How to calculate costs for beginners

When starting a business, many small business owners make the critical mistake of failing to charge competitive prices. This is often due to a failure to differentiate between revenue and profit, but more importantly, because they ignore “fixed” costs. This article will cover basic costing for beginners. You will get the answers to what is costing? What are fixed costs? What are variable costs and how to calculate costs for beginners?

Ready? Great. Let's start by understanding costs.

What are costs?

Costs: are all the money you spend to produce or sell your product or service. For example- if you are producing shirts, your costs will include the money you use to buy material i.e. cloth, buttons etc., labour and advertising expenses to promote the shirts.

What is costing?

Costing (or Break even analysis) refers to the way in which you calculate the costs of producing your product or delivering your service so as to determine the profitability and viability of your business.

Why is costing important?

Costing is important because it helps you to:

• Make pricing decisions- after calculating your total cost per item, you can then use that information to set a competitive price that will be profitable for your business.
• Gain a competitive advantage by allowing you to control and reduce costs- when you know how much it costs you to make a product, you can then work on gaining the competitive edge by minimizing costs by reducing wastage, finding cheaper suppliers or taking advantage of bulk purchases and discounts.
• Make better strategic decisions- costing tells you where the money is to be made. Some products might be nice-to-Have in your product mix but bringing little in terms of actual profits. Costing then gives you the opportunity to identify and focus on the profitable areas of your business.
• Plan for the future- once you’ve ascertained how much it costs to make a product or deliver a service, you can then plan ahead and make decisions to purchase equipment to further reduce costs or to partner with a manufacturer to supply a product at a lower cost. This also affects decisions such as your location, staff and plant set up.

Types of costs

There are two types of costs: variable costs and fixed costs, and these should be treated differently because they affect the business differently. Let's learn a bit more about these costs.

What are variable costs?

Variable Costs– these are costs that fluctuate with production volume, sales volume or the amount of services provided. Examples are the ingredients used when making a cake such as sugar, flour and milk.

What are fixed costs?

Fixed Costs– these are costs which do not fluctuate with production volume, sales volume or the amount of services provided. A common example of a fixed cost is rent because it stays the same regardless of whether you produce one unit or a thousand. Although the amount of rent might change, the change is not as a result of production volume.

Most costs are easy to classify as either fixed or variable but there are some tricky cases. Think of the salaries of marketing and sales staff who have a base salary which is fixed, as well as commission which rely on how much sales they can generate. In such a case their salary contains both a fixed element as well as a variable element.

How to calculate your costs

Step 1 calculate the variable cost per item

• List all your inputs that have costs which fluctuate with production volume or services provided
• Get the cost of purchase(Price) of each unit
• Estimate the quantity of each input needed to make one good or service.
• Estimate the cost of each input needed to make one good or service by multiplying the unit cost of each input and the quantity of that input needed to produce one unit.
• Calculate the variable cost per item by adding up all the costs of all these inputs.

Step 2: Estimate the fixed cost per unit

•  Calculate how much money you are going to spend on each item of fixed costs per month. Estimate these costs and in the case of irregular or periodic costs, simply calculate the annual cost and divide by the number of months.
• Also incorporate those small variable costs that we mentioned earlier such as salt and transport cost for retailers. They will be treated as fixed costs.
• Estimate the total variable cost of the business for the month. This means multiplying your variable cost per unit by the total number of units that you’re expecting to sell. In other words, calculate your total expected sales for the year and then divide by the 12 months.
• Calculate total fixed cost to variable cost ratio. The idea is to take the total cost and apportion it to every unit that we intend to sell. To further illustrate this, say, you have to pay $50 as rent every month. If you sell one unit valued at $25 that unit carries the burden of paying the rent. If however, you sell 1000 units at $10 each, despite the price being less, each of these units gets to contribute towards the rent and thus endures less of a burden.
• Calculate the total fixed cost per item. You achieve this by multiplying your variable cost with your fixed ratio.

Step 3: add up your estimated variable cost per item and your fixed cost per item to get your total cost per itèm.

This step varies slightly depending on whether you are a manufacturer or a service provider and a retailer.

A.) Manufacturer/Service Provider

If you are a manufacturer use the method shown below:

B. Retailer

In the case of a retailer, your variable costs are the costs of buying goods to resell. In other words, if you buy a dress from a manufacturer at $20 and intend to resell it, that $20 is the variable cost per item.

Now that you have your costs... what does that all mean?

What does this mean?

The amount you get as your total cost per item is also known as your break even price. You should not sell your product for less than this amount. Any price that you set above this amount is profitable. Just remember to do your research with regard to customer preferences and competitor pricing strategies.

How to handle small insignificant costs

Note- there are some costs which maybe variable but are too difficult to calculate mainly because they are so small. For example, if you are doing the costing for a loaf of bread, or a plate at a restaurant, the ingredients will include say a pinch of salt. Calculating how much a pinch of salt costs would be too cumbersome and waste a lot of time. We therefore bundle such costs into a reasonable amount and then treat them as as fixed costs. It's more convenient to calculate how much salt you bought and used in a month, than how many pinches go into the plates.

We hope that you now have a better understanding of costs, what they are and how to calculate them.

We hope you found this article very helpful and as always, I wish you much success, happiness, health and wealth.