“If one does not know to which port one is sailing, no wind is favorable.” –Lucius Annaeus Seneca
We often hear the term, “Cost of doing business.” But what does this really mean? Isn’t everything a cost? In business, the way you think about Costs and Expenses can help you understand how your business runs, and what decisions can affect the bottom line. Knowing the difference between Costs and Expenses allows you to know whether your pricing is enough to cover the costs and leaves enough margin to pay the remaining expenses. Understanding your business’ ratios in terms of Revenue will allow you to quickly calculate your performance, and determine if your profit expectations are reasonable.
There is a difference, and it does matter When you look at P&L statements, activities can generally be assigned to one of four areas; Revenue, Cost of Goods Sold (COGS), Expenses, Other Income and Expense. The following formula illustrates how these are related to each other.
When you think about your company’s product(s) or service(s), the most basic method to think about cost is what it takes to produce the product or service. To facilitate the discussion, the term “product” will be used to describe your company’s offerings. You should also become comfortable with the concepts of direct and indirect costs.
Let’s start with Direct Costs. For products, this is more straightforward since it is easy to put a purchase prices on your raw materials, components or other physical objects that become part of what you sell, or the wholesale price you pay for your retail products.
Another component is the Labor Costs that are directly required to manufacture the product. In a service business, costs can be any specialized supplies or labor that is directly related to revenue generation.
Indirect Costs are more difficult to identify and accurately quantify. As one example of many, what portion of management wages should be allocated to each specific revenue category? What formula would you use to calculate the correct allocation? The more sophisticated the allocations, more resources will be needed to figure this out and regularly maintain the accounting for it. For most SBE’s, indirect cost accounting does not yield sufficient net positive financial results to justify what’s required to implement it.
If you spend too much time and energy trying to calculate these Indirect Costs, you may lose focus on the bigger picture that drives the profitability of your business. Concentrate instead on making sure you understand the Direct Costs and Gross Margin so you can determine if your pricing is correct, market competitive and covers your remaining expenses.
This is the area where owners have the most experience and understanding. The usual suspects are all here: Rent, Utilities, Insurance, Phones, Payroll, etc. The question is what do you want to know? Look at the account structures and decide what level of detail provides information that guides your business in the right direction.
Written by Greg Parker
Greg Parker’s intricate knowledge of company finances, as well as their involvement in strategic planning, has made him a highly-accomplished and sought after financial and operations trouble-shooter and business mentor.