some tools you can use to control costs. Each tool is explained in detail in this book:
Cost-volume profit (CVP) analysis: CVP is a simple tool to analyze costs, sale price, and units sold. There’s a user-friendly formula — the kind of tool you can play around with on a notepad or spreadsheet. Check out Chapter 3 for more on CVP.
Variance analysis: A variance is the difference between your planned costs and actual costs. A large variance is a red flag — a number that gets your attention. You investigate variances to find ways to reduce your costs. Chapter 7 tells you more.
Activity-based costing (ABC): This analysis allows you to assign costs using the activities put into making your product or service. ABC assigns costs to products based on levels of activity: labor hours incurred, machine hours used, and so forth. See Chapter 5 for an in-depth look.
Support costs: Nearly every business incurs support costs. These are areas of your business that support your production and sales efforts. Accounting and legal costs are good examples of support costs.
Joint costing: Your business may use the same process to produce several different products. This situation is called joint production. The products will share common costs of this production, or joint costs. Now, it’s likely that each product has its own unique costs after joint production; however, you need a tool to allocate the joint costs when the products are produced together.
Setting a price
After you’ve nailed down your product’s full cost (all costs, both fixed and variable), you can price your product effectively. The difference between your price and full product cost is your profit (see Chapter 12).
Pricing and competition
Consider how pricing comes into play. Your product’s price may be limited, based on competition. Say you sell baseball gloves. To compete and maintain your current level of sales, you can’t price your glove any higher than $100.
To meet your profit goal, you start at the top and work your way down. The top is your $100 price; you can’t go any higher without losing sales. Your profit is sale price less cost. The only way to increase your profit is to lower your costs.
Increasing a price
Assume that you make a product that’s unique. You don’t have many competitors. As a result, customers are willing to pay more because they can’t get the same product somewhere else.
To meet your profit goal, you start at the bottom and work your way up. You compute your full costs first. Then you calculate a sale price, based on your profit goal. You have the ability to push the top (the price) higher because you believe that customers are willing to pay a higher price.
Changing prices after more analysis
In the section “Controlling your costs,” you see a list of tools to analyze costs. You use the tools to assign costs to your products more precisely. When you change the costs assigned, you can consider changing the product’s price. That’s because a change in the product’s cost changes the level of profit.
For an example, let’s say that you sell hiking boots. In planning, you budget a sale price of $80 per pair. During the year, you start performing cost analysis. You determine that $5 more in machine production cost should be assigned to each pair of hiking boots.
That $5 increase in cost lowers your profit. So you have a few choices to make to maintain the same level of profit. You could decide to raise your price. If you face heavy competition, a higher price may hurt your sales. The other choice is to find ways to lower other costs.
Keep in mind that pricing your product isn’t a one-time event. As you analyze costs, you may need to adjust prices more than once during the year.
Improving going forward
Successful businesses constantly make improvements. This approach is the only way companies can survive and thrive over the long term. That’s because competitors eventually take business away from you if you’re not willing to change.
One type of improvement is analyzing your business to lower costs. You can lower your costs in several ways. Maybe you remove an activity that isn’t necessary. When you eliminate the activity, you get rid of the related costs. Here are some other possible improvements.
Using the accrual method of accounting
You decide to use the accrual method of accounting. This method matches your revenue with the expenses you incur to generate the revenue. Using this method, rather than the cash basis of accounting, gives you a more realistic picture of your profitability.
Deciding on relevance
Make a judgment about what you believe to be relevant. Relevant means “important enough” to consider in a decision (see Chapter 11). Your threshold for considering relevance might be expressed as a dollar amount. Maybe any amount over $10,000 is relevant to you. Relevance can also be expressed as a percentage. You might consider a change of 10 percent or more to be relevant.
When you decide what amount or percentage is relevant, you use it as a filter for decision-making. Anything over the threshold needs to be analyzed and considered in your decision-making. Below the threshold, you “pass further analysis” — a term my old CPA firm used to mean “not important enough to investigate.”
Demanding quality
Demand is a strong word, but it should be applied to quality. You will not succeed as a business without a constant focus on quality. It’s simply too easy for customers to use technology to find a better product or service somewhere else.
Quality means more than making a product or service that the client wants. The term also means fixing your product, if it doesn’t work.
Finally, quality means asking customers what changes they want in your product or what new products they would like to see. Ask your customers, and they’ll gladly tell you.
Chapter 2
Brushing Up on Cost Accounting Basics
IN THIS CHAPTER
