How to Increase Profit and Retain More Cash: Fixing the Problem of Distorted Cost Information

Running a small business means keeping an eye on every dollar that comes in and goes out. If you’re like most business owners, you’re always looking for ways to increase your profits and hold on to more cash. One of the biggest challenges I see with small businesses is distorted cost information—when the numbers you’re using to price your products or services don’t accurately reflect what it really costs to deliver them. This leads to overpricing or underpricing, and either one can hurt your business.

In my experience working with clients to improve their profitability, one of the most common issues they face is getting a clear picture of their costs. When cost information is distorted, it becomes harder to make informed decisions about pricing, product mix, or contract bids. If you’ve ever lost a contract because you priced it wrong or been surprised by how little profit a product made, then this article is for you. Let’s talk about how to detect the signs of distorted cost information and what you can do to fix it.

Detecting Early Warning Signs of Distorted Cost Information

The first step in addressing distorted cost information is recognizing the warning signs that your current cost data might be inaccurate. Some key indicators include:

- You’re losing competitive bids, not because of poor quality, but because your prices don’t seem right.

- Certain products or services that are difficult to produce are showing unexpectedly high profits, which seems too good to be true.

- Managers are asking to drop products or services that look profitable on paper.

- No customers are complaining when you raise prices, which might mean your products were underpriced to begin with.

If any of these scenarios sound familiar, it’s time to take a closer look at your cost system. These warning signals suggest that your costs aren’t being allocated correctly, which can distort your pricing and profitability.

An Example: How Distorted Cost Information Hurt One Business

Take the fictional case of Joe, who owns a small electronics manufacturing company. Joe was confused as to why his simple products, which were easy to produce, weren’t selling well, while his custom, high-complexity products seemed to have huge profit margins. After a deeper dive into his costing system, Joe found out that his overhead costs were being allocated equally across all products, regardless of the complexity involved in producing each item.

By using the same rate to allocate costs to both the high-volume, low-complexity products and the custom orders, Joe had been overpricing the simpler products and underpricing the more complex ones. As a result, his simple products became less competitive, while the custom products were not covering their actual costs, leading to cash flow issues. After implementing a more accurate cost allocation system, Joe adjusted his pricing and quickly saw improved profitability and better cash retention.

Why Does This Happen? The Problem with Traditional Cost Systems

The main cause of distorted cost information is how you calculate your costs, particularly overhead costs. Most businesses use traditional cost systems, such as job-order costing or process costing. These systems are great for tracking direct costs like labor and materials, but they often fall short when it comes to assigning overhead costs accurately.

Overhead costs—things like rent, utilities, and administrative salaries—are typically spread across all products or services using a single overhead rate. This works fine if you’re selling just one product or all your products consume the same amount of resources. But for businesses selling multiple products, each with different levels of resource consumption, this method leads to distorted cost information.

For example, let’s say you sell two products: Product A and Product B. Product A is a high-volume, simple product that’s cheap to make, while Product B is a low-volume, complex product that requires a lot more resources. If you use a single overhead rate to allocate costs equally to both products, you’ll end up overpricing Product A and underpricing Product B. This is a problem because overpriced products are less competitive, while underpriced products don’t make enough profit to cover their costs.

How to Fix Distorted Cost Information with Activity-Based Costing

The good news is that there’s a solution to this problem: Activity-Based Costing (ABC). This method uses multiple cost drivers to allocate overhead more accurately. Instead of assigning overhead based on a single rate, ABC assigns costs based on the actual activities that drive those costs. For example, instead of simply spreading overhead based on labor hours, you might use cost drivers like the number of machine setups, square footage of production space, or the number of orders processed.

This approach gives you a much clearer picture of what it really costs to produce each product or service. Once you have accurate cost information, you can make better decisions about pricing, product mix, and even which products or services to focus on.

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Let’s say you own a small manufacturing business that produces two main products: simple widgets and complex custom parts. Your traditional cost system assigns overhead equally based on labor hours, but the custom parts require more machine setups and specialized materials than the widgets. Using ABC, you allocate costs based on actual activities, like machine hours and material handling, which shows that the custom parts are far more expensive to produce than the widgets. This new cost information helps you realize that you’ve been underpricing the custom parts and overpricing the widgets. You adjust your pricing accordingly and immediately start to see better profit margins.

Implementation Tips: How to Get Started with ABC

Switching to Activity-Based Costing may sound like a lot of work, but the benefits far outweigh the effort. Here are a few tips to help you get started:

1. Identify the right cost drivers. These are the activities that generate costs in your business. They could include machine hours, number of production runs, square footage of space used, or the number of orders processed. The key is to pick cost drivers that accurately reflect the resources consumed by each product or service.

2. Use a combination of direct and indirect cost drivers. Some cost drivers measure direct consumption (like machine hours), while others measure consumption indirectly (like the number of transactions). The goal is to use cost drivers that have a high correlation to the actual costs they represent.

3. Test the system with a small sample of products. Before rolling out ABC across your entire business, try implementing it with a small group of products or services. This allows you to work out any issues and get comfortable with the process before scaling up.

4. Use technology to simplify the process. Modern accounting software often has built-in functionality for ABC, making it easier to implement and track multiple cost drivers. This reduces the time and effort needed to gather and analyze data.

Preventive Measures to Avoid Cost Distortion in the Future

Once you’ve corrected distorted cost information with ABC, it’s important to put preventive measures in place to avoid the same problem in the future. This will help ensure that your pricing stays competitive and that you continue to generate healthy profits. Here are some preventive strategies:

- Continually evaluate your cost drivers. As your business grows and evolves, your cost structure will change. Regularly reviewing and updating your cost drivers ensures that your cost information remains accurate.

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- Consider using a Just-In-Time (JIT) costing system. JIT can help convert indirect costs (like overhead) into direct costs by streamlining your production process. For example, JIT eliminates the need for separate labor categories for maintenance or setup because those tasks are performed by the same employees who handle production. This makes your costing more accurate and helps reduce overhead.

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- Track the total fixed costs and assign them properly. Accurate costing starts with correctly assigning fixed costs to each product or service. Use prototype products to determine expected yields and establish a solid cost base before launching any new product.

Ripple Effects of Distorted Cost Information

The consequences of ignoring distorted cost information can ripple through your entire business. Overpricing products can make them less competitive, reducing sales and market share. Underpricing products can lead to losses and prevent you from breaking even. Over time, both scenarios can hurt your cash flow, forcing you to reduce staff, cut back on production, or even downsize your operations. Inaccurate cost data not only affects profitability but can also undermine your company’s future success.

What You Should Do Right Now

If you suspect that distorted cost information is hurting your business, now is the time to act. Here’s what you should do:

- Review your current cost system. Take a close look at how you’re allocating overhead costs. Are you using a single overhead rate, or are you taking into account the different activities that drive costs for each product?

- Consider implementing Activity-Based Costing. If your current cost system isn’t giving you accurate information, ABC can help you make better decisions about pricing and product mix.

- Consult with a financial professional. If you’re unsure how to get started with ABC or how to evaluate your cost drivers, working with an experienced financial professional can make the process easier.

If you like what I said in this post and want some help understanding your financials so you can grow your profits and cash, set up a call with me here so we can discuss your situation and how I can help:? https://calendly.com/pedenaccounting/right-fit-meeting

Are you struggling to keep more cash in your pocket? Check out my guide to managing expenses, maximizing deductions, and increasing revenue streams and provides you with actionable strategies to optimize your finances and enhance your cash flow:?

https://cashflow.pedenaccountingservices.com/