Do you know where your company's profits are coming from, what products actually make money, and if your strategy is geared towards maximizing profit?
If not, we will show how to get greater visibility of your product cost and help you maximize your business profitable growth:
What is Product Costing?
It is a practice used by many companies to understand the profitability of their products or services. It is mostly about cost accumulation and profit determination.
Most of the time we think about profitability in a very simple manner: buy materials, pay employees or contract labor, transform them into products or services, and sell those products or services. Profitability is usually seen as the difference between revenue received from selling the products and services and what it costs to build them (usually includes direct materials and labor).
If this is the case for your business, did you know that there is a possibility that you would still be losing a lot of money? Determining the true profitability of your products and services involves a little bit more than knowing the cost of making the product or service. You have to keep in mind that your company has other types of costs.
Product costing is the process that involves all kinds of costs to determine the profitability of your products or services. Failing to take into consideration the other costs that your company has might result to your business becoming unprofitable.
To know your true product costs, and therefore your real profit, you need to understand the following costs:
Direct costs are the costs that are directly attributed to producing the product or service of your business. There are two types of direct costs namely:
These costs are still directly attributed to producing your products or services but note the word ‘variable’ as this means that the more you produce, the more it will cost you. This type of cost will change based on the number of products you are producing.
For example, in a coffee shop business, the items that would fall under the direct variable costs are the coffee ground beans, milk, cup, lid. The more cups of coffee you produce, the more costs you will incur for the products that were mentioned.
As the word direct implies, this type of cost is still attributed to producing your products and services but the keyword this time is ‘fixed’. These costs are not necessarily linked to one specific product but to your product in general. The word ‘fixed’ refers to the fact that this cost will not change based on the number of products you are producing unlike the direct variable cost.
In a coffee shop business, a good example of this type of cost is the coffee machine used to make coffee. The cost of that machine will not change whether you produce one or a hundred cups of coffee.
Indirect Fixed Costs
Indirect fixed costs are related to the general operations of your business. These include costs like rent, salaries of support functions (like marketing, legal, bookkeeper, etc.), electrical and water bill, and so on. These costs, even if it is not directly linked to the production of your products or services, should be covered with your sales.
Understanding the nature of these different costs will enable you to efficiently tie them back to your products to determine your true cost.
Product Cost Allocation
After determining and categorizing all your costs, you have to know how you would allocate them to your products. First is the fully allocated direct cost where the entire cost of something is just for one particular type product. For example, in a coffee shop business, if you also offer tea drinks, you can allocate 100% of your tea leaves costs to that particular product.
After allocating the direct costs, you should never forget about your indirect costs also. All of these need to be tied back in some way to your products. You have to find a logical method to spread indirect costs over your products or services.
Once you have all your revenue and with this cost information, you now have a clear visibility on the profitability of your product.
Let this additional knowledge on product costing help you make an informed decision to maximize your business profitable growth.
If you need to help with product costing as well as bookkeeping and tax preparation for your business, contact us today at email@example.com or 832-437-0385.
We help you plan, forecast and analyze your financial data
so you can get on top of your finances today to grow your
small business big tomorrow.
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