As I ascend in my career, I’m running up against some fairly large gaps in my knowledge that I need to address with some extra training - particularly around business accounting.
Here’s one that’s occuring now. How do I accurately calculate the profitability of any given product?
Specifically, when calculating the profitability of a product, how are overheads calculated?
I can see an easy revenue/margin calculation when it’s something like:
Revenue generated - Cost of materials/manufacturing = Profit
But what happens when you factor in other business costs? There appear to be clear fixed overheads in any business that I can envisage being averaged out per unit sale per annum - e.g.:
Rent
Facilities
Baseline marketing activity
The accounts department
Customer support
But then there is a big gray area that I can’t get my head around, particularly product-specific costs:
R&D
Product collateral
Then sales-specific ones:
Sales person’s time
Product-specific marketing and advertising campaigns
Does any of this get factored into unit profit on a per-sale basis? Does one-off advertising/R&D get amortized out over a time period, thus increasing the profitability of the unit sale?
Or am I making it all too complicated for myself? Does everything just go into a giant pot and get smoothed out?
In the world of cost accounting, there are quite a few ways to do it among the standard options… and then there are lots of companies that adapt their own methods to get a cost the way they look at it.
It’s such a large subject that I’m not even sure the best ways to answer your questions without diving into what would be a whole course in itself at the college level. Wikipedia has a page for cost accounting, with links leading to some of the specific methods used.
What you’ll see from the Wikipedia page is that there are multiple approaches taken for many of the cost categories you list. Each method of cost accounting involves different assumptions about what to track and how to allocate it to individual products or activities.
May I suggest ABC- Activity Based Costing as a technique to answer your question? If your business isn’t too complicated, it can provide some interesting results. The biggest concern is in finding the correct and/or reasonable activity “drivers” to allocate overhead expenses. This can become very subjective and lead to inappropriate analysis.
I’m amazed how arbitrary it is… Guess I’ll have to find out how my finance department handles costing in order to calculate margin, and if I agree with their workings.
The reason for what you’re describing as arbitrary is that cost accounting is focused on trying to make estimates about how very big and general costs apply to very specific and small items. Because everything is an estimate of an unknown quantity, you can’t even say with 100% certainty which estimate is better. Furthermore, a cost-accounting system that produces good estimates for breakfast cereal may be lousy for cars.
To top it all off, employee bonuses and even company profitability or survival can depend on the estimates. So a lot of people are very motivated to try to get it right.