Costs

As ‘costs’ are a central topic in my previous articles and may also be important in the coming articles, I thought it may be useful to explain some things about costs, how costs are composed and how costs are build up in the supply chain. Again, it won’t be rocket-science but it will elaborate on costs, just enough to understand what is meant with it in the my previous and future articles.

Zimmerman (2003) argues that the simple term 'cost' has multiple meanings. If a product costs €x,- it does not reveal what it measures. A lot of different type of costs exist like opportunity costs, average costs, fixed and variable costs to name a few. In the context of should cost modeling, 'costs' should be viewed throughout a supply chain. Costs in a supply chain are built up as is depicted in figure 1.1.

 

Figure 1.1: Cost route in the supply chain

A supplier produces a product and sells it to a customer. The price which the customer is paying for a product consist of the costs of goods sold (consisting of direct material, direct labour and manufacturing overhead), general, selling and administration costs and a certain percentage of profit. Table 1.1 provides some more information about the costs-components constructing the price.

 

	Element	Definition
	Direct material	Bill of material (BOM)
+	Direct labour	Labour required to convert direct material into a finished product (production workers wages)
+	Manufacturing overhead	Indirect costs associated with the conversion process (depreciation, other plant costs, supervision, R&D, support, etc.)
=	Cost of goods sold	Sub-total (DM + DL + MOH)
+	General, Selling and Administration cost (GSA)	Costs included to keep the organization in operation (R&D, Finance, Procurement, marketing)
+	Profit before tax	Profit before taxes are subtracted
=	Price	Total of all cost elements

Table 1.1: Price composition

The price the customer is paying for the product is (part of) the direct material in their own process[1]. The customer will on its turn then add value to it and is the supplier for its customer(s) when it sells their product further on along the supply chain. This process is repeated until it reaches the end-customer (see figure 1.1).

Direct material

The direct material costs are the costs which origin from the materials used in the product. Most of the time these direct material are for the largest part bought from other organizations (suppliers).
To obtain information concerning the costs of the materials used, several options are available. You can for example ask your supplier for that information, but you can also calculate it yourself if you know the type and amount of material used by your supplier. Another option is to appeal to your experts like an engineer or use the drawings of the product if you are in possession of them. In case you have identified the type and amount of material used in a product, you can calculate the material costs for the products as the prices of the materials are normally known to a certain extent (e.g. the copper price per kilogram).

Direct labour costs

Direct labour costs are the costs for labour required to convert direct material into a finished product. The labour costs are dependent on the number of hours worked on the product and the height of the wages for the employees. If every step is known in the production process and the labour involved with those steps, these costs can be estimated with great precision. But completely knowing the production process of the supplier is actually a kind of utopia. To obtain an impression of the production process of your supplier, you should extract information of your supplier. But this can be a difficult job to do, because most suppliers will be hesitant to disclose their valuable and sensitive information. Having close relationships with your supplier will be more supporting to the information exchange, resulting in a greater and more precise estimation of the costs (in 2010 I conducted research to the information exchange between buying and supplying organizations, the results may follow in the coming year on this blog).

As will be the case in close relationships with your suppliers, but especially when your organization does not have close bonds with their supplier, you should take into account that information can be distorted or not completely disclosed because parties in the process do not want to show all their cards for free as they might lose their competitive advantage by doing so. So obtaining information for estimating the labour costs can be very tricky and time-consuming. Therefore other ways of estimating these costs can be used which are less time-consuming and which can approach accepting levels of precision and in some cases even come close to high levels of precision.

Manufacturing overhead

Manufacturing overhead (also referred to as factory overhead, factory burden, and manufacturing support costs) refers to indirect factory-related costs that are incurred while a product is manufactured. Manufacturing overhead includes aspects such as the electricity used for operating the factory equipment, depreciation on the factory equipment and buildings, factory supplies and factory personnel (other than direct labour). How manufacturing overhead is assigned to a product is of importance. The description and allocation of ‘categories’ in the manufacturing overhead differ per organization, this makes the estimation of the manufacturing overhead rather complex.

General, selling and administration costs

GSA is the sum of all direct and indirect selling expenses and all general and administrative expenses of an organization. Direct selling expenses are expenses that can be directly linked to the sale of a specific unit such as credit, warranty and advertising expenses. Indirect selling expenses are expenses which cannot be directly linked to the sale of a specific unit, but which are proportionally allocated to all units sold during a certain period, such as telephone, interest and postal charges. General and administrative expenses include salaries of non-sales personnel, rent, heat and lights. There is certain overlap between the costs in the manufacturing overhead and the GSA, this makes it more complex to distinguish the costs a supplier makes. When estimating those costs of your supplier’s product, it is important to make sure that you do not count certain expenses multiple times. Here again, as is the same with manufacturing overhead, the definition and allocation of GSA differ per organization, therefore it is difficult to determine these costs.

Profit

The remaining cost category is profit, which is making gain for certain business activities for the benefit of the owners of the business. The amount of profit must be reasonable. Reasonable means that the profit is not too high that you as purchasing party are swindled, but it should also not be too low because this would threat the continuation of the supplier, because a share of the profit should be reinvested in their business in order to stay competitive to their competitors.

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[1] When purchasing services it is no direct materials but will it be one of the other categories (dependent wherefore the service is used: maintenance of a machine will be Manufacturing overhead, temporary labour will be direct labour).