You have to know what it’ll cost you to make a product, sell a product, or provide a service. Costing is the way we calculate just how much each individual product or service costs to produce and sell. A lot of businesses get into trouble because they don’t know their costs, but it’s so important, because once you know your costs, you can set your prices, find ways to reduce those costs, and make improvements to your business.
Types of Costs
In any business, there are two types of costs: direct costs and indirect costs.
Direct costs + Indirect costs = Total Costs
Sometimes it can be hard to identify what is a direct cost versus an indirect cost, but according to Business News Daily and Investopedia, direct costs are directly linked to the production of a specific service or product. These costs might change over time (i.e., the costs are variable), especially as your rate of production changes, but they can also be fixed.
Indirect costs are those costs that might be needed for production, but they aren’t directly linked to the actual production itself; they’re the price of maintaining your business overall. It’s easiest to think of indirect costs as the prerequisites or the “must haves” for the production of your specific service/product/goods. Indirect costs can also be fixed or variable. The examples below will help clarify this further.
Direct Cost Examples
Indirect Cost Examples
It’s important to factor in what’s known as startup costs when you set up a business; these are the expenses that come up during the initial process of creating a new business (compared to the costs once your business is up and running).
To figure out startup costs:
- List any business assets (what you own) with their current market value.
- List the items that you need for ‘business startup,’ including their costs, as well as whether it’s your contribution or if it comes from loans or another specific source.
If you’ve completed your Process/Production map, you should have a good sense of what these costs might be, but make sure you’ve written them down (and factored in unexpected costs too!).
Pricing a Product
Adnan will be selling a product, so if he’s trying to figure out what to charge for his honey, he needs to answer these questions:
- What are similar businesses charging?
- What does it cost to produce that product (the direct costs)?
- What is a good “margin” to charge over and above the cost of production? Is it competitive with the other similar businesses?
Once he’s answered these questions, Adnan should have a concrete number in mind. However, he also needs to factor in the indirect costs:
- At the price he decided on, how many units will he have to sell every month to cover his indirect costs? (break-even analysis)
- Is that a reasonable goal or will he need to raise the price?
- Will he be earning a reasonable and realistic profit?
If you just cover your costs, then your business will only be breaking even and not actually making you any money. Some businesses break even in their first year or two, and then start showing a profit; you have to figure out if you can afford this or not!
Pricing a Service
If your business focus is on providing a service, like June’s personal organizer business, you need to look at some slightly different factors. You should still look at what similar businesses are charging, but you also need to answer these questions:
- What are typical industry labour charges in the same field?
- Would you use a flat fee or an hourly or daily rate?
In order to set a rate for your service, it’s best to think about the annual income that you want to earn and then work backwards:
- How many hours per week will you be working?
- How many of those hours/time will actually be income earning? (subtract any time spent on things like marketing or administration)
Once you’ve figured out your hours and what you want to earn in a year, you then need to divide the potential number of worked hours into your income goal.
Next, you need to factor in your indirect costs:
- How many clients will you need or how many hours of work are you going to need to “sell” each month to cover all your costs? (break-even analysis)
- Is that a reasonable goal or do you need to up the price?
- Will you be earning a realistic and reasonable profit?
Using your research skills will help you as you figure this all out.