Product Costing – Knowing What Your Products and Services Really Cost Means Higher Profits

August 24, 2009 by  Filed under: Management 

How much money do you lose because you don’t know what your products or services really cost to produce? Here are some “home truths” about costs that you should know.

Do you really know what your products and services cost to manufacture or provide? I would be astounded if more than 1% of business owners knew the true cost to them of what they sell. The majority of business owners will know what the total costs for all products or services they sell but it is almost a given that the costs of each individual item is not known.

If you do not know the true cost of the things that you are selling, how do you know whether any of them are making a loss? This is the classic result of the lack of information about costs. Say you sell 10 different products. Overall, you make an 18% gross margin, but you do not know which products are the most profitable. Unfortunately, what is quite likely is that one or more of the products is making a loss. It could even be your highest selling product.

Some traditional accounting methods are dangerous. Yes, I am an accountant and I am going to criticise my own profession. Over the course of the 20th century, as mass production became an important part of producing our way of life, methods developed to try to help managers calculate how much things cost to produce. The problem is that many of these methods are down right misleading. They can lead you into making the opposite decision to what you should make. And worse, the poor information can mean that a company operates at much lower profitability (or in losses) for years due to poor information.

Don’t blindly accept what accountants tell you. Some accountants can become very locked into their ways. They can get a costing system operating like clock work. The trouble is that the clock is telling the wrong time! Information is churned out and submitted to managers. Managers accept the status quo and do not understand the basis on which the accountant’s conclusions have been made. If you are relying on costing information to make important decisions for such things as product mix, the number of people that you employ, what you will spend your advertising dollar on and so forth, I strongly advise you to understand, in detail, the logic behind the information that you are being given.

Activity based costing can be a solution. When it comes to owner-operated businesses, activity based costing has got a bit of a bad name. It has been seen as something only big companies do. While it is true that activity based costing can become very complex, it can still be applied to small and medium businesses in a cost effective way. And if you are using a traditional costing methodology, the chances are good that activity based costing will give you more accurate information.

Conclusion. Owner operators almost never properly understand the costs of producing what they sell. This misunderstanding leads to poor decisions and lower profits. You should make it an important part of your management processes to periodically review your costing methods. If you are not using activity based costing, this is something that you should consider.

Wishing you easier business.

John Jeffreys

John Jeffreys brings Chief Financial Officer skills to businesses that don’t have their own CFO. His website is at http://www.businessease.com.au. John draws on 30 years of experience. He is a Chartered Accountant and has been a partner in major accounting firms. You might like to receive his free eZine that gives you valuable business tips and a bit of a laugh. Go to http://www.businessease.com.au/Newsletters/Subscribe.aspx

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