Manufacturers who don’t account for all their indirect costs are making a mistake that can impact their bottom line
In manufacturing, inventory is everything. Yet, manufacturers often struggle to understand how much money it takes, exactly, to make what they make.
Any manufacturer estimating their per-unit cost is looking at a finite group of factors: materials, labor, shipping and overhead (or indirect costs). The first three of these are straightforward. Even as prices on materials fluctuate, for instance, manufacturers know they need to set, and regularly adjust, standard costs. Where I still see manufacturers getting in trouble, though, is with that final factor: overheads/indirect costs.
No one is naive to the fact that making and selling things requires several indirect costs. They know that wages for staff, software, rent, electricity, insurance, and utilities are all required to manufacture a product and must be factored into the per-unit cost. Yet, too often, managers fail to give these overheads the attention they deserve. Faced with a dizzying array of invoices, they will rely on something they read online, an article, maybe, that told them to just add another 30 percent to their direct costs to account for overheads.
Arriving at a generalized overhead rate is necessary, but doing so without taking a close look at your business operations is a mistake. That 30 percent may work for many manufacturers. But for those operating above or below that number, a one-size-fits-all approach can cost dearly. After all, a per-unit miscalculation of just one cent in high-volume manufacturing can result in unrealized profit or substantial loss. It can even impact the valuation for some manufacturers seeking acquisition.
When undervalued inventory hurts
A true understanding of the cost to make a product is essential to running a sustainable operation. An accurate per-unit cost allows manufacturers to manage their margins, identifying inefficiencies in their production process and setting prices properly.
Businesses that undervalue their inventory are sacrificing their competitive edge. Imagine a company bids on a project with a relatively low number because they
didn’t properly account for indirect costs. They get the job because of that low bid, but later realize that the margins are far smaller than they predicted. Locked into a bad contract of their own making, the business doesn’t have the resources to go after other bids and fuel growth.
Low inventory valuation can also stunt growth by impacting a manufacturer’s credit. Banks will often calculate a company’s borrowing base by looking at its assets. If inventory is undervalued, the available money will be lower than necessary as well.
Manufacturers seeking acquisition can run into problems from undervalued assets, too. One obvious case is the asset-only deal. In such a deal, the value of the inventory is the deal, and any undervaluation will result in a loss.
It is also a problem for manufacturers who maintain a large balance of inventory and who hold that inventory long enough that its value is intrinsic to the value of the company. For companies that make things that are labor and material intensive and take longer to build, often under sophisticated long-term contracts – hydraulics for submarines, say, or diesel engines – missing an indirect cost can strip real money from a deal.
Easy-to-overlook overheads
What is required is a deep dive into all the overhead costs that have a direct or indirect impact on the cost of goods. Only when a manufacturer understands all those costs can they build an accurate overhead rate.
Simple enough. But identifying indirect costs, in particular, isn’t always that easy. Out of sight, out of mind isn’t just a saying; it’s human nature. Often a manufacturer will factor in rent but forget about the property tax. I’ve seen operations fail to take insurance and even utilities into account. Fees for lawyers and engineering consultants are often overlooked as well. And what about the people who come in after hours and clean the executive offices? Do not forget about them.
Those are the more straightforward overheads. Things can get more complicated when you factor in fractionalized costs for something like rent and utilities. If you use 25 percent of a building for the actual manufacture of a particular product, then a quarter of that cost needs to be allocated to inventory. Things get far more complicated when you are producing multiple distinct products.
The best way to fight human nature and successfully account for all these expenses is to bring in an accountant. But even accountants can miss these kinds of expenses. Manufacturers should make sure they hire someone who understands their business. A CPA who has multiple manufacturing clients is ideal. It’s important that your accountant understands inventory and has experience auditing manufacturing projects, not just businesses.
Remember that an accurate accounting of indirect costs is crucial to your business. Every manufacturing operation is unique. Its overhead rate should be too. ■
By Michael Trinks
Michael Trinks is a partner in assurance and advisory services at Fiondella, Milone and LaSaracina, a US-based multidisciplinary advisory firm. He specializes in audit and consulting for clients primarily in the manufacturing, technology, biotech, construction and service sectors. His experiences include stepping into both manufacturing and technology companies in an interim CFO role and managing audits under International Auditing Standards.