A business owner has to make dozens of decisions every week. You might make decisions about hiring an employee, changing your product packaging and whether or not to extend your line of credit- all in the same week. This process requires you to jump from one area of your business to another, which makes it hard to prioritize your decision-making. Which decision is most important right now? It’s frustrating.
If you have a list of decisions that have to be made, pay close attention to issues related to costs. Make accounting decisions about cost a high priority, because these choices can have a huge impact on your company’s results over time. Here are some decisions about cost that many businesses must face:
#1 Fixed costs per unit
A warning- when you analyze costs in your business, use total fixed costs in dollars instead of fixed costs per unit. Your fixed costs per unit are, ironically, not fixed at all. In fact, fixed per unit cost changes with your sales and production levels. Since the number is always changing, it can create some misleading analysis and produce results that are not reliable.
Say, for example, that you manufacture baseball gloves. You incur a $20,000 lease cost for your factory each month, and you compute your product costs using fixed cost per unit. In March, you produce 10,000 gloves and incur a fixed cost per unit of ($20,000 / 10,000 gloves), or $2. Production goes up to 15,000 gloves in April, so your fixed cost per unit is ($20,000 / 15,000 gloves), or $1.33 per glove. Fixed cost per unit decline, which seems like a good thing.
Your costs didn’t decline, because you’re still writing a check for $20,000 each month for the lease. Your calculation simply allocates the $20,000 fixed cost over more units- that’s not a cost decrease. You must cover your fixed costs, regardless of your level of production, which is why every business should use total fixed costs for their analysis.
#2 Special orders
Getting a last-minute customer request for a price quote that you didn’t expect can be great news. It’s a sale you weren’t planning on, which is a nice surprise. Before you quote a price to your client, think carefully about the true cost you’ll incur to produce the product or deliver a service.
Your decision about a price quote is particularly important toward the end of the month. That’s because you’re already incurred nearly all of the fixed costs for the period. Using the baseball glove example, you’re already covered the $20,000 lease payment with production earlier in the month. So, the lease cost should not be considered when you compute a price quote at month-end.
Accountants refer to these expenses as a past cost or sunk cost. You’re already incurred the cost of the lease, so that cost has no impact on the price of your baseball gloves. Instead, your pricing decision should be based on your variable costs plus your profit margin.
Assume, for example, that you normally sell baseball gloves for $100 and your variable costs are $50/unit. When that customer calls on the 30th of the month for a price quote, you should base your quote on a $50 cost plus your profit margin. If you quote a sale price of $70, for example, you would earn a $20 profit per glove.
You can use special order pricing to drive more sales at the end of the month. If a customer asks for a quote, you can offer a lower price than normal. However, your customer needs to know that your quote is a special discounted rate and that prices will return to the normal level down the road.
#3 Closing a division or product line
At some point, enough is enough. It can be painful, but you may need to discontinue a product line or close a company division that isn’t producing enough sales and profit. Before you make this tough decision, take a deep breath and think carefully about the costs and revenue you generate.
Consider the fixed costs you incur to operate the product line or division. Let’s say that a baseball equipment manufacturer decides that producing catcher’s equipment will never generate enough profits to justify the costs of production. The owner needs to go through the income statement line-by-line and review the costs incurred for this division.
Manufacturers incur direct costs for labor and materials. Rather than eliminate jobs (and payroll costs) completely, you may be able to shift those experienced workers to other company divisions. Assuming that you’re not obligated to buy a specific amount of production from your vendors, your material costs (metal, plastic, leather) will also go away.
Other fixed costs may have to remain for a time, because you’ve signed contracts. Your lease payment on your factory, for example, may require payments for years into the future. Can you use the space for another part of your business? If not, you’ll be on the hook for a large cost that doesn’t generate any revenue.
For these reasons, you may decide to operate at a breakeven profit level- or at a manageable loss amount- until certain contracts end. Rather than pay the lease payment and generate no revenue, you may decide to keep operating the catcher’s equipment product line and operate at a small loss.
These decisions are not easy, because you should also consider the impact that closing a division or product line has on the morale of your staff. Will valuable employees decide to leave your firm, because they view your business as being on the decline? Will worker productivity fall, because people are worried about further cutbacks? If you’ve worked in this type of environment, you know how difficult this situation can be. Give these “non-economic” considerations some serious thought.
When you walk into the office each day, put the decisions you need to make in order by priority. Put financial decision about your costs at the top of the list. Smart decisions about cost will have a huge positive benefit on your future sales and profits.