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A Quote is Only as Good as Its Calculations

By: Harry F. Landsburg

Harry F. Landsburg is director of business process technology at Delaware Valley Industrial Resource Center, Philadelphia PA; www.dvirc.org.

Monday, June 1, 2015
 

costingManufacturers must use the best method of costing jobs to quote competitively and grow the business profitably. Commonly used assumptions about single factory rates and “free” equipment must be replaced. Calculating fully loaded labor rates, applying depreciation costs to all working equipment, and correctly applying overhead to workcenters and operations are critical to making profit and growing business value.

It’s no secret that business is very competitive. Quoting that uses broad generalities and “rules of thumb” will not gain new customers nor more opportunities from existing customers. The business will succeed when the right costing methods and margins are used to quote winning orders.

Traditional Quoting Methods

The traditional method of costing parts was based on the average hourly direct-labor rate and then increasing that value with several overhead percentages. These company-wide calculations included adding percentages for employee benefits, manufacturing overhead and selling/general/administrative overhead. This method, while often mathematically correct, proves ineffective in accurately costing the operations required to produce each part.

All direct-labor employees are rarely paid the same and all parts are not produced using the same routings or series of operations. So why use quote rates with those assumptions? Making the right calculations to develop accurate cost rates and managing markup decisions at the net-income level are the best ways to win jobs.

Adding three large amounts of overhead cost also is misleading as all employees do not have the same overhead costs. CNC equipment costs more than welding equipment and uses more energy. More advertising and selling focus may be required for newer parts or products while jobs/parts made for many years have less selling resources directed toward them. This logical variation does not support the company-wide rates and large overhead percentages used by many manufacturers to quote work.

Get More Specific in Calculating Costs

The more specific you can be with calculating cost and assigning overhead to the correct operations, the better your cost rates will be and the more competitive your quoting will become. Consider measuring and using the best possible costs for each manufacturing process.

Don’t increase the labor rates of your direct-labor employees with a general percentage of employee overhead. Be more specific about which employees work in each workcenter. For each employee, add to his/her base labor rate the company’s cost for:

• FICA insurance;

• State and Federal unemployment taxes;

• Workers compensation;

• Insurances—health, dental, group term life;

• Holiday, personal and vacation days off; and

• Other costs (uniforms, education, etc.) that apply to each employee.

You also can calculate the full cost of overtime by adding to the fully loaded labor rate an additional 50 percent of the base labor rate and the associated additional cost of workers compensation and employer’s FICA tax on that hourly rate premium. This will provide the full cost of each employee in a workcenter. Average the cost of the employees in the workcenter to derive a fully loaded labor rate for the workcenter. This will be the first element of the fully loaded workcenter rate.

Also list the total straight-time and overtime hours worked by each employee in each workcenter. This includes employees who work in more than one workcenter. If you notice that the overtime worked in a workcenter exceeds 15 percent of the straight time worked, consider quoting the average fully loaded overtime rate for the workcenter with each job that you estimate.

Significant overtime is difficult to factor into each quote as it never is clear at the time of quoting whether a job will be worked using straight-time hours, overtime hours or both. Quoting a fully loaded overtime rate will smooth out the variation in this timing of the work and related cost.

Many companies hire temporary workers throughout the year. Include temporary-labor hours in the average cost of fully loaded labor rates for the workcenter. The rate paid to the temporary agency already is fully loaded, making an analysis of the rate components unnecessary. Use weighted-average hourly rates rather than simple average hourly rates to calculate the fully loaded rate for the workcenter, as temporary-labor rates tend to decrease the workcenter fully loaded labor rate.

Equipment Depreciation Cost

Equipment used regularly is never fully depreciated for the purpose of quoting work. While current tax laws provide for a 7-yr. depreciation life, quoting parts without considering the cost of equipment yields a competitive price that has little opportunity to return enough profit to set aside for buying new equipment.

Fully depreciated equipment should have a depreciation value based on equipment-replacement cost depreciated straightline over 7 yr. factored into the quote. This methodology, not generally accepted accounting practices, is an appropriate approach to costing equipment for all quotes.

Depreciation cost can be quoted by labor hour, by machine hour or by a measure such as units produced. Companies must relate how they quote and convert cost to the quoting factor. For most quotes, hourly rates per workcenter are calculated to determine cost per finished unit produced. Companies that run machinery partially or mostly unattended quote machine hours in calculating equipment cost per finished part. Process-industry companies often quote pounds or other units of measure based on process-flow cost.

Overhead Allocation

After calculating all labor and equipment costs, the remaining costs are overhead. Overhead costs include manufacturing overhead, selling overhead, and general and administrative overhead.

Companies can add to these categories based on the specifics of their business. Some companies can include warehouse overhead or engineering overhead to better cost significant activities in the business. Not all categories apply to products that do not include these activities in some aspect of their production.

Costs are variable, fixed or semi-variable. Variable costs align with the revenue of the business.

For example, material costs typically vary directly with revenue. Because rent does not change with the volume of business done, it is fixed. Utilities are semi-variable with a portion varying with the amount of factory activity, while utility costs are fixed for heating and air conditioning the offices of a company.

The direct cost of manufacturing, mostly materials, is costed in the bill of materials for a part. All other costs often are rolled into the cost of a labor hour. Using a spreadsheet to show whether all other costs are manufacturing overhead, selling overhead, or general and administrative overhead allows the person developing fully loaded cost rates to increase the fully loaded labor rate by the hourly cost of the three example overhead categories.

When a category of allocated overhead cost has been totaled, divide that result by the number of direct-labor hours recorded by the business for the period of time that the costs apply. Divide a year of overhead cost by a year of direct-labor hours, including straight-time and overtime hours.

The hours worked by all employees who specifically produce parts sold in the business are used to divide into the overhead cost totals by category. Include the direct-labor hours of all factory employees based on how you categorize them. For some businesses, this includes the hours of all employees at each workcenter or operation. Costs for materials handlers, nonworking supervisors and other indirect/management employees often are identified as overhead cost. Do not include the hours that the indirect employees work in the hours divided into the overhead cost by category.

Once identifying all of the overhead costs by overhead category, divide the result by total direct-labor hours to present an hourly overhead rate per overhead category.

Fully Loaded Workcenter Rates

Fully loaded workcenter rates are the combination of the fully loaded labor rate, the equipment depreciation rate and the overhead rates for manufacturing, selling, and general and administrative overhead. Use these workcenter rates to cost the traveler operations required to make the parts sold by the company.

By using fully loaded workcenter rates, the person quoting needs to focus only on desired bottom-line profit and not a markup for gross margin. If a company wants to make 10 percent bottom-line net income on a job, the total cost should be divided by 0.9 to calculate the selling price. This is a different but better approach to quoting than taking average direct-labor rate plus other direct costs and dividing by the gross margin reciprocal (35 percent gross margin divided by 1.00-0.35, or 0.65).

The method suggested in this article has been shown to be effective at many manufacturing companies. It provides the best allocation of variable and fixed costs, and provides the most accurate workup of the cost of all manufacturing operations throughout the company. By using a calculated depreciation placeholder for fully depreciated equipment as part of the cost buildup, staff who quote an opportunity have at their disposal the best calculation of the full cost of producing the part. MF

A sample calculation of fully loaded labor rates for a hypothetical metal fabricating company.

 

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Posted by: Erik Waelchli on 7/5/2015 12:12:06 PM - URL: www.IBDConnection.com
Hi Harry, interesting article. One thing I miss is the mentioning of market pricing. At the end one cannot quote competitively, if one's cost structure is not competitive. Hence, for any metal fabricator it is essential that he/she bench-marks the existing cost structure to other competitors in the industry and makes adjustment to attain a cost structure that makes the operation lean and mean; i.e. eliminate waste, optimize raw material purchases, automate in the shop as well as in the office, etc. etc. Adding costs and applying margins only, may lead to noncompetitive quotes. Always be aware of what others can do and try make sure that one can do better! Erik Waelchli – IBD Connection, Inc.

 

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