Rodrigo Rosas Ventura, special contributor

Everybody has, at one time or another, sold a product or a service.  That product or service was either sold at a loss or at a profit. But here’s the rub: many of us don’t know if we’ve actually made money on that sale or lost money.

Many companies focus on staying afloat, sacrificing financial viability in favor of surviving day to day. This situation may not seem so bad in the short term, but when it eventually manifests itself it maybe too late for the business’s survival.

Let’s look at some financial concepts first before looking at how to turn this situation around.

What is a ‘cost’?

Cost is the outflow of cash used in the direct manufacture of a product or in carrying out a service. For example, if we manufacture jeans, our costs are the materials used to make the jeans, such as the cotton, the zipper, the labor.

In other words, the sum of the parts and effort to actually produce something.

What is an ‘expense’?

This is the outflow of cash to keep the business going. Though very important, expenses are not reflected directly in the product we produce.

Expenses are critical to keeping the doors open, such as rent, utilities, transportation. They can be virtual, such as the depreciation of your machinery or other capital goods. There are other very important expenses as well: management and salespeople.

What would we do without salespeople selling our products?

So the big question is: what’s the difference between a cost and an expense?

Good question.

The fundamental difference is: cost can be recovered, an expense is gone forever.

How to determine the cost of your product or service

Based on this important distinction, I propose a methodology, a recipe if you will, to determine the true cost of your product or service.

1. List all the ingredients used to make your product.

These are also called raw materials, and there are two types:

• Direct raw materials. These are the materials that are an obvious part of a product. For example, to make a pair of jeans you need so many yards of material, a button, a zipper.
• Indirect raw materials. These are also used to make your product, but they’re hard to quantify, such as the glue used to make shoes.

2. Quantify the raw material

• Direct: we would use a standard measurement for each piece that we manufacture as these are easy to quanity.
• Indirect: we quantify the cost used to make a certain number of units, and divide the cost from there. For example, if we use a 20 lbs. drum of glue to make 100 pairs of shoes, and that drum costs $20, then we divide the cost of the drum by the number of pairs of shoes.

3. Quantify the cost of labor

This is another basic concept: quantifying how much labor is used to make each unit. The standard way of doing this is with the famous ‘time and movement’ study. Essentially, using a timer, measure how long it takes the worker to make something, multiply that by the units made in a month, and divide his or her monthly salary by the monthly unit count.

So taking the shoe manufacturing example again, if a worker takes 10 minutes to work on each shoe, that’s 6 shoes per hour or 40 per day. If the shoe maker earns $4,000 a month, and there are roughly 20 working days in a month, he or she would be able to make 800 shoes. In other words, the labor cost for making each shoe would be $5.00 per shoe.

4. Distribute expenses between the pieces manufactured

Add up all the expenses to keep your business open (utilities, rent, maintenance, etc.), and divide them between the total number of products manufactured. So in our shoe example again, if we have expenses of $10,000, and we make 200 shoes, then expenses become a cost of $50 per shoe.

5. Add all the costs and expenses

Adding the costs of raw material, labor, and expenses per unit, you get the true cost of each item you produce. If you follow this recipe for each product or service produce, voilá, you now get the true cost of your product, and you can now determine whether you’re losing money or making money.

What can we do with this true unitary cost? We’ll talk about that in a later post.

This post appeared originally at: http://axeleratum.com/blogs/27-in-the-money/1202-icomo-costear-un-producto-o-servicio-en-cinco-pasos

Rodrigo Rosas Ventura is a consultant and blogger at Axeleratum. He writes about finance, trying to demystify it and de-jargonize it so it’s not such a confusing topic.

Additional reading:

Pay Sales Staff For Gross Profit, Not Sales – Ken Kaufman, CFOWise

Inventory basics for small businesses – Becky McCray, Small Biz Survival

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