As a small business owner, you need to know the true costs of your products, so you can determine how much to charge to enjoy a good profit margin. The most effective way to find out is through cost assignment, as this is a more accurate method to determine product costs. When you use the cost assignment method, you can factor both direct and indirect costs into the total cost of a product.
How Does Cost Assignment Work?
Cost assignment occurs when you look at the expense associated with each product beyond the supplies required. For example, imagine a company that manufactures and sells different types of backpacks. The cost of materials for each backpack doesn’t tell you much about the total cost, because it fails to factor in the labour and other resources from shipping to design that are required to make the product. Some business owners might determine the cost of each backpack in relation to total business expenses, but this can result in an inaccurate assignment of costs.
Here’s how to use cost assignment for a product:
- List your cost drivers, which is the money you spend to make the product.
- Determine what percentage of each expense went into the creation of the product.
- Multiply each expense by its percentage.
- Add the results.
If one of your backpacks takes 5% of your space to produce and another takes 10%, then you would assign 5% of your rent to the first backpack’s cost and 10% to the second’s. Your cost drivers can be any expenses you have that are related to a product, and the more you use, the more precise your calculations become.
What Are the Pros and Cons of Cost Assignment?
While the exact cost of a product isn’t a chief concern for certain departments, it’s crucial to everyone involved with making decisions on production and pricing. It can help you find inefficiencies in your production process and give you the information you need to set the right prices for a product. If you think a product’s cost is lower than it actually is, you may end up charging a price that barely makes you a profit.
Cost assignment can help you determine which items you produce most efficiently and earn the most money from. You can use this information to devote more resources to your company’s biggest moneymakers instead of the products with narrow margins.
The main challenges with cost assignment are the time and complexity involved to make accurate calculations. Even though more cost drivers make your calculations better, they add more work to the equation. Each time anything changes with your business expenses or your product lineup, you need to adjust your cost assignment calculations.
To get the best of both worlds, consider using cost assignment with only the drivers that make the most significant impact on a product’s total cost. You can still get reasonably accurate calculations this way, without spending too much time running the numbers.
In terms of accuracy, you can’t beat cost assignment. Implementing it at your business helps you know exactly how much you’re spending on every product you make.