Identifying the Real Cost of Production

Author: Larry Chester

Knowing the actual cost of production is critical to setting accurate pricing and therefore profitability for any manufacturing company. How are your costs being confirmed and posted?

Bring Value through CFO Insights

Setting the proper pricing for any product is the result of understanding the market, your competition, and your cost of goods sold (COGS). The problem arises when the actual costs are different than the ones that are being “understood” by production staff, estimating, and the sales team. Getting to the real numbers are the key to profitability.

• Business – Printer
• Location – North Central Illinois
• Sales – $19,200,000
• Ownership – Single owner – second generation

Initial Contact – The business owner had used a part-time CFO for many years, but they recently moved on to a full-time position elsewhere. Current financial staff consisted of an accounts payable clerk, an accounts receivable clerk, and an accounting manager.

Significant Findings, Recommendations and Course of Action:

Monthly Reporting Package

Their ERP system was a shop floor package designed for the printing industry. Cost segregation and production reporting were excellent, but financial reporting was weak. The dashboard created by the former CFO had items on it that the owner didn’t understand, and he focused on a few numbers on the income statement rather than truly understanding how it all fit together.

Recommendations

• Create a monthly dashboard with numbers that were relevant to the owner, with additional dashboards for each significant department within the company, highlighting different KPIs based on the department activity and goals. On a monthly basis, review the dashboards, KPIs and analysis with each department manager.
• Assemble a month-end financial package consisting of Balance Sheet, Statement of Cash Flows, Income Statement, Operating Expense Schedule, YTD financials, 12 month rolling financials, YTD to Budget comparison, Schedule of Prepaid and Accrued Expenses, Inventory Report, and pending production orders.
• Include—as part of the month-end package—analyses that include a trend line analysis of sales, profitability by type of printing job, and sales by customer type.

Variance Analysis

The accounting manager cleared out the manufacturing variance account monthly by adjusting it against COGS. This created wide variations in profitability that were unexplained. The prior CFO convinced the owner that the variances were caused by a bug in their ERP package. The owner had gotten used to the variability month to month, and looked at quarterly, or 12 month rolling reports instead to determine how the company was performing.

Recommendation

• Assemble and review a table of historical monthly variances to determine their direction and scope.

Detailed Analysis and Course of Action

• Two different types of variances were discovered.
• Variances that balanced themselves out exactly in two or three-month cycles.
• Variances that were highly variable and increased over time.

Half the variances balanced out exactly in two or three months. Analysis of production showed that not all items produced were ready to ship upon completion, due to quality issues. Closing the production orders prematurely caused improper financial reporting of manufacturing. Therefore:

• Upon completion of the printing job, good product was shipped, but unapproved items were moved to a holding area for correction. The production team closed the production order. The ERP system calculated a significant material loss when raw materials used were compared to the much smaller quantity of approved finished goods. The result was a significant financial write-off as scrap.
• When the remainder finally cleared through QC, they went back into inventory at zero cost, having already been written off. This resulted in significantly increased profitability.
• c) The fix was to leave production orders open till the final items had cleared QC, with a greater priority given to product correction. With all good inventory being posted prior to closing the order, the system accurately calculated the proper COGS for each item.

The remaining variances were the result of differences between the estimates and actual production costs. A variety of production problems were the cause.

• The estimator stated that their estimates were always accurate. The IT department clarified that the estimate became the standard cost, so any variances weren’t seen in individual product COGS, they were seen in overall manufacturing variances.
• Manufacturing variances were caused by a variety of factors, but the summary GL postings didn’t provide an answer. A weekly list of each product sold was matched to the actual manufacturing cost of each lot. This information was available from their ERP System.
• Initial variances were calculated at between 15% and 35% per lot run, which in many cases exceeded the planned margin. Each production lot was scrutinized to determine the specific cause(s) of the variance.
• Primary reasons for the variances included – Production on the third shift; excessive set-up time; slow press run rate; broken printing plates; slow response time from QC in verification of pre-press samples.
• Issues were brought to the Production Manager and the Team Leads on each press. Responsibility for production was then assigned by the Production Manager to the Team Leads. A weekly production variance report was reviewed with the Production Manager and the Team Leads. Production cost variances were reduced to less than 5% in 90 days.

Financial statements tell what is happening on the production floor. If the detail isn’t sufficient to identify what needs to be fixed, a deeper analysis of the financial impact of company operations will identify where the problems lie. In some cases, the fault is in carelessness on the production floor, causing wasted raw materials, or wasted time. In other cases, the cause is procedural, where production posting doesn’t accurately reflect available product and thereby impact the company’s financial results.

The astute business owner doesn’t just look at the top line and the bottom line to determine the success of the company but reviews the accompanying analysis to see if expectations are met. The key for many companies is management by exception. Set standards and guidelines for financial and operational performance. Certainly, strive to improve. But exceptions to standard results need to be scrutinized and resolved, or the exceptions become standard practice – and quality and profitability suffer.