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Which product makes you money? Do you know your production cost?

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Operations Excellence by Sepp Gmeiner
Sepp Gmeiner is a partner with Lignum Consulting. For feedback, questions and/or suggestions please email

Many companies have not updated their product costing for years. In conversations with some of the companies I’ve meet with, they admit they really do not know how much their product costs. Having no or outdated product costing in place is not an issue for small companies only; it is the same with companies of all sizes.
How is this possible? How do companies stay in business without knowing their cost in detail? The fact that so many companies don’t know their cost is a strong indicator that you can operate a business without knowing! This seems like a contradiction to the textbooks.
“If there is sufficient money left over in the bank account each month we must be making money.”… “My prices are about the same as my competitors; if they stay in business – so should we.” or “The price is determined by the marketplace so why do we need to calculate it?” …are just some of the points made. There is some truth and some wisdom in all of them.
In good times when the product sells well you make money. You do not know on which product and what services, but it does not really matter. You do not know, or are not sure, what your great moneymakers are. As times turn more competitive, it is harder to fill the plant’s capacity. Customers put pressure on your prices. Price increases to cover material cost increases are delayed and higher discounts are given. As you know, the only thing you give away when reducing prices is profit. You cannot give cost away; they remain and increase pressure on the organization.
This is when questions come up about the actual cost of the product.

Fixed cost versus variable cost
The definition is rather simple: If a certain cost goes up as volume increases then it is variable. The most typical is material cost. For every additional customer order you need additional material, therefore this is variable cost. If you look at factory labour cost: for every extra order you need extra labour, however if you deduct orders do you really reduce labour? If you continue (pay) the labour force then the labour cost becomes a fixed cost – at least in the short term.
There are a number of different costing models in use. The costing model chart depicts the traditional costing model used in our industry.

Establishing material and labour cost is the initial work.
Most manufacturers have costing systems supported by effective software. The software determines the estimating method the company will use. The key is to understand how the software is calculating the proposed prices and, depending on the method and the desired results, you will need to develop and update the data structure.
Estimating/costing is very basic: All direct costs such as material and labour are added up, 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. 

Labour time
The following sample 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 hours/cabinet.  Most will say this is not detailed enough, fair enough; however, it is a powerful number because with whatever numbers you develop using detailed time studies, the average unit must lead to the same number as above or there is an error in your time study. Of course a detailed time study will provide you with the opportunity to differentiate the time requirements for large and small units, easy and simple finishes, simple or extensive hardware installation, etc.
Initially, the process of costing time estimation by production staff should be sufficient.

Cost per time
At first glance, the average labour rate seems a very simple exercise. Upon taking a closer look, the above time calculation might not contain all hours worked at the company. Non-productive activities are usually not included in the time standards.  However, the cost for hourly supervision, maintenance, shipping, warehousing, quality inspection, etc. needs to be recognized in the costing as well.  You can apply it as part of the overhead (see below), or you can 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 current purchase price of the raw materials.

Waste /Yield
When 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 on a regular basis, or to prevent costly rush re-makes, do you produce a ‘few‘ extra pieces (just-in-case) – who pays for those? Are these labour costs and material costs accepted as a part of doing business? Do you add these into your cost, or accept they will reduce the profit?

Indirect material
Listing every single purchased item in the BOM is impractical when it comes to small and inexpensive items, often referred to as floor stock. Screws, dowels, glue and nails are typical floor stock items. Even though these items are inexpensive, as a group they add up and should be recognized either as material overhead, or the overall general overhead rate.
The biggest indirect material group is often the finishing material. I often see it 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, for example, you put the cost for finishing material into the overhead cost that you apply for all products, then the products with no finish ‘pay’ for the material. If this cost is significant, then 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. 

Again, you can use a shortcut here. Take 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 your pricing policy. There is no theoretical limit on how detailed the overhead rate can be developed. The traditional method is to establish overhead as a percentage factor of direct 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, whereas, overhead is a relatively high share. If you apply a large overhead onto a small base (in this case labour cost) a small error in the time standards will result in big swings to the calculated price. Spreading 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 of the sum of material and labour cost. This way the base is usually over 50% of cost and the overhead factor is relatively low. The results are more balanced, however, this method will result in two similarly produced cabinets –one built with low cost material and the other with high cost material – carrying different overhead. The decision to take this route is part of your pricing strategy. 

Pricing Strategy
The higher the fixed cost in a company (or an industry) the less the price is driven by the variable cost. For example, if you take the airline industry, the variable cost per passenger is very small. How much does it cost for an extra passenger to fly in that big plane? This is why some customers pay only a small fraction of others. This has nothing to do with cost. If they all charged full price the planes would be empty and the airlines would go out of business. If they charged the lowest price for all seats the planes would all be full and the airlines would not make any profit. To calculate cost in such cases is mainly dependent on how you allocate the fixed cost to the different products. 

Most companies offer a standard product range and entertain the option of mass customization and custom work. How do you want the customers to pay for this service? The extra cost for creating specials, such as product engineers, drafts persons, special software and custom shop, can be put in the general overhead, so every product  ‘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 are 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 seen in the market place as an inflexible manufacturer. Understanding your estimating system and its consequences is important!

Activity based costing
Applying the overhead on the bigger base of labour and material evens out the costing result, 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 six employees doing the hand sanding. With these basic systems the hand sanders’ time carries double the 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, such as 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.
If your prices are based on such distorted cost allocation some of your product is priced too low (and you will get more of these orders) and some are priced too high (get less of these orders) the market forces will promote the wrong products.

The market determines the price!
Why drive the system into such detail when, in the end, the 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 are 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, nor should you sell for less and leave money on the table.
These are all valid points. You need to keep your finger on the market pulse anyway – so why go to the 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 fixed 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, 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 end of the scale: if your factory is hungry for work: How low can you go to ‘buy’ a job and still be commercially justifiable?
The only way you can make fact-based-decisions is by knowing your costs in sufficient detail.
Additionally the process of establishing the cost brings management’s attention to the actual cost of manufacturing. This attention will initiate questions and improvement activities, which will lead to cost improvements.


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