A business can use costs data for making a variety of different business decisions. These management decisions cover a wide range of issues across all business functions in the organization. Business managers will require much detailed costs information before effective strategies can be adopted.
Do not confuse costs with price. Check The Differences Between Costs, Price and Value when in doubt.
Costs. Costs refers to all spending incurred by the business in producing the product. The average unit cost of producing a hamburger is USD$2.
Price. While the amount paid by the customer to buy that product is called price. The customer needs to pay USD$3 in order to purchase that hamburger from the seller.
Using costs data to make cost-based decisions
Here is the list of major uses of costs data in any business organization:
- Setting prices of products. One reason for the need to know costs data is to help Marketing managers make pricing decisions. Without having accurate and up-to-date knowledge about the business costs, the marketing department may not be able to set appropriate product prices. This may lead to loss of sales revenue as customers may not be attracted by mispriced products, or even causing the business to make a serious loss instead of profit. Other departments in the firm such as Finance also need costs data for conducting costing: Full-Costing or Contribution-Costing.
- Calculating the profit. The basic formula for calculating profit is the most important business equation. Business costs account for as much as half of that equation with Sales Revenue accounting for another half. Therefore, it is impossible for any business manager in the world to calculate profit or loss without first correctly calculating costs. If businesses do not keep valid records of all their costs, then they surely will not be able to take effective decisions to improve their profitability through pricing and cost reductions.
- Constructing The Break-Even Analysis. Each and every business organization can only survive in the long-term, if it makes profit – its Sales Revenue exceeds Total Costs (TC). The Break-Even Analysis is used to calculate and analyze the relationship between Sales Revenue, Costs and Output produced. It determines the level of output that must be produced and sold in order for the firm to stop making a loss and start earning a profit. And, in order to construct The Break-Even Analysis, the classification of costs must be conducted first.
- Setting budgets for the business. Current and future business budgets will most likely be based on past costs data. Historical financial information from past time periods will be used to do so. Also, actual cost levels can then be compared with original targets and budgets as well as with past time periods.
- Measuring efficiency. By having detailed knowledge about costs, the firm is able to measure profitability both of the whole business as well as each division, department and product. Annual comparisons can also be made in order to assess improvements over time. If the business’s costs keep increasing, appropriate goals to work for can be set up. This will also give employees quantitative targets to achieve. Without those numbers, the concerned employees would not know clearly what has to be done in regards to costs and profits.
- Choosing the suitable location for business operations. Calculating the costs of operating a business in different locations is a pretty standard job for Operations managers. Costs data can assist them when deciding between relocation of current business operations or any future expansion. Comparing the costs of alternative locations can increase the chances of the most suitable and profitable option being decided on.
- Choosing the appropriate method of production. Operations managers usually decide which approach towards production they choose – either being labour intensive or capital intensive. If the choose the first one, then labor costs in the firm will be much higher. This is preferable in those countries where wage rates are very low. If the choose the second one, the costs related to purchasing or leasing the machinery along with regular maintenance will dominate. This is preferable in those countries where wage rates are very high. Comparing costs data can also help Operations managers make decisions about the use of scarce resources.
- Choosing whether to buy or make products. All manufacturing businesses have to consider cost-reducing decisions on a daily basis. One of those decisions is ‘A Make or Buy Decision’. There are actually three possibilities. Should the business manufacture the product by itself? Should the business purchase some components to assemble the product within its own factory? Or, should the business buy the ready product from outside suppliers based on the cost-benefit analysis, and then just resell it to its own customers? Costs data will help solve this dilemma as the decision must be based on a careful consideration of the costs and other qualitative factors.
- Continuing or stopping production of a loss-making product. Managers may also need to decide whether production of a product should be stopped. The business may no longer wish to produce a product that does not only not generate any profit but also its contribution towards paying fixed costs is minimal. This kind of decision regarding product discontinuation would not be possible unless accurate costing was made first based on costs data. After analyzing costs data, the company may need to decide otherwise and increase production of a product instead of stopping it. Or, switch to making a completely new product.
Summarizing, managers need to know as accurately as possible the cost of each product or service produced by the firm. Otherwise, such important business decisions would not be possible without correct costs data.
