The main goal of any business is to create and keep customers. If you can do that in a cost-effective way, you’ll generate profits. It’s therefore critical to your business’ success that you know the exact cost of every ingredient that goes into the production of your products or services. Owners of successful businesses worldwide will tell you that one of the main reasons they’re profitable is because their costs are tightly monitored and controlled, and their products and services are produced efficiently and at such a level that profits are possible. Conversely, two of the major causes of business failure are costs that get out of control and costs that no one understands or are aware of.
Determining Your Costs
Successful entrepreneurs are careful with their money and control their costs at all times. They practice frugality in every business activity and are continually looking for ways to reduce the costs of operation.
If you want your business to be a success, it’s essential that you know the exact cost of every product and service you sell. Because of poor cost control, many companies lose money on many of the products they sell, therefore ongoing cost analysis is a key responsibility of the entrepreneur.
When you’re determining the total cost of production. there are several different kinds of costs you must include:
Fixed costs: These are the costs, such as rent, salaries and utilities, that you must pay whether you make many sales–or no sales at all.
Variable costs: These are the costs you incur each time you make a sale, including raw materials, cost of goods sold, sales commissions and shipping.
Semi-variable costs: These are the costs that are partially fixed and partially variable, such as labor costs, utility costs and advertising. They increase or decrease with sales and business activities but not in an exact ratio.
Sunk costs: This is time and money spent that you can’t get back, such as training for employees or education costs. Once you’ve learned a subject or developed a skill, it’s a sunk cost.
Opportunity costs: This is the amount of money you could earn if you invested in another product, service or activity.
There are several other costs you must include when calculating the total cost of each product or service:
The total cost of the products and services you buy from others for resale to your customers;
The cost of all materials you purchase to produce your product or service;
The cost of all labor it takes to produce and deliver your products and services;
The cost of sales, marketing and advertising for each product or service you sell;
The cost of packaging, shipping and distribution;
The cost of shrinkage, waste and loss as a percentage of sales. This often includes theft and breakage;
Interest costs you must pay on the money you borrow;
Bad debts, which are the costs you incur for non-payment from your customers; and
All other costs that must be paid to produce, sell and deliver your product or service.
As an entrepreneur, you must also include the costs of your personal labor in your calculations. How many hours do you personally invest in the production and sale of each product or service? What’s the amount of your salary or compensation from your company? (You might be able to determine this based on how much you could earn if you worked for another company.) What’s the value of the labor of your family members?
The best way to operate your business is to reduce your fixed costs and increase your variable costs. Here are some ways to do that:
Offices and equipment: It’s often better to lease or rent than to buy.
Labor costs: It’s often better to hire people to work part time, only when you need them.
Outsourcing: Hire other companies to perform services rather than doing them in-house. The lower your fixed costs, the higher your profitability can be from sales.
There are also several ways to calculate the efficiency with which you run your business:
Determine your return on investment. This is the amount you earn, expressed as a percentage, from the total amount of money you have working in your business (which can include loans and credit).
Determine your return on equity. Subtract the amount you earn from the total amount of cash you’ve personally invested in your business.
Determine your return on sales. This is the amount of gross profit you earn from each item you sell after deducting the direct costs of producing and delivering the product.
Determine your net profit. This is the amount you have left after deducting 100 percent of all the costs listed above. This amount is the true measure of the efficiency of your business.
If your company sells more than one product or service, you must determine the exact profitability of each one. You should conduct a complete cost analysis of each product or service, and include a percentage of all fixed costs that are attributable to each item you sell. Also include the exact amount of variable and semi-variable costs per item, and deduct the costs of your personal labor at your hourly rate, plus an allowance for returns, bad debts, shrinkage, breakage and any other costs. Be honest–determine exactly how much it costs, and how much you earn, from the sale of each product or service.
The most successful entrepreneurs and businesses continually study every cost and look for ways to reduce them. The more accurate you become in analyzing and determining the exact costs of the products and services you sell, the more successful you’ll be in business.