COST FACTORS AND ANALYSIS IN ESTIMATING

Click here to see this story as it appears in the February 2018 issue of Modern Casting Cost estimating is critical in ensuring a manufacturing company continues to attract customers and be profitable. Cost estimates are predictions of what the company thinks it will cost to produce a product. They help your company determine its profits, and profit is the main reason the company is in business. An accurate cost model is also essential for being able to put the best possible quote forward to secure new business and select business that fits within the foundry’s profit model. However, an estimator may get caught in several cost traps unknowingly that cause them to contribute to the metalcasting facility’s lack of profitability or reaching its business goals. Figure 1 shows the distribution of casting costing and pricing when using very rough cost average based on little detail of the work content breakdown and an overhead calculation based only on direct labor hours. Figure 2 shows an improved distribution of casting costing and pricing when more accurate activity-based cost factors, more detailed process steps, and non-labor cost drivers are used. Cost traps often fall into two broad categories: The company estimating system is old and outdated. Estimates are being based on some products the metalcasting facility may not even produce anymore. Costs are directly tied to profits. Avoiding common cost traps can help improve profitability. In reality, costs are often underestimated because some items are omitted from consideration in the estimate. Revenue and Costs Price is most often based on costs, but other factors also affect price, including market conditions and the value of the product to the customer. Understanding the cost structures in a metalcasting facility can help provide a big picture of how all these factors contribute not only to the cost estimate, but also to the revenue stream for the metalcasting facility. Revenue includes profit since it’s related to a metalcasting facility’s ability to produce a product. The better a company is at making the product, the greater the profit should be compared to those the metalcasting facility is not “best” at making. Direct costs are directly related to a specific part that is being cast. Indirect costs are necessary costs that cannot be directly associated with the specific casting. Direct costs can include labor and materials, while indirect costs would include maintenance, material handling, and administrative. In addition to these costs, overhead costs must be considered. This refers to the ongoing expense of running a business, such as supervision, depreciation of equipment, support departments like quality control, and other general foundry costs. To know what the overall foundry operating costs are, the total department costs should be added in addition to the foundry costs. Standards in Estimating Developing standards in a foundry’s costs is a critical and necessary step towards creating accurate estimates. A standard is an established norm in regard to technical methods or practices. Formally developed standards offer greater accuracy and range of applicability. An industrial engineer or other designated and trained associates can apply standards to determine whether a job is a fit and which foundry resources are suitable to producing the part. The associate identifies the material, methods and labor requirements to estimate a competitive quote within the operating parameters of the metalcasting facility. The goal is to create an estimate that accurately reflects actual production conditions so that, if awarded, the job will be produced profitably at the quoted price. Once established, standards should be reviewed periodically since things change. With standards and known costs in hand, metalcasters can use a cost estimate model for its various jobs. A cost estimation model has inputs of various parameters that describe the attributes of a product or project and other physical resource requirements. The cost estimate is the output from the cost model. It has a single total value and may also have identifiable component values. Break-Even Analysis Creating a cost estimate model ranks among the most important steps in business planning and budgeting. Metalcasters can use a variety of cost models. This article focuses on one based on break-even analysis which tells a company when it will start earning a profit. The break-even point is the level of sales at which profit is zero (Fig. 4). The advantages of the break-even analysis approach are: Explains the relationship between cost, production, volume and returns. Shows how changes in fixed costs, variable costs and commodity prices, and revenues can affect profit levels and breakeven points. Indicates the lowest amount of business activity necessary to prevent losses. Limitations can include: It is best used for the analysis of one product at a time. It is difficult to classify a cost as all variable or all fixed. There is a tendency to continue to use a break-even analysis after the cost and income functions have changed. The two methods to calculate the break-even point are the equation method and contribution method. The equation method centers on the contribution approach to the income statement. Profit = (sales - variable costs) – fixed costs Break-even sales = variable costs + fixed expenses + profit For example, if: Sales price per casting unit = $100 Variable cost per casting unit = $50 Total fixed expenses = $20,000 Then the sales equation would look like this: $100Q = $50Q + $20,000 + 0 $50Q = $20,000 Q=$20,000/$50 Q=400 units The break-even point in this example is when 400 units are sold at $100 a unit, or $40,000 in sales. The contribution margin method is a version of the equation method centering on the idea that each unit sold provides a certain amount of contribution margin that goes toward covered fixed costs. Break-even point in unit = fixed expenses/unit contribution margin Contribution margin = sales – variable expense For example, if: Sales price per casting unit = $100 Variable cost per casting unit = $50 Total fixed expenses = $20,000 Then, Break-even point in units = $20,000/$50 per unit Break-even point in units = 400 units. Cost estimators assume three things when doing a break-even analysis. First, the average per unit sales price is the price received per unit of sales. It takes into account sales discounts and special offers, which can be retrieved from the sales forecast. Non-unit bases businesses can make the per-unit revenue $1 and enter the costs as a percent of a dollar. The most common questions about this input relate to averaging many different products into a single estimate. The analysis requires a single number, and if the sales forecast is built first, the number will be available. The vast majority of businesses sell more than one item and have to average for their break-even analysis. Second, the average per unit cost is an incremental cost or variable cost of each unit of sales. If goods are bought for resale, this is what is paid on average for the goods that are sold. If a units-based sales forecast table is used, unit costs can be projected from the sales forecast. Third, monthly fixed costs are regular running fixed costs. Technically, a break-even analysis defines fixed costs as costs that would continue even if the business goes out of business. Instead, regular running fixed costs, including payroll and normal expenses, can be used. This will give a better insight on financial realities. If averaging and estimating is difficult, the profit and loss table can be used to calculate a working fixed cost estimate. It will be a rough estimate, but it will provide a useful input for a conservative break-even analysis.