The Cost of Doing Business
What do Burritos and Brakes tell us about cost?
Let’s break it down……
By Daniel Chalfant MBA
As a business owner, do you know what it costs to produce your product?
Do you have any idea of what your competitor’s costs might be?
Would you like to know your supplier’s costs?
The answer to all these questions may be easier than you think. There is an easy new way to estimate your cost, your competitor’s cost, and your supplier’s costs.
If your business has a good cost accounting system, you may know precisely what it cost you to produce your products. But what about your Competition? What about your key suppliers? How would you know their cost?
My wife runs a family owned Mexican delicatessen in California . The business is very successful; it turns a good profit each year. They sell hundreds of burritos every day. The burritos include beans, cheese, tortilla, and salza. They preparred by loving moms and grandmas.
= $ ?
Ask her how much it costs to make a Burrito, and she’ll say “I have no idea!” She knows it takes raw material, labor, and overhead to make the burrito, but no one has time to figure it out. And who cares?
In a competitive market place, the laws of supply and demand determine prices and profitability. Her prices are set according to market prices and yearly profitability. But what happens when there is little or no competition? In these cases, the cost of the product will usually determine the price of the product. If you don’t know the cost, you are at a great disadvantage.
In Federal Government Contracting there is a law that applies when adequate competition is lacking. It is called “Truthful Cost or Pricing Data” or the “Truth in Negotiations Act” (TINA). When this law applies to a US government contractor, the contract must disclose a cost and pricing data to the US government. The Government uses this data to negotiate a fair and reasonable price with the contractor.
In commercial contracting, there is no such law. How can a commercial company obtain cost data on competitors and suppliers? Competitors are usually not willing to disclose cost data to anybody. Suppliers will sometimes disclose their cost data if they see a potential for a lot of future business.
There is another way. We can estimate the cost breakdown of our competitors and suppliers. This used to be a very complex and cumbersome process. Now there is an easy new method to estimate the cost of a product. It involves the use of Economic Census Data.
The United States Census Bureau conducts Economic Census of US manufactures. The Economic Census provides a detailed portrait of the Nation's economy once every five years, from the national to the local level. The Economic Census is conducted every five years, in years ending in '2' and '7.' The latest Economic Census is for 2012 . The next Economic Census will be conducted in 2017, and is expected to be published in 2019. The Economic Census of manufactures collects data on the cost of direct materials, direct labor, indirect expenses, and profits of most US manufacturing firms.
The data is sorted by North American Industrial Classification System (NAICS) codes. The data is collected by six digit NAICS codes. The data includes the cost of production workers wages, total cost of materials, total value of shipments and receipts for services, and something called “Value Added”. The Value Added data allows us to calculate industry average indirect cost rates.
This makes it possible to create an average cost breakdown for very specific categories of products. For example, the Burrito above would fall under NAICS code 311991, Perishable Prepared Food Manufacturing. The estimated cost breakdown for our Burrito would look like this:
Cost Element Census Data Percentage Our Burrito
Direct Labor 791,565 8% $0.40
Material 5,574,674 56% $2.79
Indirect Cost 3,624,164 36% $1.81
Sales 10,005,086 100% $5.00
What if we figure out that the cost of the beans, cheese, tortilla, and salsa actually cost $3.29 each? Her choice is either to find a way to reduce her other estimated costs, or increase the price of the Burrito. My advice to my wife; raise the price of the Burrito to $5.50, and she did. Not because I said so, but because her competition was at $5.50 or higher. I still get points though, right?
Let’s look at an industrial example with more data. Let’s say we are buying Brakes for a fleet of vehicles. The Price quoted to us is $1,000 per vehicle. Under NAICS code 336340, Motor Vehicle Brake System Manufacturing, the estimated cost breakdown would look like this:
Cost Element Census Data Percentage Our Brake
Direct Labor Wages 785,576 7% $70
Direct Labor Hours 46,348 4.1
Direct Labor Rate $16.95 $16.95
Material 6,735,337 60% $600
Value Added 4,474,778 40% $400
Indirect Expenses 3,689,202 33% $330
Value of Shipments 11,237,972 100% $1,000
The above data tells us the cost of a typical Motor Vehicle Brake System includes about 60% material or $600. Only about 7% or $70 of the cost is direct labor. The remaining 33% or $330 of the cost is included in the “Value Added”. In the example above, Value Added number includes direct labor; therefore the total is about 40%.
Using this Economic Census data, we can calculate some interesting ratios. First, we can calculate the direct labor wage rate of $16.95 per hour. That leads us to estimate the direct labor hours of 4.1 hours per brake assembly. Next, we can calculate the indirect cost as a percent of the direct labor costs. Typically, this is referred to as “Overhead”. The average Overhead rate for NAICS 336340 is 3,689,202/785,576 or about 470% of the direct labor cost.
Now that we know the direct labor rate and the average overhead rate, we can calculate the “full up” or Fully Burdened Labor Rate. The average Fully Burdened Labor Rate for NAICS 336340 is $16.95 x 5.7 or about $96.61 per hour.
What about Profit? The industry average profit is buried in the value added or indirect costs above. The US Census Data does not tell us how much profit is included. For the answer to this, we turn to the Internal Revenue Service (IRS).
The IRS collects data on the average profit reported by US manufactures on the annual income tax returns . The 2012 Income Tax Returns show Total Receipts and Net Income by major industry. Net Income divided by Total Receipts yields the average profit as a percent of sales. The average profit for Transportation Equipment firms in 2012 was about 5% of sales. We can use the IRS average profit or use our own idea of what a reasonable profit would be. Therefore, we adjust the 33% Value Added above, downward to only 28%, plus the 5% profit equals 33%.
Let’s go back to the Brake System example. Allowing for profit, the indirect cost is now only 28% of $11,237,972 or $3,146,632. Our cost model overhead rate is now only 400% of direct labor. If we assume higher profit margins, the calculated overhead rate will be lower. We can update our cost model to reflect the new overhead rate as new information becomes available.
We can substantiate our cost model against empirical data as well. A recent study of actual indirect rate data showed that the average indirect rate factor in manufacturing industries was 5.5 in 2015, which is equivalent to an overhead rate of 450% of direct labor. I am not surprised; I just negotiated some industrial Brakes that had an overhead rate of over 1,000%.
Summary:
We can use the Census Cost Model to estimate our competitor’s cost structure or estimate our supplier’s cost breakdown. All we need is the price they are charging, and the Economic Census Data. We develop our initial cost model based on the census data. We can refine out cost model continually as we obtain more information. We can use this data to be more efficient, more competitive, and to do a better job negotiating with our vendors.
Daniel Chalfant is a Cost/Analyst for General Atomics in San Diego, CA. He is an adjunct instructor at San Diego State University, teaching Contract Management courses. He teaches cost and price analysis at Fortune 500 firms nationwide.
What do Burritos and Brakes tell us about cost?
Let’s break it down……
By Daniel Chalfant MBA
As a business owner, do you know what it costs to produce your product?
Do you have any idea of what your competitor’s costs might be?
Would you like to know your supplier’s costs?
The answer to all these questions may be easier than you think. There is an easy new way to estimate your cost, your competitor’s cost, and your supplier’s costs.
If your business has a good cost accounting system, you may know precisely what it cost you to produce your products. But what about your Competition? What about your key suppliers? How would you know their cost?
My wife runs a family owned Mexican delicatessen in California . The business is very successful; it turns a good profit each year. They sell hundreds of burritos every day. The burritos include beans, cheese, tortilla, and salza. They preparred by loving moms and grandmas.
= $ ?
Ask her how much it costs to make a Burrito, and she’ll say “I have no idea!” She knows it takes raw material, labor, and overhead to make the burrito, but no one has time to figure it out. And who cares?
In a competitive market place, the laws of supply and demand determine prices and profitability. Her prices are set according to market prices and yearly profitability. But what happens when there is little or no competition? In these cases, the cost of the product will usually determine the price of the product. If you don’t know the cost, you are at a great disadvantage.
In Federal Government Contracting there is a law that applies when adequate competition is lacking. It is called “Truthful Cost or Pricing Data” or the “Truth in Negotiations Act” (TINA). When this law applies to a US government contractor, the contract must disclose a cost and pricing data to the US government. The Government uses this data to negotiate a fair and reasonable price with the contractor.
In commercial contracting, there is no such law. How can a commercial company obtain cost data on competitors and suppliers? Competitors are usually not willing to disclose cost data to anybody. Suppliers will sometimes disclose their cost data if they see a potential for a lot of future business.
There is another way. We can estimate the cost breakdown of our competitors and suppliers. This used to be a very complex and cumbersome process. Now there is an easy new method to estimate the cost of a product. It involves the use of Economic Census Data.
The United States Census Bureau conducts Economic Census of US manufactures. The Economic Census provides a detailed portrait of the Nation's economy once every five years, from the national to the local level. The Economic Census is conducted every five years, in years ending in '2' and '7.' The latest Economic Census is for 2012 . The next Economic Census will be conducted in 2017, and is expected to be published in 2019. The Economic Census of manufactures collects data on the cost of direct materials, direct labor, indirect expenses, and profits of most US manufacturing firms.
The data is sorted by North American Industrial Classification System (NAICS) codes. The data is collected by six digit NAICS codes. The data includes the cost of production workers wages, total cost of materials, total value of shipments and receipts for services, and something called “Value Added”. The Value Added data allows us to calculate industry average indirect cost rates.
This makes it possible to create an average cost breakdown for very specific categories of products. For example, the Burrito above would fall under NAICS code 311991, Perishable Prepared Food Manufacturing. The estimated cost breakdown for our Burrito would look like this:
Cost Element Census Data Percentage Our Burrito
Direct Labor 791,565 8% $0.40
Material 5,574,674 56% $2.79
Indirect Cost 3,624,164 36% $1.81
Sales 10,005,086 100% $5.00
What if we figure out that the cost of the beans, cheese, tortilla, and salsa actually cost $3.29 each? Her choice is either to find a way to reduce her other estimated costs, or increase the price of the Burrito. My advice to my wife; raise the price of the Burrito to $5.50, and she did. Not because I said so, but because her competition was at $5.50 or higher. I still get points though, right?
Let’s look at an industrial example with more data. Let’s say we are buying Brakes for a fleet of vehicles. The Price quoted to us is $1,000 per vehicle. Under NAICS code 336340, Motor Vehicle Brake System Manufacturing, the estimated cost breakdown would look like this:
Cost Element Census Data Percentage Our Brake
Direct Labor Wages 785,576 7% $70
Direct Labor Hours 46,348 4.1
Direct Labor Rate $16.95 $16.95
Material 6,735,337 60% $600
Value Added 4,474,778 40% $400
Indirect Expenses 3,689,202 33% $330
Value of Shipments 11,237,972 100% $1,000
The above data tells us the cost of a typical Motor Vehicle Brake System includes about 60% material or $600. Only about 7% or $70 of the cost is direct labor. The remaining 33% or $330 of the cost is included in the “Value Added”. In the example above, Value Added number includes direct labor; therefore the total is about 40%.
Using this Economic Census data, we can calculate some interesting ratios. First, we can calculate the direct labor wage rate of $16.95 per hour. That leads us to estimate the direct labor hours of 4.1 hours per brake assembly. Next, we can calculate the indirect cost as a percent of the direct labor costs. Typically, this is referred to as “Overhead”. The average Overhead rate for NAICS 336340 is 3,689,202/785,576 or about 470% of the direct labor cost.
Now that we know the direct labor rate and the average overhead rate, we can calculate the “full up” or Fully Burdened Labor Rate. The average Fully Burdened Labor Rate for NAICS 336340 is $16.95 x 5.7 or about $96.61 per hour.
What about Profit? The industry average profit is buried in the value added or indirect costs above. The US Census Data does not tell us how much profit is included. For the answer to this, we turn to the Internal Revenue Service (IRS).
The IRS collects data on the average profit reported by US manufactures on the annual income tax returns . The 2012 Income Tax Returns show Total Receipts and Net Income by major industry. Net Income divided by Total Receipts yields the average profit as a percent of sales. The average profit for Transportation Equipment firms in 2012 was about 5% of sales. We can use the IRS average profit or use our own idea of what a reasonable profit would be. Therefore, we adjust the 33% Value Added above, downward to only 28%, plus the 5% profit equals 33%.
Let’s go back to the Brake System example. Allowing for profit, the indirect cost is now only 28% of $11,237,972 or $3,146,632. Our cost model overhead rate is now only 400% of direct labor. If we assume higher profit margins, the calculated overhead rate will be lower. We can update our cost model to reflect the new overhead rate as new information becomes available.
We can substantiate our cost model against empirical data as well. A recent study of actual indirect rate data showed that the average indirect rate factor in manufacturing industries was 5.5 in 2015, which is equivalent to an overhead rate of 450% of direct labor. I am not surprised; I just negotiated some industrial Brakes that had an overhead rate of over 1,000%.
Summary:
We can use the Census Cost Model to estimate our competitor’s cost structure or estimate our supplier’s cost breakdown. All we need is the price they are charging, and the Economic Census Data. We develop our initial cost model based on the census data. We can refine out cost model continually as we obtain more information. We can use this data to be more efficient, more competitive, and to do a better job negotiating with our vendors.
Daniel Chalfant is a Cost/Analyst for General Atomics in San Diego, CA. He is an adjunct instructor at San Diego State University, teaching Contract Management courses. He teaches cost and price analysis at Fortune 500 firms nationwide.
