Profit by Controlling COGS
Cost of Goods Sold is often referred to simple as COGS and it is what every factory is most concerned with financially.
COGS has two components. First is Prime Costs and the second is Overhead. Prime costs include only the Raw Materials and the Direct Labor that goes into the product and Overhead is everything else.
PRIME COST: Raw Materials
Your product is costed based the fact that it requires a very specific amount of Raw Material to be used in creating the finished product. Typically, a Bill of Material (BOM) is used to establish this required quantity. Additionally your company locks down material pricing within the accounting system to develop what is the material standard cost. When you multiple these the required quantity, times the material price you get a stand cost of the direct material that gets built into every one of your products.
What are Raw Material Variances?
A cost Variance happens when the actual cost differs from the predicted or budgeted costs. Material variances can come from three places:
- First is material usage variance or scrap. When you scrap raw material or product that is work-in-progress you are tossing away material that is not accounted for in your standard costs, so this is considered material usage variance.
- Second is Purchase Price Variance or PPV. When prices fluctuate up and down after your products standard costs have been set, well then this price difference is called PPV.
- Third is Cycle Count Variance. It is extremely important that all your inventory transactions are completed in an accurate and timely manner. If this doesn’t happen correctly, it can wreak havoc with your accounting system. Your factories material costs are going to be inaccurate until a physical inventory or cycle count is completed and then an inventory adjustment is going to hit your books. Ultimately, you are throwing away mystery materials and dollars. I’m sure your factory controller discusses the importance of proper inventory transactions and this is why.
What Can You Do To Improve Material Variances?
First you can minimize scrap. This includes scrap from poor quality but also any raw material that you see in the trashcan represents a cost savings opportunity. Second you can help purchasing by implementing lower price materials and third you can ensure that timely & accurate material transactions are happening within your department.
PRIME COST: Direct Labor
Direct labor is the labor costs that are directly tied to the making of your product. Typically this includes only your operators. Its not the maintenance staff, supervisors, office staff or the forklift drivers. It is only the resources that are directly tied to your production processes. In most factories, production routers are used to determine the direct labor costs and process times of each product. Your accounting department has these standard costs captured in their budget file.
It is very important that you account for your labor accurately too. Never try to hide direct labor by falsely moving an employee in an indirect labor account. If a person is doing direct labor work, charge them there. If they are in a meeting or in training then charge them to indirect. If your machine breaks down or you have a lack of work, try hard to find them other direct labor work. One of the worst things for a factory is to have an imbalance of indirect labor.
Here’s why:
- First, if you move direct labor to indirect to hide a direct labor variance, then you are hiding a problem. If the problem surfaces correctly, then it can be solved. Hidden problems can’t be solved.
- Second, when a factory has too much indirect labor – it begs the question – do we need to downsize?
You want to have all your labor accurately accounted for and run breakeven or positive labor variances by being efficient.
FACTORY OVERHEAD
Factory Overhead includes every factory expense that is not a Prime Cost (aka Raw Material and Direct Labor). Overhead falls into two financial categories: Fixed Overhead and Variable Overhead.
FACTORY OVERHEAD: Fixed Overhead
Fixed overhead includes the building rent or mortgage, property taxes, property and asset insurance, the wages of salaried employees and sometimes a portion of utilities. In theory, fixed overhead costs do not fluctuate with the ups and downs of your sales volumes. For example, your landlord will not lower the rent if your sales are down in December. The monthly cost is fixed.
Fixed overhead costs are estimated during the budgeting process and the total projected fixed overhead costs are then divided by you volume forecast. This provides you with the absorption rate for each of your products. Lets say you have $2 million dollars in projected Fixed Overhead costs this year and you are forecasted to sell 1 million cases of product. In this case your controller will allocate two dollars of fixed overhead costs to every case that moves from your production into the warehouse as finished goods. So if you make 1 million cases, you earned $2 million to pay for the fixed overhead costs.
Fixed Overhead Variance
Fixed overhead variances happen when you either have an excess or a shortfall in fix overhead absorption and this can happen in a two-ways:
- First, an unanticipated and unbudgeted fixed overhead cost can change. Maybe you reduced or increased salaried staffing or property taxes increased or property insurance increased.
- The second way to create a Fixed overhead variance and the most common way, is for your volume to be different that what was forecasted and budgeted. If you were supposed to sell & make a million cases and earn a $1 million dollars, but you only sold & made 900000 cases because sales were light, well then you have a $100,000 unfavorable fixed-overhead variance. But on the other hand, if sales were good and you sold and made 1.1 million cases, well then you earned $1.1 million in fixed overhead, but you only need to spend $1 million on actual fixed overhead costs, now have a $100000 favorable overhead variance and this will drop to the bottom line as added gross profit.
FACTORY OVERHEAD: Variable Overhead
The concept behind variable overhead is that it should increase and decrease with factory volume. Variable overhead costs include things like hourly indirect support labor and factory supplies. If sales volume increases you would expect to use more supplies like packing tape and pallets, but if volume decrease you would consume less factory supplies.
The expectation with variable costs is that if volume decreases, you should then reduce indirect labor costs proportionally. For example, you could eliminate all overtime for indirect labor to prevent unfavorable variable overhead variances.
Variable overhead can be tricky though when it comes to indirect labor. If for example, you only have 2 forklift drivers in your plant and sales volume drops by 20%, then reducing one fulltime forklift driver would be a 50% reduction in driver capacity however one driver can’t support 80% of the volume, but two drivers is 20% too much. So often, it is difficult to "right-size" the indirect labor costs when volume is light. The best approach is to eliminate all indirect labor overtime and get flexibility via cross-training.
A word of caution; when volume in a factory drops, we like to move direct labor employees into indirect roles to keep them busy and this is a double whammy. Now you are earning less fixed overhead absorption and spending more in variable overhead. Accounting can you help develop a proper Direct Labor vs. Indirect Labor ratio and you'll need to develop a plan to achieve that proper ratio.
Strong Sales Volume is like having a Royal Flush!!!
I learned a long time ago that in a factory having strong volume is like having a royal flush in poker! When you have sales volume that is meeting or exceeding the annual budgeted forecast, your factory will have great leverage against its overhead. High volume can hide a lot of sins and low volume forces the company to make tough decisions.
Because of this fact, always play your cards right by doing whatever you can to support your customers, your sales team, your marketing team, your R&D department and ship good product on-time to your customers.
Standard Cost
Every product, whether you are making tires, cases of product or bars of metal, your product is assigned certain standard costs at the beginning of your fiscal year through the budgeting process. It works this way; a company’s total COGS budget gets applied to every product that you make thus creating your products' standard cost and then you earn COGS credit every time you make a finished goods product and transact-it to the warehouse.
Thus, when your product is transacted to the finished goods warehouse, you earn standard cost credit for successfully producing that product however, you only get credit for the standard cost amount and this standard cost credit is what pays all of the bills in your factory.
Additionally, if you made this product at a cost that was actually above or below the standard cost then you created either a favorable or unfavorable variance. These costs differences that happen in the factory are not considered part of the standard costs and they get captured in a separate line item in your P&L statement.
Ultimately, manufacturing leadership is accountable for these variances whether they are favorable or unfavorable. Favorable variances are like flowers and everyone high-fives and unfavorable variances are like weeds and your goal is to eliminate them so you can achieve budget. If you don’t eliminate unfavorable variances, they will be the subject of conversation in your board room.
Does your team know how to read and interrupt a P&L? If not, consider providing a professional development platform for them. If you are in manufacturing, checkout Tools for the Trenches.
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