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Why do costing?

Why do costing?

Why Do Costing?

The answer is very simple. It is about budgeting.

To explain what is costing and budgeting, we shall start with a very example.

Let us say you have learnt how to make wooden chair, and you want to set up a wooden chair making business.

After doing some market survey, you believe that you could sell the chair at $200 per unit.

But, what about the cost of producing one chair?

Only when you know the cost, you will be able to calculate the profit.

That is why we must learn how to do costing. And costing is the essential part of budgeting.


Plan First

A business must have a plan. A plan is about what the firm wants to achieve in say, five years’ time. The target can be revenue, profit, market share, or any key performance indicators that the management wants to achieve.

Planning is about managing business expectations. You must be confident of what is achievable, not dreaming. Make it clear that projections of all types, including understanding the market, customers, competitors, technology, and the economic changes.

Only after you understand what is going to happen externally your plan will be realistic.

To plan for new financial year budget, the firm may not want to continue what it does in the current year. Existing product may end, and new product will be introduced. Also, external factors like customer preferences, technologies, product features, etc may change too.  Therefore, it is important to stress that the management should define fact-based and non-historical criteria. Historical targets (i.e. this year’s budget) should not be a factor to consider.

So, a lot of practical questions like “what, why, and how” should be asked at this stage. For example, some key questions about demand can be asked. Will there be demand? Why are customers buying our products in the first place? Why is demand projected to increase or decrease? Given customers’ demands, why will our offers win with them instead of our competitors’ offers? Plus many more.

Thereafter, the firm should set objective criteria to derive sales targets, define market size, target market share in its sales and marketing budget.

When you have all the above answers, you are ready to move to next stage of planning. Say you plan to produce and sell 10,000 chairs in the first year. The next thing is doing costing.


Working Back

The next step is working back to determine what costs, capacity, and capability your firm need to manage. It is about resource acquisition and allocation. All these considerations lead to costing.

You can start understanding costing be dividing the costs into fixed costs and variable costs.

Fixed costs remain unchanged for a certain period, and these overhead costs may be along term burden if the company commits to incur such costs. For example, a three year warehouse rental contract paying $50,000 a month is a long term burden.

Fixed costs also define the capacity and capability the firm can achieve. A machine that can produce 10,000 chairs per year sets the maximum limit of production per year. Of course, the firm could acquire such machine and decides to produce only 2,000 chairs per year, but this implies waste of money and resources.

Variable costs will change in line with the business activities. If more chairs are produced, more raw materials and labour resources are needed, and such costs will rise accordingly.

Many firms today prefer to operate at low fixed costs, so that it will not be overburdened by such overheads in times of poor business.


Budgeting is not always about cost cutting

It is not always true that budgeting is about cost cutting. There is a limit that a firm could cut costs. Of course, it is important to emphasise that in cost management and control, the benefit received must be greater than a dollar spent. In economics, it says marginal revenue must be greater than marginal cost. This is the guiding principle of cost management and control.

In some situations, a firm must spend more than before. For example, before the launch of a new product, research and development costs must be spent, followed by investment in plant and equipment to produce the products. During the launch of new product and service, the firm incurs costs in marketing, distribution channels so as to create awareness and generate revenue.


Resource allocation is about opportunity cost

Resources are scarce, and therefore we should find a good way to help us to allocate resources in an efficient and effective manner.


Opportunity cost concept could guide us in making the right budgeting and costing decision.

If a dollar spent in promoting product A could bring in revenue of $5, but the same dollar spent in promoting product B could bring in revenue of $10, then it is obvious that we should allocate our budget to promote product B.

Another example. Currently, the warehouse is rented at $10 per square foot. If we could relocate to another location with the same warehouse space but only $9 per square foot rental, it will help the firm to save money.

Therefore, a firm will be able to improve its budgetary planning and control by applying such opportunity cost concept.


Top management commitment

Many a time, many people and organisation treat budgeting as merely a paperwork and annual spreadsheet fill-in-the-blank exercise. One of the main reasons of causing this misunderstanding is the lack of top management commitment.

There is always occasions whereby the actual results are not in accordance with the budget – Actual costs incurred are higher than the budgeted costs, actual revenues are lower than the budget revenue. Staff need guidance on how these discrepancies could be resolved.

To achieve the greatest benefits in budget planning and control, top management must lead – from the planning stage to the implementation and control stage. Regular budget review meetings should be held between the top management and the staff.

Top management’s active involvement in budgetary planning and control could motivate the staff and organisation to perform better in the coming years.


Costing and Budgeting Management Skills

In today’s fast changing business development, it is very important for the management staff in any organisation (private sectors, not for profit organisations, social services providers, etc) to acquire the following costing and budgeting management skills:

  • Align the organisation’s missions and budgets
  • Understand different types of budgets
  • Identify problems in implementing budgetary planning and control
  • Manage budget variances
  • Factors to be considered when preparing budgets

To know how to improve cash flow management, we have created an intensive 1-day workshop on “Cost Accounting & Budgeting for Business” to enable participants to understand the different costing and budgeting related terms and learn how to implement good budgeting practices for an organisation.

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