One of the big questions in any business involved in selling goods is (or at least should be) “How much does it cost?” Even the hot dog vendor outside the home improvement center on the weekend needs to know what his costs are. It actually should be one of the prime business questions, although the practical reality is that product pricing is often derived based on what the market will bear rather than what is a reasonable price based on the cost. And that makes sense; the initial product price based on low production volumes is usually too high to use cost-plus pricing. At the same time, if the market is willing to pay 99 cents for a fast-food soft drink that costs 6 or 7 cents, most of which is the cup, why charge less?
Still, there are many nuances to identifying and computing product costs. On August 15th, The Sunrise Sip Club, sponsored by Expandable Software and the Mirador Software Group, was fortunate to have Karen Wallace of Lighthouse Worldwide Solutions share her insights on the process. Karen is an uncommon individual these days – a guru in Cost Accounting in general and generating product costs in particular in an environment where producing in the United States has been waning.
Karen reviewed her process with the Sip Club, and at the highest level, her methodology for setting standard costs relies on sound source data. I should note that the rest of this discussion focuses on using Standard Costs, as it is the most prevalent method for manufacturing companies. We define a Standard Cost as a cost which is currently attainable under existing efficient conditions at the time the standard is set. The source data supporting this process can be broken down as follows:
- Purchased Part Costs: These are the fundamental building block for generating product costs. They are typically a weighted average cost based on relevant history [depending on review cycle and purchase history, three months] provided by a Purchasing Team with a few caveats
- Purchasing estimates may be used for first-time buys
- Small lot purchases, expedite charges or other price extremes [I.e., aberrant prices] based on purchasing history, are typically excluded from the weighted average.
- Prospective, i.e., future-looking, costs may be used if purchase orders with confirmed delivery dates and prices are available.
- Shipping, freight, delivery, expedite and other similar costs may be included in the material cost, although typically it is easier and more accurate to include these as an Overhead or Period cost.
- Material Costs for Assemblies: These are computed utilizing the product Bill of Material [also called Product Structure or BoM]. A Bill of Material is a document that shows the quantity of each type of direct material required to make a product.
- The accuracy of the Bill of Material is critical to the accuracy of the cost. If the Bill of Material is inaccurate, the resulting cost will be inaccurate.
- The standard quantity per unit for direct materials should reflect the material required for each unit of finished product
- Production Yield % can be included but typically not scrap costs [a Period Cost] in assemblies costs.
- Labor Costs: Direct labor price and quantity standards are usually expressed in terms of labor hours and labor rates.
- Labor costs are usually established using a Process Routing including Workcenter(s) utilized in the operation and Labor and Overhead rates by Workcenter.
- A Process Routing is the equivalent of a Bill of Material for Labor. It includes the sequence of steps or Operations to be performed by workcenter with standard times per step.
- The Process Routing is also used for directing product and material flow through the production process
- Process Routings are typically established, maintained and controlled by Manufacturing Engineering and validated by Finance.
- Finance typically establishes, maintains and controls standard Labor and Overhead rates for each work center.
- Outside Processing Costs: Outside Processing Costs are costs incurred that are generated by functions/entities outside the Company, sometimes called Outsourced Manufacturing Costs.
- Outside Processing Costs are a hybrid of material and labor standards; these costs are established like Purchased Components (i.e., cost per piece) influenced by normal lot size.
- Production Overhead Costs: These are costs incurred in the Production process that are not Direct Costs (i.e., directly attributable to the Product), such as Facilities costs, equipment depreciation, production supervision, warehousing costs, etc.
- Overhead Costs are usually assigned to products using an allocation process.
- The allocation base can be any metric that causes or drives the Overhead Costs. Typical allocation bases include direct labor costs, direct material cost, or machine hours by machine or workcenter.
- Multiple Overhead rates and bases can be used depending on the complexity of the Production process.
Data, Data, Data
As you can see, there are many data elements to manage in this process, and depending on the complexity of the product, can relate to tens of thousands of parts; think about the number of items to make a supercomputer or jet aircraft.
To paraphrase Doctor Who, computer systems are very sophisticated idiots; they do exactly what you tell them at amazing speed, even if your instructions, and most importantly, your data, are wrong. If your source data has issues, how can your cost be accurate?
How Often Should I Change Costs?
The process of “rolling up” and revising product costs really depends on the volatility of your products. In some Companies, once a year is sufficient. Given the efficiency of new ERP systems, some companies have moved to quarterly or even monthly cost roll up cycles. The bottom line here is this: consider cost rolls based on your business needs, material events and key business drivers and not necessarily on traditional calendars. If your market is dynamic with rapid (and significant) price fluctuations and volatile Bills of Material and new product releases, you may want to review costs more frequently.
Who’s Driving the Bus?
So, given all the data requirements, who owns the cost generation process, and specifically, who owns the cost? My answer is simple: The Company Does.
- Purchasing owns Purchased Parts and Outside Processing Costs
- Manufacturing/Manufacturing Engineeering own the Bills of Material, the Process Routing and the Labor estimates per operation.
- Finance owns Labor and Overhead Rates and data audit and validation. Most importantly, Finance owns the process, coordinating the efforts of all the functions in the Company participating in the process.
The critical point is that a Product Cost is not “Finance’s Cost” – it is the Company’s cost based on all the inputs provided by the functions that actually produce the product. Finance conducts the Orchestra, but the Orchestra plays the music.
Jeff Osorio is a Consulting CFO with over 30 years of experience in operationally oriented companies ranging from pre-Revenue to $4B with 40 ERP implementations in his portfolio. He has also served for over 15 years as an Adjunct Professor in the MBA program of the Leavey School of Business at Santa Clara University.