Your Approach to Costing Might Be Killing Your Business

Congratulations — your bid won the job! You should be very proud, and maybe even a little worried. On the surface, winning any competitive bid sounds like a boost to your business. But if you’re not adequately covering job-related costs, securing that new business could become a money-losing proposition.

Unfortunately, far too many plastics manufacturing business owners and estimators operate by intuition with no real idea of the best way to account for costs. The good news is there are simple and proven methods that can help quantifiably determine profitability.

The cost of not knowing costs

Over the last several months you’ve won many new contracts, completed the job runs, and delivered the orders for these and other products you produce regularly. The payments arrived and are deposited. All is good.

Sure, cost estimates may not have accounted for each penny, but you’re sure to turn a nice profit. At least that’s what you thought until a few months later, after expenses were paid, and it was discovered that your jobs, including the new ones, didn’t yield the anticipated profit. Worse yet, you may have even lost money.

How is this possible, and how can you ensure that future contracts will be profitable? Could it be that these new jobs, the orders from your regular customers, or some other indirect sales and administrative expenses were the root cause?

There is no single or best way to calculate costs. That said, no matter what approach you take, you may be leaving some money on the table — perhaps lots of it. Fortunately, there are a variety of cost-determination methods available to manufacturers.

Many business owners consider the production profit contribution method, or a simplified version of the standard costing method, to be their best option. This approach is both effective and relatively simple to implement. There are still other costing verifications, such as customer profitability analysis, budgeting overhead costs, and cash generation analysis, that are equally effective.

Before scrapping your current approach, consider this: If your business is consistently maximizing profitability, you’re crushing goals, and investors are thrilled, then don’t break what isn’t broken. But if that’s not the case, and you look at costing as more of an art than a science, then perhaps it’s time to re-evaluate your approach.

While there are several ways to calculate costs, this article will focus on production profit contribution. This method can be quickly implemented and yields significant profitability information. Other costing approaches will be addressed in future articles.

Production profit contribution

To many successful manufacturing business owners, raw material is the only transient cost in and out of the production floor. Similarly, the only important aspect is that it is vital to know the exact contribution to profit of each finished-good work order that is produced — week by week, day by day, and shift by shift. Eventually, when these finished goods are shipped, the company will be profitable.

Produced finished goods net sales – used raw material costs = profit contribution

It’s important to understand that, when taking this approach, all costs associated with running the business are fixed, including direct labor. This keeps things simple and free of complicated administrative tasks that delay obtaining the essential profitability information you need quickly. These fixed costs require a small amount of control (mostly on a monthly basis) as they progress throughout the year. There are several ways to accomplish this, including assessing them as a percentage of sales (like direct labor), comparing them against a set budget, or against last year’s numbers (comparable to sales and administrative costs). Each fixed-cost component matters and it’s important to reduce such expenses as much as possible.

Setting up basic data parameters

Implementing the production profit contribution costing method requires identifying two basic variables for each product — its net selling price 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 the profit contribution.

It’s also important to note that special consideration must be made when multi-step production takes place at different times. This will not be a problem if the multiple steps are done simultaneously. However, if these steps are done at different times, a net selling price must be identified for each step, allowing production profitability to be tracked. An example of this is a molded bottle that is sent to a printing step a week later. A price for each step is required, with the total of these two steps adding up to the total net invoiced price.

The raw material unit cost begins with the unit-cost invoice from your supplier. This includes any material such as resin, additives, and packaging material used to produce the finished product and is usually listed in the bill-of-material. Costing alternatives may include FIFO (first in/first out) or the average cost based on what is in inventory. These methods involve constant updates of your profit contribution and may require administrative task interventions.

Ideally, one would want to automate unit-cost updates with your current system. However, if this isn’t possible they can be set up as a standard unit cost to account for such factors as small market or expected price fluctuations. The standard unit cost can also account for waste generated on each job, including non-recoverable material or depreciation of virgin material left over in regrind. Again, however, these should be minimal in percentage — act to avoid administrative tasks and create a small margin for error in profitability tracking.

Tracking production profitability information

The first task involves tracking quality-approved, packaged finished product generated for each production job, something generally done by most manufacturers. While scrapped finished products should not be included in the packaged finished-product count, tracking rejects has its benefits. Scrapped parts can indicate a profitability problem while helping to establish true production yields. Often, pricing estimates alone do not accurately reflect proper production yields.

While raw material tracking can be quite simple, it can also involve some rather complicated aspects. One simple method is to weigh material sent to the production floor for the work order of a specific product and weighing the material that comes back when the run is completed. The net difference will indicate the amount of raw material that was used. You will then know what the contribution is for that work order.

If a large-size scale is not available for resin packaged in gaylord, a ruler may be used to measure the before-and-after depth of the material. The downside to this approach is that a work order could take days or weeks to produce. What’s more, it can be difficult to track raw-material usage when material is stored in a silo connected to multiple machines. Profitability information will only be available when the work order is completed.

If you wish to determine profitability by shift, days, or weeks, consider a different approach. One way to track raw-material usage is to count the finished goods that were produced, including rejects if they are not reground inline back into the machine. Each part produced is multiplied by the shot weight of the product. Because the shot weight can vary, it is preferable to use the actual production shot weight. At that point, each part can simply be entered on a spreadsheet and converted to raw material according to the plastic recipe percentages of different resins or additives used for the product. Again, if the recipe was changed for production, it is preferable to use the production recipe.

Because the production profit contribution costing model does not track time, it’s recommended to track the number of products produced in a shift that pass QA inspection and display the average shot weight per good product versus the standard shot weight. This will help indicate, among other things, if the night operator might have taken an unscheduled break and reground the good products upon return.

The production profitability target

Generally, the overall profitability target is easy to establish. Simply deduct raw material from the expense part of your financial income statement and add net profit before taxes desired and divide by sales:

(Expenses – raw material + net profit) / sales = % profit contribution

For example, let’s say that your total expenses are $9 million and raw material cost is $3 million. You have a $1 million desired net profit and annual sales of $10 million. In this scenario, your contribution target is 70% of sales.

There are, however, a few things to consider. Larger manufacturers organized by divisions may wish to track the contribution by each division, or profit center. And it is not uncommon for each profit center to have a unique costing and profitability model. Also, because depreciation is not a cash expense in the income statement, some may prefer to replace it with cash used for capital expenditures. This allows the contribution to be more in line with the cash required to be generated.

The important thing is to keep it simple. If you just need a basic understanding of whether your company is profitable or not, the production profit contribution approach is worth considering.

Simplifying quoting

As the owner of a plastics processing company, you’re probably comfortable with the day-to-day operation of your business. But when it comes to costing out a proposal, you generally rely on the expertise of your estimators or sales manager.

The production profit contribution model can simplify quoting. Using the above example, if the part weight costs three dollars in raw material, the net price should be $10 — raw material cost divided by 30% to equal 70% contribution. This could also include sales commissions and percentage payment terms if they are part of the net sales price. Finally, the product price is divided by the production yield to establish a realistic sales price.

The issue here is that the production yield must be included in this equation. To assist your sales team, you may choose to validate the quote for production yield, which could be a complex set of production and product-design parameters.

Pricing can also be very complex. For instance, you may have loss leaders versus other very profitable products for the same customer, providing you with a very profitable outcome. However, knowing production profit contribution in advance will reveal the overall profitability of all the products you produce, even by customers.

Is it right for you?

As with all costing methods, the production profit contribution approach has its pros and cons. Careful consideration should be given prior to implementing any costing strategy.

Advantages:

Disadvantages:

Many manufacturers are enjoying great success with the production profit contribution costing method. While not perfect and not suitable for all plastics processors, it provides reliable quantitative profitability information, allowing business owners to respond quickly to problems. With this method, production quality issues can be quickly identified and with a few tweaks — such as tracking the average-shot-weight per good, packaged finished products in a production shift — will counteract any weaknesses in tracking production time.

Read part two of this three part series: The Simplified Standard Costing Method

Read part three of this series: Managing Profitability and Cash Flow

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.