Calculating and Lowering the Cost of Doing Business- A Complete Guide
The barriers to entry for starting a new business are as low as ever. While places with developed economies, such as New Zealand, Singapore, Hong Kong, Denmark, and South Korea, have long been known to support SMEs (small and medium-sized enterprises), even developing economies are making great strides of their own.
Since the World Bank Group's first iteration of its Doing Business study, the cost of doing business in emerging markets has fallen by more than 100 percent between 2004 and 2020.
Due to the constantly growing number of costs that go into starting and running a business, including costs associated with raw materials, manufacturing supplies, wages, rent, utilities, and general office equipment among many others, carefully calculating these expenses is a task that should not be overlooked.
Whatever the type of cost, each one must be considered to determine how much money is needed for the business to sustain itself and make a profit.
Why Calculating Business Costs is Important
It can be a challenge for owners and managers to identify their total cost of operation and find ways to control them. However, this insight can be especially valuable when attempting to optimize expenses and set a business budget for upcoming quarters.
Tracking the cost of doing business is helpful in any industry as this information gives businesses a clearer understanding of their spending habits, as well as pinpointing areas where costs can be minimized.
Operational costs are one of the many things that eat away at a business's profits and cash reserves. According to a startup post-mortem report by CB Insights, 29% of enterprises cited a lack of capital as the primary reason for closing down. Therefore, it makes sense to regularly identify areas within the business where it is possible to limit expenses. This can optimize business practices by informing owners on areas where they may be overspending, which can prevent unnecessary losses in capital.
By determining the optimal level of expenses for every aspect of the business, such as labor, inventory, marketing, etc. companies can maximize profits. However, it's important to remember that certain aspects of business finance also generate revenue. Costs, like marketing and advertising, for example, can result in large returns on investment (ROI), making it a good idea to increase spending in these areas to increase sales. For example, a Nielsen report found that the average return on advertising spend (ROAS) is $2.78 for every $1.00 spent.
Forecasting of Future Sales and Labor
Predicting future sales is a complicated process. Predicting future expenses, on the other hand, is much more simple. Accurate calculations regarding a business's total annual costs, including how much money the enterprise will need to spend on rent, payroll, utilities, manufacturing, and shipping are helpful starting points when developing other forecasting projections for sales, revenue, and demand.
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Variables Involved in Cost Calculations
There are different ways of looking at business costs and their relation to operations and output. An overview of how business costs are usually categorized is based on-
Fixed and Variable Costs
Fixed costs, also known as overhead costs, are incurred regardless of output. Examples of this would include rent, property taxes, and insurance payments.
On the other hand, variable costs, as the name suggests, can fluctuate alongside changes in output. For example, if Nike, Inc. were to produce only 1,000 pairs of shoes in a year, the company would naturally spend less on wages, fuel (for the machines), and raw materials. Other examples of variable costs include shipping costs, sales commissions, and advertising spend.
Direct and Indirect Costs
Direct costs are expenses that can be directly linked to the production or delivery of goods and services. It's for this reason that many variable costs can also be considered as direct costs. However, certain fixed costs, like the cost of renting a manufacturing facility, can also be tied to production. Examples of direct costs include raw materials, manufacturing equipment, and wages of production staff.
In contrast, indirect business costs are tied to multiple business activities not necessarily related to production. These can include general office expenses, administrative salaries, rent, and utilities.
Product and Period Costs
Product and period costs are very similar to direct and indirect costs. The key difference is that these expenses are typically viewed from an accounting perspective.
Product costs are associated with the production and sale of goods. With retailers, for example, this can include the total cost of supplies plus the cost of delivering them to the warehouse. Product costs are often recorded as inventory assets when the goods are unsold and become costs of goods sold as soon as they are purchased by consumers.
Meanwhile, period costs are closely associated with the passage of time, rather than transactional events. For example, rent is a period cost recorded within the current accounting period. It is not associated with the cost of goods being manufactured, therefore, it is not recorded in inventory.
How to Calculate the Cost of Doing Business
The most widely used formula for calculating the cost of doing business (also known as total operating costs) involves finding the sum of the cost of goods sold (COGS) and the operating expenses (OPEX), both of which will be found in the company's income statement.
Total operating costs = COGS + OPEX
- COGS - Also known as the cost of sales, this refers to all expenses tied to the production of goods or services. These expenses can be categorized as direct costs or product costs, depending on the perspective.
- OPEX - Operating expenses, on the other hand, are business expenses not accounted for in the COGS, which can be indirect costs or period costs.
Calculating Startup Costs
With startups, the general formula for calculating total operating costs still applies. However, since there are no income statements to work with, startup founders will have to make educated guesses to estimate their expenses.
When calculating the cost of doing business for startups, consider the following steps.
- Determine the type of startup - This can include brick-and-mortar businesses, online services, or eCommerce.
- Identify the common business expenses associated with the startup type - For example, with online startups, common expenses include website hosting fees, web developer costs, market research, and accountant fees.
- Estimate the cost of each business expense - This process is easier with well-defined expenses, like permits and rent. With variable expenses, like contractor charges, it may be necessary to inquire about rates and benchmarks.
- Add all business expenses - This will give a full financial picture of the cost of launching the startup.
Because these expenses can vary wildly depending on the location and industry, it's important to carefully research and calculate before formulating startup launch budgets.
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Labor Demand Projections
Calculating business costs is only the first step in planning expenses. The next step businesses should take is to control these costs to maximize the company's profitability.
Most business owners and managers focus on labor expenses when looking to cut costs, and for good reason. According to research by Paycor, labor costs, which include wages, benefits, and payroll taxes, can account for as much as 70% of total business costs.
Labor-related expenses are also categorized as variable costs, which means they can show patterns of peaks and troughs throughout the year, depending on the level of production of goods or delivery of services. By calculating labor costs and tracking how demand fluctuates throughout the year, it becomes easier to forecast future staffing needs and plan worker schedules.
This ensures that the appropriate number of employees are on-hand to meet client and customer demands during every season. This, in turn, prevents cash flow problems caused by having too many or too few employees during busy periods.
As enterprises (especially those in the retail and food and beverage industries) grow their customer base and scale their operations, one of their primary challenges will be to mitigate the uncertainty of managing inventory.
According to research by Stifel, U.S. retailers typically sit on approximately $1.43 in inventory for every $1.00 of sales they make. By calculating and tracking direct or product costs throughout the year, business owners and managers can identify peaks in demand, when stocks are expected to fly off the shelves, and slower periods when fewer consumers are expected to make purchases.
This information can then be used to make inventory forecasting more accurate, so that the right amounts of goods are in stock at all times, regardless of seasonal fluctuations.
Calculating the total annual costs also offers the benefit of revealing hidden expenses associated with the supply chain, such as warehousing, handling, loss, and returns, further highlighting problem areas the businesses can work towards optimizing.
Reducing the Costs of Operation
Operating a business isn't just about selling X number of goods, but it's also about how much profit you can make from the sale of each item. This is often referred to as the company's profit marginthe ratio of profits to business costs, both direct and indirect.
If the cost of producing an item is higher than the price it sells for, the next logical step would be to re-examine these costs and work on reducing (possibly even eliminating) them.
- Implement a telecommuting policy - Allowing employees to work from home can not only improve their work-life balance but also reduce operating costs. For example, offering remote work options allowed insurance giant Aetna to shed 2.7 million square feet of office space, saving $78 million.
- Cut supply expenses - Negotiate for lower rates with existing vendors or contact other vendors to shop for quotes. With office supplies, for example, big-box stores may have special packages for corporate accounts.
- Reduce financial expenditures - Business insurance is one example of an unavoidable expenditure. Evaluate insurance policies to check if you're over-insured or have overlapping coverage. For startups, be sure to compare insurance quotes to get the most competitive rates.
- Optimize marketing efforts - Focus on marketing channels that have already been proven to be effective but don't be afraid to explore lesser-used strategies that can scale, such as search engine optimization (SEO) and content marketing.
Using the Right Tools to Control Expenses
Incurring costs is an unavoidable aspect of doing business. The trick is to know where these costs are coming from and, if necessary, find ways to reduce them. One way to simplify this process is by using sales and labor forecasting software, which automatically analyzes inventory and financial data to detect patterns in seasonal demand, redundant costs, and areas of inefficiency.
Unlike spreadsheets that require manual data entry and interpretation, forecasting software crunches the numbers and provides projections instantly by integrating with the business' existing point of sale system. This means no more guesswork and no more time wasted on repetitive tasks.
Additionally, these tools provide reporting insights regarding what these projections mean, allowing business owners and managers to make strategic decisions and help them scale their operations.
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- Calculating and Lowering the Cost of Doing Business- A Complete Guide