Controlling Costs

Tracking costs is one of the most important things that a business owner does. Your business’s survival depends on keeping costs under control and so you need to know how much you are spending on the things you need to run the business.

Tracking your business’s costs may seem like a challenging (and perhaps boring) task. Fortunately, there are a number of tools you can use to make the task easier. Which tool you use depends on how much of the work you want to do yourself. In general, business use two different ways to track costs. One way is to hire professionals to track and report on costs. The other way is to utilize one of the many software programs designed to track costs.

Professionals. Just like you use lawyers for legal matters, you can use accountants and bookkeepers for financial matters like tracking your costs. Large businesses have accountants and bookkeepers who are employees of the business. Smaller businesses often hire independent accountants and bookkeepers to spend a few hours each week, month, or quarter to track costs and prepare financial statements.

Bookkeepers and accountants are not the same. Bookkeeping is the process of recording an organization’s day-to-day financial transactions. Tracking the checks you write, the money you deposit in your savings account, and the charges on your credit card are bookkeeping activities. One of the jobs of a bookkeeper is to provide accurate information on financial transactions to the business’s accountant.

Accounting is the process of converting the transactions reported by bookkeepers into information that managers use to make decisions. Accountants create reports and make recommendations regarding cash flow, income and profit, and the assets and liabilities of the business. They make recommendations on investments, tax planning, and where to get more funding. In general, accountants have more training than bookkeepers. Certified Public Accountants, CPAs, have passed a standardized test that proves they have the knowledge and skills to provide accounting services to the public.

Software. Small business owners have a number of software options for tracking costs and performing basic bookkeeping functions. Most of these software options are internet-based, are relatively inexpensive, and provide up-to-date information on your business’s financial situation.

The most popular small business accounting software programs in the US in 2019 are Quickbooks, Freshbooks, Zoho, and Xero. These programs offer different options depending on how complex your business is and what kind of reports you would like the software to generate. Of course, the price of the software depends on these features as well.

The most important features of software for accounting and bookkeeping are:

• Easy to set-up and use.

• Provides multilingual technical support.

• Tracks both expenses and income.

• Creates invoices for customers.

• Pays your bills online.

• Integrates with your business’s checking account and credit cards.

• Prepares financial statements for your accountant.

Additional useful features include managing accounts receivable and accounts payable, and the ability to accept online payments.

Every business, small or large, needs to track costs in order to stay healthy. Fortunately, there are many options for performing this vital function. Before you select the best option for you and your new business, you should consult with others in the business, talk with you accountant, and carefully review the features you need for your business.

Now that you have a method to track your costs, you need to think about how to organize your costs.  First, we will review the differences between fixed and variable costs, then we will assign costs to products, services, and profit centers. 

Fixed costs are costs that are independent of volume. Fixed costs tend to be costs that are based on time rather than the quantity produced or sold by your business. Examples of fixed costs are rent and lease costs, salaries, utility bills, insurance, and loan repayments. Some kinds of taxes, like business licenses, are also fixed costs. Since you have to pay fixed costs regardless of how much you sell, you should be careful about adding fixed costs to your small business. Fixed cost is often called overhead.

Variable costs are costs that change as the volume changes. Examples of variable costs are raw materials, piece-rate labor, production supplies, commissions, delivery costs, packaging supplies, and credit card fees. In some accounting statements, the Variable costs of production are called the “Cost of Goods Sold.” 

(To review product and sales volume and fixed and variable costs further please Fixed and Variable Costs)

The main reason for tracking costs is to make good decisions about your business. One of the most important decisions that you make will be deciding which products and services are you going to offer. This decision is easier if you organize your revenue and costs around the product and services that you offer.

For example, suppose that you own a bakery that sells cakes and pies. Cakes and pies require different ingredients and different amounts of labor to make. If you know the costs of the ingredients and the cost of the labor for these products, and you know the price at which you sell them, you can calculate the profit per item. If you know the profit per item, then you can make good decisions about whether or not to offer a product, how much to charge, and where you need to reduce cost.

The following table illustrates this idea:

Even though cakes have a higher price than pies, the expenses for cakes are higher than the expenses for pies, so pies are more profitable. With this information, you can decide whether to continue to sell cakes, whether to charge more for cakes, or whether to try to reduce the cost of making cakes.

Organizing your financial information around products or services will help you make better decisions for your business. In the next section, we look more closely at the different kinds of expenses that you have.

A helpful way to learn more about your expenses and how to manage them is to put your costs in different categories. By categorizing your costs, you get more information about how you are spending your money and so you will be able to make better business decisions. You will also be ready when it is time to pay your taxes. Below we talk about different ways to categorize your business expenses and the way to use the information to make good decisions.

Direct vs Indirect Costs. Direct costs are costs that are assignable to a specific product, service, location, or project. Direct costs can be raw materials or ingredients, equipment, or labor. Indirect costs are costs that you need to pay to run your whole business and cannot be assigned to only one product or service. Examples of indirect costs are the costs of bookkeeping, insurance, the office computer, cell phones, and vehicles. By the way, your salary as an owner is an indirect cost because it is assignable to all you business’s products and services, not just one.

Tracking direct and indirect costs tells you how you are spending your money on different products, locations, and projects. If you know how you are spending your money, you can make sure you are charging the right price to your customers and you know where to focus your attention to reduce cost.

Costs of Good Sold. The cost of goods sold (COGS) is the sum of all the direct costs used to make the products that a company sells. It is only relevant for companies that make and sell products. If you take the total revenue that a company gets from sales and subtract the COGS, you get the gross profit of the company. COGS is an important number on the income statement for your business and you should watch it from month to month to make sure that costs aren’t increasing.

Tracking COGS tells you if productivity is changing (discussed later) or if the cost of materials and labor is changing for the products that your business makes.

Capital Expenditures. Capital expenditures are costs associated with assets that last longer than a year like buildings, property, technology, and equipment. Since these assets last longer than a year, they don’t get “used up” like regular operating expenses. They continue to have value over many years. For example, at the bakery described in the preceding section, the oven used for baking is a capital expenditure that will be used for many years.

Tracking capital expenditures will help you understand whether the business’s assets are being used productively. By knowing the cost of capital expenditures, you can decide whether or not the business should lease or buy equipment, for example. Knowing the cost of capital assets is especially important when you are preparing your company’s tax return.

Necessary and Ordinary Expenses. According to the Internal Revenue Service (IRS), businesses can only deduct expenses that are “ordinary” and “necessary” from the calculation of income taxes. Ordinary expenses are expenses that are “common” and “accepted” by businesses like yours, and necessary expenses are expenses that are “helpful” and “appropriate” to a business like yours. The IRS watches small businesses to make sure that owners do not deduct personal expenses as if they were business expenses. It is illegal to deduct personal expenses as business expenses on your tax return.

If you use part of your home as a business office, then you can deduct part of your home expenses (a portion of your rent, for example) as a business expenses. Similarly, if you use your car for both business and personal activities, then you can deduct part of your car expenses as a business expense. You should consult with your tax preparer to make sure that you are complying with tax law.

Inventory Shrinkage. Shrinkage is the loss of inventory due to theft, errors, fraud, or damage. Shrinkage costs can be a real problem for retail firms and can add up to a lot of money. It is measured by comparing the difference between the recorded inventory and the actual inventory. Inventory is an asset owned by the company and when inventory “shrinks” then the value of the inventory declines.

Tracking inventory shrinkage will reveal whether or not inventory is being stolen or mishandled. With this information, you can decide to invest in security measures.

In this section, we discussed several ways of categorizing business expenses in order to make better business decisions. In the next section, we present several strategies for reducing costs.

As the owner of the business, it is your job to manage costs and keep them as low as possible without sacrificing product quality or failing to deliver to your customers. There are a number of strategies for keeping your costs low:

1. Consolidate purchasing for a better price. Many suppliers will offer better prices for consolidated purchasing. If you are buying supplies for many different sources, then explore the option of using one supplier and asking for lower prices.

2. Encourage competition between your vendors. If there are multiple possible suppliers for your business, encourage them to compete for your business by reviewing purchasing agreements and contracts frequently.

3. Ask for discounts based on loyalty. If you have been served by the same supplier for a long time, you can ask for a discount based on your loyalty. It may be possible to enter into a contract that keeps costs low.

4. Convert fixed costs into variable costs. Whenever possible convert fixed expenses into variable expenses. Variable costs take the pressure off your cash flow needs by converting fixed costs to variable costs.

5. Outsourcing. You might be able to “outsource” some of the work that you do “in-house.” Outsourcing means finding another company to do part of the work instead of doing the work yourself.

The best strategy for controlling costs is to be frugal. Whether you are talking to partners, employees, or lenders, you should let them know that you are careful with money and expenses. By being frugal, you sent an example for others and build trust with your investors and your employees.

Productivity is an important measure of business performance that is closely related to cost. A common definition of productivity is the amount of products or services that the business makes with a given quantity of inputs. Usually, productivity is expressed in terms of output per hour of work. For example, a less productive bakery might produce 25 loaves per hour of work and a more productive bakery would produce 30 loaves per hour of work.

More productive companies produce more goods and deliver more services with the same amount of inputs. By producing more with the same inputs, your business reduces the cost of meeting the needs of your customer and you increase your profitability. A word of caution -- don’t increase productivity by sacrificing quality. Sacrificing quality may lead to short-term profit, but your business will lose in the long-run as customers decide to go elsewhere.

Good businesses measure productivity over time to see if they are getting better, worse, or staying the same. Here is a simple example for a bakery.

In this example, productivity is high in week 2 and low in week 3. A good owner asks why this happened and works to improve productivity over time. Remember, as productivity increases, the cost per unit of production declines, and profit increases.

Download and complete the Controlling Costs Worksheet to test your knowledge.

In this session we discussed the importance of tracking, organizing, categorizing, and managing your business’s costs.  Controlling costs leads to increased profitability and growth for your business. Costs can get out of control fast if you don’t keep an eye on them.  Make sure you have a plan for tracking costs and asking questions when they increase.

THE TOP TEN DO'S

1. Before you select an option to track your costs, consult with others in the business, talk with your accountant, and carefully review the features you need for your business.
2. Be cautious about adding fixed costs to your business, since you will have to pay fixed costs regardless of how much you sell.
3. Remember that the main reason for tracking costs is to make good decisions about your business.
4. Watch your Cost of Goods Sold (COGS) from month to month to make sure that costs aren’t increasing.
5. Organize your financial information around products and services to make better decisions for your business.
6. Understand your cost of capital expenditures to help in deciding whether or not you should lease or buy equipment.
7. Only deduct “ordinary” and “necessary” expenses from the income tax calculation, according to the IRS's guidance.
8. Manage costs and keep them as low as possible without sacrificing product quality or failing to deliver to your customers.
9. Measure productivity over time to see if you are getting better, worse, or staying the same.
10. The best strategy for controlling costs is to be frugal.

THE TOP TEN DON'TS

1. Underestimate the importance of knowing how much you are spending on things you need to run the business.
2. Make pricing decisions about your products and services without understanding the costs to produce them.
3. Forget that your salary as an owner is an indirect cost because it is assignable to all your business’s products and services, not just one.
4. Deduct personal expenses as if they are business expenses on your tax return.
5. Overlook the impact of shrinkage, whether through theft, errors, fraud, or damage. It can add up to a lot of money. 
6. Be afraid to encourage competition between your vendors if there are multiple possible suppliers for your business.
7. Increase productivity by sacrificing quality. This can potentially lead to short-term profit, but may hurt your business in the long run as customers decide to go elsewhere.
8. Evaluate all your costs together, categorize your costs to get more information about how you are spending your money.
9. Feel like you have to do everything, sometimes it can make sense to outsource some of the work you do in-house. In other words, finding another company that can do specific portions of your work more cost-effectively.
10. Take your eyes off your costs, they can get out of control quickly.

For a quick reference guide on ways to impact your business from this session, download the Controlling Costs Important Takeaways infographic.