Your P&L measures the overall profitability of your business, but it does not measure the profitability of individual customers or services that make up your business. To continually improve performance, every company should understand the economic building blocks that drive their business. In simple terms, this is the true cost to handle one unit or serve one customer.
Measuring the revenue generated by a specific customer or an individual product line is easy. However, many companies cannot translate revenue into profitability because they do not have a costing method to measure the cost to serve each customer or the cost to perform each service.
A costing methodology is really just an economic or cost model of the business. This is not an accounting model which focuses on GAAP standards or your financial statements. An economic model should focus on costs (inputs), cost drivers (activities), and how they relate to products or services (outputs). This model may be conceptual in nature or a complex system depending on the needs of your business.
A costing methodology should provide accurate and relevant cost information. Accurate cost information is not the same as exact or precise cost information. In fact, we believe it can be a mistake to go to great lengths to provide exact information and lose sight of the intent of the analysis. The intent is to provide actionable information to support decisions. Relevant cost information takes into account the decision at hand and does not necessarily require an ongoing costing system. It can be a point-in-time analysis which correctly measures customer or product profitability to support a specific decision. Depending on the business situation, direct activity costing information may involve analysis of fully-absorbed costs, incremental costs, historical costs or estimated future costs.
The process of developing a costing model is as important as the methodology itself. Traditional activity-based costing models are often useless for decision support. Every company has unique issues, including their core business model, time and resource limitations and access to data. A successful costing method for most small to mid-sized businesses will rely heavily on the 80/20 rule in applying 20% of the appropriate concepts to realize 80% of the benefits.
Employing such a costing model in your company may help you increase your profitability and provide additional guidance in your decision-making processes. The professionals in our firm can assist you in developing these models and analyzing the results. If you would like to discuss how to measure customer or product profitability in your business, please feel free to contact us.