NFIB

Accounting for Costs
04/ 15/ 2002

Whether you've been in business one month or 15 years, we wouldn't assume that you have the particulars of a good cost accounting system down unless you told us so. We don't doubt your intelligence; we just know how tricky cost accounting can be and how many other small business owners are losing their hair over it.

So we called in Workshop contributor Hugh Rushing to help us out with some specifics. He's got some pointers and a good piece of advice: this is one of those areas where it pays to call in the professionals from time to time.

You've heard the old story about the accounting manager who complained that a product's selling price was less than its variable cost. "Don't worry," laughs the sales manager, "we'll make it up on volume."

Many small businesses' cost accounting isn't that bad, but the issue of proper accounting for fixed costs stymies many managers. Fixed costs sound easy -- you just divide those costs on expected volume of sales and calculate the additional percentage needed to cover them. Trouble is, fixed costs are not that simple.

First of all, using a predicted volume to spread the fixed costs over is always subject to error. Most product demand is not stable enough to produce a sales forecast even within plus or minus ten percent for many businesses. For industrial suppliers, the product demand derived from consumer product demand makes forecasts even more shaky. Make sure your sales forecast used to allocated fixed costs is absolutely obtainable, or you run the real risk of red ink.

Beware of hidden fixed costs. Without a solid three to five year history of fixed cost expenses available for your predictions, you're likely to overlook significant costs. Insurance or workers comp costs can soar unexpectedly. In case of a lawsuit, legal expenses could balloon. The temptation is to simply allow for a large contingency amount, but the risk of becoming uncompetitive with your firm's pricing is very real. If you have good records, take a look over the past several years. What sort of unexpected expenses occurred? Allow for a similar percentage in calculating total fixed costs.

Remember there are volume costs for significant ramp ups (or ramp downs) of production rates. These stair-step costs can play havoc with predictions of profit. Every machine, every process and every group of workers has a limit beyond which it cannot produce profitably. When that point is reached a new machine, new process or new shift has to be employed, usually at a large fixed expense. When pursuing new business relentlessly, small business owners often overlook these realities. They find themselves with hopelessly overwhelmed machinery, workers sick of overtime or shift work and poor quality of production. Before calculating costs for new business, make sure the existing setup can handle it, or that you've set aside the investment necessary to profitable produce the additional business.

Realize that fixed costs don't turn on and off instantly. Just as firms can carry an inventory of variable cost items that help produce the product, there's a similar inventory of fixed costs. Demand rates for water and electricity are frequently sources of confusion, since they are sometimes set with a floor which may not match up with a firm's demand during the year. Insurance costs don't end when an employee layoff occurs, but a month(or in some cases a quarter) later. If you expect demand to vary widely during your firm's year, make sure you cover those "trickling" fixed costs that lag sales and inventory cycles.

Remember, sooner or later, the old "back of the envelope" cost system which may have served you well in years past won't do any more. There comes a time in every growing firm's life when the owner or managers can't account for or remember all expenses. That's the time to hire professional help to either set up or manage a cost system appropriate for the size of the firm.

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