Entrepreneur magazine, April 1998
Do you know the real costs of the products and services you provide? Charles L. Norman, a CPA and senior manager specializing in entrepreneurial services with Ernst & Young LLP, says many business owners don't, especially when they have a significant amount of indirect costs. One solution is activity-based costing, the process of associating costs with the activity which produced the cost.
One way to do this is with sophisticated software. But while precise, this option can cost you nearly $10,000 for the program, installation and training--no small change for most entrepreneurs. A more affordable alternative, Norman says, is to keep a very detailed chart of accounts and carefully allocate overhead costs back to the appropriate product or service. It's a technique that, while not 100 percent accurate, will provide a clearer picture of the cost of your products.
The key is to attach specific costs to the product involved. For example, if you spend a disproportionate amount of your advertising budget on one particular product, you need to charge the real cost of the promotion to that one product to get a realistic profit picture. The same procedure should be applied to depreciation, equipment expenses, interest and debt costs, building occupancy costs, freight and delivery expenses, and even executive compensation.
"Most people do a good job allocating the direct labor to the product," Norman observes. "What they don't do well is allocate [the cost of] management labor. For example, the president or chief operating officer may be spending most of his or her time on a certain product line, trying to get it off the ground, and if you allocated all his or her wages to that line, it might not be as profitable as it looked."
Norman says the process of determining where you're really making your money is often an eye-opening experience. Just remember, the information will allow you to make better management and pricing decisions, and ultimately create a more profitable company.
Ernst & Young LLP, 1 SeaGate, Toledo, OH 43604, (419) 321-5470
Jacquelyn Lynn is a business writer in Winter Park, Florida.