Why is costs important in a business

This is not easily done. Many accountants are reluctant to divide fixed costs into these categories or to allocate shared costs to specific product areas, because it is impossible to do this with the precision that accounting professionals normally use to develop traditional financial statements. There is a natural aversion to shifting numbers around in any imprecise manner.

There is simply no way, however, to know how well or how badly a product or product line is doing without getting these cost data clear—without knowing which are bedrock fixed, managed fixed, direct variable, or shared and without allocating them to their various business units and product lines. At the divisional or business unit level, cross-functional teams of all the department heads and the general manager should be responsible for hammering out the allocations according to the actual activity levels of each cost category.

Shared costs are a particularly difficult problem for most companies and difficult to attack as a lump. Managers with hands-on profit responsibility will argue about the fairness of the allocations. But it is critical to take a stand lest discussions get endless, acrimonious, and fruitless. There is no other way. Allocating all costs is the only way to know what is really going on. When done, product groups traditionally regarded as the best profit producers were not as profitable as everyone thought, and some of the worst were actually near the best.

The instrumentation division overall had a reported gross margin of Sales and gross margins were reported by product line, but pretax profit was reported only for the division overall. Fully loading all producing lines with their real costs resulted in adjusted gross margins that varied between Adjusted gross margin percentages for standard products D and E improved their relative pretax profit performance dramatically; gross margins on custom-engineered products A, B, and C declined by several percentage points once appropriate overhead costs were allocated against them.

Looked at in another way, products D and E contributed less than half It is obvious that the way that management assigns its sales, manufacturing, and engineering priorities can change drastically once the actual cost-profit pictures become clear.

When companies allocate these costs to specific products or profit centers, they show up as a charge against earnings, and managers responsible for profits carefully scrutinize and challenge them. This can be a powerful force toward reducing and getting large chunks of overhead costs under control that would otherwise never be scrutinized by someone with a direct profit responsibility.

Knowing the true cost and profit structure for product groups is also an immense help in selecting products, markets, and customers for emphasis. They more often focus on sales potential—with the assumption that profits will follow. Companywide Cost-Profit Awareness. Once costs are known and detailed for product lines, markets, and key customers, you should share detailed cost and profit information with many people in the business unit.

Hand-in-hand with driving unit costs down is the need for leading-edge production technology and an obsession about quality. As a result, we can produce a box of cereal at a lower unit cost than anyone else in the world. We have many teams of production workers that are responsible for keeping quality up and keeping costs down… We have a very disciplined approach to costs across and up and down the organization.

We spend a lot of time talking about costs, because cereal is the only business we have. The drumbeat is that we will remain a lower cost supplier. Managing Cash and Liquidity. Finally, there is the matter of cash. Cash returns can be more important than reported profits.

Cash returns lead to liquidity, and liquidity is a top priority whenever there are high risks and great uncertainties. Cash and liquidity help withstand surprises, facilitate adaptation to sudden changes, and can help you capitalize on the narrower windows of opportunity that are common in a turbulent environment.

Any entrepreneur who has lived through a startup and built a market position knows the importance of cash and liquidity. A business can go bankrupt while reporting profits.

But it will never go bankrupt as long as its cash and liquidity positions are strong. Most senior corporate executives understand this, but many do not make sure it is sufficiently stressed or understood at the operating level. The results are apparent in most corporations.

Working capital is allowed to build without adequate regard for its carrying costs. Over-investment in plant, equipment, and working capital often disguises sloppy business practices and control.

These are practices that inevitably lead to a bloated investment base—too big for the business and too marginal for profits.

Many operating managers are unaware of the costs of excessive capital tie-ups. The reason that so few managers know this is that the costs of working capital are not charged against their earnings, even though they are real costs of doing business. Cash management deserves far greater attention than it gets in most companies.

Management must put more emphasis on, and be held accountable for, managing liquidity. Planning and reporting systems should be modified to highlight actual cash flow and liquidity against objectives.

None of these actions are difficult if senior management has the will and as long as the accounting system is set up to do so. Ideally, every manager should think like a small-business entrepreneur whose own money is at risk and who has little of it at hand. If managers did this, we would see fewer companies with bloated balance sheets and marginal returns and see lots more that thrive efficiently. You have 1 free article s left this month.

You are reading your last free article for this month. Subscribe for unlimited access. Create an account to read 2 more. The true cost […] by B. Charles Ames and James D. Read more on Accounting or related topics Finance and investing and Costing. James D. For example, a brick-and-mortar store will likely have higher startup costs than an online business, and a coffee shop requires different equipment and furniture than a bookstore.

Though this is optional, some business owners hire market research firms to help them assess the industry and market before starting their business. You can save money by doing this step on your own, but if you hire a research firm, include this cost in your business plan. Creating any new business requires a lot of capital, which is usually acquired in one of two ways: equity financing or debt financing.

Debt financing means borrowing money directly, whereas equity financing means selling a stake in your company to receive financial backing. Most businesses take out small business loans — including SBA loans — from banks or other lenders. If you take out a loan, calculate the costs of the loan payments into your budget, and ensure payments are made on time.

As you write your business plan, research the licenses, permits or insurance required of your business. You should carry some form of insurance to cover yourself, your employees, and your business assets from any liabilities that may arise, and be sure you consider the continuing cost of renewing licenses or permits as needed.

This is an umbrella category that covers anything from the cost of creating and maintaining a website , setting up information systems, computers, and the use of accounting software and a payroll service.

Some small businesses may outsource their payroll and accounting needs to save money, though there are many budget-friendly options available. There are also plenty of ways to save on other technology costs, such as building your website. As with startup costs, the exact equipment and supplies you'll need will depend on your specific business. In your business plan, you should outline a general list of all the equipment and supplies you think you'll need and whether you plan to lease or buy each piece of equipment.

It's recommended that you involve a professional to ensure all of your necessary documents are in order. A lawyer can help you get your business incorporated , register for licenses or permits , oversee contracts, minimize your risk and liability, and more.

You should start getting the word out about your business so you have customers once you open. Marketing costs include all of your advertising and promotion costs, plus whatever you spend creating a marketing strategy. You may choose to create a strategy on your own or hire a marketing company to help you. If you do your own marketing, carefully track your spending. Key takeaway: Every business will have unique startup costs, but, generally, you should look at costs for legal assistance, marketing, technology and licensing.

Startup costs may be eligible for tax deductions. However, large purchases are not deducted all at once on returns. Many expenses are amortized — meaning the deduction is spread out over time, usually around 15 years. You must depreciate the cost during this period. As an example, if you buy new office equipment, you can list pieces as a tax deduction but must claim depreciated cost.

The reason you can't take the tax deduction all at once is that the IRS categorizes startup costs as capital expenditures. This category is for purchases, such as equipment and vehicles, that the business uses over the course of several years, not in one tax year. You must file in the same year that you opened, or submit an amended tax return to reflect the deduction.

Amortization is beneficial because you can make the deduction over a year period. To learn what other tax deductions your business might be eligible for, review IRS Publication Keep in mind that business deduction rules change year to year.

View shopping cart. View mytutor2u. Account Shopping cart Logout. Explore Business Business Search. Explore Blog Reference library Collections Shop. Share: Facebook Twitter Email Print page. Costs are important to business because they: Are the thing that drains away the profits made by a business Are the difference between making a good and a poor profit margin Are the main cause of cash flow problems in business Change as the output or activity of a business changes Fixed and Variable Costs An important distinction needs to be made between variable and fixed costs.