Knowing your costs is vital for good decision-making<\/p>\n
Understanding your costs is vital for informed business decisions. It helps you determine the profitability of your operations and\u00a0how to set prices<\/a>.<\/p>\n But proper costing is complex, and many businesses aren\u2019t doing a good job. Costing is a specialized process that is different from regular\u00a0bookkeeping<\/a>\u00a0for payroll or financial reporting purposes. Even companies with a CPA on staff often don\u2019t have proper costing practices in place because of a lack of time or expertise.<\/p>\n \u201cMany business owners believe they have good costing in place, when in many cases they don\u2019t,\u201d says BDC Senior Business Advisor Jorge Henao, CPA, CMA, who specializes in financial management and strategy. \u201cIf you don\u2019t know your costs accurately and in a timely way, it\u2019s very hard to make\u00a0well-informed<\/span>\u00a0decisions about your operations.\u201d<\/p>\n<\/div>\n<\/div>\n<\/div>\n Henao advises businesses to follow these five steps to understand their costs.<\/p>\n The first step is to define what you want to determine the cost of. Accountants call this the \u201ccost object.\u201d It could be anything from a specific product, service or project to type of client or geographic area.<\/p>\n The key is to ask yourself what are the critical things you need to cost in your business to improve\u00a0decision-making<\/span>\u00a0and profitability. For example, you may want to know total costs of product A, B and C, or compare the costs of serving individual versus institutional customers, or Quebec versus Ontario. Or you may want to determine the costs of various projects to compare their profitability.<\/p>\n In most cases, businesses look at their overall costs, but they don\u2019t know their profitability\u00a0by project, product or service line.<\/span><\/blockquote> \u201cIn most cases, businesses look at their overall costs, but they don\u2019t know their profitability by project, product or service line,\u201d Henao\u00a0says.<\/p>\n The next step is to determine whether costs should be treated as\u00a0direct<\/a>\u00a0or\u00a0indirect costs<\/a>.<\/p>\n What determines this classification is whether costs can be traced to the cost object in an economically feasible (cost-effective<\/span>) way or if they need to be allocated. For example, the cost of cocoa used to make chocolate is a direct cost as the amount used can be traced in a\u00a0cost-effective<\/span>\u00a0way to each unit produced.<\/p>\n On the other hand, the cost of building insurance for a plant is an indirect cost as it\u2019s not cost effective to trace the monthly insurance cost for the production of a specific chocolate unit.<\/p>\n Allocating indirect costs to a cost object can be complex and prone to error. \u201cBusinesses often don\u2019t know how to allocate overhead and don\u2019t do it properly,\u201d Henao\u00a0says. \u201cAllocations tend to be arbitrary. The objective is to allocate indirect costs according to the use of resources by the cost object as best as possible. If you misallocate costs, you could end up subsidizing one product or service at the expense of another and drawing incorrect conclusions.\u201d<\/p>\n Next, it\u2019s necessary to determine the nature of the specified cost object (variable or fixed) and the factors that cause costs to change for the cost object.<\/p>\n It\u2019s very important to determine key drivers of costs in your operations so you can optimize them. For example, in a transportation company, this could be the number of kilometres driven. For a processed meat producer, it could be the number of days to cure meats. At a warehouse business, it may be cost per square foot.<\/p>\n\n\n\n\n\n1. Define your cost object<\/h2>\n
\n\n\n\n2. Determine traceability of cost objects<\/h2>\n
3. Identify the nature and key drivers of the costs<\/h2>\n
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