Nearly 40 percent of every company is unprofitable by any measure–a harsh conclusion drawn in an extensive study of corporate finances. The study also found that roughly 20 to 30 percent of the products are so profitable that they provide all reported earnings and cross-subsidize the losses. The rest of the company is only marginally profitable. The dilemma is that executives often don’t know which products belong to which segments.
In order to improve financial performance, it is imperative to gather factual costing information about each product. Are the products, which are believed to be unprofitable, truly unprofitable and, if so, then to what extent? What can be done about them? Inadequate segmentation of resources cleanly along product lines contributes to ineffective investment decisions whether focused on bottom line improvements or growing the top line.
Most companies use normal costing to estimate cost of manufacturing and distributing products. Such an approach typically uses standard costing where costs are divided into three categories: direct material, direct labor, and factory overhead, which is allocated to various products based on machine hours, labor hours or some other similar metric. This approach is adequate to estimate costs of individual products when the product volume, product batch size, product and processing technologies, and labor use do not vary significantly by product, and the overall overhead is significantly smaller than direct costs.
However, in recent years, with increases in productivity and advanced technologies the share of overhead has increased dramatically such that it no longer correlates with machine hours or labor hours. The product portfolios have also changed with diversity of product volumes and dissimilar batch sizes. This change is large enough that analyses based on standard costing are insufficient for directionally correct decisions.
Although standard costing coupled with variance analysis is still suitable for reporting purposes it is no longer acceptable for managerial decision making. It has become imperative to understand the true cost of manufacturing based on requirements for manufacturing for each product within the product portfolio of each fiscal unit. The same product manufactured at two different locations using identical technologies can have dramatically different cost structures depending on its placement in the product portfolio at its location. Restructuring of operations should not be undertaken without clearly understanding the operational requirements of each product and their associated costs—the risks are simply too high.
Accurate Assignment of Resource Consumption to Products Is Key
- Resource Use Cost—per use costs (e.g., labor, supplies, material, maintenance, inventory carrying cost).
- Resource Access Cost—costs incurred to have a resource available when it is needed whether or not that resource is used (e.g., assets, supply chain, maintenance, overhead).
In our experience controlling the degree of extension into overhead has to be dictated by the need of the situation and, therefore, it is a unique solution for each corporate entity. Our approach is a Predictive Operational Analytics methodology of process and financial integration technology to develop a roadmap to solve the problem at hand, hence the name ProFIT-MAP™.
Working with resource use and access costs is a more dynamic perspective over traditional and static terms of direct and indirect (fixed and variable) costs. The dynamic approach allows for greater precision in distributing costs based on the actual level of effort and contribution by each resource towards the stated objective.