What is the true cost of the products and services that you sell? Now, that may sound like an odd question. After all, you generate and review your income statement each month, which reports the total costs incurred on the items you’ve sold.
That review, however, doesn’t address an issue that may have a huge impact on your profitability. The price of your product must allow you to recover every cost you incur in your business. Said another way, the only way you can cover all of your costs is to generate sales.
Use these tips to compute the true cost of your products, assess your profitability, and consider increasing your sales price.
The most common problem
Some costs are easier to assign to a product or service, while other expenses are more difficult to pin down.
Overhead costs are the most difficult costs to assign to a product, and business owners frequently have difficulty analysing these costs. Overhead or indirect costs cannot be directly traced to a product or service. Insurance premiums and utility costs are two good examples.
On the other hand, direct costs can be easily traced to a product or service. If you manufacture cricket gloves, you can compute the amount of leather material you use in each glove, and the amount of labour cost it takes to run machines. As a result, material and labour costs are frequently classified as direct costs.
To determine the true cost of your product or service, you need a method to allocate overhead costs.
Julie owns and operates Hillside Landscaping, a business that provides lawn care, landscaping and tree removal services. Here is Hillside’s income statement for 2020:
|Income Statement ending 31 December 2020|
|Cost of Sales|
|(sod, mulch, flowers)|
|Total Cost of Sales||380,000|
|Home office costs||7,000|
|Repair and maintenance||4,000|
|Total Operating Expenses||70,000|
As you scan the income statement, note the following:
- Direct costs: You’ll notice that the income statement lists gross profit as sales less cost of sales. Cost of sales, in this case, includes material (sod, mulch, flowers) and labour costs. These are direct costs because they can be directly traced to a particular client.
- Operating expenses: Gross profit, less operating expenses, equals net income for the year. Operating expenses, such as depreciation on assets and insurance costs, cannot be directly traced to a particular job. These costs are indirect costs, or overhead.
- Each customer job: To calculate the profit earned on each job, Julie must subtract both direct costs and some amount of overhead costs from each sale.
Julie’s next step is to decide on a method to allocate overhead costs to each customer job. For this, she will need to understand her business’ activity level.
Why activity level is important
Overhead costs can be allocated based on a level of activity.
The logic here is that a business incurs costs based on activities, such as the number of labour hours worked, total kilometres driven, or total units produced. If your company didn’t produce or sell anything during a particular month, many costs would not be incurred.
Your next step is to decide on an activity level that causes you to incur each overhead costs. In some cases, the connection is obvious. You can allocate travel costs based on the number of kilometres driven to and from a particular customer’s location.
Other connections between costs and activity level are harder to determine.
The allocation process
Here are three overhead costs, and the activity level used to allocate the costs:
|Type of overhead cost||Activity level||Amount to allocate|
|Travel costs||Kilometres driven||$1,500|
|Office salaries||Direct labour hours worked||$30,000|
|Home office costs||Direct labour hours worked||$7,000|
Travel costs have an obvious connection to kilometres driven, but the other two costs are harder to allocate. When there is no obvious connection to an activity level, companies most often use direct labour hours worked.
If “Job A” required more labour hours than “Job B”, it makes sense to assign more overhead costs to “Job A”. It simply takes more effort and should be assigned more costs. It’s not a perfect allocation, but it’s an accepted approach that many companies use.
If Hillside Landscaping’s total direct labour hours worked is 6,000 hours, Julie will assign office salary costs at a rate of ($30,000 / 6,000 hours), or $5 per labour hour.
If the Johnson landscaping job requires 5 labor hours, the customer would be allocated $25 in office salary costs.
Every expense in the operating expenses category will be allocated, based on this same process.
How does a job estimate look?
In the landscaping business, Julie must provide a bid price to each customer, and the price is based on a specific job estimate. Assume, that the Johnson family needs a 10-metre tree cut down and removed. The Hillside’s job estimate may look like this:
|Job description||10-metre tree removal|
The customer is quoted a price of $300, and that price includes a $45 profit. Note also that the $50 overhead cost includes a dollar amount for each type of operating expense.
The bottom line?
Every cost required to complete the job is included in the job estimate, and Julie is able to quote a sales price that includes all costs, plus a profit amount.
Why you should make the effort
Allocating all of your costs to each sale requires a great deal of effort, so why bother?
Cost allocation helps you identify individual sales that are not profitable.
In 2020, Hillside generated a total net income of $52,100, but that total does not reveal the profitability of each sale. That’s important information, because you may need to increase the price of some jobs, or not pursue that work at all.
Julie notices that she earns far less money on jobs that are more than 16 kilometres from her office. Those jobs require more travel, and she must pay workers who are on the clock during longer trips to the work site. Based on her cost allocation work, Julie doesn’t pursue jobs that are more than 16 kilometres away.
Increase profits and work smarter
All businesses, even those that are profitable, can benefit from cost allocation. Use these tools to compute the true cost of your product or service, and make changes to increase profits.