• Introduction

• Identify cost components

• Systematise Costs

• Calculate variable costs for each product/service

• Calculate fixed costs for each product/service

• Calculate total costs per unit

• How cost calculation improves business

  • Price Setting

  • Deduction of the breakeven point

  • Strategies

  • Ways to reduce costs

   

1.  Introduction  [top]

Many people are unaware of costs and waste scarce resources. Cost calculation is the way to calculate the total costs of making and selling a product or providing a service. How can it improve the business?

   - Costing helps to set prices

   - Costing helps to control and reduce costs

   - Costing helps to plan for the future

   - Costing helps to make better decisions

   - Costing helps to write a business plan  to obtain a credit

Steps

   1. Identify cost components

   2. Systematise costs

   3. Calculate variable costs

   4. Calculate fixed costs

   5. Calculate total costs per unit

   6. Set Prices, deduct the breakeven poin

2.  Identify cost components  [top]

What cost components are involved in this enterprise?

PRODUCTION

      -  Manpower

      -  Raw Materials

      -  Electricity, Transport, Rent, Water, etc.

      -  Machinery, Equipment and Tools

      -  Others

MANAGEMENT

     -  Manpower, Entrepreneur’s Salary

     -  Stationery

     -  Telephone, Rent, Electricity, Insurance, etc.

     -  Equipment

     -  Others

SELLING

     -  Publicity, Promotion, Commissions, etc.

FINANCE

     -  Interest

List all costs in simple tables, such as

Material, electricity.....

Machinery, equipment, tools

Calculate the labour costs per hour for each employee

Manpower

Calculate the working hours and the direct labour costs needed to finish the product/service

Production Process

The cost of a step in the production process is calculated by multiplying the manpower cost per hour of the employee executing this step and the required time.

3.  Systematise Costs  [top]

Make the operator think about the difference between costs like rent and flour (e.g. in a bakery) to deduce the concept of fixed and variable costs.

• Fixed costs are the sum of all costs required to produce any product. They do not change when the volume of production/service is changed. Fixed costs can include facilities costs, certain general and administrative costs, and interest and depreciation expense.

• Variable costs are costs associated with producing additional units. They do change with the volume of production/service. They can include direct material and labour costs, transportation and sales commission expenses. Variable unit cost: Cost associated with producing one additional unit.

• Total costs: Sum of fixed costs and variable costs.

This concept implies that (due to contracts, commitments etc.) fixed cost components can be reduced only after a certain period of time.

In principle, the classification of costs depends on the type of production. Furthermore, some components, can be both fixed and variable in the same enterprise: Electricity consumed by a production unit is variable, while electricity for the office building is fixed cost. However, there are some rules of thumb:

• Raw materials usually cause variable costs

• Productive work being directly related to the product/service causes direct labour costs which are variable.

• Administration costs are mostly fixed costs.

Examples of fixed and variable costs

Ask the operator to classify one by one all his costs as variable or fixed. Does he understand the difference between fixed and variable costs? Only when he is able to classify his costs, he can calculate the fixed costs and the variable cost per unit of each of its products, the basis of pricing.

4.  Calculate variable costs for each product/service  [top]

Variable Costs

If a unit produced is very small (e.g. cake) and during the relevant period thousands of units are produced, it is not necessary to quote exactly the quantity raw material used per unit. Rather, one can take quantities used per 100 or 1000 units. However, at the end variable costs have to be adjusted to one unit. (see example)

5.  Calculate fixed costs for each product/service  [top]

Fixed Costs

Depreciation is the theoretical price to the use of an asset. One of the various methods of depreciation, and the simplest one, is to divide the purchasing price of the asset by his period of usage.

Example: A machine costs 6.000 Birr and is supposed to work for 5 years

Depreciation per year: 6.000 Birr / 5 years = 1.200 Birr per year.

Depreciation per month: 1.200 Birr / 12 months = 100 Birr per month.

If the business produces more than one product, the fixed costs first have to be split between products as exactly as possible. The relation of total variable costs for each single product can be used as an estimator for the split up of fixed costs.

6.  Calculate total costs per unit  [top]

Add up variable and fixed costs per unit

7.  How cost calculation improves business  [top]

7.1  Price setting

To set prices the operator needs the following information

• His costs

• Competitors’ prices

• How much the customers are willing to pay

In general the price must be

• Low enough to attract customers to buy

• High enough to give the business a profit

To make a profit, the price must be higher than the total costs of the product! Hence, knowing the total costs of a product is essential in determining the price.

There are two methods:

• The operator takes his total costs per unit and adds a percentage margin to get his selling price.

• The operator takes the prices of his competitors and makes sure that his prices are competitive with theirs. But he has to make sure that his prices cover his total costs!!

However, only if the product is better than that of competitors and the operator is able to communicate the additional benefit to the customers, he can charge more than his competitors. (Þ marketing)

7.2  Deduction of the breakeven point  [top]

The breakeven point is an estimate of the level of sales necessary to operate a business profitably, i.e. how many units of a product must be sold at a given price to make a profit.

The following steps are involved in calculating the breakeven point:

1. Identify the total fixed and variable costs of the business based on actual results during a relevant time period.

2. Calculate the contribution margin as follows:

contribution margin per unit = selling price per unit – variable costs per unit

This amount is available to offset fixed expenses and (hopefully) produce an operating profit for the business.

3. Calculate the breakeven point as follows:

breakeven unit volume = total fixed costs / contribution margin per unit

If sales exceed the breakeven unit volume, the business makes profit; if not, the business makes a loss.

By performing a breakeven analysis and then varying the assumptions regarding sales levels and variable and fixed costs, the real factors behind the profit potential (or lack thereof) of a business become more clear. This process will highlight the most significant factors and assumptions (particularly assumptions about the ability to set prices) in the buyer's business plan.

7.3  Strategies  [top]

Generally, the sales price for a product or service should more than cover the variable costs of producing that product, but the margin from sales must be enough to cover fixed costs as well.

If the sales price does not cover total costs, it can, however, still cover the variable costs. Then an appropriate strategy would be to implement measures to increase sales. If the market share can’t be modified, this can require to reduce fixed costs, to make fixed costs become variable, etc.

But if the sales price is below variable costs, it does not make sense to sell more. With every additional unit sold, the operator increases his losses. Then measures to increase sales would not be an appropriate strategy, the operator rather has to reduce his variable costs. Reducing fixed costs – though never unnecessary – would not be sufficient!

7.4  Ways to reduce costs  [top]

Many people are unaware of costs and therefore waste scarce resources. Making an operator cost conscious is always a good point, particularly when he has the potential to reduce costs (variable and fixed costs) without neglecting quality.

• Very simple instructions are universal and easy to be carried out by everyone

• Turn off a tap which is running

• Handle your tools and equipment with care; clean your tools perfectly

• Switch off any unnecessary light

• Switch off machines, if they are not used for hours

• Work faster, but still be precise

• ....

And according to the situation, more specific proposals have to be found...

Reducing variable costs

• Find cheaper suppliers, but at the same or better quality

• Find others and co-operate to order larger quantities

• Share expenses with others

• Optimise the stock level: The higher the stock, the higher the interest expense; but: the lower the minimum stock the higher the risk of running out of stock

• Improve the workplace layout: Good workshop layout means that the product travels and is handled as little as possible between processes from the beginning to the end of its manufacture

• ....

Make fixed costs become variable

• If average utilisation of equipment or human resources is low, it can make sense to outsource these services/production. Then the operator has to rent/buy the product/service only when necessary

• ...

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