We’ve helped numerous companies improve profitability through strategic approaches and financial best practices. (Don’t miss our insights on Supply Chain Management as well.) And for companies experiencing profit erosion, we’ve generated million-dollar-plus profit turnarounds. In this blog, let’s deep dive into effective costing: what it is, why it’s important and how to leverage costing inputs to improve the visibility of your company’s key drivers of profitability.
What is effective costing?
Well, let’s start in broad terms. Costing describes the inputs or components that help you assign costs to various element of business – and from that cost data, key decisions are made in regards to your company’s profitability.
Many companies believe they have systems in place that will help them leverage costing data when the time comes to make important, granular decisions. But in reality, that information may not be as readily available as they thought. So when we talk about effective costing, we’re referring to configuring your system in a way that allows you to drill down into the key components needed to make important decisions.
In other words, effective costing allows you to trace back to your inputs — and analyze the sources that lead to profitability or loss.
What types of decisions can be made through effective costing?
Pricing is a big one. At the end of the day, effective costing provides answers to a host of pricing questions: Is a price point excessive? Or excessively negative? What’s your profitability at different price or volume levels? What is your pricing flexibility – for example, can you allow a lower price in certain situations? Do your products share common resources which, in turn, could affect pricing?
Those are just some of the many pricing questions that can be evaluated and determined by accessing your costing inputs.
What other critical decisions can you inform, apart from pricing?
In manufacturing and distribution especially, knowing your true product costs and all its value-added components is fundamental in determining and analyzing multi-dimensional metrics including the following:
- Contribution margin analyses (overall or applied to individual product lines)
- Total landed cost
- Total delivered cost to the customer
- Breakout of material, labor, overhead for a product
- Analyzing sources of significant manufacturing variances by work order
- Break-even point/break-even analysis
- Products with the highest margin
- Optimal product mix
How can you leverage effective costing for profitability?
Ultimately, the metrics mentioned above drive insights that help companies understand where to target efforts for process improvements, which in turn leverages their ability to make sound, profitable decisions. Ideally, through effective costing, companies should have the ability to readily generate this data at multiple levels of granularity to make those decisions. Now, for a product-based business, there are several additional questions that must be evaluated as well. Let’s take some common examples of a manufacturing company. Your organization would typically want to evaluate the following questions as they relate to profitability:
- Make or buy? Should parts be made in-house, or outsourced through an outside supplier? And what are the opportunity costs for each scenario?
- New vs existing? Should your company invest in new product development and building new markets? Or is it better to drastically improve existing products?
- Where are your opportunities? What is your most profitable sales channel? B2C Internet sales? B2B retailers? Distributors? Also, what is your profitability by product – and by customer?
These questions are all pieces of a chain. And by effectively analyzing each piece, or each costing input, you can better evaluate the key drivers of big-picture profitability for your organization.
Does effective costing apply only to manufacturing and distribution companies?
Effective costing is critical to every organization. Many service-based and online-based businesses use effective costing to understand the effectiveness of various strategies or business functions.
Take, for example, the advent of online commerce: decision-makers look to cost metrics more than ever to determine whether or not an investment in a particular channel is profitable. Also, sales and marketing functions are deeply immersed with key cost metrics that are critical to their success. Some examples include:
- Customer Acquisition Costs: understanding the costs to acquire a new customer
- Cost Per Action: applying cost metrics to online behavior tracking, such as pay-per-click, click-through rates, etc.
- Measuring “Profit-Lift” Potential: looking at a customer’s existing purchasing behavior to determine profit potential of future purchases
- Customer Support Costs: evaluating the cost of support for a various product or channel
What if your company is experiencing profit erosion?
One of the most powerful and underutilized tools is contribution margin analysis: a product’s or service’s price less the associated variable costs. This shows earnings available to pay for fixed costs and generate varying levels of profitability, depending on volume and pricing levels. Companies should leverage this metric across a broad swath of decision points – by product, by customer, by sales channel, and so on.
From a consulting standpoint, we’ve been able to “redimension” a company’s profitability profile by applying this type of analysis to many of the costing inputs mentioned previously. This approach has uncovered key insights in identifying the source of a problem (for example, profit erosion for a particular product), and more importantly, has revealed some very profitable solutions with respect to pricing. All in all, applying a contribution margin analysis has proven to be an incredibly powerful tool in helping companies gain critical insights on cost and pricing.
If you’d like to learn more about costing, then contact us for more information. We have a team of consultants that can help you be more effective in your approaches.
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Categorized in: Manufacturing Operations Finance