The cost price of your products form the foundation of your business financial activity, but it’s not always a clear cut number that you can depend on. In a perfect world, you would buy an item at a set price, whack on your mark up, and when you sell it you’ve made a reasonable profit.
You could be dealing with price fluctuations, with items such as fresh produce, or imported items where the exchange rate affects your cost. Perhaps you’re a manufacturer, and the figure to calculate for labour and other costs is a constantly changing picture. Other factors that can significantly change your cost price would be things like excessive wastage of raw materials, or variable delivery costs.
But it’s not just the fluctuations that you have to worry about. First, you need to know that you have a true and accurate cost price to start with. Have you incorporated the cost of everything that goes into your product? Anything that directly forms a part of your finished product should be listed in your costings. You may have little incidental things pop up that have not been factored in, and that will eat into your profit margin.
What’s the best way to deal with this uncertainty? You could possibly over-inflate your mark-up to compensate for all the variables, but then you run the risk of pricing yourself out of the market. I have always encouraged my clients to not be the cheapest, but you don’t want to go too far the other way, especially if your customer can’t see value for money in the price you’re asking.
Here is an example of a basic cost-price calculation, or costing, or bill-of-materials.
Hamburger with the lot (something that all self-respecting Australians can relate to)
|Bread Roll||1 ea||$0.49 ea||$0.49|
|Pineapple||2 Rings||$2.70/tin (6 rings)||$0.90|
|Cheese||1 Slice (20g)||$10.00/kg||$0.20|
|Oil (for cooking)||10ml||$5.00/ltr||$0.05|
|Total Cost of Ingredients:||$5.83|
|Total Cost Price for Burger with the lot||$10.00|
It seems fairly straight forward at first glance, but look a little deeper and we can see how things may change the cost. Will there be wastage from the bacon, lettuce or tomato? Does the weight of the tinned goods include the liquid that’s discarded? Where have we accounted for the cost of the packaging? Being directly related to the delivery of the end product, it should be listed in the components. Even items costing a few cents each make an impact on the total cost. The labour cost used should not be what you pay your staff. Add at least 30% to cover superannuation, work cover insurance, lunch breaks and annual leave, or better still, calculate the overall cost of your employees, and compare with the actual working hours to arrive at an accurate cost price per hour. How can you be sure that the quantities used in the costing will be adhered to in the kitchen? Maybe your cook is a little too generous? In this example, we are using fresh produce, which is subject to price fluctuations. If you get too many variables affecting your carefully calculated cost price, you would find that the sell price doesn’t give you the mark up that you need, and you end up not making enough profit, or worse, running at a loss.
The example here is fairly simple in comparison to the cost-price calculations that many entrepreneurs face, but the system remains the same.
- Break your product down into every little component, don’t leave anything out that is directly related to the finished product offered for sale.
- The quantities of each component should be measured and recorded.
- The price of components should include directly associated costs like freight in.
- If you’re registered for GST, use GST exclusive costs. If you’re not, use the GST inclusive cost.
- Put the list into a spreadsheet, and use an equation to automatically calculate the extended cost. This will help when quantities or prices change.
To address the issue of changing costs, and to stay on top of your profit margin, you must always be on top of your cost price. The trick here is to constantly keep your costings up to date. It is necessary to regularly revise your calculations to make sure that any changes in the cost of any component are captured as quickly as possible.
The frequency of your cost price revisions will vary depending on your specific product, and how many variables affect you. If your components are always the same cost, you can get away with doing it maybe once a quarter, just to make sure. For most people, though, it should be more like monthly. If you find that you have lots of variables, do it weekly. This doesn’t mean that you change your selling prices weekly, but it does mean that you will be aware of what your final mark up is, and you will have a real-time heads-up when it gets uncomfortably small.
The effort of establishing your true cost price – for each and every product you make and sell – can be complicated and time consuming, but it so worth it. Once it’s established, you will need to create a system to revise your cost prices in a method that is as streamlined and efficient as you can achieve. Experiment, and find out what works best for you and your business. Without this, the process of reviewing costs will be far too labour-intensive to be sustainable. With a good costings system in place, you will find that knowledge it power. Knowing what your costs are in real time will give you the ability to stay on top of the game.
Numbers never lie. Our job as business owners is to understand what the numbers are telling us, and to rely on the numbers when we make decisions. In next month’s article, we will look at the process of establishing what the right mark-up is for you.
Until then, keep the numbers working for you.
Evertrue Business Solutions