What is the true cost structure of your company and why is it important for you to understand?

 

By: Alvin A. Rhoney CPA, CMC

 

Do you price your goods or services for a certain net profit percentage but see a substantially lower percentage on your monthly financial statements?

 

If so, then maybe you don’t understand your true cost structure.

 

There are far too many elements of cost to describe here but let’s use an example to see how critically important the “little things” are in your overall cost and pricing structure. Note well that this example has nothing to do with how well you do the technical side of your business. Whether you’re a baker, a repairman, a retailer, a job shop, a distributor, an engineer, or anything else – this example assumes that you are excellent in “what” you do but not necessarily in “managing” what you do - or the “business of your business”.

 

A SIMPLIFIED EXAMPLE:

 

How much does it cost your company for one hour of production time?

 

·        Is it the hourly wage?

·        Is it the hourly wage plus labor burden?

·        Is it the hourly wage plus a markup for overhead and profit?

 

If you pay a production worker $10.00 per hour plus your company’s share of FICA, Medicare, FUTA, SUTA, etc. of - lets say $2.50 then your out of pocket cost per hour is $12.50. ($10.00 + $2.50) But is that your cost per hour worked?

 

Lets say this worker is paid on a 2,080 hour per year basis (5 days/wk x 8 hrs/day x 52 weeks per year). But let’s also say that you give him two weeks off with pay each year for vacation, sick time, personal time and so forth. That means that he has only 2,000 available hours to produce for you even though you’re paying him for 80 hours more. So your cost per available hour to work is $13.00 per hour – not the $10.00 base wage and not even the $12.50 out of pocket cost per hour. ($12.50/hr x 2,080 hrs = $26,000 / 2,000 hrs = $13.00)

 

 

 

 

 

Now let’s say that this worker is extraordinary and that for every available hour to work, he produces at 100% efficiency, each and every hour of the year. But let’s further assume that you give him two 10-minute breaks in the morning and two 10-minute breaks in the afternoon. What does that do to your cost per hour worked?

 

Forty minutes a day times 5-days a week equals 3 1/3 hours per week that you pay for, but get no production from. That works out to about 167 hours per year of lost productivity.

 

So now the available hours to work are 1,833 (2,000 – 167)

 

Divide the available hours to work into your total company cost to arrive at a “real” cost per production hour of $14.19.

 

To highlight how critical this is to your cost and pricing decisions, let’s take an example project that will take 40 hours to complete. To keep it simple, it’s a labor only job and you want to earn 10% profit on your labor. If you did not consider the 10 minute breaks, here’s what would happen:

 

$13.00 /hr plus 10% profit of $1.30 equals billing rate per hour of $14.30

 

40 hours times $14.30 = $572.00 bid price for the job.

Expected 10% profit is $52.00 (40 hrs x $1.30)

 

Your actual cost to produce 40 hours of work is 40 hours x $14.19 or $567.60

 

Bid Price              $572.00  based on the flawed cost calculation

Actual Cost          $567.60  based on the real cost per hour worked

Actual Profit           $4.40

 

There are many other elements of the cost structure of a business. Some are unique to your business and some are general in nature. But once you understand the “business of your business”, then you’ll see that they are as simple as these 10-minute breaks and have nothing to do with how well you “do what you do”.

 

If you’d like to understand the business of your business better and see how you can increase your profitability – contact us today for a no-obligation consultation.