Costing for Internet Companies

The Internet changes everything it touches and touches almost everything.  Worldwide e-commerce revenues are expected to reach $2.7 trillion.  $721 billion of which will take place in the US.  The companies generating this revenue are called Internet companies.  These companies face new challenges as well as opportunities.  The Internet has changed the way companies interact with their customers. It has also made customers more price sensitive because of the large supply of products with little or no differentiation.  Internet companies need to be able to price competitively and make a profit at the same time.  But how do they decide on the price of their products?  The answer is costing.

Costing.

Costing is the process of determining the resources required to make a product available to customers.  Most often, this includes labor, materials, and overhead costs.  If the company is purchasing the product rather than making it, costs would include the purchase cost, overhead, and selling costs.

Materials and labor have direct and indirect costs.  Direct costs are those that can be specifically traced back to the product.  For example, direct materials used to make a rubber mallet would be rubber and wood.  Direct labor would be the amount of labor used to assemble the mallet.  Direct labor can be expressed as direct labor hours where the number of hours or a fraction of hours needed to complete the job is recorded.  Alternatively, direct labor can be expressed as direct labor dollars.  This is calculated by multiplying the direct labor hours by the hourly rate of the worker doing the labor.  Not knowing actual product costs can cause managers to focus on non-profitable products, markets, and customers while thinking that they are profitable.  Indirect costs are those that cannot be specifically traced to the product.  An example of indirect materials would be the cost of bubble wrap used to wrap the rubber mallets when they are shipped.  Indirect labor would include the labor hours used for quality inspection of the mallets.

Selling costs are the costs associated with presenting your product to target customers.  Products that are inexpensive to make or buy may be expensive to sell thus changing the price you can charge for the product.

Some costing methods include the job order costing system, process order costing system, and Activity Based Costing (ABC).  Companies need to determine how much costing information is needed and the costs of obtaining it in order to decide which method is best for them.

ABC provides the most accurate information on the cost of a product but it is also the most expensive method to implement.  The reason for this is because ABC is a two stage procedure consisting of tracing overhead to activities and the activities to cost objects such as products or services.

Two less expensive methods are job-order and process costing.  The decision between job-order and process costing systems lies in what is measured.  If the company wishes to determine the cost of producing each order then job order costing is best.  However, process costing is best for determining the cost of producing one batch of a product.

This fundamental knowledge of the types of costs and costing methods provides the groundwork for evaluating costing for Internet companies.  Now we need to understand what exactly an Internet company is.

Internet Companies

An Internet company is defined as a company who generates the majority of their income through Internet transactions.  Examples of Internet companies would be eBay or Amazon.  Each of these companies generates the majority of their income via online transactions.

Internet companies are part of a larger group of competing businesses for the same pool of customers.  Customers cannot be expected to analyze each company individually.  Instead, they use the baseline of price for comparison.  This is why it is so important for Internet companies to know the cost of each product.

Internet companies do have some advantages over brick and mortar companies.  It is easier to determine some indirect costs for these companies.  The length of time spent on their web site can be used to find the hosting cost for each customer.  The source of where the customer came from can be used to allocate specific advertising costs.  Many Internet companies use banner ads to bring potential customers to their sites.  The source of each viewer can be traced to determine which banner ads are bringing in customers.  Internet companies call this form of traffic analysis “click through”.  Also, they type of customer can be compared to the source.  For example, let’s assume that drill bits are a high margin item.  A banner ad on doityourself.com brings in many customers who purchase our drill bits.  We can purchase drill bits at a lower price if we purchase in greater quantities.  With this data, a company could increase banner ads on doityourself.com and site similar to it to increase drill bit sales and receive the quantity discount.  Unused capacity can be measured by comparing the bandwidth available with that used.  Hosting contracts or hosting in-house may restrict a company from reducing or increasing their bandwidth costs.  These companies could outsource additional bandwidth or try to increase usage of the site. For more information regarding hosting and Internet companies, you might want to check out something like Certa Hosting to help get you started.

Hurdles

Internet companies must keep pace with emerging technology in order to stay competitive.  This brings new challenges for management in the way of costing.  Managers must choose whether to lease or buy the equipment needed to conduct business.  Studies have shown that leasing is generally a better option for short-term equipment.  Irv Rothman, president and CEO of HP financial services says “buying makes sense if you plan to keep something for a long time, but technology typically becomes outdated every two to three years.”   Costing information should be used to make the final lease buy decision.  Costs would be calculated for the product using both methods to find the lowest cost solution.

The cost of acquiring customers is higher for Internet companies than it is for traditional companies.  Customers feel little loyalty to Internet companies because the Internet’s fast pace makes it harder for companies to develop a relationship with the customer.  One cause of this is the lack of physical interaction between the company and the customer.  The addition of price meta search sites such as pricewatch, PriceGrabber, and Yahoo shopping have made it easier for customers to find the business with the lowest price.  These meta search sites let customers search thousands of stores for the lowest price on a product.  Customers consistently choose the lowest priced company further decreasing company loyalty.  However, companies can use the same service to easily compare prices with competitors.

Internet companies have responded by creating personal sites for each customer where they can offer specific content based on customer needs and previous transactions.  Amazon has used this method with much success.  The downside to this method is the added time it takes customers to log into the company web site.  Some customers will leave a web site because they do not want to go through the registration and login process.  The costs of implementing this method are increased bandwidth usage and increased web site administration costs.  Other companies have tried email correspondence as a way to increase customer loyalty.  This method is extremely inexpensive to initiate.  The downside to this approach is that some customers see the emails as spam.

Managers of Internet companies need to constantly monitor the costs of their products to stay competitive.  Costing systems should be set up to produce results at any time so that management can adjust prices when needed.  Competitors can change prices at any time and Internet companies must be ready to meet competition pricing.  Accurate costing information will determine if price changes are feasible.

Implementation

The logical choice for Internet companies would be for them to integrate a costing solution into their existing databases.  There are several companies offering software packages that do this and more.

One example is Sage.  Sage is described as being able to break down cost elements into as much detail as needed with an unlimited number of tiers to accommodate specific needs.  Wizards are provided to aid in setting up the cost elements.  The software also lets managers compare actual costs with budgeted costs.  The producers of Sage claim that the software will integrate with other sage products such as Sage payroll and line 50.  The software would be of more use if it were compatible with other packages on the market.

Another software package called ABC MB (Activity Based Costing Management Budget) offers ABC costing tools and simulation features.  Best of all, the software is compatible with many ERP business management systems making ABC MB more valuable to Internet companies.

Internet companies should seek out a costing solution that provides continual costing information at the desired level with the ability to integrate the solution throughout their inventory system.  The “right” solution will vary with company needs.

Conclusion

Increasing use of the Internet has created a vast marketplace.  Companies have flocked to the Internet with hopes for low costs and high profits.  Unfortunately, many of these companies have tried to compete in this marketplace and lost due to incorrect pricing decisions.  Companies with accurate costing systems will be able to stay competitive and operate successfully.  A solid costing system can show managers which areas are indeed profitable.  Internet companies are facing new challenges and opportunities.  Most notable is the need to adapt.  Customers require instant service and managers need instant access to costing information for accurate pricing and diversification.  Various software packages are available to aid managers in determining product costs.  Managers should evaluate each package to find the one that fits their specific needs.  Companies who adapt easily, price competitively, and manage costs effectively will be profitable.  Those who cannot and will not survive.

References

  1. eMarketer. Worldwide B2B revenues to pass one trillion.  01 Apr. 2003.  NUA Surveys.  05 Apr. 2003.
  2. Sage Job Costing. Adobe PDF.  Sage Software Limited.    20 Mar. 2003. 
  3. Decimal Technologies Inc. Home Page.    Decimal Technologies Inc. 19 Mar. 2003. 
  4. Adam Stone. The Lease-Versus-Buy Equation.    Jupitermedia Corporation.  April 16, 2003. 
  5. Gordon, Lawrence A, and Loeb, Martin P. Distinguishing between Direct and Indirect costs is crucial for Internet companies.    Accounting Management Quarterly.  19 Mar. 2003. 
  6. Atkinson, Banker and Kaplan, Young. Management Accounting 3rd  New Jersey: Prentice Hall, Inc.  2001.


About The Author


Eric Vanderburg

Eric Vanderburg is an author, thought leader, and consultant. He serves as the Vice President of Cybersecurity at TCDI and Vice Chairman of the board at TechMin. He is best known for his insight on cybersecurity, privacy, data protection, and storage. Eric is a continual learner who has earned over 40 technology and security certifications. He has a strong desire to share technology insights with the community. Eric is the author of several books and he frequently writes articles for magazines, journals, and other publications.

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