Successful businesses set prices and then deliver services or produce goods at costs that are lower than these prices. The difference between the cost and the price creates the profit that the business earns as goods and services are sold. To price correctly, most companies develop some type of Cost/Price Model to estimate their costs, and then they apply a markup to calculate the price.
For a new business owner, estimating accurate costs can be difficult because there may be unexpected expenses not included in the initial Model. As owners and companies mature, cost estimates usually become more accurate. Unfortunately, once the Model is trusted, businesses may not re-evaluate or update the cost estimates in their Models. If actual costs increase above the cost estimates, profits can shrink. The income statement, however, can be used to periodically check a company’s Cost/Price Model.
As an example, let’s assume that a company buys steel shelving units and delivers and installs them in customer warehouses. The company has eight installers, and two installers work together on each team. One leased truck is provided per team (4 trucks) and fuel cards are used to purchase gas. The shelves come in different sizes and shapes, and only a small markup can be added to each shelving unit. Most of the profits are earned from the installation service.
A Cost/Price Model is used to quote jobs which includes material costs based on the shelf sizes and estimated direct labor hours including travel time. The labor estimate is multiplied by $50.00 per hour, another $50.00 is added to each job as a trip charge, and a 25 percent markup is added to the total cost estimate to cover all other costs and provide a profit. Last year, the company completed about 1,200 jobs.
To check the Cost/Price Model, we identify those costs on the income statement that we believe are included in the Model, and we calculate average component costs based on some quantity (quantity produced, hours worked, days, etc.). In this example, we know that the company completed 1,200 jobs last year, so we divide the income statement expenses by 1,200 to calculate average costs per job and compare these to the Model. Each number below matches and explains a red circle on the table:
1. An average Cost/Price Model appears on the right. The material cost is estimated at $1,000, installation will take 5 hours, and a $1,687.50 price is calculated.
2. Based on 1,200 jobs, the average material cost per job in 2013 was $900, so the material estimate seems reasonable.
3. All labor and benefit costs are totaled and divided by 1,200 jobs. The Model could be under-valuing labor costs per hour and job, so more research may be needed.
4. Truck, fuel and insurance costs are added and divided by 1,200 jobs. The $100 trip charge in the Model seems adequate.
5. There are Cost of Sales expenses on the income statement that are not specifically estimated in the Cost/Price Model. These costs must be covered by the markup, or there will be an income loss on the job.
6. In this example, the job will be profitable if a price of $1,687.50 is charged. Unfortunately, the average price per job in 2013 was $1,500, so the company had a year-end loss.
By using the year-end income statement as one large Cost/Price Model, you can identify cost estimates that might be inaccurate. In our example, the company might decide to increase its labor rate charged, or add some additional costs to the Model, or increase its markup to increase 2014 profits.