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Management Accounting – Ensuring Every Shipment is Profitable

Monday 20 February 2017

Doug Hicks

By Douglas T. Hicks
IASeminars Instructor

hand stop gestureA gatekeeper is an individual who controls access to something. Ancient cities had gatekeepers whose job was to keep out undesirables. A college admissions officer is a gatekeeper who controls the makeup of the school’s student body. A newspaper editor is a gatekeeper who decides which stories will be included in that day’s edition. Gatekeepers are critical to an institution’s security, quality and overall success.

Businesses have gatekeepers as well. They control access to the company’s resources. Their job is to insure that only business that enhances the company’s ability to meet or exceed its financial objectives is permitted through the gate. They must be constantly on the alert because it only takes one gatekeeping failure to wipe out the financial benefits generated from scores of gatekeeping successes.

A key member of the gatekeeping team is its cost estimator. Although the market – not cost – determines the price a company can charge for its products and/or services, the cost of manufacturing those products and/or providing those services is a critical component in determining whether that business should be allowed through the company’s gate. An effective cost estimating process must exist before gatekeepers can consistently admit only desirable business and turn away the undesirable work.

Cost estimators have been able to keep up with changes in their company’s business by developing new, more sophisticated processes for estimating and optimizing the cost of “direct” items. In manufacturing, for example, cost estimators have taken steps to better estimate the prices to be paid for raw materials, purchased components and assemblies, outside manufacturing services, and other “direct” items purchased from vendors. At the same time, most manufacturers have continued to provide their cost estimators with outdated and inaccurate methods of linking the company’s operating costs with the products, services, contracts or customers whose potential value to the company is being evaluated. Most often, these methods take the form of a direct labor-based assignment of manufacturing costs to products and a single SG&A “add on” percentage to assign non-manufacturing costs. Consider the experiences of two mid-sized manufacturers:

$8 million of a $24 million stamping company’s annual sales came from a product it viewed as “the jewel in its crown.” After replacing its direct labor-based costing practices with a methodology that more closely matched its actual operations, it found that it was losing $1 million annually on this product. When it met with its customer to discuss the situation, the customer said, “We wondered when you’d figure it out. Every time we’ve re-bid this product during the past six years you’ve always been 30% lower than the next lowest bidder.” A single bad cost estimate/quote made six years earlier cost the company millions in the years that followed.

For several years, a mid-sized forging company sold a product to an auto manufacturer for $9.18. Since its direct labor-based costing model showed the product’s cost to be $7.80, it was elated as it shipped several thousand units monthly. After developing a costing methodology that better matched is plant’s operations, it found that the cost of the product was not $7.80, it was $9.88. Instead of a $1.38 profit per unit, it was selling this high-volume product at a $.70 loss per unit.

In both cases, undesirable business was welcomed through the company’s gate by a dysfunctional, direct labor-based cost model. In both situations, the business had a negative impact on financial performance for many years after being admitted. And at both companies, elimination of the unprofitable product led to a significant improvement in profitability.

A predictive, activity-based economic cost model provides companies with an effective tool for developing product and service costs that truly reflect the fundamental economics that underlie its operations. This is true for individual core business pricing decisions that require fully-absorbed costs based on practical capacity, strategic pricing decisions that require total costs based on various volumes and mixes of business, or special orders which require the incremental cost impact on the organization.

To be successful, 21st Century companies must insure that only business that will help it reach its financial objectives is admitted through its gates. The likelihood of that being accomplished, however, is reduced when a key member of the gatekeeping team is provided with a seriously flawed model to use in evaluating potential business.

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