Accurate costing of your products can aid you in making well-informed decisions. Business costs must be accurate for several reasons, which we shall explore a little more in this article.
Sales and budgeting
Firstly, sales prices must be set accurately to ensure that firstly the company makes a profit, and secondly that they make the most profit possible. In order to do this, the exact cost of acquisition or production of the goods is essential after which a percentage is usually added, entitled the profit margin. In the worst-case scenario is selling the finished product for less than the production cost and subjecting the company to financial loss. Even if this seems minimal at only a cent or two an item, it can result in huge losses over time, which can significantly affect the budgeted production cost, place the company under huge financial strain and possibly result in altered future investing decisions.
Predatory pricing is where companies sell their service or product so cheaply that it forces other companies out of the market because they cannot compete. In fact, the prices are often set so low that they are deemed illegal as the net effect is the driving of the competition out of the market altogether. In the US, predatory pricing is generally outlawed so it is recommended to base all product prices on real operating costs so that in the event of suspected predatory pricing, you can have a legitimate defence at the ready.
The success of the company, particularly in the eyes of an investor or the bank, is the value of the bottom line on paper. Even though you and I know there is so much more that goes on when running a business, the net return is a very important and trusted indicator of company health. Now, if there are products that have been sold at far less than they are worth due to ignorance or otherwise, any profits will be eroded by inflated cost of goods sold (COGS) versus the actual sale price. The reduced net profit can be a concern for how the company is run and may instigate an investigation to help the company realise its full potential.
Theoretical wealth and subsequent important decisions
Another part of costing (which must be done accurately) is the valuation of the assets and inclusion on the balance sheet. When all assets have been correctly assessed and weighed up, the overall wealth of the company can be ascertained. It is only with these valuable snippets of information that vital decisions around future investments or new products for example, can be made with confidence.
Method of costing product
There are several methods of costing products where correct selection and accurate execution are imperative. Firstly, the method of costing differs for bought or acquired product versus manufactured product. As soon as product goes through manufacture in the company, there are a multitude of associated costs which must be accounted for in the final product price. The temptation is to look only at the material costs as opposed to considering all the administration and process costs that might also be associated with the generation of product. The two most commonly used methods to allocate other associated costs to the product price are the direct and step-down methods of cost allocation.
The underpinnings of product costing
We have mentioned some important reasons for cost allocation in production, including possessing the ability to produce meaningful financial reports based on real data that are indicative of company health and vital in financial and investor decision- making. But what is so imperative to get right initially for product costing?
Reliable and real-time inventory data. Knowledge is power and having access to meaningful and accurate inventory information is essential to producing detailed financial assessments, which are the precursors to any important strategic decision.