Over the years I have found out that most clients are not confident in the product costs. Unfortunately, if the costs of the products are wrong then their product prices may be incorrect. They could be too expensive, losing them business, or possibly they could be losing profits by undercharging. My first work as an accountant was in manufacturing plants where we used the best product costing methodologies. Since then I started working as an independent accountant offering part-time controller services. I have helped clients in construction, engineering, manufacturing, and service, develop and improve their costing approaches. Here is a list of 5 common problems I have come across over the years.
The client doesn’t prepare an annual budget
Preparing product costs, in essence, is trying to allocate the total business costs across the product range. In order to do that, we find the total product costs for the business for whatever period we are working with. In the end, the total of the product costs that we plan on making should tie back to the total costs we expect to incur. That is our key check – our key control. We need to start off with a reliable budget for the year. To know how to, I recommend you prepare a budget. You can look at this article on Predicting Business Costs.
How to fix this problem
The best practice for all clients is to prepare an annual budget. If your business is small, then this will be a fairly easy task. On the other hand, if your business is larger or more complex, then it’s slightly more difficult. All in all, it’s still really important that you do it. The greater the complexity, the greater the benefits of doing it. It should be possible to develop a spreadsheet that can be updated from year to year.
The client doesn’t know what is actually being used to make the product
Many clients are not using their accounts for management purposes. Their accounts exist solely to comply with requirements. They have a figure for the materials purchased but no idea how much material is used for each different product. Moreso, they may have a document that tells what should be used in making the product in a perfect world but are somehow detached from real-world conditions. Therefore, they need information showing how much of each of the various raw materials are used to make each of their different products. If they have a controlled product, say a food product, they must keep data for traceability but it may not available to help with management support.
How to fix this problem
Every product should have a bill of materials. This is essentially a recipe. A bill of materials is basically not telling you what is in the product but what gets used to make one of the products. It should reflect normal waste and normal working practices. What you want is to identify the average quantities needed for a good production item.
The client ignores waste or scrap
In some cases, the production process is generating waste or scrap but the client was ignoring this. Let’s say, the client buys in timber to make chairs but the moisture content of some of the timber is too high. That timber has to be discarded. However, it may not be possible to send the timber back to get credit. Maybe the supplier is overseas or maybe the supplier is arguing that the timber was not stored as recommended so the supplier is passing on the responsibility. In any event, the cost of the unusable timber is a real cost to the manufacturer. He/she may not be able to pass any or all of that cost on to the customer. But he/she has a timber cost that they need to be aware of. At a minimum, they should have an improvement project to try to reduce the losses due to substandard raw material. Another example could be where the manufacturer has to trim a raw material, let’s say meat, fat, or bone. The raw material is natural so the amount of trimmings can vary from batch to batch. We understand that there will always be some trimmings. What we need to do is identify a reasonable average and use that in our costing. We should be saying something like “for every 100kg of meat we buy, we use 95kg in the process”. The cost that we have to bear and pass on to customers is the cost of the 100kg.
How to fix this.
Ideally, you would have a system where raw materials are issued to a batch and at the end of the production period (day, week, month) you can identify the normal usage for each completed item. If you don’t have that detail, you should still be able to quantify how much raw materials were used and compare that to what you think should have been used. The difference will quantify your scrap or waste and you should have programs in place to reduce this.
A client using inaccurate input costs
When you are preparing costs, you need to have a good handle on what the inputs are costing. Ideally, you will track the costs of each input and know if they are going up or down and how they compare to historical costs. In some cases, clients initially knew what the inputs were costing but they had not kept up to date with recent changes.
How to fix this
You should either have a product code for each raw material and should track the costs for each order or invoice. You should have a list of current prices for each of your raw material items.
Client charging for unused production capacity
At the top of this article, we said that we are trying to spread our actual production costs over all of the products that we are producing. However, if we are a start-up and the business is not fully loaded then it may not be sensible to try to pass the costs of our unused manufacturing resources on to our existing customers. Let’s say, our plant can do 1800 production hours in the year. But we are only selling 50% of our capacity. If we are competing with other factories who are working to full capacity, then our costs for our output should be higher than theirs. However, if we have higher costs and there is no difference in the products, then a sensible customer would buy off the competitor as its cheaper. We may have to bear the cost of the unused capacity until such time as we can get the sales up to a point where we are using the full capacity. However, if we have a unique product that has benefits that the competing product does not have, then we may be able to charge more. That’s an issue we should be aware of and have a proper discussion about internally.
How to fix this
When preparing your budget, you need to be able to express your production output as a percentage of your capacity. Where there is significant unused capacity, you should be aware of that. Then you can have the conversation about whether or not you can pass that cost on, or not, to your customers.
These are the five most common costing problems that I have come across. You should review your own situation and see if any of these are relevant to you. If you have any comments, you can leave them below. If you have any questions, please feel free to email me.