Understanding Your Estimating System
By AICC Staff
May 17, 2022
Everyone has an estimating system that they utilize to make pricing decisions on, and with a few exceptions, no one seems to be entirely happy with theirs. During this era of rapid price increases for materials, labor, and just about everything else that converters need to manufacture and get their products to market, many of you are concerned about whether your estimating systems are able to keep up with all of this change.
There is an old adage that says that costing is a science and pricing is an art, but after observing how this industry operates for the last 30 years, I don’t think that any of this rises to the level of either art or science. My observation is that in a time of rising prices just about everyone makes more money and in a time of falling prices they make less money. The simple fact is that prices rise when supply seems to be constrained and demand is still strong, and that is what we are currently experiencing. None of this has anything to do with estimating system design; you are simply raising prices based upon market conditions. However, there is a bit of danger lurking in the future if you don’t really understand what is going on in the mysterious realm of estimating, where only chief financial officers, controllers, cost accountants, costing consultants, and other brave souls dare to go. So, let’s take a deeper dive into this dark place so we can begin to understand and demystify what goes on there.
First, a bit of historical perspective. Cost accounting, as we know it today, was invented by Josiah Wedgewood of the famous Wedgewood Pottery Co. during the depression of 1772. Demand for his products dropped, inventories rose, and prices were cut. Could he cut costs enough to avoid bankruptcy? His answer involved understanding cost accounting in enough detail to make informed decisions. Wedgwood was able to determine costs for materials and labor for each manufacturing step for each product. An attempt was made to allocate such overhead costs as breakage and interest as well as transportation costs. He could charge less for lower-cost items and was able to modify his production costs based upon the demand in the marketplace. A hundred years later during the Industrial Revolution, when machinery began to dominate the manufacturing process, machine output and costs became more important measurements than labor costs. Machine center costs and cost allocation utilizing a planned level of activity became the new norm. The champion of what is now called “absorption costing” was a 19th-century accountant by the name of Alexander Hamilton Church. He developed the machine-hour method of allocating and applying fixed costs such as power, land, and building costs. This 150-year-old system is still what is in use today as the backbone of your estimating systems.
Costs are charged to each order based upon a complicated yet entirely rational system. Materials are charged directly to the order. Labor is charged to the order based upon a buildup of an hourly machine rate, which often includes an allocation of various factory overhead items. Other factory overhead items—repairs and maintenance, utilities, indirect labor—are charged to the order based upon their estimated usage. Fixed costs are allocated based upon a planned level of activity, and finally, a provision for profit is added. In theory, this system is pure financial poetry, and as long as you estimate your costs conservatively (that means high) and your planned level of activity (usually expressed in MSF or tons for converters) low, you will always make the desired profit. The cost of materials, plus the cost of labor, plus the cost of delivery, plus an allocation of all other costs, plus a provision for profit equals sales price. If you can apply this to every order, then you will always make the desired profit. It is neat, orderly, rational, and guaranteed to make you successful, right?
Based upon this full absorption costing system that you all utilize (whether you realize it or not), your estimating system calculates contribution and a return on sale for every order. Contribution is the systems calculation of the variable profit of the order (sale price less variable costs). Return on sale is the amount the order is expected to contribute to net profit (contribution less fixed costs). However, it is the market that determines the price, and you are probably not the lowest-cost producer for most of what you sell, so the market price is often lower than your estimating system says you need to charge.
So, the problem with all of this is that the real world is a very messy and in normal times a very competitive place. Seldom do you achieve the planned level of activity or the budgeted level of cost. Your competitors often charge much less than what you want to charge, and this is hard for you to understand. The cost accountants and costing consultants tell you that you need to update your costs and your machine efficiencies if you want to improve the situation. In their minds, there is nothing wrong with the system that some regular maintenance won’t improve; but most of you don’t really trust your systems, so you go out of your way to put in artificial material costs and other artificial adders and fudges to get the system to calculate the prices that you want it to. You then price at a lower ROS for some items and at a higher ROS for others.
Right now, the levels of activity are much higher than you planned they would be (you are shipping more footage), and the budgeted levels of cost are also much higher than you planned (shortages and inflation). For the most part you are making more money because you are raising prices much faster than your costs are increasing, and the perception in the marketplace of paper and converting capacity shortages keeps the market dynamics in your favor. You’re in a good place right now, but will these dynamics last forever? Almost everyone I talk to has equipment on order, which will dramatically increase converting capacities in the not-too-distant future, and there are millions of tons of additional mill capacity scheduled to hit the market in the next few years. So, the short answer is, probably not. Once these capacities go back to some kind of equilibrium, you will need to rely on your system again to decide what orders to accept and at what price. Right now, your customers don’t have a lot of options, and you can pretty much name your price. But what steps do you need to take to ensure your continued profitability in an up market and to limit your exposure in a down market?
The key word that comes to mind is “simplify.” A system that continually spits out prices that are disconnected from the market that you are constantly tricking to give you the prices that you want is probably too complicated for your business. In my experience, full absorption costing systems make a lot of sense when you are making large batches of a homogenous product or products. This kind of costing in a paper mill makes perfect sense. The output of the mill is highly predictable, and therefore using a planned level of activity is a very sensible way to allocate costs. A sheet feeder or a corrugated plant that is dedicated to making the same packaging over and over for major customers will also lend itself to this kind of a system. However, a custom job shop that runs a multitude of different orders daily, where the overall output can vary significantly from month to month, is generally not a good candidate for this type of costing. It is way too complicated, and using output in terms of tons or square footage to allocate costs will lead to all kinds of over- and underallocations.
My view of this world—based upon many years of experience and a lot of financial and operational data—is that there are very few truly variable costs in most converting operations. If you change the definition of a variable cost to be an incremental cost of the order, then other than materials, commissions, and maybe contract labor for assembly and fulfillment, almost every other cost is relatively fixed over a wide range of activity. If you have 100 plant employees, it is likely that you will have this number of people whether you are busy or slow on any particular day or month. Some months may have more overtime than others, but other than that, plant labor is a fairly fixed cost. The same goes for variable factory overhead and delivery—these costs just don’t vary very much from month to month. So, if you simplify your systems definition of contribution and stop inflating the material costs, you will at least have a system that predicts the correct variable profit of the order.
Secondly, I would look at the profitability of the order in terms of how many machine hours the order took up rather than how many dollars per square foot or ton you sold it for. Machine hours are the ultimate constraint in most converting plants, and when an order goes over multiple machines, this often gets overlooked. In addition, long runs with lower contribution percentages often look much better than shorter runs with higher contribution percentages when you look at them in this manner.
If the market turns downward and you continue to use the same flawed estimating system that you have always used, the race down to lower prices and lower profitability could be fast and furious. My advice to you in this era of profitability is to simplify your cost estimating and start focusing on machine hours. Change is often difficult, especially when your organization has been looking at fully loaded return on sale numbers and contribution calculations that include inflated material costs and allocation of fixed costs for as long as it has been in business. It is often difficult to initiate change when times are good, but if you want to protect the long-term profitability of your business, you need to focus on the orders where you really have an advantage and not on orders that you can charge more for now based upon the current market dynamics. You can continue to rely on a 250-year-old system of cost accounting that has most recently been updated by a 150-year-old system of cost allocation and perpetuate the archaic alchemy that your costing system produces—or consider effectuating change now while you are still profitable.
Mitch Klingher is a partner at Klingher Nadler LLP. He can be reached at 201-731-3025 or email@example.com.