(COST) KNOWLEDGE SHALL SET YOU FREE
The importance of knowing your cost structure
Knowledge…especially financial knowledge about your company, can help you make better decisions, increase your profits, increase your competitiveness, avoid bankruptcy & (ultimately) pay yourself more dividends.
However, many small business owners & managers make the mistake of not analyzing their cost & expense structure on a monthly basis (at a minimum). They only see the general line item of the Income Statement without asking for more details. For example:
- Cost of sales;
- Payroll expenses
- General & Administrative Expenses;
- Depreciation Expenses
And that’s it. Unfortunately, this is not enough information for you to make the right decision. Have you ever thought:
- What is your cost of sales composed of?
- Is your entire payroll an expense or does it have cost elements as well? The same goes for depreciation (i.e. desk depreciation vs a machinery depreciation);
- What is considered as a general & administrative expense?
In this article, I would like to discuss the cost aspect, leaving expenses for another post, since the decisions that can stem from them are very different.
What Does Your Cost Affect?
Your cost not only affects your gross margin (what you have leftover from sales after deducting costs)…it also affects your competitiveness & the sales price you offer to your clients.
How?
Think about it. Costs are (basically) what you are able to recover through your sales price if the market allows you.
For example…If a laptop costs you US$ 500 to make & you sell it for US$ 1,000, then you have US$ 500 to “spare” for the rest of your company.
But what if you are not considering the salaries of the employees that assemble the laptop? Or the depreciation of all fixed assets involved in the production line? Maybe, if you add all of this to your cost, you really only have US$ 250 to “spare” when instead you should have sold it for a higher price.
“What Should I Do Then?”
Small business owners & managers don’t have the time (nor should they) to analyze every single line that makes up their cost every single day…but they should at least analyze this every single month.
You need to know what makes up your cost & ask yourself the following questions:
- Is this cost structure correct or has something been left out?Alternatively, is there anything else that should be considered? Your cost structure is what determines if you can lower your prices to become more competitive or not…if you need to increase your sales price to become profitable or not. Take a moment every month to understand how is it being calculated.
- Is there an expense that should (in part) be considered as cost? A good example would be the energy invoice of a manufacturing company. 80% of this energy bill is probably attributable to the machinery & the rest to administrative offices. This division should be registered as such in your financial statements.
- How can I lower my costs? Are there any investments that I can make to become more efficient? Continuing with the last example, a manufacturing might want to invest in solar panels for example to lower its energy cost, increase their profitability & lower their prices if the market calls for it while still making more profits.
Giancarlo Jiménez, founder of The Finance Course, is a Finance Professional with more than 11 years of experience in the field of Finance and more than 4 years of experience teaching about Corporate Finance in a Business School.
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