It can be difficult to bid accurately and track profits when you’re running a service business (when what you’re really selling is hours of labor). But what if you’re running a business where you actually make products? How much should you charge?
There are two factors that impact the answer to this question: costs and competition. For the past two years I’ve spent a lot of time with consultants from the Manufacturing Extension Partnership, a federal entity with branches in all 50 states with the mission of helping small businesses succeed. Based on exchanges with these consultants, as well as many of the small manufacturers they serve, I know that most small manufacturers are aware of what their competitors are charging. But the knowledge of how much it really costs to make a product is more elusive.
The reason for this lack of precision has to do with conventional cost accounting, which essentially takes all the overhead costs and assigns them to products based on only one activity: operating the machine that makes it. So if job A involves 100 machine hours and job B involves 50 machine hours, job A gets twice the overhead allocation as job B.
This type of accounting was developed in the heyday of mass production when factories churned out the same small set of products day after day. But for many smaller manufacturers, and especially job shops, this is not today’s reality. Typically, some bread-and-butter product lines still run like that, but there are many other jobs that only run occasionally or perhaps only once. These jobs require setup time. They also may require special engineering. And if they use special materials or subcomponents, that means extra costs associated with procurement and handling.
In the past couple of decades a new approach to costing has emerged called activity-based costing, or ABC, that takes these factors into account. You should understand that ABC is a discipline that’s a little like lean manufacturing, in that it has spawned a movement that includes consultants, gurus who write books, and so on. But you don’t need to redo your books, change all your accounting processes, and hire experts to get some of the most important benefits of ABC. You can make huge advances by just thinking about costing in this new way.
The main difference between ABC and traditional costing is that it takes into account the cost of making a product at every level where costs are incurred:
- Unit level: These are the direct costs associated with making one unit, for example, touch labor, machine hours, and material costs. They are the traditional costs all manufacturers track.
- Batch level: These are costs associated with every batch, such as production planning and setup, the costs incurred whether you make 100 units or 10,000.
- Product level: It takes a lot of hours to develop a new standard product, and product level costs account for these hours.
- Business level: These are the overhead costs, such as keeping the lights on (and paying the accounting staff), that apply “globally” to every unit of every product you make.