Measures of Manufacturing Costs
In today’s highly competitive environment, with shrinking margins and overseas competition, manufacturers are forced to minimize production costs, and maximize efficiency and productivity. It is essential that a manufacturer be able to compute the cost per unit to determine how profitable either a specific product, product line, or the entire manufacturing function is. Measures of Manufacturing Costs provide an overview of the relationship between revenues, costs and profits.
This article is the 5th in this multi-part series examining manufacturing measures and the production environment. Article One looked at the concepts of performance measures, and defined the various metrics. Each of the subsequent articles has looked at different measures, their computation, and interpretation of the measures, using a real world applicable to of the analytics. In this article we will look at measures directly related to Manufacturing Costs.
Total Manufacturing Costs Per Unit
This is the aggregate amount it costs to produce one specific unit. In its broadest sense it represents the total of direct materials, direct labor, and overhead expenses as Total Manufacturing Costs, divided by the number of Units manufactured as result of those costs.
Direct Materials – The total cost of materials purchased for production of the specified product. If you are on a sophisticated inventory or manufacturing control system, you should be able to pull this figure easily. If not then you may have to use the ‘periodic value of inventory’ for this metric. In those cases the formula is:
Direct Materials = Beginning Inventory + Inventory Purchases – Ending Inventory
Let’s say that you started with $20,000 of crushed rock, sand and Portland cement used to produce concrete mix, and you purchased $20,000 of these materials over the past month, and the total amount of these materials on hand at the end of the month is $13,000. Then the formula would be:
Direct Materials = 20,000 + 20,000 – 13,000 OR Direct Materials = 27,000
Now crushed rock, sand and Portland cement is NOT the only ‘direct material’ that goes into the making of concrete mix, but for purposes of this computation we are going to assume that it is.
Direct Labor Costs – When you add-up all the actual labor costs including gross wages and other employer costs of personnel directly involved in the manufacturing or production process you had the direct labor costs. Sophisticated manufacturing control systems that include Shop-floor production with time-tracking can give you these costs down to the second, but otherwise you may need to simply add up gross wages for production workers and multiply (or combine) that with the additional costs.
If you have been reading our example, you know that it took 24 man hour per day to run the ‘batch plant’, so let’s assume that everyone is paid ‘gross wages’ of $10/hour with a 110% multiplier for costs in excess of wages. At 21 work days per month, that’s 504 man hours for the month, or $5940.00 of labor costs for the month.
Overhead – the aggregate costs of factory expenses (rent, repairs, utilities, maintenance, etc.), including labor for non-production personnel, represent your overhead. Typically a percentage of these expenses are allocated toward manufacturing/production costs, usually representing the overall non-material costs divided by the total costs. Sound cost accounting should readily produce this value for an efficient business.
Since we have no actual overhead costs, we are going to make an assumption that overhead is 30% of total direct materials and labor costs. This means our overhead is 30% of $27,000 + 5940.00, or $9882.00.
Total Manufacturing Cost per Unit Excluding Materials
Another common measure of manufacturing costs is a measure that looks at potentially controllable manufacturing costs in relationship to the produced product. This is accomplished by using the same parameters specified in Total Manufacturing Costs Per Unit, but removing Direct Materials Costs. The rationale for this measure is based upon the assumption that ‘material costs’ are in-line with production because of the direct relationship of materials to finished product.
For example, you can’t produce the concrete mix if you don’t have the essential materials of crushed rock, sand and Portland cement. Since we know we must have these materials and the quantities and amount paid for those materials are directly related, we want to look at how our ‘other costs’ compare in relationship to total costs, because we may ‘target’ these other costs as the basis for improving production costs by reducing costs not directly related to production materials.
Manufacturing Costs as a Percentage of Revenue
This is a ratio of total manufacturing costs to the overall revenue produced from the manufactured units sold. If we multiple the total number of units manufactured by the sales percentage and then by the price per unit, we have the revenue from manufactured units sold.
In our example, if we sold 80% of what we produced, and each sold unit was sold at a 300% mark-up of total manufacturing costs, then the sale price for each unit was $47.98. But we need to then multiply this price times the number of units produced, times 80% representing the number of units sold. So our revenue was $102,773.16. When we recall that our Total Manufacturing Costs equal $42,822, then we can easily see that the Manufacturing Costs as a Percentage of Revenue equals: 0.41682. In other words, Total Manufacturing Costs represent almost 42% of the actual Sale Revenues.
You can’t always ‘compare’ these numbers across industry averages because a lot of situations can cause these numbers to be significantly different from one manufacturer to another; however, you can compare them against your own results in one period over another period. In addition you need to apply the ‘test of reasonableness’, and that will include comparing total revenues per units sold to other suppliers. If you are not ‘competitive’ then you had best be figuring out why. Are your material costs in-line, are your labor costs too high, is overhead appropriate. Perhaps it is solely on the sales side, is your mark-up too high, or are sales of product in comparison to product produced too low? It’s only when you can answer these questions consistently with a high degree of accuracy will you know if your manufacturing/production performance is exceptional, doing OK, or in the dumps.