The Product Cost Problem
There are inherent dangers of running a manufacturing business with little insight into your true product costs. This often results in the following:
Dangers of poor insights:
- Low profits
- Difficulty in pricing your products
- Knowing which products to push and which to eliminate
- Knowing where to focus for cost reduction programs
- Knowing whether I am improving or sliding
- High sales of low margin products
These lack of insights can commonly happen in three instances.
Product Cost – Paper and Spreadsheets Don’t Add Up
In the first instance, costs are gathered on paper, spreadsheets, and the like. It is difficult or impossible to gather these records together and consolidate them into accurate product cost reports.
Product Cost – The Peanut Butter Problem
In the second instance, product costs are determined by allocation of huge buckets of costs, applied by generic methods that mismatch the true underlying drivers of those large costs. A common example of this lies in production overhead, typically applied on direct labor hours. In today’s automated world, labor has become an insignificant portion of total product cost, and is usually mismatched to overhead costs. For example, today’s high-tech expensive machines have large maintenance costs that consume large portions of overhead costs, and use little direct labor. And manual operations use little overhead, but are allocated large amounts of the total overhead costs. As a result, high tech expensive operations are under-costed, and manual operations are over-costed. It is not unusual for managers to scratch their heads about the overloading of the high tech operations, and the poor profitability of their businesses.
Product Cost – Your Costs are Hiding
In the third instance of poor insight into product costs, major components of cost are totally ignored. This typically occurs in areas where special efforts are made uniquely to certain products. These areas include engineering, purchasing, marketing and sales, inbound logistics, outbound logistics and administration.
An example will clarify this problem. Company A has two lines of business. One is a standard line of coolers used in the restaurant market. The second is a custom line of coolers for restaurants that have special requirements. The first line is a make-to-stock product, and the second is an engineer to order. Company A has always treated engineering as monthly expense line on their income statement, and never allocated the cost to the individual product lines. Since the margins are typically lower on the standard cooler line, management had been focusing on selling more of the custom line of coolers. However, when they identified what the true engineering costs were for each line, they found that they were actually making more margin on the standard line. Management subsequently corrected their focus, and bottom line profits began to steadily climb.
The Product Cost Solution
Eliminate multiple disconnected systems
A centralized product cost solution can go a long way to gathering all the activities of your operations, and providing the insights you need. This eliminates the inability to consolidate the records into one true product cost. It also provides a uniform standard, for which all the product costs can be applied to. Gone are product cost reports that don’t reconcile together.
Automate the collection
The more you can automate the collection of data, the less likely it is to be error prone. Bar codes can eliminate part number errors. Digital shop orders eliminate errors on work order no. and operation numbers. Digital shop orders can also eliminate lost paperwork.
Monitor against standards
Yet another way to improve product cost accuracy is through the use of standards. Exception reporting can quickly spot things that deviate too far from the norm. Operations that are not performing to standard can be identified and corrected before a long tail of bad parts are produced. Bad part-nos., bad quantities, and other miss-entered items can also be found.
Standards can also provide insight into in the area of performance. Through the use of KPI’s, management can determine operations that are under performing, thereby causing product costs to be higher than expected.
Eliminating input errors
Computerized ERP manufacturing systems also provide controls on input errors. Every part-no. operations number, and work order no. are checked against existing lists to make sure they are valid. In some operations, the BOM can be back flushed to inventory, eliminating errors and speeding input time.
Including all the product costs
Measuring significant product costs of non-production areas can be handled in several ways. First, a value chain analysis needs to be performed to identify the areas where product costs are being misapplied. This can be done by mapping all the major activities that go into producing your product. Remember to include the following areas:
- Design of Products, Services, or Processes
- Marketing & Sales
- Customer Service
You are looking for areas of product cost that vary for different products that you produce. For example, in one product, purchasing may have to apply special procedures because of an unusual component (ex. Hazardous materials with special paperwork, shipping and handling). As another example, one product may require special paperwork in sales to handle Federal requirements which takes time to complete, and waiting time for the government to approve. Once you have found those areas, you need to determine a cost driver which best reflects the application of those costs.
Now, you can use your ERP system to account for these costs and roll them into your product costs. Depending on the nature of these costs, they can be applied by several methods. In the first method, these costs can be applied as an item in your bill of materials (BOM), or shop routing. This treats the costs as another step in your production process. This has the advantages of automatically rolling into each shop order, tallying how much of the resource was consumed, and, if desired, comparing to standards for the process step. You can then know your exact product costs, monitor the progress of the use of that product cost, and set performance targets to improve it. Still another advantage is that if the cost area refuses to capture the costs by product (try getting sales to report hours), you can still back flush the costs from the standards on the BOM or shop routing.
In another method, the costs can be rolled into either fixed or variable burdens and applied. This does not offer insights to improving the costs, but does give insight into total product costs.
Determining your accurate product costs is critical in pointing your organization towards profitability. Lack of insight into your costs, can cause you to focus on the wrong products-often, the low margin ones. By establishing a centralized system with all the right checks and balances, you can focus on the right activities to build your business.