Cost Accounting Basics
Do you have a best friend? What do you value the most about him/her? Why do you want to be friends with him/her?
My best friend in business is an entire topic- Cost Accounting.
Why? Because to understand profitability and how to increase it, you must understand the costs related to your business. Cost accounting provides value to my life because it helps me understand why I’m not making money. I like money… therefore Cost Accounting=Value.
I’m not going to ramble on about defining things and using huge words that we all dreaded in accounting class; instead I want to draw attention to why you may not be making as much as you should, and make some bullet points on topics to consider when analyzing your costs. If you have a CPA, ask him/her about cost accounting and the services they provide to mitigate high costs in your business. I know the answer already.
These are the typical practice areas of a cost accountant:
- Product Costs
- Product Line Costs
- Employee Costs
- Sales Channel Costs
- Customer Costs
- Contract Costs
- Cost Reduction Analysis
- Constraint Analysis
Fixed Vs. Variable
So, you might be asking yourself… what’s the difference?
Variable: Costs which change in proportion to the good or service that a business produces
Direct Materials (Raw Materials), commissions, utilities, credit card fees, production supplies, billable staff wages (like my consulting firm, for example)
Fixed: Expenses which are not based on the level of goods or services produced.
Direct Labor (yes! Everyone who works for you on salaried payroll is a fixed expense), rent, research and development, machine maintenance, advertising.
Direct vs. Indirect
Direct: Costs which are accountable to a cost object (project, facility, etc), raw materials, labor
Indirect: Obviously the opposite of direct. This is… security, administration, selling/distribution costs
I like to start with Indirect Fixed Costs. They are my favorite things to review first, as they typically are the products or services which someone doesn’t really need (ie. Cable TV) nor are they business critical, and often drive down profit. I call it “Cherry Picking”.
Cost of Goods Sold (COGS)
Simply put, this is the costs of the item(s) that you sell. If you sell a cup of coffee, these are your costs:
- Beans
- Water
- Cup
- Sleeve
- Lid
- Sugar/Cream
- Stir Stick
- Napkin
- Labor
Each of these items cost you something- therefore, it’s COGS. These items should be bought in bulk to ensure lower COGS, and often this is where we go first, after the “Cherry Picking”.
This might be a simple example- but hey, I’m drinking coffee while writing. If you make ANYTHING (or even sell anything), you have costs. Add up all of those costs, and you can calculate your profit margin.
Cost Accounting Margins
If you want to understand profit, then you must understand how each of these effect profit in your business. In one phrase, it all means “know your costs”. If you have no idea what your costs are in any of these cost areas, you may not be as profitable as you think.
When determining profitability and where to initiate cost reductions we start with the following formulas:
- Breakeven analysis
- Target Net Income
- Gross Margin
- Contribution Margin
- Pre-Tax Dollars Needed for Purchase
- Price Variance
- Efficiency Variance
- Variable Overhead
- Ending Inventory
What does this tell us in the end? Profitability. Ever heard of a calculation called EBITDA? That’s “Earnings Before Interest, Taxes, Depreciation, and Amortization”. Banks care about EBITDA when lending, as they care about each of the calculations above. Obviously some of these calculations are important on a periodic basis- you wouldn’t check your weight every day, or your 401(k), but every month it is good to review these against the previous.
While EBITDA is concerned with your revenues and operating income, cost accounting makes up the other end for investors and lenders. They will ask about your highest costs and what business decisions you have made to adjust for higher contribution margins (by high I mean the ratio of variable costs to revenues is high).
My Favorite Margins
Contribution Margin- Percentage of variable costs to revenues. Often, this is raw materials, or rising costs of fuel in transportation. “CM=Sales-Variable Costs”. Maybe you don’t have variable costs (challenge me to not find some, I dare you) making this irrelevant. If that’s the case, please have a list of your fixed costs.
Gross Margin- Ever heard someone ask “what’s your margin?” Well this calculation tells you. It’s simply “Sale Price-Cost of Goods (or sales)”. Why is this hard to determine? You better know what your product costs are.
Ending Inventory- If you don’t do inventory on at least a periodic basis, please call me. Otherwise, you should be calculating “Purchases+Beginning Inventory-Cost of Goods (Sales)”
Break Even- This is “$0=Sales-Fixed Cost-Variable Cost” Typically here you would know what your costs are and work to determine how much to sell to cover said costs.
Profit Margin- Revenue-COGS
I personally live to reduce costs in a business. At the end of the day, you should too- or at lease know someone who can be in a role to make you more profitable.
There is cost management to be done in both the product and service industries. If you want to find investors or lenders, they will ask.
This information is based on the experience of Ryan Dietrich, consultant and principal at Finance Jack, LLC. Ryan has over 10 years of strategic management accounting experience, and has led finance activities at Fortune 500 companies and small businesses alike. Ryan has developed policy, managed risk, and led teams at all levels. Finance Jack focuses on strategic business consulting in the accounting and finance areas of small business, startups, and scaleups. To contact Ryan Dietrich please email ryand@financejack.com.