One of the big decisions in running a business is establishing the price of your product. The price leads to the top line of the financial statement, which has an immediate impact to the bottom line. The little amount of effort many companies put into this mission critical data is not proportional to its importance.
There was an old carpenters rule for estimating: Material cost times 2.5 is your price. That still works if your current material cost is about 40 per cent of sales, the product range is narrow and homogenous and you are interested in the details!
Most manufacturers have costing systems supported by effective software. The software predetermines the estimating method the company can use. The key is that we need to understand how the software is calculating the proposed prices. And depending on the method and the desired results you need to develop and update the data structure.
The estimating /costing is very basic: Add up all direct cost like material and labour, add a fair share of indirect cost (overhead), add the desired profit and you have your proposed price. The challenge is, as always, in the details.Direct Cost
Labour cost [$] = Labour time [hrs] x Cost per time [$/hr]Labour time
The sample below is a simplification to establish labour time: A cabinet manufacturer with 40 workers @ 8 hrs/day accumulates 320 hours/day. If they produce an average of 95 cabinets per day the labour time is 3.4 hour/cabinet. Most will say this is not accurate enough – fair enough. However it is a powerful number, because with whatever numbers you develop with detailed time studies, the average unit must lead to the same number as above or there is an error in your time study. Off course a detailed time study will provide an opportunity to differentiate the time requirements for large and small units, for easy and simple finish, for simple or extensive hardware installation, etc. Cost per time
The average labour rate seems, at the first glance, a very simple exercise. On closer look, the above time calculation might not include all hours worked at the company. Non-productive activities are usually not included in the time standards. However in the costing, the cost for hourly supervision, maintenance, shipping, warehousing, quality inspection etc. needs to be recognized. There are different options. You can apply it as part of the overhead (see below) or you build it into the hourly rate of direct labour. Additionally, all workers have a certain element of non-productive work. The cost for vacation, sick days, meetings, training and other in-direct work needs to shore up the hourly rate.Material cost
Establishing the material cost is usually the most accurate and easiest element of the costing exercise. According to a bill of material (BOM) the individual material quantities are priced at the valid purchase price of the raw materials.Waste/yield
For using lumber, sheet goods, veneer, leather and fabric the waste/yield factor is significant. In many companies these factors are not established and provide potential surprises and false results.
Production overage and quality fall out. If you lose an amount of material due to quality problems or to prevent costly rush remakes you produce a few extra pieces (just-in-case) – who pays for those? Are the labour cost and material cost accepted as a part of doing business and do you add it into your cost, or do you just accept the fact that they will reduce profit?Indirect material
Listing every single purchased item in the BOM is impractical when it comes to small and inexpensive items, often referred as floor stock. Screws, dowels, glue and nails are typical floor stock items. Even if they are inexpensive, as a group they add up and should be recognized either in material overhead or the overall overhead rate.
The biggest indirect material group is often the finishing material. I see it often ignored completely in costing exercises. This brings us to a critical point where you need to decide on the level of accuracy you need. If you, for example, put the cost for finishing material in the overhead you apply for all products than even the cabinets with no finish “pay” for the material. If such a cost is significant, than the calculated price for laminate products is too high, and for finished wood too low. In a price sensitive market the underpriced finished product will attract more customers and the overpriced laminate product will turn customers away. As a result the sales mix will shift to the underpriced product and the financial objectives are not achieved.Overhead
Again, you can take a shortcut. Take all of your projected overhead (manufacturing, general & administration, and sales) and divide it by the projected number of cabinets. The result is overhead per cabinet. In this case every cabinet is carrying the same amount of overhead charge. Is this right or wrong?
It depends on what level of detail you need and on your pricing policy. There is no theoretical limit on how detailed you want to apply the overhead. The traditional method is to establish overhead as a percentage factor of direct labour and apply it on top of labour. Most textbooks show this as the dominant model.
The potential problem is that in a highly automated factory the labour cost is usually a small share of the entire cost structure; overhead is a relative high share. If you apply a large overhead onto a small base a small error in the time standards will result in big swings of the results. So applying overhead with a big brush on top of direct labour cost does not meet our need for accuracy.
A more stable solution is to apply the overhead as a percentage on the sum of material and labour cost. This way the base is usually over 50 per cent of cost and the overhead factor is relative low. The results are more balanced, however this method has the effect that two similar produced cabinets - one built with low cost material and the other with high cost material – carry different overhead. The decision to take this route is part of your pricing strategy. Specials
Most companies offer a standard product range and offer the option of mass customization and custom work. How do you want customers to pay for this service? The extra cost for creating specials, like product engineers, drafts persons, special software and custom shop, can be put in the general overhead – so everyone pays for it – or you create a separate pool on costs and let the specials carry themselves.
This requires a strategic decision! In the first case the price for specials is kept artificially low, you are seen as a flexible manufacturer, and this business segment will grow. In the second case you protect the price competitiveness of your standard product line, but are seen in the market place as an inflexible manufacturer. Understanding your estimating system and its consequences is important!Activity base costing
Offloading some part of the overhead smoothes out the costing results; however there are still potential systematic inaccuracies. For example if your company’s technology is unbalanced. Let’s say you are highly automated in the machining area, but very manual, low tech in the sanding area. The automatic storage and retrieval system combined with panel saws and high-end nesting machines integrated with the edgebander produce the parts with three operators. However you have three employees doing the hand sanding. With that systems the hand sanders time carries the same amount of overhead as the machining time. Again this distorts the real picture and if the details are not understood it could lead to wrong decisions.
Another example is finishing in a cabinet plant producing laminate and finished wood doors. In order to differentiate you need to create a separate pool of costs linked to finishing and apply it to the finished product only. This pool can include a number of costs, like finishing material (see above), energy cost for the drying ovens, proportional factory space, disposal cost of finishing material, customer service cost (cost of quality) related to finishing problems, lease cost or capital depreciation for finishing equipment. Such a calculation accumulates a more accurate picture of the true costs. The market determines the price!
So why drive the system into such detail, when at the end the day, final price is determined by the market? Would it not be easier to compare and analyze the price lists of your competitors and find your price level in their price structure? They use similar materials, equipment and processes, and if they making money - so should you. If you do not provide a better value to the customer than your competitors, you cannot sell for a much higher price and you should not leave money on the table.
It is a valid point. You need to keep the finger on the market pulse anyway – so why go through such an extensive and expensive exercise of estimating and costing?
For good decision-making you need facts you can trust. You need to know what products cost you and how much contribution to fix cost (profit) the product will actually achieve.
When your factory has sufficient work, the bills are getting paid and there is sufficient money left over at the end of each month and job costing/estimating might not be the most important project in the company. The reality however, is a constant balancing act. You are either overloaded or do not have enough work for your capacity. So if you are too busy: Which job do you give up or go after? On the other hand: If your factory is hungry for work how low can you go to “buy” a job and still be commercially viable?
The only way you can make fact-based-decisions is by knowing your cost in sufficient detail.
Additionally, the process of establishing the cost brings management attention to the actual cost of manufacturing. This attention will initiate questions and improvement activities, which will lead to cost improvements.