Importance of Costing in Managerial Decision Making
While it may sound trivial, knowing how much it costs to make a product is extremely useful information about your business. Often, small-business owners do not realize how expensive production can be, and only turn to costing techniques when trouble is on the horizon. By understanding the importance of costing before you run into trouble, you can use these techniques to do more than just set a normal sales price; costing can help you make other data-driven decisions about your business process.
Knowing how much your company spends to produce a unit of product is invaluable when figuring out the sales price. If you plan on competing on price, you will want to ensure that your product is priced lower than that of your competitors, but if you sell your product for less than its cost, you won't be in business for very long. While costing is useful for setting a normal sales price, it is also useful for determining whether or not to take special orders at lower prices. In many cases, fixed costs of production, such as rent and management salaries, are already covered by normal production. Companies in that situation can accept a lower price than normal in order to win a special order. Costing techniques allow you to determine how long you can go and still come out with a profit.
Because costing methods have uniform rules, managers rely on the consistency of costing techniques to evaluate performance across companies. For example, if you are the manager of a small soda business, you can look at a publicly-traded competitor for a rough ballpark estimate of how that company is doing. By examining the company's filings, you can determine how many units of product the company sold and at what cost. You can then determine the cost per unit, and compare this to your company's cost per unit. While a larger company could be expected to have a lower cost per unit than a smaller company, figuring out if the two companies are in the same ballpark can be worthwhile.
Adherence to specific costing techniques are required under generally accepted accounting principles, called GAAP, for external financial reporting purposes. GAAP requires that all manufacturing costs are assigned to product, and that no non-manufacturing costs are assigned to products. Costing systems that treat costs in this manner are known as absorption, traditional, or full-cost costing systems. Small-business owners should recognize that not all costing systems treat costs in this manner. For example, variable costing systems seek to stabilize net income with regard to changes in production levels, so they do not assign all manufacturing costs to products. This method of costing may be useful for internal decision making, but would not be appropriate for external reporting.
Costing methods are important when companies are deciding whether to sell an intermediate product or to process the product further. For example, a dairy has many options to consider when determining what products to bring to market. The dairy could sell raw milk to a creamery, process the milk into pasteurized dairy products, make butter or ice cream, or produce cheese. By using a costing technique called relevant cost analysis, the dairy's owner can determine what amount of processing is the most profitable for the dairy.