How to know when revenues lead to profits
How can you gain a good understanding of the contribution that each product or service makes to your overall profitability? One way is through a costing model called Activity Based Costing.
Activity Based Costing is used to identify, describe, assign costs to and report on your business operations. ABC helps you identify opportunities to improve the effectiveness and efficiency of your business processes by determining the true cost of your products or service.
The basic premise of ABC is that cost objects (products, services) consume activities. These activities in turn consume resources and these resources drive costs. ABC thus focuses on work rather than workers. ABC determines which activities add value to your business; which activities will best accomplish a mission, deliver a service or meet customer demand.
ABC allows you to measure the costs of each activity and compare those costs against the importance of that activity in your business. It identifies where the real cost drivers in your business are, and it shows where you are using resources most effectively and, more importantly, least effectively.
How does ABC work?
In order to apply ABC to your business you would first examine all the steps involved in producing your products or services. These costs include tangible and intangible costs.
The next step is to gather information on the activities that are connected to the steps involved in producing your products or services, but which you wouldn’t readily associate with those steps. For example, when you receive supplies somebody has placed an order for these supplies. When they order supplies, how long does it take them? And do your sales reps spend a lot of time on the phone talking to your customers about products?
You are likely to take these activities for granted, while in fact they can cost you a considerable amount of money.
Once you have sufficient information on these cost drivers, you need to analyze them to see where
you are spending the most money and whether this money is being spent with reason. You can now rate the costs of activities in your business against their importance and determine if there are steps that you can modernize or get rid of completely.
ABC could be particularly useful to you if:
You have high overheads
You produce diverse products or services
The cost of errors is high and/or
Competition is tough.
Terence Shepherd is a partner in the accounting firm of Shepherd & Goldstein, with offices in West Yarmouth, Worcester, Framingham and Hopedale. He is a member of the American Institute of Certified Public Accountants and the Massachusetts Society of Certified Public Accountants and has authored numerous articles focusing on accounting, finance and business issues. He can be reached at terences@sgllp.com. This material is licensed by Ran One Inc.
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