Estimating: Know Your Costs to Determine Your Profits
by Mark Porter, president
Dienamic MIS Software, Inc.
A good product estimate not only determines the selling price to give to the customer, it also should determine the true costs to produce the product. This is very important because if finishers do not know their costs, how will they know their profits? After all, profit is the reason we are in business.
For many finishers, the price they present to their customers is a result of simply adding up numbers they know the market will bear. Unfortunately, they do this without knowing what their costs for these processes will be. What if the customers ask them to reduce their costs? Are finishers then paying out of their own pockets to produce the jobs? There is no way to know, because they did not calculate their own expenses beforehand.
When I talk to finishers about this topic, they usually say the market dictates the price. This is true; however, the market does not dictate their costs. By identifying their costs beforehand, they can identify the true profitability of various types of work and start to learn which work generates the greatest profit. Once finishers identify this, they can start to target their businesses to those specific types of work.
The following article will identify components of true costing that should be accounted for in the estimating before companies make sales decisions as to what markups and returns they want to achieve for this work.
Firstly, determining production standards – through a variety of methods that will be listed later – will aid in the estimating process. The times then can be multiplied by hourly cost rates that accurately reflect the cost of running that machine per hour. These rates are called budgeted hourly rates (BHR), and they encompass financing charges, labor costs, miscellaneous materials and allocation of overheads. Assumptions are made on the number of shifts and productivity levels that will be obtained, and now finishers have an accurate cost per hour to operate each piece of equipment.
Once the hourly rates have been determined and applied to the production standards, finishers have an accurate representation of how much the proposed job will cost to produce. Now, risk can be evaluated, along with the desired return and the markup of the estimate, in order to determine the selling cost.
Of course, the market will not always bear the desired price. When or if that happens, finishers now have all the data required to evaluate at what market price they are unwilling or unable to bid on a particular job. There even may be times when a company will bid on work that is below cost. The difference is, now they know they are below cost.
Once the time standards and BHRs are in place, it is vital that all graphic finishers monitor their production processes to ensure they are staying at the production standards that estimating is using. This is done through the constant monitoring of production factors, such as labor and machine time, and the comparison of actual vs. estimate calculations.
These concepts of cost accounting and management information systems are vital to the job manufacturing industries – such as finishers – no matter how big or small. The results will provide more data for companies to manage their businesses in a more profitable manner.
How to determine budgeted hourly rates
The process of determining BHRs is fairly simple: Identify all costs for each cost center of the plant.
The purpose is to recover all costs incurred in the production, sales and administration of the product. It is important not to include costs that are really not associated with that production process, because that will make a finishers hourly rate too high and price them out of the market. In addition, finishers must not miss legitimate costs. Doing so would result in their hourly rate not reflecting all costs. They will be losing money each time they quote that production process.
Determining BHRs begins with the breakdown of processes performed in the plant. Finishers then must collect and determine their own data. Just because ABC Graphic Finisher and DEF Foil Stamper have the same press does not mean they will have the same hourly rate. ABC may have paid cash for its press. Its rent may be cheaper, and it may hire people with lower skill levels to run the machine. This will lead to lower hourly rates for ABC Graphic Finisher.
A sample BHR sheet for a press is included below to demonstrate the type of information that is required for the BHR calculation. Keep in mind, the manufacturing cost per chargeable hour is not the budgeted hourly rate, but it is useful if finishers must charge back house error to the company.
Also remember, BHRs are not prices. They simply reflect all costs incurred to produce the product, as well as the administrative and selling overhead. The calculation of the BHR multiplied by the time estimated should reflect the time cost to produce that product with no profit. There are several BHR software programs available that walk through the process of determining budgeted hourly rates.
Another thing finishers need to consider is adding multiple shifts. For instance, when cost centers reach 40 percent overtime, adding a second shift may be necessary. The advantages of the second shift are the reduction of overtime and the spreading of the fixed costs over a larger time block. This can result in up to 15 percent savings.
Determining accurate production standards
In addition to having accurate BHRs, finishers also must have accurate production standards in order to have a more precise estimate. Production standards are a measurement of the output that will be achieved on a certain machine under a certain set of circumstances.
Having an accurate determination of production standards can be achieved one of the following six ways:
3. Published Results
6. Time and Motion Studies
It can be cheaper to utilize methods two through four as they use information that now is the finishers own. This makes it less expensive to accumulate but also lowers its value. Method six is highly accurate but also more costly and not continuous in its monitoring basis. Method one is the best combination of cost and accuracy. Method one collects data from the shop floor, either through the use of time sheets or data collection devices. The information goes into the job costing software where it then can be analyzed and sorted by different jobs and cost centers. This not only collects the beginning data, it allows companies to monitor the standards on an ongoing basis.
Having a precise measurement of BHRs and production standards allows finishers to confidently quote on work, all the while knowing they will be covering their costs. It allows for knowing when to walk away from a job as the desired returns at the current market values are unacceptable. Production standards are used by the estimating department to provide the time element of the estimate. This requires that they be constantly monitored to ensure that production is achieving what is being quoted. Equipment ages, new equipment is purchased and operators come and go, which means a review process must be in place to ensure accurate data.
This review process starts with all jobs. An estimate versus actual comparison report should be produced with each job and reviewed by management to highlight any significant differences in what was estimated vs. what actually was achieved. Differences should be investigated and understood so that processes can be more closely monitored or changed.
Every month, a production comparison report should be run to determine how the processes, on average, are comparing to the standards. Employee efficiency reports should be run to ensure all employees are reaching the production standard set. If certain employees are not meeting the standard, then retraining should be considered. If none of the employees are reaching the standard, the standard needs to be investigated and estimating notified. If estimating is using standards not based on actual data, then finishers may be giving money away on each estimate. If estimating is using standards higher than actual results, then finishers risk losing work.
This should be a standard policy in good times or low times. In good times, when there are never enough hours in the day, why would finishers want to work overtime on jobs that dont make their desired return? During low times, it is important that finishers know their exact profit position when people start demanding price cuts.
By employing good production standards and BHRs, finishers have the ability to properly monitor their estimates and production area. Again, software is available to help calculate all of the above, making the job easier and allowing finishers to have a more informed and profitable business.