The Price Is Right, Part 1

By CHARLES FRANCE & MICHAEL P. COLLINS, Author, Saving American Manufacturing

One of the most important questions for small manufacturers to answer is: Do you know if you are making adequate margins on each product line, model or job?

This question is extremely important because competing in any industry or supply chain where the customers are relentlessly forcing price reductions will require better costing\pricing systems than small- to mid-sized manufacturers (SMMs) have used in the past. This is particularly true if customers seek price quotes on large-volume orders or when they compare your prices to foreign competitors. Suppliers must have sufficient cost information to know whether or not to bid.

Here are three typical examples:

1. How will SMMs establish prices and discounts?

Example: A machine shop with less than five employees. The owner, a gifted toolmaker, has been in business for five years and only looks at the income statement monthly to see if he is in the black.

He establishes prices by using estimated material costs, estimated hours per job and a shop overhead rate used by his friends in similar businesses. He multiplies the estimated hours per job times his shop rate, adds to this the amount of direct materials and an estimated profit margin to arrive at a price he thinks will sell the job.

Thus, his price has more to do with whether he needs work (sales volume) than attaining a sufficient margin. He hardly ever goes back to check his quote sheet to see if his estimates were correct because he doesn’t have time.

But now, customers are asking him to discount his prices, and he doesn’t know what to say or do because his costing\pricing has always been “estimated.” He doesn’t know how much to discount for fear of losing the job and\or margin.

2. How can manufacturers determine a reliable pricing strategy that will allow them to more accurately estimate margins on each quotation or bid?

Example: Machine shop with 50 employees and annual sales of $5 million. This company has a work order system that captures direct labor, material costs, set-up times, and tooling costs and generic accounting software that includes a job-estimating module based on a shop overhead rate as in the previous example. Typically, the work order system and the accounting software are not integrated, and cannot share data.

Moreover, actual costs from the work order system are not available to the accounting system, so the owner lacks the ability to use actual costs in the estimating process. As in the previous example, pricing is built on estimates and the shop overhead rate. Thus, a pricing strategy or target margin pricing to ensure profitability cannot be established.

3. How will manufacturers know if the company is breaking even each month based on the prices they are quoting?

Example: A small manufacturer of custom machinery that quotes every job with a custom price. Sales and shipments were never stable. They shipped machines in bunches every two to three months. The boss never knew if he was breaking even or losing money until the income statement finally came out.

How to Get Started?

Many SMMs have avoided the cost\margin problem for a long time by using “rule of thumb” pricing or by using aggregate information from an income statement. But, the new game of discounted competitive pricing is serious, and there is less room for error. Developing a practicable costing\pricing system is crucial to knowing how to play the game and deciding whether or not to bid.

A. Hire an advisor.

Hiring an advisor who has worked with manufacturers and who is familiar with manufacturers’ cost structures would be helpful. A bookkeeper or accountant would be preferable, since certified public accountants (CPAs) are more focused on taxes and do not specialize in manufacturing accounting.

B. Re-format the income statement.

Re-formatting the income statement is needed to put costs into their appropriate place for cost\margin analyses. My experience is that many small manufacturers’ income statements do not break out cost of goods sold into direct materials, direct labor (typically hands-on labor) and manufacturing overhead (salaries and indirect labor for production employees, depreciation, etc.).

Rather, these costs are co-mingled with other expenses, making it impossible to see them individually on the income statement. To re-format the income statement, cost of goods sold should include direct material and labor, and manufacturing overhead, and be listed separately from sales, general and administrative expenses (S, G & A).

The income statement now can be used to identify direct production costs (material and labor), as well as indirect costs (manufacturing overhead and S, G & A), both of which are needed to prepare quotes that reflect desired\target margins. The revised format will also facilitate identifying opportunities to reduce production, office and selling costs.

C. Implement procedures to capture actual material and actual labor costs.

Good pricing requires knowing actual material and labor costs. But SMEs typically do not implement systems and procedures to capture actual material and labor costs per job, work order, customer, etc. because of the administrative costs. This is a primary reason for “rule of thumb” pricing. The administrative costs that these firms save upfront, they lose in ineffective pricing, and losses on some jobs and work orders.

This is one of the major shortcomings of small firms — not seeing the need to know actual costs or wanting to pay to get them. Nevertheless, it’s a foundational step to survival.

D. Develop an annual budget that separates fixed costs from variable costs.

Fixed and variable costs are accounting terms typically unfamiliar to SMEs. Fixed costs are called “indirect,” and include manufacturing overhead (depreciation, production, salaries, etc.) and S, G & A (office salaries and wages, rent, office supplies, advertising and promotion, miscellaneous, etc.).

They do not vary with production or sales ($215,500 in Table 1). Variable costs, on the other hand, do vary with production or sales, and primarily are materials and production labor ($715,500 in Table 1). The separation of costs into fixed and variable will be very useful in the development of an effective pricing strategy … which is explained later.

Ask your accountant or advisor to help you develop an annual budget using last year’s income statement as a basis, and to break out fixed and variable costs.

Table 1 is an example. Sales are budgeted at $1,000,000 with a 25 percent gross profit stemming from $750,000 in cost of goods sold. S, G & A expenses budgeted at $180,500 leave a pre-tax income of $69,500. Fixed costs are $215,000 and variable costs are $715,000. The budget will be used subsequently to calculate two very important financial numbers:

Breakeven sales (a minimum sales volume to cover fixed and variable costs before profit is realized).

Contribution margin (the margin remaining after material, labor and commissions are paid).

Breakeven is important to overall budgeting and business\sales forecasting because it shows the minimum sales volume needed to make a profit at your business’ current cost structure and overall level of profitabilty. The contribution margin is critical to effective pricing strategy and policy.

E. Contribution margin is a concept that can be an effective means to establishing not only pricing policy, but also developing basic marketing strategies.

It is defined as sales less variable costs (in Table 1, this is $1,000,000 less $715,000 = $285,000). It is the amount of revenue remaining after paying for direct materials, direct labor and commissions (in this example) to contribute to overhead and profit.

Think about this on a single product basis. Assume a unit selling price of $100, direct material price of $55, direct labor price of $15 and a commission of $2. After these costs are paid, $29 remains to contribute to factory and S, G & A overhead and profit. This equates to a 29 percent contribution margin ($29 contribution margin/$100 unit selling price) and is an excellent measure of the inherent profitability of the single product. The higher the contribution margin percent, the more margin to contribute to overhead and profit — the greater the profitability of that product.

Tune into the Chemical Equipment Daily for part two of this two-part series. Michael P. Collins is the author of the book Saving American Manufacturing. You can find more related articles on his website via www.mpcmgt.com.