Some years back I heard a listener complaining that an electrician who had spent ten minutes at their house had charged R300. This was followed by many other calls in the same vein. The talk show host then did some multiplication and announced that at these kind of fees an electrician was earning more than a brain surgeon.
This was of course rubbish. When the electrician spends 10 minutes at a customer’s house what needs to be recovered in the fee is the running cost of the vehicle, travelling time, rental on premises, an accountant, advertising and so on. Plus customers are paying for expertise. People could, of course, do it themselves. And electrocute themselves or burn their houses down.
In a business the lack of understanding of costs can have fatal consequences – for the business.
The factory manager of a tile manufacturer in South Africa was given costing information on the tiles being produced. The cost of each tile included the cost of raw material plus each tiles share of the company overheads. He noticed that when production increased the cost per tile came down – and when production decreased the cost per tile went up. As he was judged on the cost per tile figure he took action.
This factory manager was a really good production engineer. He set about streamlining production methods, coaching supervisors, buying raw materials in bulk to reduce input costs and making several other innovations. He received a pat on the back.
It took a few months for a decline in the company’s profits to emerge.
What the factory manager had ignored (because he did not fully understand costs) was the following.
He had not taken into account sales forecasts. As a result the stocks of unsold tiles built up. The reduction in profits was caused by a dramatic increase in holding costs.
Interest. If a company that is in a borrowed situation it is, in effect, paying interest on unsold stock. If the company does not borrow money it is losing the opportunity to invest surplus funds and earn a return on them.
Obsolescence. When stock is around for longer there is the risk that the product may go out of fashion and may not be sold. This applied to some types of tiles this company manufactured. There is also the risk of damage when being stored for lengthy periods. And the increased risk of theft.
Another area where not understanding costs can be detrimental to profits is in calculating the charge out rates for staff. Managers generally know that people cost more than the salary they are paid. After all, one must add the cost of the company’s contributions to medical aids, pension funds and any other so-called fringe benefits. When I ask groups of managers how they arrive at charge-out rates I get a range of replies. “We add 25%” or “40%” and other percentages. When I ask why I get told, “Because that’s what we’ve been told to do.”
The percentage they’re using may or may not be correct. Consider the following extract from the notes I use on my Finance for Non-Financial Managers workshops:
Most people think that the amount that is paid for something is its cost. It may be in some cases. But usually it is not. Let's take the case of what we pay for labour. Consider the question, "If we pay someone R10 per hour what do they cost the business per hour?" The immediate response is often, "R10". Then after thinking about it people remember things called company contributions: things which the business pays in addition to the wages paid such as the businesses contribution to employee’s pension funds, medical-aid schemes and so on. Yes, these do add to the cost of employing someone but they are only part of the cost. The real cost per hour of an employee will depend on how many hours of work we get from the person while they are at work.
This is probably best illustrated by way of an example. Let's stay with our employee being paid R10 per hour for 40 hours a week.
Example of a cost per hour calculation:
R10 per hour x 40 hrs per week x 52 weeks R20 800
Contribution to pension fund - say 7% of R20 800 1 456
Contribution to medical aid - say R200 per month 2 400
Other payments (Unemployment insurance etc.) say 1 000
There could be other payments such as training
costs, protective clothing but this is enough
to illustrate the point.
Total of annual payments R25 656
Available hours 40 hrs x 52 weeks 2080
Annual leave 40hrs x 3 weeks 120
Time off sick 8hrs x 5 days 40
Paid public holidays 8hrs x 10 days 80
This totals 240 hours
But every day, for a variety of reasons, people are not working. This could include bad management, waiting for material, waiting to be given work to do, or loafing. The 240 hours above amounts to six weeks. Let's assume that for the remaining 46 weeks or 230 working days 2 hours per day is lost. In surveys I have conducted I have been given figures ranging from 2 to 4 hours per day, but let's use two hours.
230 x 2 = 460
So in total we lose
Leaving us with (2080-700) 1380 hours worked in a year.
If we now take the total annual payment amount R25 656
and divide it by the hours worked in a year 1380
then we have a cost per hour of R18.59
The R10 per hour paid increases to R18.59 because of the businesses additional payments in respect of its contributions to employee benefits and the hours paid for but not worked. Naturally the employee benefits and hours lost will vary from business to business but the above example serves to illustrate the point about costs not necessarily being what they seem to be at first glance. The figure of R18.59 is only the direct cost associated with our person earning R10 per hour and does not include any indirect costs applicable to that person and there are many; we have to pay people to calculate his wages, there is the cost of the people who manage him and his fellow workers, the cost of the canteen where he eats and so on, and on.
It is therefore important for managers and business owners to fully understand how to calculate costs. Not being able to do this could have disastrous consequences.