a price
Assume that you make a product that’s unique. You don’t have many competitors. As a result, customers are willing to pay more because they can’t get the same product somewhere else.
To meet your profit goal, you start at the bottom and work your way up. You compute your full costs first. Then you calculate a sale price, based on your profit goal. You have the ability to push the top (the price) higher because you believe that customers are willing to pay a higher price.
Changing prices after more analysis
In the section “Controlling your costs,” you see a list of tools to analyze costs. You use the tools to assign costs to your products more precisely. When you change the costs assigned, you can consider changing the product’s price. That’s because a change in the product’s cost changes the level of profit.
For an example, let’s say that you sell hiking boots. In planning, you budget a sale price of $80 per pair. During the year, you start performing cost analysis. You determine that $5 more in machine production cost should be assigned to each pair of hiking boots.
That $5 increase in cost lowers your profit. So you have a few choices to make to maintain the same level of profit. You could decide to raise your price. If you face heavy competition, a higher price may hurt your sales. The other choice is to find ways to lower other costs.
Keep in mind that pricing your product isn’t a one-time event. As you analyze costs, you may need to adjust prices more than once during the year.
Improving going forward
Successful businesses constantly make improvements. This approach is the only way companies can survive and thrive over the long term. That’s because competitors eventually take business away from you if you’re not willing to change.
One type of improvement is analyzing your business to lower costs. You can lower your costs in several ways. Maybe you remove an activity that isn’t necessary. When you eliminate the activity, you get rid of the related costs. Here are some other possible improvements.
Using the accrual method of accounting
You decide to use the accrual method of accounting. This method matches your revenue with the expenses you incur to generate the revenue. Using this method, rather than the cash basis of accounting, gives you a more realistic picture of your profitability.
Deciding on relevance
Make a judgment about what you believe to be relevant. Relevant means “important enough” to consider in a decision (see Chapter 11). Your threshold for considering relevance might be expressed as a dollar amount. Maybe any amount over $10,000 is relevant to you. Relevance can also be expressed as a percentage. You might consider a change of 10 percent or more to be relevant.
When you decide what amount or percentage is relevant, you use it as a filter for decision-making. Anything over the threshold needs to be analyzed and considered in your decision-making. Below the threshold, you “pass further analysis” — a term my old CPA firm used to mean “not important enough to investigate.”
Demanding quality
Demand is a strong word, but it should be applied to quality. You will not succeed as a business without a constant focus on quality. It’s simply too easy for customers to use technology to find a better product or service somewhere else.
Quality means more than making a product or service that the client wants. The term also means fixing your product, if it doesn’t work.
Finally, quality means asking customers what changes they want in your product or what new products they would like to see. Ask your customers, and they’ll gladly tell you.
Chapter 2
Brushing Up on Cost Accounting Basics
IN THIS CHAPTER
This chapter provides the rules of the road for cost accounting. Use these basic terms and ideas to understand more complex topics later in the book. If you read another chapter and start to get lost, head back here and take a look at these concepts again.
Understanding the Big Four Terms
Direct costs, indirect costs, fixed costs, and variable costs are the four most important cost accounting terms … and these four terms can be confusing. The following sections outline a process for understanding the differences among these words. If you follow this process, you should be able to keep these important terms straight in your mind. Ready? Let’s go!
Comparing direct and indirect costs
Direct costs are costs you can trace (or tie) to your product or service. Indirect costs can’t be traced directly to the product or service. Instead, indirect costs are allocated. (Indirect costs are also referred to as overhead costs.)
Material and labor costs are good examples of direct costs. Say you manufacture cotton gloves. You buy cotton, yarn, and leather to make the gloves. You can trace the materials directly to the gloves; for example, you can take a glove apart and see the materials that were used to create it. Cotton, yarn, and leather are considered direct material costs, because they can be directly tied to one unit of product.
You pay workers to cut, sew, and dye the materials. Because you can trace the hourly labor cost directly to the gloves, these costs are direct labor costs. You can review each employee time sheet and determine how many hours each employee worked, and how many gloves he or she moved through production.
Indirect costs can’t be traced directly to a product or service. So instead, they have to be allocated. You typically allocate costs by assigning a cost per unit. The per-unit rate attaches all the indirect costs to your products. The term overhead is also used to describe indirect costs.
Allocating indirect costs
To allocate overhead, you need to compute a rate or amount of cost per product. Assume you lease the building where you manufacture the cotton gloves. Obviously, the reason you’re leasing the building is to make gloves.
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