Products and Services Costs
ABOUT
One of the critical principles behind accounting statements is that revenues are matched with the related costs of providing the products or services from which the income is derived.
This enables the profit of the business activities to be properly measured, whether that is over a time period, by a product group, by market sector, or by customer.
If you don’t know exactly how much it costs you to deliver your products or services you are putting your business at significant risk. Businesses have failed just as they were starting to grow because they got these numbers wrong.
1. We know the average cost of materials or goods purchased for resale relative to revenue.
Why is this item important?
It is important to know the cost of material input into the product so as to know the gross margin when we sell a product. Where products are made to order, the pricing must factor in the cost of input material.
In an environment of competitive pricing, it is important to know the current average cost of material at any given time so that selling prices can be adjusted and / or informed decisions can be made about replacing Vendors or the input itself.
How can I tell if I meet this item in my business?
The inventory system used in the business tells us the last purchased price and the weighted average price of stock at any given time.
What do I need to do to meet this item?
Accounting packages have basic inventory module built into them. Use this module of your software to “itemize” the major material items your business purchases.
Where material is used in “Projects” or “Jobs”, it would be a good idea to allocate the cost of the material to that “Project” or “Job”. This will give a report on the Gross Margin of the Project or Job to help with profitability analysis and future pricing or, if possible, amendments to existing contracts.
2.We know the total cost of our direct labour per unit, after allowing for wage on costs, leave and non-chargeable time.
Why is this item important?
Labour is our most valuable asset and also the most costly one. It is imperative to know the full cost of workforce to be able to determine our profitability. The cost of labour, when using it as a rate per hour for costing purpose, must include not just the base wage and super, but also the other costs like Payroll Tax, Work Cover, the cost of processing payroll, the cost of time when the employee is on leave or when they are on training or other such “non productive” time. Also the cost of external courses or other training that you may provide.
How can I tell if I meet this item in my business?
The calculation for the labour rate factors in the above mentioned items.
What do I need to do to meet this item?
Add your payroll tax % and work cover % to the to the gross rate that you pay (including Super). Then add 25% on to that for leave allowance for permanent employees who are entitled to it. Then add another 5% for time that the employee would spend on training. Also add on the cost of external courses or other training that you may provide.
3, . We know the labour resources required to achieve production volume targets.
Why is this item important?
Labour is one of the most valuable resources needed to achieve production targets. Having spare people at hand is very costly. Having too few will create bottlenecks in the supply chain thereby delaying delivery time leading to dissatisfied customers.
Another reason to know the labour required is to be able to gain efficiency. As is commonly observed, work expands to fill available time. When more work comes, the human reaction is to ask for more resource. Knowing how long a unit of output should take is imperative in working out the cost of labour in the product.
How can I tell if I meet this item in my business?
The production schedule for the fortnight has the labour associated by name.
There is spare skill available to fill spots in case of personal leave and emergencies.
There are arrangements in place with labour hire agencies in case of emergencies or higher than normal volumes.
Work time studies have been done and job cards are maintained to ensure that output is as per standard time.
What do I need to do to meet this item?
Asses all labour by skill and availability. Make sure that Annual leaves are planned and backfilled.
Make a rolling Fortnightly production schedule and map the labour by name to it.
Shut downs or maintenance should be planned when multiple people want leave at the same time (like Christmas).
Have an arrangement with labour hire agency to provide labour at short notice.
Conduct work time studies and maintain job cards to ensure that output is as per standard time.
4. We only purchase stock when we have a high degree of certainty that it will be used promptly for client work or resale.
Why is this item important?
Purchased stock lying in inventory is locking up working capital. With working capital being so valuable and scarce, the business can’t afford to keep stock for items that re not likely to be used promptly.
How can I tell if I meet this item in my business?
Purchase Orders with Vendors are placed only when stock has reached Re-Order Level or when confirmed Customer orders have been received and lead period is within acceptable range.
Re-Order levels are based on supply lead period.
What do I need to do to meet this item?
Purchase material or other items only when confirmed orders have been received for the product. If items have long lead times, negotiate finished product delivery times with the customer.
For consumables and common items, maintain a Re-Order Level and order only when the business has that low level of stock.
5. We calculate the level of stock or work in progress at the end of each month.
Why is this item important?
Stock or Work in Progress is an asset which will be able to be used to generate revenue in the future. It is also probably cost which has already been paid for. Having a high level of stock or work in progress is therefore a major drain on working capital. Hence there should be control exercised on minimising these. An essential part of control is knowing their value.
If your business is project based or has its ups and downs, then you can see that the profit reported for the period is not accurate due to timing of the sale and associated cost. The Valuation of Work in Progress allows for inventorising the cost of labour and direct overheads spent on products that have not yet been completed thereby matching your current period revenue with current period cost and not future cost.
How can I tell if I meet this item in my business?
I have inventory accounts in my books and I value my Work in Progress
What do I need to do to meet this item?
Inventory accounting can be done at a basic level within most accounting software or at a more sophisticated level using specialised add ons.
Introduce a process for valuing Work in Progress.
6. We ensure that all direct costs related to revenue are recorded in the same time period that the sales are made.
Why is this item important?
Very often, the material is paid for first. Then labour is paid for to convert the material to finished product. Then the finished product is stored until it is sold. If we record everything on cash basis (which is legal to do for small business), one can see from the flow that the business will be recording income from sale for what they made in an earlier period and recording cost for what they will sell in a later period. If your volumes are consistent and costs are stable and evenly paced, then this does not matter so much. However, if your business is project based or has its ups and downs, then you can see that the profit reported for the period is not accurate due to timing of the sale and associated cost. The Valuation of Work in Progress allows for inventorising the cost of labour and direct overheads spent on products that have not yet been completed thereby matching your current period revenue with current period cost and not future cost.
How can I tell if I meet this item in my business?
I have inventory accounts in my books and I value my Work in Progress
What do I need to do to meet this item?
Before you take steps to meet this item, analyse the benefit to the business for introducing this process into your business. This is because this process of inventory is administration heavy and can be costly too.
Inventory accounting can be done at a basic level within most accounting software or at a more sophisticated level using specialised add ons.
Introduce a process for valuing Work in Progress.
7. When negotiating supplier terms we take steps to slow down the rate of cash payments wherever possible
Why is this item important?
Businesses purchase material and services from supplier to be able to sell products and services to customers. Therefore, they incur the cost before they earn the revenue from it. The time lag between the payment to the vendor and the payment from the customer is the working capital that the business finances from its own pocket. The shorter this lag, the lesser is our working capital requirement and consequently cheaper to run the business. It would thus make sense to pay the supplier as late as possible and get paid from the customer as early as possible. Having said that, delaying payments to supplier may cause them angst and consequently impact their supply to you in terms of delivery reliability or price. It is therefore imperative to negotiate the best terms and then pay according to these.
How can I tell if I meet this item in my business?
The business maintains “Accounts Payable” & “Accounts Receivable” in the books and the average days to pay is near about the average days for customers to pay.
What do I need to do to meet this item?
Include payment terms as a discussion point whenever buying from a new Vendor. Also discuss this whenever there is a price change or volume change requested.
Maintain “Accounts Payable” in your books
8. Our prices are reviewed regularly (At least annually and when market conditions change) against all associated factors including costs of materials or goods purchased, labour costs, overheads, market sale volumes, customer expectations and other market forces to ensure we are maintaining acceptable profit margins across all of our products and services for the sustainable viability of our business.
Why is this item important?
That’s a mouthful. Its necessary to review prices regularly to ensure market competitiveness and profitability.
How can I tell if I meet this item in my business?
I have a business process of reviewing prices at least once a year
What do I need to do to meet this item?
Set up a formal process including Finance, Sales & Marketing and Human Resource to review what is and what can be. Introduce this as part of the annual budget.