Why costs are important to a manufacturer

The revenue that a company generates must exceed the total expense before it achieves profitability. Costs of production include many of the fixed and variable costs of operating a business. Raw materials and labor are production costs. Fixed costs typically include:.

Variable costs increase or decrease as production volume changes. Some variable costs are:. Manufacturing businesses calculate their overall expenses in terms of the cost of production per item.

That number is, of course, critical to setting the wholesale price of the item. As the rate of production increases, the company's revenue increases while its fixed costs remain steady. Therefore, the per-item cost of manufacturing falls and the business becomes more profitable. A lower per-item fixed cost motivates many businesses to continue expanding production up to its total capacity.

This allows the business to achieve a higher profit margin after considering all variable costs. Manufacturing costs, for the most part, are sensitive to changes in production volume. Total manufacturing expenses increase as production increases. The opportunity to achieve a lower per-item fixed cost motivates many businesses to continue expanding production up to total capacity. The per-item cost does not change substantially. Nonetheless, additional production always generates additional manufacturing costs.

Manufacturing costs fall into three broad categories of expenses: materials, labor, and overhead. All are direct costs. That is, the salary of the company accountant or the accountant's office supplies are not included, but the salary and supplies of the foreman are.

These expenses stay the same regardless of the level of production, so per-item costs are reduced if the business makes more widgets. To break even, the business must produce 10 widgets every month. It must make more than 10 widgets to become profitable. Financial Analysis. I can answer that with one succinct statement: knowing your product cost is not so important for setting a price as it is to manage your costs for operational purposes. In my opinion, the disadvantages far outweigh the advantages.

The most important factor in setting the sales price is the sales demand as a function of your price. What does all this mean? For most of my clients, the price they can charge is dictated by the market. The latitude to reduce costs by eliminating direct labor hours and subcontract work no longer existed. No one had raised this point when the company had evaluated the new equipment. The ranges would be quite different for a process industry because of the much higher plant and equipment investment with the consequent greater pressure for high-capacity utilization.

The opposite is true of most service businesses with lower investments and fixed costs. These profit returns must be achieved in order to be a truly outstanding profit performer. Operating consistently within this framework requires the following.

Total assets employed for plant and equipment and working capital should not run more than about 60 cents on each dollar of sales in a manufacturing company, with variations in the split between them, depending on the type of business. A company can be profitable if its performance does not fall precisely into this framework. In fact, the ranges show that there will probably be significant differences in the percentage for any cost element, depending on the nature of the industry and its business strategy.

Two numbers are crucial, however, to meet or exceed the profit targets shown. First is the gross margin, which is the profit-generating fuel for any business. Given the pace of technology, however, most manufacturing businesses cannot sustain product and market position while effectively managing and controlling the business with less cost in expense areas. While this percentage again will vary widely, depending on the nature of the business, it is a reasonably good standard for most manufacturing companies.

It is clear that the business must generate higher earnings than indicated in our framework in order to yield the desired return if the percentage of total assets to sales is higher. Conversely, the earnings could be much lower and still yield a satisfactory return if the assets were lower, as they are, for example, in many distributor or service businesses. None of this should come as a surprise to anyone who has been involved in the business world.

The problems become readily apparent in this framework. It is essential to first determine what it should be for each particular business and then to make sure the business actually operates around this structure. When profits decline or disappear, companies might tighten the belt in the wrong way in the wrong places. This can easily generate a self-feeding cycle of competitive decay. The most common and almost most hidden thing that sets off such a cycle is management operating with the wrong type of data—that of accounting rather than that of control.

Unfortunately, most data management uses are derived from accounting systems designed primarily to meet outside financial reporting requirements. Even when the data present the cost and profit picture for individual product lines, they are often focused on gross or operating margins, not the true picture after all manufacturing, engineering, sales, and administrative overhead costs are taken into account.

Finally, traditional accounting systems typically do not provide a clear picture of how costs and profits behave as unit volume moves up or down. Thus they are not particularly helpful to managers who must evaluate sales, marketing, and manufacturing alternatives that involve different levels of activity.

For these reasons, you should reorganize, reorder, and reformulate these financial data. This may mean extra effort, but it is not as difficult as it sounds. First, you must agree on a few commonsense cost definitions that provide the basis for categorizing all costs associated with each product or product-line business. The following cost categories can provide a definitive framework for any manager. Bedrock Fixed. These costs are related to physical capacity and include plant and equipment costs such as depreciation, taxes, and facility maintenance that cannot be avoided unless the facility is sold or written off the books.

These are the only true fixed costs. Typically, they are not as large a factor in the cost strucure of companies as you would think, though they become greater as companies automate. Managed Fixed. All tend to build up as a business grows. Once in place, managers often treat them as integral and bedrock fixed costs. They are not. You can and should manage them. Understanding their makeup is important to keeping them under control and distinguishing them from the overhead costs that organizations share.

Direct Variable Costs. These costs rise or fall directly in proportion to the business volume. They are easily identified and can be traced back to the specific units produced or services rendered where, again, they can be better examined and managed.

Shared Costs. These are all the other costs incurred to support the business that are not readily traceable to any one product or line or activity. They can also include operating costs for plant and equipment. All are manageable. Agreeing on these cost definitions is the first step. The second step is assigning the various operating costs to these classifications. In most businesses, few costs are either absolutely fixed or variable.

Make no mistake, costs in the managed category are not fixed, even though they are commonly bundled under this label. Generally, as a business expands, costs tend to be far more variable than they should be, and when it contracts, they are far more fixed than they should be. This is not easily done. Many accountants are reluctant to divide fixed costs into these categories or to allocate shared costs to specific product areas, because it is impossible to do this with the precision that accounting professionals normally use to develop traditional financial statements.

There is a natural aversion to shifting numbers around in any imprecise manner. There is simply no way, however, to know how well or how badly a product or product line is doing without getting these cost data clear—without knowing which are bedrock fixed, managed fixed, direct variable, or shared and without allocating them to their various business units and product lines.

At the divisional or business unit level, cross-functional teams of all the department heads and the general manager should be responsible for hammering out the allocations according to the actual activity levels of each cost category.

Shared costs are a particularly difficult problem for most companies and difficult to attack as a lump.