Cost Reduction Strategies: Closing the Gap Between Estimated and Real Costs
Accurate costing is fundamental to profitable manufacturing. If you don’t understand and control your costs, you cannot be profitable. Unfortunately, the cost of operating a manufacturing business is not entirely straightforward, with direct and indirect expenses such as material costs, utilities, wages, rent, and more. It’s relatively easy for costs to creep up, gradually squeezing profits to the point where it becomes clear that you need to consider some cost reduction strategies. So how do you get a handle on costs?
It starts by understanding the two basic costing options: standard and actual. By tracking your standard or actual costs, you can compare them to your forecasts and better understand why your profits aren’t what they should be. This, in turn, will help you formulate cost reduction strategies.
Standard and actual costing: what are they?
Every ERP system has some mechanism for tracking costs by standard or actual costing methods, although some only accommodate standard costing, often considered the more traditional approach.
Standard costing requires you to assign some predetermined estimate values to each manufacturing element – materials, labor, and overhead. Often discrete manufacturers, who produce large volumes of standard products whose raw material costs vary little over time, prefer standard costing because it can be a “set it and forget it” approach. Any change in cost is considered a variance due, say, to different labor requirements or the number of components needed.
For cost reduction strategies, standard costing’s variances enable you to evaluate the root cause of a costing discrepancy and develop a solution for it. In general, standard costing is more common in manufacturing because inventory valuation is simplified and it’s easier for accounting to maintain, manage and reconcile.
Actual costing requires the manufacturer to assign constantly-changing costs to every component in the manufacturing process, every time, to get an actual price. This approach tends to be more work, but produces more accurate cost reporting. As you might imagine, it’s the method preferred by process manufacturers such as job shops with variable raw materials and volatile pricing. One benefit to actual costing is that median prices can be determined by reporting inventory at a weighted average over time, which can help with forecasting.
Accurate estimating: it’s all about the data
Whichever costing methodology you employ, it’s crucial that data that going into your ERP system is as accurate as possible. That ancient computing saying still applies – “garbage in, garbage out.”
Depending on your stage of ERP utilization, costing data will vary in quality. A recently implemented ERP system might be populated with initial information gleaned from tribal knowledge –a mental “data dump” from knowledgeable workers. Over time, that data will be replaced with more accurate data accrued from actual material purchases and real labor costs, enabling the ERP system to make estimating suggestions based on the history it now contains. Armed with that knowledge, you can more easily introduce variables into your estimates, such as inflation or product variations.
A large part of manufacturing costs, of course, is labor and performing processes that may be, in part, developed and revised by experience and tribal knowledge. A sophisticated ERP system such as Visual enables can enable you to incorporate tribal knowledge and test it against known, standard processes entered into the system. Variances or discrepancies between estimated costs and actual costs can reveal process deficiencies or even omissions that may be affecting labor estimates and driving up actual costs.
As accurate data increases in the ERP system, including a range of possible variables that can affect pricing, you’ll find that expected costs will increasingly mirror real costs, enabling more accurate estimating and closing the gap between estimated and real costs.