Plastics processors are fortunate to have several options for managing and calculating costs. In part one of this series, we discussed the benefits of a production profit contribution model. This article introduces the simplified standard costing method (SSCM). A third costing approach — managing profitability and cash flow — will be presented in the final installment of this series.
While production profit contribution provides fast and reliable quantitative profitability information, the SSCM centers on qualitative information such as:
- Tracking production setup times, production speed efficiency rates, and downtime percentages;
- reporting on raw material efficiency and finished good yield rates;
- actual versus predicted standard usage and rates for labor, material, and machines.
It’s important to understand that production profit contribution and SSCM models are not mutually exclusive and may co-exist for plastics processors.
SSCM provides greater detail on a production run than any other costing method. This information helps to confirm which production metrics are good while identifying those needing improvement, such as inadequate production speed or adjustments to the machine or mold/die relative to part weight. Moreover, this approach addresses other aspects such as examining the costing rates in question.
Let’s take a closer look at the SSCM.
Simplified standard costing
It is critical for plastics processors to avoid negative cash production and truly understand profitability when an order is produced. This can be accomplished by applying the concept of “direct costs” through the implementation of the SSCM.
In other words, only consider using the direct cost such as material, direct cost of labor, and direct overhead costs. These should add up to the standard cost of your product and match the cost of goods sold (COGS) in your financial statement. Below that level, you essentially lose cash making this product with absolutely no profit or any help paying down your fixed indirect costs below your COGS in your financial statement.
Traditional standard costing also includes making complicated costing variance analysis at month’s end, which can be extended in its entirety into your general ledger. This variance analysis can create a serious and costly administrative burden when you consider that the most important aspects of standard costing are to:
- Ensure product profitability on the production floor;
- understand why it is not performing to expectations;
- establish the appropriate product pricing to your customer.
However, you may still want the option to consider indirect costs in your standard costs, such as plant indirect expenses like supervisors and general plant operating expenses. The problem is that they may not be directly related to a specific production run and you will incur these expenses whether or not you have anything to produce. For control, these are better managed like department line items (i.e., actual versus budget). Such indirect costs may simply be taken out of your COGS to determine your gross margin goal which should relate directly to your product standard cost goal and gross margin. As a result, your COGS should include the following direct cost components:
- Direct labor costs;
- raw material costs;
- direct overhead costs.
Setting the parameters
SSCM implementation is more involved than the production profitability contribution method when establishing the correct parameters. However, it also requires identifying the same two basic variables required for the production profitability method for each product — the product’s net selling price to a customer and the raw material unit cost.
The net selling price could start with the unit price invoiced to the customer. However, any associated payment terms, such as 2%/10 days, or sales commissions may be deducted from the sales price. This will act as a small buffer when calculating profits over the standard cost. Also, it could be a product sold to many customers. In this case the lowest price sold could be another buffer, or average could be the norm.
Raw material standard cost rates
The raw material unit cost begins with the invoice from your supplier. Generally listed as bill-of-material (BOM), this includes any material such as resin, additives, third-party parts, and packaging material used to produce the finished product. Alternative costing methods may include FIFO (first in/first out) or the average cost based on what is in inventory. These methods involve constant updates. The preferred approach, and the simplest to maintain, is the average-cost method, which is widely accepted by tax authorities.
No matter which method you choose, one would want to automate unit-cost updates with the current system and compare them to your standard unit-cost monthly. This will ensure that a favorable variance is maintained.
Setting up a standard unit cost will normally require adding costs based on a multitude of factors and situations. The standard unit cost can account for waste generated on each job, including non-recoverable material or depreciation of virgin material left over in regrind. The standard unit cost might also include a small buffer against price increases. Again, these should be minimal in percentage and act to avoid repetitive updates, administrative tasks, and create a small margin for errors in profitability tracking.
Labor standard cost rates
Next in line is the labor-cost key component of the SSCM. To begin, you may need to distinguish between different types of operations and create production labor groups. Generally, most processors will have two or even three such groups. The primary group will likely consist of “line plastics operators.” You may have a more experienced senior group, such as “setup operators,” demanding a higher salary. If your philosophy is to have separate people doing live production quality assurance, you could include a ‘’quality operator’’ group. Because labor costs must be reconciled with the payroll to ensure the accuracy of those rates, it’s important not to have too many groups. Each labor group will have to be totaled at standard rates versus what each group is compensated through payroll. This will be covered later.
For each labor group, you will need to establish an average payroll rate and add in the expected annual payroll increase (i.e., cost-of-living increases). Then, a percentage must be applied to that rate of what I call ‘’employee benefits,’’ such as healthcare insurance, government charges, or expenses paid by the company on behalf of employees. Finally, you will need to consider that production operators rarely work on production 100% of the time. Other activities such as training, administration, meetings, and maintenance or downtime can affect the hours that are purely live production work. Taking the number of yearly production hours into account provides that percentage.
For example, if the average hourly rate for a line operator is $15 with a potential 3% annual salary increase and you pay 16% more of their gross salaries for different employee benefits with 85% of their time spent on production lines, the hourly rate is $21.08. However, for simplicity purposes, I would recommend rounding the rate up to $22.
Standard line operator rate = ($15.00 * 1.03 *1.16) / 85% = $21.08
Machine and tooling standard cost
While there may be a machine rate at which a selling price is set, the standard cost machine rate could be set using a different method. Generally, rates are set by the usable hour capacity over the life of the machine. If you just purchased a very expensive machine and will have limited hours of production the first year, calculating a machine rate would be an unrealistic rate over the life of the asset. Therefore, an evaluation of the estimated useable production hours over the life of the asset should be used. Annual maintenance costs expressed in percentage should also be applied to that rate.
Available machine production hours could be 24 hours a day for five days over 50 weeks, which is 6,000 hours per year. However, if the machine is only usable for an average of 85% per year for 10 years, the total would be 51,000 hours. Obviously, fewer hours will be useable the first few years but much more in later years.
If the cost of the machine was $2,500,000 with an expected $10,000 maintenance cost per year, the rate should be:
Machine Rate = (($2,500,000 + ($10,000 * 10 years)) / (5,100 hours * 10 years) = $51
The same could apply to other inline equipment representing significant investments, such as a robot. Tools like molds in molding or dies and calibrators in profile extrusion are often owned by the customer, but if they are not, the same situation applies and must be taken into consideration using the same method.
Machines and tools are investments and are fixed costs but are also direct costs. Such costs must reflect what will be recovered over the life of the asset. That period, unlike material and labor costs, will be in terms of years.
Direct overhead cost
Obviously, electricity consumption or shipping charges are also direct costs and should be taken into consideration with a rate per hour or per part. More and more, electricity meters can be installed to know exactly what consumption you have by machine. However, other indirect costs, such as heating, should not be included. If you want to keep costing simple and pertinent, I would not go further because they are indirect costs. Such costs will be incurred whether you produce something or not. We want to draw a line in the sand for what is inevitable spending.
Standard cost calculation
We are now ready except for one small detail. We need to know the minimum size (or usual size) of an order and operation time estimations. Why? you might ask — we have all the different direct cost components!
Because we have direct but fixed cost components like a setup time, which must be amortized over an entire production run. It’s no wonder why many processors charge for a setup charge for small orders — they are quite justified to do so.
For a given product we produce, we need to know the following:
- The operations, labor factor, and time spent for each;
- the speed of production;
- the equipment and materials used;
- the size of the order.
For example, a minimum repeat order for product ABC will be for 10,000 parts at a price of $500 per thousand with six parts per shot at a shot weight of 413.40 grams produced in 30-second cycles. It will require a pre-production setup time of three hours. Please note that this standard cost example includes indirect costs, such as the molding center and plant overheads, that do not have to be included.
Image: Pierre Maillet
|Figure 1. This is an example of a product standard cost report with the estimated technical specifications of the product.|
The importance of tracking the actual cost
When any given part is produced, it is very unlikely that the actual cost will exactly match the standard cost. This may be due to the production size, downtime, average material unit cost versus raw material standard cost, production speed, setup time, and reject yield rates related to quality issues. These may or may not be in your favor. The goal is to have a small favorable variance against standard cost.
Collecting this important data on the shop floor allows us to understand what went right versus what went wrong and identify improvements that will make it a better run the next time.
Image: Pierre Maillet
|Figure 2. This is the detailed production run of actual performance results, such as labor, raw material, and finished good efficiency, as well as yield, rejects, and downtime against the standard expected results.|
When the production run is completed, an actual cost sheet versus standard cost should be produced. It is also wise to compare multiple production runs in a summary report to evaluate profitability over time and adjust the standard cost and selling price over time.
Image: Pierre Maillet
|Figure 3. This is an example of a summary profitability of 2 production runs.|
Image: Pierre Maillet
|Figure 4. This is a summary of the actual financial results against what was expected at standard for a specific production run.|
Costing financial controls
At month’s end, your accountant must compare actual costs to standard costs to ensure that your standards are in line with reality. Establishing a “reliable” standard cost system does not happen overnight. It must be adjusted gradually until we get those favorable cost variances, be it a small percentage. All this can be easily done without a general ledger entry in a spreadsheet.
You basically need to compare monthly and year to date for the following:
- Raw material usage (inventory count) in the financial statement at average unit cost including shipping costs versus actual material consumed at standard unit cost in your production reporting for each raw material component.
- Salaries paid for each labor groups (i.e., line operators, setup operators, and so forth) versus the hours used for each group at standard cost rates of each group in the production reporting
- Actual machine hour consumption versus estimated standard machine hour consumption for each machine. The same needs to be done for machine maintenance.
This analysis will explain the variance between the hard numbers of your financial statement COGS and the actual usage at standard cost rates to verify that your cost rates are accurate. Then, the same needs to be done to compare the standard expected usage versus the actual usage of labor groups’ hours and each raw material component. This second analysis will explain the profitability variance and if it was met as expected. To summarize, you need to compare financials to actuals and then, actuals to standards, and correct your standard rates and usage as needed.
A monthly summary of the production efficiency report will be extremely useful to outline the products that may need to be re-assessed in terms of cost and selling price. Note that production speed has a direct bearing on the consumption of labor and machine hours. Products operating at a lower speed than quoted (or lower quality yield) may need to be reviewed at lower speed if the speed or yield quoted is simply not attainable. Finally, are the machine rates and expected throughput capacity realistic?
A final word on shipping costs. You will need to verify that shipping costs match or are below the revenues you receive. It is wise to separate that revenue in your general ledger and charge the shipping costs in a separate GL account to examine them side by side. I have seen this make quite a significant impact on the bottom line.
Simplifying quoting and re-issuing a new order
If I were a plastic processor, I would use both the SSCM and the production profitability model to establish a selling price to determine if it’s feasible to get that new sales order at a reasonable profit margin.
Basically, with the SSCM, you calculate standard cost and apply a profit margin. It should match or exceed, on average, what your financial statement gross margin indicates. With the production profit contribution model, you estimate the raw material cost at standard unit cost and apply the margin. This should provide an excellent range to quickly establish a selling price. The SSCM is more involved with production parameters that may come from various expertise in the organization but considers better metrics and unforeseen difficulties the production profitability model doesn’t offer.
If you have implemented a standard costing model, it is important to review past actual costs results and recalculate standard cost as part of your business process before renewing or accepting a new order from a customer. For instance, did the raw material costs change? Should a past job with poor efficiency be taken into account? All excellent companies I have encountered in the past have always used that approach. It is the best way by far to ensure that you continually improve profitability and avoid unprofitable orders.
As the owner of a plastics processing company, you’re probably comfortable with the day-to-day operations of your business. But when it comes to costing out new product proposals, providing the right tools to your cost estimators or sales manager can make a big difference.
Is it right for you?
As with all costing methods, the SSCM has its share of pros and cons. Careful consideration should be given prior to implementing any costing strategy.
- Provides detailed qualitative information such as production efficiencies by tracking machine time and labor efficiency on the finished products produced that could pinpoint directly where a production problem resides.
- Calculates a detailed cost that includes raw material, direct labor, and overhead costs as well as any tooling-related product cost (i.e., amortization of a tool).
- Tracks downtime or provides any sort of production and material planning capabilities that a SSCM contributes to this type of management capability.
- Identifies profitable versus unprofitable products helping you to remain uniformly competitive by eliminating non-profitable products.
- Takes longer to implement. It can be simplified to minimize administrative overheads but will involve more people.
- Is not the best fit for limited product production runs with a few established products for which the production profitability model is the only model needed.
- Requires an internal discipline to track production floor data and compilations which may require IT systems in place and develop in-house costing expertise.
- Involves different parts of the organization such as product design, quality assurance, maintenance, accounting, and more to establish the costing metrics.
- Slows down quoting unless IT systems are in place but often requires input from various people to get a standard cost and selling price.
Many manufacturers are successfully employing the SSCM. While not perfect, and not suitable for all plastic processors, it provides reliable qualitive information.
With a variety of costing techniques at their disposal, any plastics processing business owner should ask: Is there a more optimal or practical way that I should calculate costs? Before tossing your current method into the scrap bin consider this: If your business is consistently maximizing profitability, reaching goals, and meeting investor expectations, then stay with what’s working. If that’s not the case, however, then it might be time to adopt something new.
Coming soon: Part 3 in this series — Managing Profitability and Cash Flow
About the author
Pierre Maillet is President of CyFrame International Enterprises Inc. A graduate of the University of Ottawa, Maillet is a CPA. Prior to CyFrame, he worked as a Software Applications Specialist (Hewlett Packard) and IT Management Consultant (KPMG). Today, as head of CyFrame, Maillet helps tooling/plastics manufacturers improve production efficiency and profitability.