When doing competitive analysis, it is important to properly align cost with the predominant method used in your industry or you fail to compare apples to apples. The main goal of classifying costs is to determine the total cost attributable to one unit of product or service. When doing competitive analysis, you need to understand your costs for various reasons such as:

• Understanding how you compare to your competitors. If you are selling at much lower margins, the comparison will give you a place to begin the analysis process.
• The ability to analyze costs to see where non-value added costs can be eliminated
• Reallocating costs to your most valued products and services
• If you potentially decide to sell your business, aligning with the industry will ease the due diligence process

The study of costs should be done along the value chain. The value chain is the set of interrelated value-creating activities in your business. This goes all the way from conducting research to providing customer service in a business. To achieve an organization’s goals, managers must understand the entire value chain as well as the related cost-causing factors known as cost drivers.

What is Cost?

A cost is the sacrifice made to achieve a particular purpose. A cost can be an asset or an expense. For example, when you exchange cash for a computer, the computer is an asset to you. On the other hand, an expense is defined as the cost incurred when an asset is used up or sold for the purpose of generating revenue. For example, when you buy ink for your printer, you immediately use that ink to serve clients. The ink to you as an expense to your business.

Costs on Financial Statements

There is a difference between the way costs is represented on the financial statement for businesses who carry inventory and businesses that do not. Businesses that carry inventory have an expense line item called cost of goods sold. The cost of goods sold is the cost associated with the sale of one unit. Below are the equations that represent how costs is represented in a service versus product based business:

    Balance Sheet

On the balance sheet a service business does not carry inventory while a product based business carries inventory

    Income statement – Service business

Revenue – Operating Expenses = Net Income

Income statement – Product based business

Revenue – Cost of Goods Sold = Gross Profit

Gross Profit – Operating expenses = Net Income

Cost and profitability

A business profit is measured as the difference between its gross receipts (revenue) and expenses. The income statement (as shown above) represents the profits of the business. Expenses play a very important role in determining profitability. If you make 1 million dollars but spend 2 million dollars then you are actually worse off than when you first started. The trick is knowing what percentage of your revenue you need to spend to make $1 back. This is called your breakeven point. Once you know your breakeven point, you need to ensure that the revenue you get from each unit of sale exceeds your breakeven point.

In determining your full costs, you need to add even the uncompensated value of your time to the business. Small business owners often overlook the value of their time when determining cost. This is erroneous as the time you put in your business is important. After all, if you were not doing what you do, you will need to pay someone else to do it.

Moreover, when planning for the profitability of your business, it is wise to allocate maximum expenses to different categories. The basis of this information can be derived from industry specific reports. Here is an example of how to allocate expenses so you maintain a minimum level of profitability:

Summary

Why the reasons for going into businesses are as varied as the number of people starting businesses, everyone who goes into business must aim to make a profit. The way you do this is by understanding your costs and how your costs hinders or fosters your profitability. Understanding costs helps you become more focused by deterring you from wasting resources which enables you to allocate resources to the most valuable products and services. With focus, more can be achieved from your business.