Measuring the Cost of Doing Business
By Willard W. Lindquist

There are many companies that make or offer good and services and provide them to customers at a price that’s largely driven by what sells.  What sells, or what’s competitive means pricing your goods and services to match what people are willing to pay for them. Let’s say that you have a marketable commodity and you’ve it priced to sell, people are buying it and you are happy.  The real question you ought to be concerning yourself with is are you making any money on it?  Just saying to anyone; even yourself “we think so” or “we designed it to make money after all” just isn’t enough.  What’s really important is to find out if your efforts to bring the service or commodity to market are making money, otherwise you’re wasting your time.  That’s an incredible dilemma for most businesses.  Without the concrete, on paper, black ink answer you’re just kidding yourself.

The Profit Motive Is Central
Making profit implies that you sell for more than you pay. Isn’t that what your intentions are? And, yes, profit is not a four letter word.  If you don’t make profits you’d be out of business and none of your customers want that.  Let’s take an example. Say it costs you $45 per hour in salary (or use the price per unit of your widget if that fits your situation better) to do what you want to sell.  That’s not the end of the cost.  You also must cover your rent, telephone, administrative salaries, benefits, and other costs of doing business that are reasonable and customary. Your logical question is how much do we add to the $45 per hour to cover the costs for each of those items?

The US Government has been requiring most of its contractors to keep close accounting of all of those type costs for decades. Some other companies have embraced cost accounting whether or not they do work for the Federal Government. Others simply don’t know, get lucky and make money in spite of it. Several go bankrupt (if they’re lucky).

So, What Does It Cost?
What it really costs only begins with the $45 per hour salary cost or the cost of your widget. Those are probably called the direct costs of providing the service or the product. You are probably wondering about the rest of the costs including that administrative salary and the costs of running the company. How your salary relates to delivery of your services or products is called a “beneficial and causal” relationship. If the delivered item either benefits from your salary or if the delivered item caused your company to incur your salary, that’s beneficial or causal.

The customary way of adding some of your administrative salary to the $45 is by allocating it to each unit of delivered service or product based on a beneficial and causal relationship. This may sound boring and complicated but it’s important to determine if you are making money so you’d want to read on.  How you spread or allocate that depends on what you do to help deliver that hour of work or that widget.

Simple Example
If you clean the office that your employees work in then you support their effort. You probably support each employee equally, based on the amount of time they spend making dirt in the office.  Maybe you even support the more advanced employees with more because their offices are bigger or they receive more benefits.  If you added up their salary and spread your cost over their salaries, that would be fair.

Let’s say you have one employee (Mr. $45 per hour), and he works 1000 hours each year. The base for calculating overhead is $45,000. If your administrative salaries are $15,000 per year, the overhead rate for running the business is 33% ($45,000/$15,000 = 33%). If you add 33% to the $45 per hour you get $60 per hour.  Now, if that’s the only cost you have, other than his salary, it cost you $60 to provide Mr. $45 per hour to your customers.  If you don’t sell Mr. $45’s time for more than that, you lose money on every one you sell. No, you cannot make it up in volume.

There are lots of other allocation bases you could choose and lots of ways to do the allocation. Some of them are based on:

Square feet of factory space
Machine hours
Direct labor hours
Miles driven
Tons of cargo hauled
Total cost of operation
Many more to choose from

The key is that you need to know what it costs you to do business and it’s not that complicated.

What About The Whole Company?
Now, lets look at the whole company and assume that you have the following expenses.

$45 per hour to deliver an hour of that person’s time (remember, we said above that we’ll deliver 1000 of those hours during the year)
$15,000 each year for your administrative salary
$5,000 for rent
$10,000 for supplies and insurance
And $15,000 for all other operating costs
To make it easy let’s presume you only want to have one overhead pool all of the costs we discussed above are allocable using that salary as the base.

So, Where Are We?

Total Direct Labor = $45,00 Total Hours = 1,000 Total Overhead = $45,000 Overhead Rate = 100% Salary Rate = $45 Overhead Rate at 100% = $45 Total Cost Per Hour = $90 Selling Price for Labor Per Hour = $95 Estimated Profit Per Hour = $5

What’s The Income Statement Look Like?

Sales $95,000 Less Expenses   Labor $45,000 Cleaning 15,000 Rent 5,000 Supplies & Insurance 10,000 Other Costs  15,000     Net Income $5,000

If I Sell More Hours, Will I Earn More Profit?
Now, what do you do if you find you can sell another 1000 for $85 each?  You could say, “No, I’d lose $5 on each one.” But would you – some things to consider:

For sure, you have to buy some more labor at $45 per hour.
You can probably clean up after two laborers, so the cleaning probably won’t rise much.
Rent won’t go up, because you’re only using your facility half-time now anyway.
Supplies will likely double maybe another $10,000
Other costs might go up $5,000
 

So, Now What Does The Income Statement
Look Like?

Sales $180,000 Less Expenses   Direct Labor $90,000 Cleaning 15,000 Rent 5,000 Supplies & Insurance 20,000 All Other Costs 20,000 Total Costs $150,000     Net Income $30,000

Hey, not bad, and your profit percentage went up from just over 5% to almost 17%. Maybe more importantly, your cost per unit is now $75, not $90.  Now you can see how it’s critical to know, not just what it costs, but what the relationships are.  Now you can predict the affects of future events. Crystal balls are neat too.

Here’s another argument for knowing. Suppose, you have two projects and you make 5% on one and 25% on the other. Now, if you could expand only one, which would you choose? You can only ask the question if you know what each costs.  Not just the direct costs but all the costs.  After that, the answer is simple.

About the Author
Will Lindquist, President of The Management Link Incorporated, is a sought-after expert in the field of business management. He has a broad background and experience in business strategy, finance, and operations with both large and small corporations such as L-3 Communications, Orbimage, and Fleishman-Hillard. Will approaches every problem with an appreciation for the bottom line and how to grow his clients’ businesses. He brings both strategic and tactical know-how, focusing on financial considerations, business development, and operational excellence. His solutions are practical as well as innovative. Contact Will at Will@TheManagementLink.com. You can find out more about The Management Link at www.TheManagementLink.com