A while ago in the blog Why Fixed Overheads Are So Important we discussed fixed costs and their negative effects. These are even more important when looking to make decisions in times of trauma, especially if sales are falling. This is when the effective costing of products & services can make the difference between make and break.
It is beyond the objective of this blog to go into great detail. If you want more help please Contact What we can do here is look at the basic principles of effective costing to help make decisions in these difficult times.
I’m really talking about contribution or the difference between selling price and any true, variable cost. Fixed costs are just that, fixed and so whilst it is important to cover them and make a profit, too many organisations look at things on an individual product, contract or service level insisting that everything must make a per unit “profit”. If you do this you may turn away work that you should accept if you have the capacity.
Here’s a simplistic example. I have a shop – annual rent £30,000 and for simplistic reasons, no other fixed costs. I sell one product which costs me £100 to buy in and I expect to sell 1,500 a year. My total cost per unit is therefore £100 plus overhead of £30,000 divided by 1,500 = £20. Total £120.
Now – here’s the question. Times are hard. Someone comes in and offers to buy 500 units at £110 – should I accept? If I use full costing the answer is no. I will lose £10 on each one and so I would be stupid to accept. The reality is as follows:
Don’t accept – sales = zero costs = £30,000 loss = £30,000
Accept – sales £55,000, cost of sales £ 50,000, rent £30,000 LOSS = £25,000.
Under these circumstances we are better off accepting.
It’s an over simple example I know but in reality if you really understand what you are doing it works every time, even in a super complex environment.
In order to do effective costing you must fully understand your business and what is really being assessed.
Profit or loss per piece tells you absolutely nothing.
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