Managing costs is always challenging and more so in inflationary times. A client recently asked us for some help. They found their costs for raw materials and subcontract services were going up rapidly. You are probably experiencing the same thing.
Margin Erosion
Margin Erosion is a problem for any business, but especially for manufacturers. It’s easy to find yourself selling for less than direct cost; without even counting overhead or labor.
For example:
With a normal 60% margin, add 47% increase in cost, your margin drops to 41.1% that = 50% reduction in margin.
If you are in a price-constrained market and have a 40% margin, that same 47% increase in cost drops your margin to 11.8% that = a 75% reduction.
Lower margins are a problem but they do not paint the whole picture. For example: Sales and Marketing
- Let’s say you average 10% of sales
- Your cost used to be 17% of the margin and now it’s 25%
- If you have a lower margin, your cost of sales went from 25% to 90% of margin.
Why Your ERP Is Not Telling Your Current Cost
Recognize that your ERP software probably will not give you a good answer. ERP and Production Orders are based on historic costs. Many of our firearms clients purchase large amounts of smaller products that will last more than one year. Every production order will use that year-old cost to calculate your current margin. Technically correct, but really a poor gauge of your margin. Your P&L will do the same.
Why is that? Most companies use FIFO (first in, first out) or Average inventory costing methods. Both are backward-looking measures. There was another method used extensively in the 70’s and 80’s (our last period of prolonged inflation). LIFO (last in, first out) made sense because you used the most recent cost to offset your profit. (The IRS does not like you changing methods because it is a huge opportunity to play with earning.) We are not offering accounting or legal advice, just telling you why your ERP isn’t a good choice for managing costs in an inflationary period.
The problem may be worse if you are using Standard Cost for you inventory. While your P&L will immediately reflect the cost difference for purchased items and services, your production cost will not report any changes because you set the standard cost.
Finally, ERP is doing what it must, however, that may not answer the question correctly for your cost question. Recognizing that moves you to the next level of understanding.
What can you do to manage forward-looking costs?
Your ERP can provide you with good information to understand what your costs look like today. If you are like most manufacturers, you have three or four main elements that make up your cost of goods. First is Raw Material, the things you buy to make the Finished Good. Consider these as things that you can shop around or negotiate a price. On the other hand, you might also look for a different way to build the product that will provide the same quality, but reduce the material cost.
new quote. Compare the cost to the cost your last production order used. Is it higher or lower? FIFO or Average are slow to respond to long lead times.
Second is your labor or subcontract service cost, the effort it takes to make something. Your Routing tells you this and it is a tough one. You need labor or subcontract services to make and put things together. However, you have an opportunity to revise your method of machining, treating or assembly to reduce costs. You can also compare the cost and efficiency of doing a process internally vs. subcontracting it. Perhaps you subcontract your employees through a service to reduce overhead and increase benefits. Alternatively, you outsource the whole process. Perhaps changing out more efficient equipment makes the difference in reducing cost and improving throughput.
Third, you probably have transportation costs during the manufacturing process, if you are like many of our firearms manufacturers. It is rare for one company to do all processes in-house. You may have your product forged in California, machined in Minnesota, heat-treated in Arizona, coated in Texas, and assembled in Colorado. That is a lot of transportation. Obviously, there are several important considerations: capacity, quality, cost, responsiveness, ease of doing business, and timeliness. Too frequently, we look at the cost per part and don’t consider the logistics and quality costs until after the fact.
If each of the processes plus transportation takes two weeks, our production lead-time is 10 weeks. Finding suppliers nearer to each other can cut out significant transportation and lead-time. Next, if your customer pays net 30, you may have a 90 to 120-day gap from the time you pay for the forging to the time you are paid for the finished product. Half of that time may be spent on a truck.
Finally, overhead costs are very challenging. You pay the rent, lights, heat, air, water, office expense, insurance, and many other costs every day. It can be tough to assign these costs to your product, but it is important to consider them in the cost equation, otherwise, your BIG margin becomes a little margin. These are also costs that may be reduced by shopping or by changing procedures. (Shameless plug – one of our customers, a plastics distributor, put in our software and, while their volume doubled, they kept the same staffing level; another customer using our software, found they were able to ship the same amount of packages every day with half the number of shippers.)
The best way to reduce overhead costs? Increase your volume! Yes, you can reduce your actual overhead, but removing the impediments to workflow so you can handle more volume makes a bigger difference to your bottom line. We find that the employers we work with do not reduce headcount to reduce costs; they have a hard time getting enough qualified people. Improving workflow, whether in the physical process of making your product or in the paper flow can make a huge difference. It’s possible for a 10% reduction in cost per unit to translate to 100% or more in improved bottom line profit.
How to Make It Easier
Our client asked for a “Most Recent Cost” report. In other words, your ERP is using FIFO for accounting; I want to know my LIFO cost to manufacture the next product. Imagine looking at a BOM with 125 components, four levels deep Routing. Getting the cost for each is, at least, an all-day job. Now, add on 60 route steps. You have another day of work. Next, look at the other 35 products you make and you are now two and a half months down the road.
The client asked for a report to export to Excel to make the analysis easier. Our report/spreadsheet looks at Raw Materials, sub-contract cost, labor cost, machine cost, and overhead for each to roll up all the costs in seconds. You are free to do the analysis quickly and easily. You can do it every day if you like. Now you look for the outliers – perhaps items with no cost or low cost. Determine what is wrong with them. Check the high-cost items. Can you do something about that?
Wrap It Up
Most of all, you can make informed decisions about pricing, sourcing, and other things that directly affect your profitability. Maybe you bundle things slightly differently; maybe you increase the price on the higher cost, more desirable options and leave the price alone on the low-end product to bring people in the door.
Above all, times of rising costs are the perfect time to review your normal operating procedures. “Normal” does not mean right or best – it is just what you are used to doing. Normal is easy and excellent is harder – until it becomes normal. Maybe you have gotten out of your continuous improvement mode. Kick-start your next “Kaizen” event and get your lean engine purring again. Those who innovate while others stagnate succeed.
Best wishes for your innovation.
