Solutions should not be more com

Solutions should not be more complicated than the problems they are trying to solve!

ABC Product Costing

Background

Many companies see the benefit of categorizing their products (or SKUs – Stock Keeping Units) into ABC groups. For example, sales and marketing see the A’s as being the fast movers, and the C’s as slow movers. However, how you measure fast and slow movers is often inconsistent. Are the A’s the top Pareto (the 20% of the SKUs having 80% of the sales)? Also are fast and slow determined by dollar sales, or by units sold, or by some other measure? Warehouses have other measures of ABC SKU classifications based on order-lines or cube shipped. Such classifications are important considerations in defining warehouse layouts and picking methodology. A future TransportGistics white paper will address this issue. An ABC categorization that interests accountants and financial controllers is the sales cost of individual lines, and hence the contribution that they make to the bottom line. This white paper addresses this issue which we call ABC product costing.

Issues

The concept of product costing may be easy to understand, but very difficult to determine. Most companies can easily determine the purchasing price of their individual raw material (RM) SKUs, and the selling price of their individual finished goods (FG) SKUs. The first issue is that price is not cost. Price is the result of a negotiation between the buyer and the seller – a “take it or leave it” price falls into the category of zero negotiation. Cost is an actual value based on the correct allocation of incurred expenditure to create that SKU. The second issue is determining this method of allocation. Many companies are unable to correctly allocate costs for a variety of reasons such as:

	Lack of data
	Lack of expertise
	Too time consuming
	Systems not designed to capture and/or retain the appropriate data
	The company is a “stage I” company, driven by departmental budgets, and hence not focused on product costs

This white paper discusses an approach to cost allocation - a separate TransportGistics white paper deals with Stages of Excellence that defines and discusses stages I to IV

Cost Allocation

Assuming a reasonable relationship between price and cost, then the difference between purchasing and selling prices is a measure of the value added to a given SKU by the manufacturing and/or distribution processes that the company performs – i.e. it is all about the WIP (work in progress) costs. Most manufacturing processes tend to be SKU or SKU-group specific, whereas distribution/supply-chain costs tend not to be. Herein lies the major problem as illustrated below.

There is usually not an issue with the purchasing price since it is SKU specific. However, a knowledge of ABC product costing can be applied to the vendor in order to assess how close the vendor’s price is to a true cost. These types of analyses are used in strategic sourcing and in 3PL (third party logistics) negotiations. Future TransportGistics white papers will address these areas.

Manufacturing costs are usually adequately understood, in that machine rates for producing specific SKUs are readily quantifiable. In addition, production machinery is a major capital asset whose costs are, or should be, tracked even in the most basic Stage I budget control process. For production efficiency, several SKUs can be grouped to save production set-up time, but an analysis of production planning and control can provide acceptable cost allocations. Manufacturing costs can be performance adjusted to distinguish between theoretical and actual.

The first major issue is the allocation of inventory and warehousing costs. In many cases inventory costs are not tracked and companies do not perform accurate EOQ (economic order quantity) and/or bottleneck-analysis in determining the batch size. Company accounts need to be carefully analyzed to determine if inventory is assessed a standard finance charge, or whether an all embracing “cost of holding inventory” is used. Two types of warehouse costs must be considered, the storage cost and the handling cost. The storage cost is part of the cost of holding inventory. The issue is that warehousing costs are not controlled at the SKU level, and an analysis of budget line items is not sufficient. A detailed analysis of the inbound orders, the outbound orders, and the warehouse methodology is needed in order to allocate warehouse costs at the SKU or SKU-group level. As the above diagram shows, the SKU specific base data is available at some stage in the process. What is typically missing is data collection and analysis techniques. Moreover, even if these techniques exist and costs can be allocated, the question arises concerning the correctness of using actual costs in making strategic decisions about SKU profitability. Maybe “should costs” based on an efficient warehouse should be used. TransportGistics has tools and techniques that not only can perform cost allocation, but can also determine warehouse should costs.

The issue with transportation is that costs are usually readily available, but the issue is all about allocation. Transportation costs are correctly minimized using load and drop consolidation wherever possible. There are some businesses that perform SKU specific point-to-point transportation, but not many. There can be hundreds of different SKUs consolidated on one truck. The issue here is to assess how detailed the ABC product costing data needs to be. Should it be customer specific? Should it take account of seasonality? Most companies find it beneficial to offer prices to customers based on costs associated with different order size. Such cost profiles affect warehousing as well as transportation, e.g. depending on pallet pick, case pick, or item pick

The “shipping and handling” mark up often indicates that the supplier cannot identify the true costs. Indeed many companies see this mark up simply as another way of creating revenue. This brings us back full-loop to the need to perform the cost-unbundling process of strategic sourcing

Benefits

The focus is on determining the true supply chain costs in order to evaluate SKU profitability. Typically there are some surprising results as the graph below illustrates.

Graph of cumulative profit against SKUs ranked by individual profit

The first observation is that many of the SKUs are supplied at a loss – “many” can be as high as 50%. The potential profit can be at the 125% mark. The second observation is that the 100% profit mark can be achieved by as little as 30% of the SKUs. Whether or not the non-contribution SKUs should remain available for customer service reasons is a Marketing issue. The analysis provides input to Marketing to better help them make the determination.

But there are other benefits from undertaking a detailed ABC product cost analysis such as:

	Identifying planning and control problems in manufacturing
	Demonstrating under-utilization of capital investment both in manufacturing and in warehousing
	Identifying the gap between warehousing actual costs and should costs
	Recognizing that the pricing structure that correctly reflects transportation and warehousing costs can influence customers’ ordering practices to gain shared supply-chain savings
	Revealing hidden practices that do not add value

Observation

Unit IT costs are about the only costs that are declining. However, IT costs are rising because we deem it necessary to collect so much data. The questions to ask ourselves are:

· Are we collecting the right data

· Do we know how to analyze the data

· Do we have the expertise to draw the appropriate conclusions from our analysis

· Or are we still running the business based on “experience and feelings”

TransportGistics can help in answering these questions

For more information please contact Robert Munro, Consulting Division, TransportGistics

bmunro@transportgistics.com

About TransportGistics, Inc.

TransportGistics is a global, multi-product and services company that provides market leading, simple, incremental solutions for transportation management and logistics functions within the supply chain.

TransportGistics commitment to education is portrayed through its advancement of professional logistics and transportation programs. Its white paper site presents important and timely transportation and logistics subjects each month, and is regularly visited by more than 125,000 clients and readers representing companies in the private and public sectors, universities and governments, worldwide. TransportGistics is a founding partner at the Center of Excellence in Wireless Internet and Information Technology at the State University of New York-Stony Brook.

Disclaimer

The information presented herein represents the opinion of the author, but not necessarily the opinion of TransportGistics, Inc. This white paper is not presented as a legal position or as a recommendation.

“Freight Lifecycle Management”, “Convergence” and “Today’s Freight Paradigm” are sales marks of TransportGistics, Inc.

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Additional Resources

The Freight Audit Function and Utility. Driving Corporate Performance.

The Role of the Logistics Leader in Driving Supply Chain Value Co-Authored by Frito-Lay

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