Accurate costing can help start-ups and small and medium enterprises (SMEs) to be competitive. In order for your business to be as competitive as possible, you need to understand exactly how much your company spends on any given asset. This way, you can be able to come up with reliable means of setting competitive sales prices that will encourage profit and attract consumers.
With that said, it is important for start-ups and SMEs to understand the difference between direct and fixed costs when pricing their products. When you know the true costs of production, you can be able to price both competitively and accurately.
If we look at a business, you will see that it has two types of costs for producing goods and services. These two kinds of costs are called-direct costs or variable costs and fixed costs.
Direct Costs: Direct costs are expenses that a company can easily connect to a specific cost object, such as wholesale- purchased products for resale, the raw material used to manufacture your own products, or the labour associated with the work to produce the product. For example, if your company manufactures furniture, your direct materials would be the wood or timber that goes into making your furniture along with the nails, varnish, and other products used to make furniture.
Direct costs are often referred to as variable costs. Since variable costs have to do directly with providing your product or service, they increase as your business manufactures and sells more products or provides more services, or they decrease if your business takes a downturn and slows down production.
Fixed costs affect the entire company, not just one product. They can include advertising, office supplies, utilities, and rent. For example, the rent you pay for your office is likely to stay the same every month. Sometimes, fixed costs can be variable. For example, your water or electricity bill may fluctuate monthly. Also; tools, cleaning, and office supplies forms part of the company’s operations, yet they cannot be assigned to just one product.
Activity based costing versus traditional costing
In the field of accounting, activity-based costing and traditional costing are two different methods that can be used for allocating indirect costs to products. Both methods estimate the operating expenses costs related to production and then assign these costs to products based on cost-driver rate. The differences are in the accuracy and complexity of the two methods.
Activity based costing has been successfully implemented in large firms, and researchers are now finding that activity-based costing can be the key to creating a competitive edge for SMEs, especially in the global marketplace. It assists companies in more accurately costing their products. Examples of cost drivers include machine hours, size, complexity, type, and any other product attribute that can determine its cost.
Steps in activity-based costing
1. Determine the activities that go into producing each product and the cost drivers for measuring them.
2. Determine the costs associated with each activity.
3. Determine the percentage of time employees spend on these activities for each
product-through interviews, observation, or logs.
4. Calculate activity cost driver rates.
5. Assign costs to products or customers by dividing activity costs by the output of each
Traditional costing systems apply indirect costs to products based on a predetermined overhead rate. Unlike activity-based costing, traditional costing systems treat overhead costs as a single pool of indirect costs. It is optimal when indirect costs are low compared
to direct costs. There are several steps in the traditional costing process, including the following;
1. Identify indirect costs.
2. Estimate indirect costs for the appropriate period (month, quarter, year).
3. Choose a cost driver with a casual link to the cost (labour hours, machine hours).
4. Estimate an amount for the cost -driver for the appropriate period (labour hours per quarter).
5. Compute the predetermined overheard rate.
6. Apply overhead to products using overhead rate.
7. Predetermined overhead rate calculation.
Use the following formula to calculate predetermined overhead rate:
Predetermined Overhead Rate= Estimated Overhead Costs /Estimated Cost-Driver Amount
E30/labour hr = E360 000 indirect costs/E12 000 hours of direct labour.
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“The moment you make a mistake in pricing, you’re eating into your reputation or your profits.” - Katharine Paine.
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