The value of getting your costing right

Cutting costs

Understanding costing is vital if you want your business to grow. Sue Hirst says many small and home business owners are working hard without seeing the results, and she has some tips to help you make your business more profitable.

Firstly what is ‘Costing’?

If you sell a product, it’s the cost of buying the product, plus preparing it for sale e.g. freight, storage, currency exchange, importation etc.  This excludes overheads e.g. rent, admin wages etc.

If you sell a service or jobs, it’s the cost of direct labour i.e. those who deliver the service and materials.  As per products it excludes overheads.

If you manufacture goods it’s the costs of raw materials, labour, equipment, storage etc. as per selling a product.

Costing, or costs are sometimes referred to as Direct Costs, Cost of Goods Sold, Variable Costs in management reports.

It’s important to understand what are all the costs associated with a product or service, because you need to know that you’re making a reasonable margin i.e. the difference between sell price and cost price.  A reasonable margin covers overheads and contributes to profit.

It’s sometimes considered that selling more volume i.e. more product or service will fix lack of profit and cash flow.  Here’s an example of where this falls short:

Example:

Scenario 1

Business with yearly sales  =  $1,000,000  
Costs      =  $   700,000 (70%)
Overheads     =  $   300,000 (30%)
Interest      =  $     10,000  
Loss      =  $     10,000  

Scenario 2

If Sales grow to = $ 1,300,000             
Costs remain at 70% = $    910,000  
Overheads remain at 30% = $    390,000  
Interest = $      12,000  
Loss = $      12,000  

Why has the interest gone up?  In the example of this business the debt collection days are running at just under 53 (recent national average per Dunn & Bradstreet) and it has an overdraft of $100,000.  If we sell more and the debt collection days remain the same we will need to borrow, waiting for customers to pay more money i.e. an extra $29,000.  The overheads would likely go up as you would have to spend more on advertising, sales etc. to achieve the extra sales.

Whereas if we could reduce the Costs in this business by 2% it would look like this:

Scenario 3

 

Business with yearly sales   =  $1,000,000            
Costs =  $   680,000 (68%)
Overheads =  $   300,000 (30%)
Interest =  $       8,690  
Profit      =  $     11,310  

The interest has gone down because we need to borrow less funds to pay for the costs.

The difference between Scenarios 2 and 3 is a $23,310 improvement in profit.  This would likely be a lot less expensive to achieve than a $300,000 increase in sales.

To add to this, if we could reduce the debt collections days from 53 to 43, it would mean a $29,340 reduction in borrowings and a further $1,956 interest saving.

This is why it’s so vital to keep a keen eye on your costs and overheads. A small reduction in them can far outweigh a large increase in sales.

Here are a few ways to reduce costs

  1. Review and negotiate with suppliers.  Technology has opened up many opportunities to improve efficiency.
  2. Get suppliers to ‘tender’ for your business.
  3. Look for innovative ways to improve processes.  Research your industry to find out what ideas are available.
  4. Check ‘Industry Benchmarks’ to see what the top performers are achieving.  Investigate how they achieve their margins.
  5. Lock in good exchange rates with forward cover on foreign currencies.
  6. Manage margins by regularly looking at percentage of Cost of Goods so you know when it’s time to renegotiate or seek alternatives.
  7. Use ‘Purchase Orders’ – don’t allow everyone in the business to spend money.  One piece of paper (i.e. a purchase order) could save thousands of dollars.  People ordering goods or services may not know something you know about a change or potential obsolescence.

If you’re in a Service Based Business:

  1. Reduce materials on jobs by managing wastage and write offs.  Review ordering methods and introduce systems like job cost sheets to track goods on jobs.
  2. Maximise efficiency of contractors and staff e.g. check any ‘non chargeable’ time.  Work could be done by someone less expensive, freeing up a more costly person to focus on chargeable work
  3. Have a quoting/estimating system and measure actual costs against them for each job to see which took longer.
  4. Have a system for following up quotes and tenders - the quicker you get started the quicker you finish.  Review operations for efficiency and ask yourself “Am I getting deals over the line quickly?”  Create a sense of urgency.
  5. Have one person managing jobs with a good understanding of status and progress to ensure jobs get finished efficiently.
  6. Manage labour resource allocation and track staff/contractor time spent on jobs.  Schedule jobs and travel efficiently.
  7. Make allowances for variations to material prices on jobs to avoid hold ups.
  8. Have good quality control to avoid rework and investigate write offs.
  9. Use checklists and templates to maintain standards.
  10. Keep equipment maintained to avoid down time.
  11. Have ‘Key Performance Indicators’ for jobs such as Number of Quotes versus Jobs won and lost.
  12. Use a job management system to keep information easy to access and available for improving job profitability.

Topics: 

  • Finance
  • Forecasting
  • Income
  • Performance

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Sue Hirst's picture

Sue Hirst is director of CFO On Call. CFO On Call is a team of financial and business advisors who work with open-minded people, committed to business growth and achieving success. They have been helping business owners achieve their goals for over 20 years. For help call them on 0800 180 400 or...