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Money Matters

Cost of Materials

Managing strategic costs

By Andrea Hill

I still clearly remember an evening years ago when I sat at the table doing bills, my 5-year-old son at my side. He was fascinated with the checkbooks, computer, and calculator, and he wanted to know what I was doing and why. So I explained. After a long pause he slowly shook his head and said, “I’m never going to be able to figure all that out.”

For a business engaged in the manufacture of goods—particularly goods constructed of materials that experience frequent price fluctuations—managing costs can be challenging. Most business owners understand their fixed costs: rent, utilities, security, and insurance. But the two areas of cost that require the most careful management are human resources and material costs, because they represent the biggest costs in most businesses and have the greatest influence on your margins.

Human Resource Costs

The saying “you get what you pay for” is truest as it relates to the quality and productivity of the people you hire. I am not an advocate of overpaying for work, but cutting corners in the area of payroll expense can damage your business reputation by causing you to miss critical deadlines or fail to meet your customers’ quality expectations.

Managing human resource costs is a threefold process:

• Define roles carefully to determine what those roles are worth in your market at the experience level you require. This is called benchmarking.

• Evaluate your processes and do the work as efficiently as possible to eliminate wasted labor hours. This may include outsourcing some steps to a provider who can do those steps faster and/or at higher quality than you can accomplish.

• Create a compensation strategy that rewards the entire company for improving overall productivity, measured as operational costs as a percentage of revenue.

In a start-up business, everyone must be capable of doing any of the tasks. Start-ups develop a certain pride in their ability to multitask, and the rhythm of the company is often staccato—people jumping from one task to another, trying to stay one step ahead of customer requirements. That approach can be a great way to start. But when a company continues to hire jacks- of-all-trades rather than experts, and values its people based on their ability to do all the jobs rather than a particular job, human resource costs can get skewed.

Not long ago I consulted to a small manufacturing firm in a cash crunch. With 35 employees, it had two well-paid managers, a CFO, four supervisors, and several people working in administrative roles—but it was paying less-than-market wages to most of its manufacturing staff. The company’s payroll was too high as a percentage of revenue (it was 45 percent of revenue, and our target was 32 to 36 percent). But we needed to raise the wages in manufacturing to attract and keep the right skills. We analyzed all jobs in the company and established the correct wage range—for a company of that size, in that market—for each role. What the company owners had not considered was if they hired more highly skilled and mature manufacturing workers, they would not need as many supervisors and managers. This would shift wages into the production area of the company, where the value is created. This strategy should (and did) increase overall productivity and quality.

Material Costs

The most challenging costs to understand and manage are material costs. Your business is a constantly shifting sea of parts: parts purchased from vendors; metals transformed into bands, castings, and findings; parts being combined in a variety of different ways to make different goods; parts being reclaimed (metal buys, scrap, filings, etc.).

Your job is to make sure you understand exactly how much money you have tied up in each part and in each type of part (components and raw materials versus finished goods). You should know this number by the day, not by the week or the month.

The cost of your components isn’t just the last cost you paid for them—it’s a little more complicated than that. Imagine that you have a casting that you use in five different ring styles:

The complexity of this constant calculation across dozens or even hundreds of items is the reason a sound inventory control system is the most important investment you can make in your business.

How All This Relates to Pricing

The jewelry industry does not have the luxury of setting prices for a year. In most cases, you can’t even set firm prices for a seasonal line. If you quote each order you must quote from an understanding of both your current inventory value and today’s costs. Nothing has a greater impact on cash flow or profitability than your inventory, and the value of your inventory includes the value of the labor used to produce it.

This is the reason why it is so important to understand how much time goes into making each piece. If you calculate your labor costs accurately, and you understand your real-time material costs, you will notice immediately whether (or not) you are pricing your line to make a profit. When customers apply price pressure, you need to know just how far a price concession will cut into your profitability; otherwise, the emotional urge to get the sale might just put you in the profit hole.

Accurate knowledge about parts and labor time will also help you decide which products return the greatest profit and how to design more like them, which products you probably shouldn’t be making, and if using an outside service provider will put you in a position to make a better profit. At the end of the business day, nothing adds more value than managing your inventory and labor details well enough to turn a profit.

It’s the same principle my son witnessed that evening I was paying bills at the kitchen table. Today, he manages money better than most. As it turns out, he remembers that night 15 years ago, too. When I asked why he was such an excellent money manager at such a young age, he recalled what I said to him that evening: “When it’s important to you, you’ll figure it out.”

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