Competitive job costing

Print Action, Apr 2003 by Goss, Al

[Graph Not Transcribed]

I was talking last month to a printer who gently upbraided me over my enthusiasm for print-on-demand and toner-based technologies. "What businesses really need," he said, "is advice on how to make some money on what we sell now." As we continued to talk it became clear that he was suffering from intense price competition. His shop was busy, but both revenue and profits were falling. He could not see how his competitors could afford to do the jobs at the prices they were quoting. Certainly he couldn't afford to take them on and he wasn't sure whether he was inefficient or if his competition just didn't know how to quote.

I pointed out that letting unprofitable jobs migrate to your competitors is rarely a bad strategy. After all, as long as your estimating system can accurately allocate costs, why not let the guy down the street win all of the unprofitable work? Strategic customer selection is a concept you'll find discussed in strategy literature. But the strategy assumes the firm understands its own costs. Any strategic plan needs to be overlaid on a strong foundation of business processes. And few of those processes are as fundamental as costing. But, the definition of cost is far from simple and, as we'll see, far from trivial. Alas, many costing systems are just not up to the task.

Out of pocket, in your books

Throughput costing is the simplest method of determining the cost of a job. It measures only the direct out-of-pocket cost. The cost of the job is what you paid for the paper, ink, plates, and other materials. Everything else is an operating overhead cost. While it is simple, it is of limited value in a job shop environment where you want to know the costs of a specific project. Variable costing goes one step further by tracing variable direct costs to specific jobs. Finally, absorption costing allocates indirect production costs as well as direct variable costs. That gives you the most complete picture of costs, but you can't see a job consuming indirect resources. As the sheets run through the press, there is no magic counter to tell you how much of the cost of your maintenance mechanic was consumed. So absorption costing requires some judgement.

The easiest way to handle the problem is to average all of the indirect costs and allocate them. But here is where it gets tricky. Choosing the wrong cost base can distort your costs and lead you to choose unprofitable work while passing up higher margin projects.

Assume that you take the direct-labour and the direct-material costs and use that as a cost base to apply a mark-up to cover all indirect expenses. The mark-up will be based on the total estimated overhead costs for the year divided by the estimated sales for the year. The system is simple and easy to implement, but it relies on several key assumptions. The first is that you need to be able to predict your period (indirect) costs. Often, companies will use the previous period as the forecast for the current period. The second - and infinitely more difficult - prediction is the level of sales for the upcoming period. If you underestimate your sales, you will over-allocate overheads to the remaining jobs and estimates will be too high. The market will very likely correct that problem for you. However, if sales fall below expectations, the firm will be under-absorbing overhead costs. There simply will not be enough jobs to spread your fixed costs over. The final assumption is that the jobs being processed are homogeneous; that is, they each use the same overhead resources in the same intensity. If they do not, distortions in pricing will potentially lead to the acceptance of jobs at levels below true cost.

But why

To see why the cost base matters, consider the case of a hypothetical $2 job where the ratio of labour to materials is 1:1. So you have $1 of direct labour and $1 of direct material and overhead is applied to the total $2 value of the job. Let us assume overhead is estimated at $0.50 for each $1 of direct costs. The total cost is then $3. Assuming the company has correctly estimated overhead costs and the expected volume of jobs for the period, then overhead is adequately covered. Simple, right?

Now, suppose the customer decides to supply his own paper. The printer should be indifferent to this. After all, you are being paid for your value-added, so your costs should fall by the cost of the paper and your cost is now $2. Just as much work is being done. Just as many company resources are being used. But now overhead will be applied on labour only. At our predetermined overhead rate of $0.50 per dollar, the company will now recoup $0.50 instead of $1. Nothing has changed from the perspective of the company and yet they are now only covering half of the overhead.

My example is obvious and transparent enough that any printer would quickly see the problem and adjust his pricing. But actual cost distortions are usually more subtle and harder to spot. Nonetheless, they have real impacts on the competitive position of the company. Solving this problem is fairly straightforward. The problem is in the choice of the cost base. Simply reallocating overhead based on value added and passing through material costs without any markups (or a nominal mark-up to cover carrying costs) will solve part of the problem. But there is that homogeneity assumption, and those distortions are even more insidious because they are so difficult to detect.