Adding 35% to cost has been a long-standing calculation of selling price for many manufacturers, particularly those costing and quoting as job shops. The 35% figure is derived from the gross margin value on the company’s income statement, estimated at 25%, and 10% for profit. However, it is a generality to assume that any company’s gross margin, sales less cost of goods sold, is exactly 25% or that the preferred markup is 10%. The gross margin of companies can vary and the markup that the marketplace is willing to pay of 10% is just a guess.
Also, not all expense categories of cost of goods sold are included on the income statement for greatest accuracy. In our more than 20 years of experience helping area manufacturers calculate work center cost rates and quoted prices, we have seen many incorrectly organized income statements. Often critical costs of production are not included in cost of goods sold. The most common examples are healthcare costs and payroll taxes for direct labor employees and a portion of rent that represents the total area of the factory. These costs are often presented on an income statement below the gross margin “line,” causing cost of goods sold to be understated and gross margin overstated. This also means that work in process inventory is also understated, as not all allowable manufacturing overhead costs have been included in WIP.
Once all costs of manufacturing have been correctly placed on the income statement, the resulting gross margin is a fair representation of actual performance. The remaining selling and administrative costs can then be calculated as a percentage of revenue. Then an expected profit can also be determined in support of the cost plus methodology of pricing a part, a job, or a product that is made to stock.
A Simpler Approach
DVIRC recommends a simpler approach to costing quoted product; when we assist our clients, we look at all overhead to determine a “fully loaded” work center rate for each operation. We add to the average direct labor wage in an operation/work center payroll overhead, equipment depreciation, and costs for manufacturing, selling, and administrative costs to derive the full work center cost. The analysis of equipment depreciation is of critical importance as the amount and value of equipment in any one work center can vary dramatically. (ex. CNC machining vs. welding or injection molding vs. finishing operations)
To calculate the overhead cost per labor hour (or machine hour for process industry companies), we total all the manufacturing, selling, and administrative overhead and divide by the number of productive labor hours (straight time and overtime but not holiday and vacation) to create an hourly overhead rate for each direct labor hour or machine hour that produced revenue.
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To this cost, a factor for profit can be added without referring to the gross margin reported on the income statement. This rate of profit is not based on standard costing (variances) nor budgeted utilization of the factory. Prior period actual productivity (direct labor or equipment hours) is used to derive current hourly overhead rates. Quoting strategies are based on factors associated with specific customer opportunities and overall marketplace conditions of competitiveness.
Whether you use DVIRC’s recommended method or you have a method that you believe works best for your organization, please avoid any “rules of thumb” when executing your cost plus quoting strategy.
Harry Landsburg, DVIRC’s Director of Business Process Technology Consulting, has worked with approximately 100 companies to ensure that their costing and the information they use to quote new products or jobs provides the best possible profitability. Since joining DVIRC in 1992, he has worked with over 300 companies to document how their business processes from “quote to cash” will best be supported by upgraded or new software. His approach to relating the way his clients operate to the technology marketplace results in a better selection and implementation outcome.
Learn more about DVIRC’s Costing for Competiveness course, taught by Harry Landsburg.
To discuss opportunities to make sure that your quoting and costing methods are working to best position your company for new or more profitable business, learn more or contact us.