Companies today recognize the importance of measuring profitability. Unfortunately, they fail to measure it at the most meaningful and controllable level - by customer. Most companies measure profitability at the business unit level. While this is important, it fails to identify either the sources or causes of poor profitability. Those that have attempted to determine customer profitability have often based their analysis on product gross margins alone, or in conjunction with cost allocations. These attempts are unsuccessful at best, and at worst can be severely misleading. Understanding the underlying components of cost, and addressing specific causes of poor profitability will significantly improve bottom-line performance.

Product gross margin (PGM) is the starting point for all profit analysis; therefore an accurate costing system is imperative. Product costs are generally the greatest single cost for any account. A failure to assign product costs properly will result in a fundamentally flawed analysis. While PGM can be an effective tool for monitoring cost and profit potential for a specific product or SKU, it is a poor means of measuring account profitability. Using PGM alone simply ignores all non-product-related costs, and as any business manager will tell you, there are many other costs.

Even those companies that have developed an effective costing system fail to properly measure account profitability. Instead of directly assigning real costs to individual accounts, costs are simply allocated on a percentage basis. This type of analysis doesn't really tell you anything about the true profitability of a specific account. You are, in effect, just subtracting the same number from the PGM of every account. Not only does this type of analysis offer little insight, it can also create delusions of profit where none exists. Invariably, a customer profitability analysis based on allocation saddles your best accounts with excess costs and dilutes their true profitability. An example of the misinformation created by using allocation can be seen in Table 1.

In a mature, highly competitive market like coatings, developing a clear understanding of customer profitability and the components of cost associated with individual accounts can be a tremendous advantage. You will identify opportunities for profit improvement that will immediately add to your bottom line. You will identify those areas where you are the most successful and that allow you to develop your strategy from a position of strength. You will identify areas of poor performance that can be addressed or you can stop wasting resources on unprofitable areas. Our experience has shown that undertaking an account profitability improvement initiative can improve a business' Earning Before Interest and Taxes (EBIT) overall profitability by as much as 2% of sales. According to David Sherman, president of Absolute Coatings, a leading wood floor coatings company headquartered in New Rochelle, NY, "This is one of the best things that we have done for our business recently. Using the Orr & Boss approach has enabled us to improve our corporate profitability by a significant amount."

Defining the Process

Undertaking an account profitability improvement initiative is a five-step process:

1. Costing System - A product costing system that fully and accurately assigns product costs must be implemented.

2. Profitability Modeling - All costs associated with individual accounts are identified and assigned to specific accounts. A four-quadrant analysis is then conducted to segment the high-performing accounts from those with poor profitability.

3. Profit Improvement Planning - Account-specific action plans are prepared and executed for accounts with poor profitability.

4. Strategic Planning - The results of the profitability analysis and the four-quadrant analysis are used to identify those areas where the company should focus its resources.

5. Ongoing Systems - It is important to ensure that the account profitability process becomes institutional and not simply a one-time event. This requires an ongoing profitability-monitoring system as well as a new account pricing system.

This article addresses step one, the development of an effective costing system. The remaining tasks will be addressed in a future article.

Product Costing Systems

There are many different types of costing systems used in the paint industry, but they all have one thing in common. They try to reflect, as closely as possible, the actual costs incurred to produce the products. Some systems are more successful than others in this endeavor. We typically see four major types of costing systems, with many variations of the four major types, which are as follows.

The Sum Of All Fears (Total Costs/Total Gallons)

The Sum Of All Fears costing system is the simplest of the four systems. In this system all costs related to production are added together and divided by the number of gallons or units produced. This costing system produces an average cost across all products. When using this system it is not possible to differentiate costs between products. For example, the effect of different manufacturing methods or processing time on individual product costs. While this costing method is not common in the paint industry we know of at least one supplier to the paint industry, with sales of over $1billion/year, that uses this system.

The Price Is Right (Price Charged Less All Costs = Manufacturing Cost)

The Price Is Right system starts with the price that you would like to be able to charge. From that number you subtract the margin dollars you would like to have. Then subtract all costs except for conversion costs. What remains must be what the product costs to produce. Clearly the sales department likes this system since they will always achieve their margin percentage. However, manufacturing is left guessing their actual costs.

Just Your Average Joe (Allocation of Averages)

In the Just Your Average Joe system, the cost of the raw materials and packaging are calculated using the R&D formula. All other costs, such as labor, warehouse, QC, R&D and overhead, are applied on the basis of gallons produced. This tends to minimize the cost differences between the products and hides the fact that some products are more difficult to produce.

The Real McCoy (Assignment of True Costs)

The Real McCoy system measures the actual costs to produce products and assigns them to the individual products whenever possible. While much more difficult to accomplish than the other systems, it provides the means to understand the true costs of a product.

Developing The Real McCoy Costing System

There are five main steps that must be accomplished to develop a costing system based on The Real McCoy costing approach. They are:

1) Identifying product characteristics that add cost to products.

2) Developing labor standards for each manufacturing process.

3) Identifying and applying cost for quality control, and research and development.

4) Identifying overhead costs to be applied and the basis for applying these costs.

5) Bringing it all together.

Identifying the Product Characteristics

Before true costs can be assigned to the products, it is necessary to understand what characteristics of the product add cost. For example, does the product require additional quality control tests, or does the product require application of additional information stickers to the product. Table 2 shows some of the characteristics that may add costs to your products, and should, therefore, be included in the costing system.

When a list of product characteristics that add cost has been developed, it is necessary to document which products have which characteristics. This is easily done using a table or spreadsheet. Table 3 shows a portion of a product characteristics spreadsheet.

The table lists the individual products vertically and the characteristics horizontally. Developing this table can be quite labor intensive, but it should not take a person more than one week in a typical paint company.

Developing Labor Standards

The key reason many companies do not use the Real McCoy costing system is that they believe that collecting the information needed to develop the labor standards is time consuming and takes many months to develop. But actually, that is not the case. According to David Sherman, president of Absolute Coatings, "We were really surprised at how quickly this model could be developed and implemented. With the assistance of Orr & Boss, we were actually up and running within a few short weeks of project startup." The fact is that for most companies, the basic data can be collected on the plant floor in about two weeks. This data can later be further refined as needed. The best source for this information is from observations on the plant floor. For each manufacturing operation in the plant we need to measure two pieces of data. First we want to know how many labor hours each piece of equipment takes to set up before a batch is run and how many labor hours it takes to clean up after the batch is finished. We refer to this as the fixed time per batch. For example, a 1-gallon filling line may take two people 45 minutes to set up and clean up. This means that the fixed time per batch is 1.5 man-hours.

The second factor we want to measure is the run speed of the equipment. When we take into account the run speed and the number of operators per machine we refer to this as the variable labor time per gallon. A moderate-speed, 1-gallon filling line might run at a speed of 300 gallons per hour and have two people operating the equipment. This filling line would then have a variable run speed of 150 gallons per man-hour. In order to use this number in the model we need to convert it from gallons per man-hour to man-hours per gallon. We do this by dividing 1 by the gallons per man-hour. In the example above, 150 gallons per man-hour equates to 0.0067 man-hours per gallon.

To ensure an accurate cost model we must take into account the labor hours that are not used for production. Therefore we must adjust our measured labor standards for this non-value-added labor. Non-value-added labor hours are things such as safety huddles, meetings, paid breaks and time used to adjust equipment during a run. To adjust for non-value-added time we calculate the number of labor hours that should have been used to produce the production for the last six months to a year and compare that figure with the actual man-hours that were paid. We then calculate an adjustment factor by dividing the actual man-hours by the calculated man-hours. It is typical to calculate an adjustment factor of between 1.5 and 2.5 in most paint manufacturing operations. The adjustment factor is then applied to the standards to adjust them for non-value-added time. Table 4 shows the variable labor standards for an automatic filling operation. Note that the last column shows the man-hours per gallon adjusted for non-value-added time.

Applying Other Costs

The third step in the process for developing the Real McCoy system is to apply all other costs other than overhead. These costs include quality control, research and development, compliance costs, and warehouse costs. These costs should be applied directly to products or to product groups whenever possible. For example, if solventborne products go through a milling process and have an additional set of quality-control tests performed, then additional QC costs should be applied to solventborne products.

Applying Overhead

The best method of applying overhead is to gather the stakeholders together and assign an allocation method to each element of overhead. The following are the most common methods of allocation.

a) Allocated on a gallon basis.
b) Allocated on a batch basis.
c) Allocated on a unit basis.

This process can often take several hard days of negotiation to come to agreement.

Bringing It All Together

Before this information can be used to make decisions we must have a simple method of bringing it all together. We often use a simple spreadsheet program like Excel because it allows the data to be updated simply without any programming. Figure 1 is a schematic showing the different spreadsheets and how they all feed a summary cost sheet.

Results

Using a model as described above will not change the total costs, but will likely change the cost of individual products. Some of these changes may be quite dramatic and may not be in the direction that you were expecting. For example, IMP Group, a strong regional coatings company headquartered in Des Moines, Iowa, recently underwent this process with Orr & Boss. According to Marty Herrmann, the vice president of Operations, "We began this process with certain assumptions about our product costs. But as we got further into it, we discovered that many of our long-held beliefs were incorrect. In using this system, we have become much more confident about knowing what our true product costs are. The next step is to use the accurate costing information to assist in determining and improving our customer profitability."

In the case of one client it was believed that waterborne products had a disproportionate share of the costs and solventborne products had costs lower than actual costs. On completing the model it was discovered that these assumptions were incorrect.

Conclusion

Before a complete and accurate analysis of profitability can be undertaken, an accurate product costing system is needed. Failing to accurately calculate product costs will provide a flawed analysis of profitability since product costs are usually the largest single cost for any account.

For more information, contact the authors at 734/453.3033.