I received a call from a client the other day asking about how much they could reduce their selling price if one of their major customers would dramatically increase their volume of business. The client realized that part of his cost was associated with fixed overhead in the manufacturing environment. He also realized that as volumes increase, that spread of fixed costs can be reduced simply because the base is larger.
Although we have not yet finished our conversation, I am sure that he believes that whatever portion of overhead is being assigned to this customer’s products can be reduced. I believe that he believes if volume is doubled, let’s say, then he can cut his price in half.
We recently worked through a very similar example with another client in a completely different industry. In this case, the owner was attempting to dramatically reduce his selling price thereby capturing a greater share of the market and substantially increasing his volume, and his question to us was how much of a difference would that make?
There are mathematical techniques available that allow cost accountants to make precise calculations as to the nature of the cost being assigned in the current allocation method and readily determine which of those costs are fixed and variable. Even though most business owners think of overhead as purely fixed with careful analysis, it’s easy to determine that there are variable components that need to be recognized separately. With our first example, precise costing was an absolute necessity for this business owner, and he would not tolerate even a few percentages of error in his product costing. As a result, we were able to determine that roughly two-thirds of the costs being allocated to the overhead costs were truly fixed and will result in lower cost per the product if volumes are substantially increased. However, one-third of the cost was clearly variable and had to be considered very similar to any other purely variable component in product costing, such as raw material. With this information he was able to accurately adjust his sales prices purely based on the anticipated volumes with new lower selling prices.
In the second case, the client was looking for some general guidelines that he can use to talk to this customer about what to expect, and I believe based on our preliminary review that some cost reduction is possible but I suspect it will be far less than the customer is anticipating because a good portion of their costs are truly variable and volumes have little effect on that cost band.
We are constantly running across costing issues like these that are generated by an improving economy and customers demanding continuous streams of cost reductions to keep their business competitive in a global economy.
Precise product costing is the foundation for good management decisions related to make or buy, continuation of customer or product line and overall profitability by operation, location, customer, nature of raw material or any other myriad of things that business owners find relevant to maintaining or improving the overall operations they are responsible for.
If your product costing does not provide reliable information that is timely and relevant to your needs, you are limiting the possible effectiveness of your management team.
