In speaking to an insolvency practitioner recently I was reminded about a critical aspect of business that SMEs generally deal with very poorly.
The practitioner was discussing the position of one of his clients, Peter, who had become insolvent. In the course of determining how this had come about, when there had been plenty of jobs on the books, it became apparent that very few of those jobs had been profitable. When questioned, on his pricing methodology, Peter stated that he just quoted the price he thought would win him the work.
As accountants we shake our heads at just how irrational this is; it is beyond our comprehension that a businessperson could set a price without taking their costs into account.
And yet such situations are far from uncommon. There are many business owners who price on the basis of what their competitors charge, without considering whether the competitors have a different cost structure, which can result from different sources of supply, different volumes, different overhead levels and a multitude of other variables. Nor are competitors necessarily clever – they can price themselves into insolvency as well.
Benchmarking prices against competitors is a commercial necessity, but it must not be done blindly in the very flawed rationale that if you sell enough widgets you’ll make a profit. Obviously to us, the more widgets you sell at a loss, the quicker you’ll become insolvent. It is one thing to make a small margin above cost and work on volume to cover your overheads, it is quite another thing to make no margin at all.
And in many cases, this is the real issue – so many business owners just don’t have a handle on how much their products or services cost to produce.
There is no doubt that costing manufactured products can be a fairly sophisticated process often with the need to determine standard costs and thoroughly analyse variances.
Even quite sophisticated manufacturing businesses fall short of using full absorption costing, with fixed manufacturing overheads often excluded from inventory costing.
And while computer inventory modules help with the arithmetic, they’re still only as good as the information they’re fed. One business I know of continued to report profits on the basis of rising inventory levels because the inventory clerk was using incorrect standard quantities – selling out packaged items as one unit instead of the number of items in the package.
It is not uncommon for cost components to be carried forward year-after-year without anyone really comprehending how they have been derived, much less analyse whether they are still relevant. Take the case of the business that used the same factory overhead allowance in their job costing for twenty years before their external accountant was finally brought in to find out why the business had become unprofitable.
I realise that costing is not a very sexy part of running a business. Selling widgets and services, and making those widgets and performing the services, are usually what SME owners are good at and why they started their business careers.
Most SMEs at least in the early stages, have little internal accounting resource, often relying on bookkeepers who rarely have strong experience in costing and pricing. If they wait until the end of the financial year to see their external accountant it may be too late to correct fatal pricing flaws. Indeed if they don’t conduct a stock take until the end of the financial year the lack of gross profit margin may not be detected – other than through a tight cash flow. And there have been any number of businesses – some very large – whose losses have been hidden by overvalued inventories. It is all too easy to explain lack of cash flow by ever-increasing inventory levels. The discipline of reviewing, those inventory values, product by product, is not something that many business owners involve themselves in.
Businesses that rely on high volumes to compensate for low margins are at enormous risk if costing and pricing are not precise and current on a daily basis. A small currency movement that is not built into product cost and immediately passed on in pricing can be the difference between profit and loss. All too often SMEs lack the systems and procedures to accurately measure the impact of foreign exchange movement on their costs and to be able to act quickly enough to compensate for it.
A product profitability analysis can be performed to calculate the profitability of each product line and take into account not just the product cost but also the cost of customer support and marketing. By comparing the total costs of each particular product with the income generated by those products a business owner can get a true picture of what each product contributes to the profitability of the business. There are many templates commercially available to help with these analyses, and it does not have to be a highly expensive exercise, especially if the external accountant just gets the process going, then hands over to an internal resource and reviews the results.
But the cost of not doing such an exercise, or indeed any review of costs and pricing, can be vastly greater than the cost of doing it. It’s a long way from comparing this year’s gross profit margin with last years and trying to high-level rationalise the variation. If we can convince small business owners to get serious about costing and pricing it is one of the most valuable services we can ever provide. If Peter had realised he was losing more money with each job he won perhaps he would have stopped operating before the business became insolvent, saving him and his suppliers from financial disaster.