In the manufacturing industry, cost accounting is a fundamental requirement for achieving success. To be competitive and profitable, a manufacturer must understand and control the three basic elements of manufacturing costs – direct materials, direct labor and factory overhead.
Direct materials consist of all of the materials that become an integral part of the finished product. Direct materials should include the actual cost of the materials, as well as freight in, import duties, purchasing costs, receiving costs, storage costs and other directly attributable costs of acquiring the materials. Direct materials should be recorded net of any trade, quantity or cash discounts attributed to the materials.
Direct labor consists of all of the personnel costs required to manufacture the finished product. Direct labor should include wages, payroll taxes, and benefits associated with personnel who are integral to manufacturing the finished product.
Factory overhead consists of all of the other costs required to manufacture the finished product that do not fit into the direct material or direct labor elements. They consist mainly of indirect material, indirect labor, depreciation, utilities, rent, repairs and maintenance and insurance.
In the current economic conditions, companies have been searching for ways to improve efficiencies, in order to maintain profitability and a competitive advantage. Phase one of this effort should be to perform an operational assessment to identify the strengths and key deficiencies within the manufacturing process. The assessment would include a detailed review and analysis of manufacturing areas such as service and quality, management and personnel abilities, reporting metrics and systems, inventory management and plant physical layout. The assessment exposes areas within the manufacturing process that can be used to initiate and concentrate improvement efforts and cost reduction strategies. Cutting costs prior to performing an operational assessment might not result in improved efficiency or profitability.
Phase two of this effort would be a cost reduction project. The first step of this phase should begin with a comparison of the company’s profitability to the average profitability within the industry. It’s important to consider multiple industry resources and publications to obtain appropriate and comparable regional profitability averages. All fixed and variable costs within the manufacturing process should be focused on the goals of reduction, elimination, modification, substitution or innovation. Scrutinize direct material purchases, freight, utilities, insurance, inventory carrying costs and other indirect manufacturing costs.
During any process improvement or cost reduction project, it is critical to engage employees from all levels in the process. Engaging employees in process improvement initiatives keeps them focused on the company and its profitability, as well as their job. Employee engagement will enhance the benefits of the project, since production personnel possess the most hands-on experience in the manufacturing process, and can provide invaluable insight.
Poor economic conditions tend to result in an increase in efficiency improvement and profit improvement projects. However, don’t overlook the importance of considering some level of one of these projects each year. When poor economic conditions occur, it frequently pays to be the first company to react and position for the conditions. These projects can also lead to better than average growth during good economic conditions.
Understanding and controlling manufacturing costs can be the difference between making the sale or losing the sale. It can also be the difference between making a profitable sale or making an unprofitable sale. Lost sales and unprofitable sales can both result in a disastrous conclusion. Schneider Downs can help manufacturers achieve the profitability and competitive advantage that is necessary to be successful in this or any economy.
Schneider Downs provides accounting, tax, wealth management and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh, PA, and Columbus, OH.
This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.