Fundamental to any enterprise the question of cost as opposed to price of a service or product. Price is often set by the market, the business has little lee-way to set the price either below or above market expectations depending on various circumstances. However, the cost of a product/service is something more delicate to evaluate and yet so very important for the strategy of the business. The cost not only determines the profits and the margins available to drive the business expansion. Profits of a company can easily be determined at each financial year-end, or at any point in time with a balance sheet exercise, but profitability as a function of product/service, or as a function of a client can only be determine with an accurate evaluation of the real cost of each product.
I will refer to products of a company through out this article, but this can be interchanged for service with minor adjustments.
What is the cost?
A product has some raw materials, labor, packaging and possibly suppliers’ services associated with it. These cost can easily be computed and added to determine the direct cost of a product. However, these products are also sustaining a variety of other indirect cost in a company, for example the machinery investment, the infrastructure, the administration labor, the maintenance, and other various expenses that directly impact the manufacturing of these products. So how does one go about evaluating the total cost of a product, especially when most companies has multiple products?
Each company is unique
I explore two examples of product costing that highlight the complex nature of cost calculation that arises from the uniqueness of each company. A food manufacturing company In this first example I take a SME in the food industry that relies heavily on manual labour to manufacture its products. The company has over 50 different products manufactured at various period during the year according to seasonal availability of certain fresh ingredients. Furthermore, this company has close to 20 different suppliers and as many clients, selling their products in bulk quantities.
As it turns out the MRP of their products are fixed by market demand and competitive products already on the market. They are unsure of each product cost. The raw material cost of each product is low, and as it turns out represent only 20% of the total cost of the product. The packaging and labelling cost is another 10%. In order to determine the remaining cost, I proposed to evaluate the labour cost per minute as a function of all the overheads incurred by the company. We evaluate this over the last financial year, and the total cost of the company. This is the cost involved in running the company, in other words we remove all the cost associated with the manufacturing process, such as delivery cost, taxes, transport charges of materials or products etc. If we assume that the company is making is making not a single product in the year, what are the cost in maintaining its existence, in other words all the cost involved in staff maintenance, infrastructure maintenance and administrative costs. Let us call this cost as the Running cost. We can summarise this cost as
Next we need to know what is the total manufacturing labour time available to the company. This is the total number of staff involved in manufacturing processes into the total number of hours of work in the year. To evaluate this, we look at how many working hours there are in a day, multiplied by how many working days in a year, and again multiplied by how many productive staff in the company. We need to subtract from this the number of hours spent by productive staff in non-productive activity such as maintenance of facilities, cleaning duties, lunch breaks, tea breaks, sick leave, holidays, and other duties that stop them from actual productive work in manufacturing products. Let us call this the Productive Time. We can summarise this as
The Labour Cost can then be calculated as the Running Cost divided by the Productive Time, or
The Labour Cost is has a value of Rupee per minute. However, it is important to realise one important assumption made in the above calculation. We assume that all the Productive Time is actually used in manufacturing. The reality is quite different. A business is exposed to the market forces of demand and supply, hence in a given financial year, the manufacturing potential may not be fully utilised.
Only when the demand is maximised in expansion years and supplies optimised can the full manufacturing potential of a company be used. In most years, this is not the case and therefore, the pace of work will adjust itself to meet the demand for manufacturing, if demand is low, the work pace is slow, if demand is high, the work pace will pick up, often encouraged by the promise of bonus payouts. As a result the real labour cost will vary in time. Ideally, the business strategy should ensure a continuous growth or as best a steady demand. In order to calculate the actual labour cost, we need to look at past demand in order to evaluate the actual productive time. We shall call this cost Actual Labour Cost, and this productive time, Actual Productive Time. To evaluate the Actual Productive Time, we need to work backwards, from the sales data of products in a given period of time (the last financial year perhaps) and derive the total productive time spent in the period. Therefore, for each product sold in that period, we need to evaluate how many such product was sold into the time it takes to make that product. We can summarise the Actual Productive Time as,
The product manufacturing time is simply the time to make a batch of that product divided by the number of products in that batch. We can therefore calculate the Actual Labour Cost as,
The Actual Labour Cost will be considerably higher than the Labour Cost calculate above. It implies that the outlook of the company will be much improved if the demand increase since that would mean a drop in Actual Labour Cost and consequently an improved margin. Similarly, if the coming period sees a drop in demand, the Actual Labour Cost will increase, reducing the profit margins. We assume the MRP to be fixed.
A good indicator of performance
The Actual Labour Cost is an excellent indicator of performance of the company. A business that is equipped with an ERP system with Bills Of Materials (BOMs) functionality can be easily configure to calculate the real-time Actual Labour Cost on a monthly-averaged period, giving an insight into the overall demand and manufacturing health of the company. Such an indicator is plotted in Fig 1 below.
Fig 1: Actual Labour Cost (plotted in blue) normalised to theoretical Labour Cost (in green).
Both are normalised such that the Labour Cost remains constant and the Actual Labour Cost vary in time. The monthly data is average of the last 12 months in order to indicate demand of products as well as running cost. Decrease in Actual Labour Cost shows improved outlook for the company, while an increase shows decrease in demand and/or increase in running cost.
In the second part of this article, I will explore the cost of a very different kind of product, one that is not based on labour dependent manufacturing, but rather on service and intellectual property. The assumptions required to determine an effective cost are much more complex, therefore requiring another set of indicators to determine the accuracy of the costing model.
(To be continued…)