The goal of most businesses is to make money. Doing so is simple if you sell your offerings for more than it costs you to acquire, make or provide them.
Let’s look at some of the core elements of a business and how understanding cost will impact these decisions. In this column, I will refer to “products” for writing simplicity but mean products or services or a combination of both. In later columns, I will discuss some of the issues uniquely related to the costing of services.
First, a clarification that was noted in the introductory article in the December 2021 issue of FORGE. The idea of cost is to understand the cost of a single item that you sell. Fully understanding the cost of what you sell can be a challenge. You must make assumptions and estimates. Sometimes the best you can do is to understand the costs of a group of like products. However, the goal is a cost at the most granular level.
Here are 10 reasons why costing is so important.
1. Calculation of Margin
Margin is simply the price you charge less the cost of the product you provide. Margin $/unit and particularly margin % (margin/sales price) are likely the top analytic measure that will help you understand the profitability and health of a business. A business with negative margins is almost invariably doomed.
Closely related to margin is pricing. Many businesses develop their prices based on their estimate of their cost for a unit. Pricing is a decision; cost is a calculation. Setting prices is perhaps the most im-portant determinant of business success and failure. While setting your price is always a decision, sometimes the negotiating power is with the customer, and they will usurp your decision-making and tell you what they are willing to pay. Then your decision is whether to take the order or not.
3. Business Process Development
An owner evaluates his business and its costs and finds that his cost is too high to make a margin at prices the customers will bear. To stay in business the owner must reevaluate their business processes: how they buy, how they add value, investments in capital or other assets, how they pay their employees, etc. Understanding cost is fundamental to these evaluations.
4. Sourcing and Hiring
All businesses need to understand where their input costs (material and labor) need to be to manage what they pay for these inputs.
5. New Product Development
Any new product plan should require a target price, margin and a target cost. The new product development process must carefully include ongoing cost calculations to ensure the end result is potentially a success.
6. Price/Volume Considerations
Most businesses are faced at one time or another with taking on a “big” new order or customer who wants special pricing treatment. Understanding current costs and cost/volume behaviors are key to making these decisions.
7. Capital Expenditures
Most capital expenditures (new machines, new buildings, new software and new technology) will have an impact on cost. These presumed cost improvements can justify the purchase. Conversely, capital spending to increase output will impact costs. Understanding the full impact of these costs may lead to deciding yes or no on these expansions.
A business may have opportunities to outsource some or all of its processes. Cost is one of the key determinants of informing these decisions.
9. Customer and Channel Management
Costs will often vary based on specific customers and specific channels of going to market. Under-standing how cost varies by these segments will impact decisions on what type of customers to seek out and which you might consider firing.
10. Mergers and Acquisitions
While in the process of evaluating an acquisition, the impact of the acquisition on product costs can make a substantial impact on the synergy (or lack of) in the deal negotiation. In negotiating a sale, understanding post-sale costs and margins can create opportunities to negotiate a bit more of the synergy into the sales price.
Cost is a core knowledge point for running a business. Few business decisions can be intelligently made without understanding cost and its behavior. These 10 considerations are of great strategic im-portance. I’m sure the diligent reader can identify 10 more. In our next article, we will look at the core decisions for building your cost model.