Should cost model based on industry averages

Should cost model based on industry averages

This method determines the costs based on the averages of the industry in which the supplier operates. Then these figures are compared to those of the supplier. As the supplier is dependent on its context in which it operates, this method will not be the most accurate one because it uses (industry) averages to estimate costs and does not take the context specific characteristics of the supplier into account. On the other hand, it has the advantage that it is one of the quickest methods.

Although this method relies on comparing industry averages with the supplier’s quotation, for some discrepancies between the supplier's figures and the industry figures, the supplier may have valid reasons (more added value, customized products, etcetera). Next you will find the steps how to determine each cost category based on industry averages.

Direct material

The first step is to identify the materials required for the product. The ‘direct materials cost category’ is the baseline for this should cost method on which the percentages of the industry averages are calculated. The costs for the materials used for the product (direct materials) is the base[1] for the estimation of the other cost elements; therefore it is an essential step in the process. The reason why this is chosen as base for other cost calculations origin from the fact that it is relatively easy to calculate (compared to the other cost categories) because it is possible (but not always easy) to exactly determine what material is used and the amount of material used. To obtain information concerning the materials used, several options are available. You can for example ask your supplier for the relevant information, but you can also calculate it yourself if you know the materials used by your supplier. Another option is to appeal to your experts within your organization like an engineer or use the drawings of the product if you are in possession of it. In case you have identified the material used, you can calculate the material costs for the products as the prices of the materials are normally known (e.g. the copper price per kilogram).

Direct labour costs

The direct labour costs are based as a percentage on the direct material costs. These averages can be extracted from sites of statistical institutions like the ‘US Census Bureau’ and Eurostat’[2]. On these sites you can find the annual labour costs and the annual direct material costs.  With these two figures it is possible to calculate the ratio (percentage) of direct labour costs compared to the direct material costs. In possession of this ratio, the direct labour costs can be calculated by applying the ratio on the actual direct material costs calculated in step 1. 

As mentioned before, you should take into account that industry averages can be very general, sometimes too general because it does not take into account certain differences between suppliers which can exists (and which can be explained by the supplier). Take for example supplier A which is more expensive than supplier B because supplier B has a great percentage of its production process computerized and its products standardized while supplier A has still much manual work in its process because it delivers customized products and offers flexibility. You are then paying for the customized products and the flexibility and that is (one of) the reason why supplier A is more expensive than supplier B. It depends on you and your organization whether you need the customized product and the flexibility of supplier A, or whether the customized product of supplier B will due and enjoying the costs reduction as a result.

Manufacturing overhead

The next step is the estimation of the manufacturing overhead. As this is very difficult to estimate with great precision because not every organization define manufacturing overhead in the same way. The concept manufacturing overhead could contain different aspects within different organizations. It becomes even more difficult because there is a great variance in the way different organizations allocate these costs as there are several accepted allocation methods known in accountancy.

Nevertheless, you should again search for industry averages of manufacturing overhead. In possession of these averages, you should calculate the percentage of manufacturing overhead based on the direct material costs in the same way as is done in the step before (in the step with the direct labour). This percentage can then be used for calculating the manufacturing overhead based upon the direct material costs also in the same way as in step two (with the Direct Labour). 

General, selling and administration

For GSA the same method is used as is used in step two and step three (direct labour and manufacturing overhead); find the industry average of the GSA by using (the same) statistical sources and then calculate the ratio. Next use the ratio to calculate the real amount of GSA costs based upon the direct material costs.

Profit

Summing up these costs and then adding a profit percentage on it will result in the price of the product. The profit percentage must be reasonable which means that it should not be too high or too low. Too high will damage your organization, but too low may threaten the continuation of your supplier (which is also not beneficial for your own organization in case it concerns strategic products and you want to build long-term relations with your (key) suppliers). In order to abstract the right industry averages you should first define the right industry the organization is active in. Furthermore it can be the case that not all cost categories are represented in the industry averages. Sometimes the figures are just not present and sometimes the composition of the costs categories may differ from your (pre)defined cost categories.  In case of this last situation, you may be able to shuffle, puzzle and calculate the cost categories which you require.
Whether the right information is present depends on several aspects like the source of the information, the type of industry, the geographical location of the industry and the sensitivity of the information.

In short, the following steps you should follow in order to determine the should cost price of the product:

1)      Determine the industry you are active in or select the one that is the nearest to your activities (take also geographical aspects into consideration).

2)      Use the most relevant and recent source for your information (or combine multiple sources)

3)      Extract (and calculate if necessary) the figures per cost category

4)      Calculate per cost category the percentages of the total sales

5)      Calculate the price for the materials used in the product

6)      Apply the percentages calculated in step 4 on the direct material price calculated in step 5

7)      Take forecasts and inflation into account

The foregoing text, may be somewhat theoretical, examples often make it more clear. Therefore if you are interested in a more detailed(and real) example of this method in which the price of a specific type of cooling-equipment for a large machine is determined, please contact me for more information.

More methods will follow.

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[1] For services the this won’t be the base, here the direct labour may be more important

[2] Later I will compose a list of these institutions