Cost analysis: definition and how to calculate

How can you effectively forecast the profit a given product or project will generate for your business? The way you answer that question can make or break your business.

Getting a handle on costs means better understanding how to make informed financial decisions related to your expense management and project planning. This is where cost analysis comes in.

The analysis of cost helps you calculate the actual cost of doing business, which can streamline your operations and increase profits once you understand the best way to use the calculations effectively.

In this article, we explain cost analysis, why it’s important for your business, how to analyze cost, and the benefits of integrating price analysis into the process.

Cost analysis, which is sometimes referred to as analysis of cost or cost accounting, lets you compare the projected costs of a product, service, or project with the return on investment it generates. As you analyze cost, you can:

• Identify and categorize the direct and indirect costs involved
  • Are expenses one-time or recurring?
  • Are they fixed or variable?
• Discover hidden costs
• Dig into the underlying factors that influence the costs
• Understand any intangible costs, which may not have a monetary value
• Conduct a cost-benefit analysis (CBA) to understand the benefits and profits you can generate

As you review the expenses involved in producing your product, it’s also important to identify which are within your control and which are outside your control. For example, the cost of labor is within your control. However, the cost of raw materials may depend on vendors.

Types of cost analysis

Although the idea of calculating cost analysis might seem daunting, it's crucial for maintaining financial stability, identifying areas for improvement, and understanding a project's benefits.

These are the three methodologies to be aware of:

• Activity-based costing (ABC): Identifies and assigns costs to specific activities within a business. Unlike traditional costing methods, which allocate costs based on a single metric, like labor hours, ABC looks at each activity contributing to overhead costs. This method provides a more accurate picture of how you spend money.
• Marginal cost analysis: Refers to the cost of producing one additional unit of a product or service. It includes variable costs like materials and labor but excludes fixed costs, which remain constant regardless of production volume.
• Break-even analysis: Determines the point at which total revenue equals total costs, resulting in neither profit nor loss. This analysis helps businesses understand the minimum sales volume needed to cover expenditures.

Why is cost analysis important?

Cost analysis is essential for your business for four main reasons. Analyzing cost:

1. Aids in the decision-making process: If a proposed project’s estimated costs are more than the expected benefits, you can adjust to increase profits or lower expenses
2. Helps keep stakeholders informed: Cost analysis provides easy-to-consumer financial data points to share with stakeholders that will help them make informed decisions about budgeting, future costs, and project management to allocate resources effectively
3. Solves financial problems: It helps you get ahead of issues so you can address them before they get out of hand and hopefully improve your profits
4. Enhances operational efficiency: You can identify areas where you can reduce costs without sacrificing quality

How to do a cost analysis

It may be hard to know where to begin to analyze cost. But let’s walk through the steps to get you started:

Identify your need

Before you get started, it’s helpful to determine why you need a cost analysis in the first place. Are you trying to lower expenses or increase profits—or both?

Once you have a handle on the why, identify the project or cost object to review. Cost objects can include products, services, projects, or departments. Identifying cost objects helps you understand where your money goes and how different business areas contribute to overall expenses.

Some examples of cost objects include products, services, special initiatives, campaigns, or functional areas within your organization.

Gather and evaluate cost data

Accurate cost data forms the backbone of effective cost analysis. Collecting comprehensive data ensures a clear picture of your expenses. Incomplete or incorrect data can lead to misguided strategies and financial losses. Verify and cross-check all data sources for consistency and reliability.

Source of cost data include financial documents like:

• Income statements
• Balance sheets
• Cash flow statements
• Invoices and receipts
• Payroll records
• Operational logs, like data from production processes, utilities, and maintenance.

As you evaluate your cost data, be sure to distinguish between direct and indirect costs to the project. Consider the finance automation benefits of streamlining this process.

Direct costs are expenses directly tied to a specific cost object, such as raw materials and labor. Indirect costs are overhead expenses unrelated to a single cost object, like utilities and administrative salaries.

Define stakeholders

Stakeholders are anyone who has an interest in the project. They may include departments that are investing funds directly into the project or members of the management team overseeing it. These people or groups will want to understand the data you pull from the analysis and aid in decision-making related to this and future projects.

Analyze and interpret results

The next step is to analyze and interpret the results. This involves identifying cost drivers and using the insights to make strategic business decisions.

Cost drivers are factors that cause costs to increase or decrease. Examples include production volume, labor hours, and machine usage. Identifying these drivers helps you understand what influences your expenses and where to focus your cost-reduction efforts.

As you interpret results, you may find you’re on track to hit financial goals. But if not, you can work with your stakeholders to discuss feasibility, lower costs, and increase profits. And ideally, you’ll be able to set future budgeting goals across an appropriate timeframe.

Benefits of cost analysis

Efficient cost analysis can make a massive difference in how you run your business, from setting prices to allocating resources. These are three important benefits:

Improved pricing decisions

Understanding the costs of producing goods or services allows you to set prices that cover expenses and generate profit. This ensures that your pricing decisions are grounded in actual data rather than guesswork.

Cost analysis makes it easier to avoid underpricing or overpricing. Underpricing can lead to losses while overpricing can drive customers away. Analyzing costs helps you find the sweet spot where your prices are competitive yet profitable. This balance is key to maintaining market share and ensuring long-term sustainability.

Enhanced operational efficiency

By breaking down your expenses, you see where you spend your money inefficiently. This might include excessive labor costs, high material expenses, or unnecessary overheads. Once identified, these areas can be targeted for cost-saving measures.

Streamlining processes based on cost insights leads to more efficient operations. For example, if you find a particular process consuming too many resources, you can look for ways to optimize it. This might involve automating tasks, renegotiating supplier contracts, or changing workflows. The goal is to reduce costs without compromising quality or productivity.

Better resource allocation

Knowing which activities generate the most value allows you to focus your resources where they have the most significant impact. Depending on what drives your business success, this could mean investing more in product development, marketing, or customer service.

Effective resource allocation and cost management lead to leaner and more efficient operations of projects worth pursuing. This improves your bottom line and positions your business for growth and competitiveness in the market.

Cost analysis vs. price analysis

Cost analysis breaks down your expenses, revealing the true cost of producing goods or services. But what is price analysis?

Price analysis is the process of reviewing proposed pricing for a product or service and comparing it to historical data and market prices without including cost or profit calculations.

You can learn a lot about the total benefits by integrating the two into one cohesive analysis process.

Why you should integrate cost analysis with price analysis

Combining cost analysis with price analysis gives you a comprehensive view of your financial landscape. Knowing your costs allows you to set prices that maximize profit margins without alienating customers. This dual approach ensures you remain competitive while maintaining healthy profit levels.

Balancing cost, price, and value is key to business success. Cost analysis shows you where to cut expenses without sacrificing quality. Price analysis helps you set competitive prices that reflect the value you offer. Together, they ensure you provide value to customers while maintaining profitability.

Master expense efficiency with Ramp

Managing expenses effectively is crucial for your business's success. With Ramp, it's easier than ever. Our all-in-one finance platform streamlines cost analysis, helping you precisely track every dollar.

Whether you're implementing Activity-Based Costing (ABC), conducting break-even analysis, or optimizing pricing strategies, Ramp automates the tedious financial tasks, freeing up your time for what matters most.

With real-time insights into your cash flow and advanced reporting tools, you can make data-driven decisions and cut unnecessary costs effortlessly. Save time and money with Ramp—your key to smarter expense management. Discover how at Ramp today!