There’s a critical question that nearly every company, whether they’re involved with manufacturing or distribution, has asked in the past year or two: When should we raise prices?
That answer requires an understanding of the costs associated with the many inputs that underlie your company’s products.
Accurate costing is crucial for pricing strategies, profitability, decision-making, and financial reporting. In addition, it helps with process improvement, sourcing and hiring, resource allocation, procurement, budgeting, forecasting, and reducing operating expenses.
Understanding the Environment
The first step in effective costing during periods of uncertainty or inflation is understanding your company’s (and industry’s) macro and microeconomic challenges. COVID-19 showed us how complex and fragile our supply chain networks can be, so understanding how today’s headlines can affect your business is essential.
You want to develop different cost scenarios based on macro and microeconomic factors to assess the potential impacts, and to conduct sensitivity analyses to understand how changes in variables affect your overall costs.
Staying connected to industry groups, tracking shipping and commodity rates, and following macroeconomic forecasts will help your teams understand the broader market and enable timely costing decisions.
Accurate Costing is Critical
Costing and pricing accuracy depend on identifying and categorizing costs into variable, stepped, and fixed categories. Knowing the difference between the three helps you calculate break-even points and contribution margins.
Overhead allocation is another important factor to consider. There are different methods of allocating overhead costs, such as using a predetermined rate based on direct labor hours, machine hours, or units produced. However, these methods may not reflect the actual consumption of overhead resources by each product and may result in under- or over-costing.
One of the more advanced methods of manufacturing cost analysis is activity-based costing (ABC). ABC assigns costs to products based on the activities they require, rather than a simple allocation basis.
Instead of using a single overhead rate for all products, for example, ABC would identify the different activities that each product involves (such as design, testing, packaging, and delivery), and assign costs to each activity based on the resources they consume. This method provides greater accuracy but requires more detailed record-keeping compared to other methods.
Even if you don’t have the time and resources to implement ABC costing, monthly cost variance analysis (which compares actual costs to budgeted or standard costs) can help you monitor and control your manufacturing performance, and identify any problems or opportunities for improvement.
Optimizing Cost Structures
Developing a more flexible cost structure starts with gaining a better understanding of the exact source and size of different expenses. For most companies, 80% of their materials spend goes to about 6% of their suppliers. COVID-19 has shown that manufacturers need to have “lean-ish” practices that include caveats for critical items with longer lead times, or that can be expected to have price increases.
Flexible cost structure best practices include:
- Review product mix. Will a certain product hold greater appeal to customers? During a downturn, it’s all about maximizing margin and controlling variable costs. That shift could mean temporarily halting production or the availability of certain goods.
- Prioritize scenario planning.
- Consider leasing more assets. While this can be more expensive, it may give the company an ability to stop paying for a resource that is no longer needed.
- Build a contingent workforce. Using workers who are not on the company’s payroll offers greater flexibility as production and staffing needs change.
- Avoid single-source suppliers where possible.
- Monitor your supplier contracts for limits on pricing adjustments. Some contracts have incentives to bring prices down, but suppliers may ignore these clauses until they’re audited.
Demand Forecasting
Demand forecasting is the process of using predictive analysis of historical data to estimate customers’ future demand for a product. Demand forecasting helps management make better-informed supply decisions by forecasting expected sales and revenue for a future period.
Demand forecasting plays a crucial role in manufacturing by improving:
- Production Planning – Accurate demand forecasting allows management to plan their production schedules effectively.
- Inventory Management – Demand forecasting helps management optimize their inventory levels, maintain the right amount of stock on hand, minimize carrying costs, and reduce the risk of stock obsolescence or shortage.
- Cost Reduction – By aligning production with demand, management can minimize waste, avoid overproduction, and optimize resource utilization.
- Supply Chain Efficiency – With accurate forecasts, management can work closely with suppliers, ensuring timely delivery of raw materials and components while reducing lead times.
Best practices for effective utilization of demand forecasting include working with customers proactively to update demand, collaborating with vendors to secure supply and lead times, updating the model weekly, and reviewing the model monthly.
While working with customers can bring valuable information to forecasting, we also need to be aware of customer biases that can influence the conversation. Customers may be concerned, for instance, about having adequate supply, the deferral of purchase orders, delays in shipments, and other self-interest risks. Blanket purchase orders and long-term supply commitments may help mitigate forecasting risk.
Navigating macro and microeconomic uncertainties requires proactive measures in manufacturing costing and standard costing. By adopting best practices, embracing flexibility, and leveraging technology, manufacturers can better manage uncertainties and make informed decisions for sustained success.
To learn more about effective inventory costing strategies, contact us.
