When starting a business, many small business owners make the critical mistake of failing to charge competitive prices. This is often due to a failure to differentiate between revenue and profit, but more importantly, because they ignore “fixed” costs. This article will cover how to calculate costs for beginners.
Costs: are all the money you spend to produce or sell your product or service.
Costing or Break even analysis refers to the way in which you calculate the costs of producing your product or delivering your service.
Costing is important because it helps you to:
- Make pricing decisions- after calculating your total cost per item, you can then use that information to set a competitive price that will be profitable for your business.
- Gain a competitive advantage by allowing you to control and reduce costs- when you know how much it costs you to make a product, you can then work on gaining the competitive edge by minimizing costs by reducing wastage, finding cheaper suppliers or taking advantage of bulk purchases and discounts.
- Make better strategic decisions- costing tells you where the money is to be made. Some products might be nice-to-Have in your product mix but bringing little in terms of actual profits. Costing then gives you the opportunity to identify and focus on the profitable areas of your business.
- Plan for the future- once you’ve ascertained how much it costs to make a product or deliver a service, you can then plan ahead and make decisions to purchase equipment to further reduce costs or to partner with a manufacturer to supply a product at a lower cost. This also affects decisions such as your location, staff and plant set up.
Types of costs
There are two types of costs and these should be treated differently because they affect the business differently.
Variable Costs– these are costs that fluctuate with production volume, sales volume or the amount of services provided. Examples are the ingredients used when making a cake such as sugar, flour and milk.
Fixed Costs– these are costs which do not fluctuate with production volume, sales volume or the amount of services provided. A common example of a fixed cost is rent because it stays the same regardless of whether you produce one unit or a thousand. Although the amount of rent might change, the change is not as a result of production volume.
Most costs are easy to classify as fixed or variable but some might not. These include the salaries of marketing and sales staff which might contain a fixed element as well as a variable element.
How to calculate your costs
Step 1 calculate the variable cost per item
The method varies slightly depending on whether you are a manufacturer or a service provider and a retailer.
A.) Manufacturer/Service Provider
- List all your inputs that have costs which fluctuate with production volume or services provided
- Get the cost of purchase(Price) of each unit
- Estimate the quantity of each input needed to make one good or service.
- Estimate the cost of each input needed to make one good or service by multiplying the unit cost of each input and the quantity of that input needed to produce one unit.
- Calculate the variable cost per item by adding up all the costs of all these inputs.
Or if you are a retailer use the method below to calculate your variable cost per item
In the case of a retailer, your variable costs are the costs of buying goods to resell. In other words, if you buy a dress from a manufacturer at $20 and intend to resell it, that $20 is the variable cost per item
Note- there are some costs which maybe variable but are too difficult to calculate mainly because they are minimal costs and thus are treated as fixed costs. These include transport and salt during the baking process.
Step 2: Estimate the fixed cost per unit
- Calculate how much money you are going to spend on each item of fixed costs per month. Estimate these costs and in the case of irregular or periodic costs, simply calculate the annual cost and divide by the number of months.
- Also incorporate those small variable costs that we mentioned earlier such as salt and transport cost for retailers. They will be treated as fixed costs.
- Estimate the total variable cost of the business for the month. This means multiplying your variable cost per unit by the total number of units that you’re expecting to sell. In other words, calculate your total expected sales for the year and then divide by the 12 months.
- Calculate total fixed cost to variable cost ratio. The idea is to take the total cost and apportion it to every unit that we intend to sell. To further illustrate this, say, you have to pay $50 as rent every month. If you sell one unit valued at $25 that unit carries the burden of paying the rent. If however, you sell 1000 units at $10 each, despite the price being less, each of these units gets to contribute towards the rent and thus endures less of a burden.
- Calculate the total fixed cost per item. You achieve this by multiplying your variable cost with your fixed ratio.
Step 3: add up your estimated variable cost per item and your fixed cost per item to get your total cost per itèm.
What does this mean?
The amount you get as your total cost per item is also known as your break even price. You should not sell your product for less than this amount. Any price that you set above this amount is profitable. Just remember to do your research with regard to customer preferences and competitor pricing strategies.
We hope that you have found this article very helpful and as always, I wish you much success, happiness, health and wealth.