Pricing Products and Services

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