Key Business Skill: Finance – Costing a Product
Everyone making commercial decisions in a business needs to have a basic understanding of finance, so that they appreciate the financial implications of their decision on the business.
If you are involved in the management of a small or medium business, you need to be able to read and write a cash flow forecast, and ideally understand business models and pricing models. You don’t need all the skills of an accountant, but you do need to be familiar with basic bookkeeping to comply with reporting regulations. It is helpful to be able to read and understand a profit and loss forecast and a balance sheet.
In a larger business, with an accounts department, you probably won’t have to deal with the cash flow, but you still should appreciate the elements of finance that affect your ability to make sound commercial decisions, such as costing a product , the principles of pricing , and breakeven points
You need to understand how to cost a product. If you don’t cover your costs, you won’t make a profit. Simple as that!
There are many ways to do this, but you need to know how to ensure your costs are covered, and the implications of a loss leader on the bottom line, if you do decide to sell under cost.
Quick Facts: Finance – Costing a product
You need to cover both the fixed and variable costs
Divide your costs under two headings:-
Fixed costs, or overheads, have to be covered, regardless of how little or how much you sell.eg rent, salaries and business rates.
Variable costs increase as your sales increase, such as raw materials, additional labour and distribution costs.
So the product cost needs to include both variable costs, and a contribution to overheads.
When you set a price, it must be higher than the variable cost of producing your product or service. Then each sale will make a contribution towards covering your fixed costs, and making profits.
For example, a company has variable costs of $200 per item sold and total fixed costs of $40,000 a year that must be covered. If the company sells 5000 items each year, it needs a contribution towards the fixed costs of at least $8 per item ($40,000 divided by 5000) to avoid making a loss.
Knowing these figures allows you assess the consequences of setting different price levels.
If the company sells products at less than $200 (the variable cost), it makes a loss on each item it sells and does not cover any of its fixed costs
Selling 5000 items at $200 means a loss of $40,000 per year as none of the fixed costs are covered
Selling items at $208 results in breaking even, assuming the target 5000 items are sold (5000 contributions of $8 per item = $40,000, the fixed costs figure.
Selling items at $220 results in a profit of $20,000, assuming 5000 items are sold (5000 contributions of $12 = $6000o i.e. $20,000 over the fixed costs)
If more or fewer than 5000 items are sold, profits vary accordingly.