Cost Accounting Shows Profitability, Opportunities
Knowing your costs can be the difference between success and failure in the pallet business. One pallet industry leader shares his thoughts on cost accounting and profitability.
By DeAnna Stephens Baker
Date Posted: 9/6/2011
Do you know how much it really costs you to make a pallet?
Implementing a cost accounting model can help you understand your true costs and more. This goes beyond what is typically thought of as accounting and often done by a paid accountant. Rather, the information gained from cost accounting is designed for whoever is managing the business as they make operational decisions.
The following is an overview of some basic cost accounting principles and how they can be applied to a pallet company. Much of the information in this article is based on a presentation given by Jim Schwab, president of Pallet Logistics of America.
In order for any company to make good financial decisions, all of the financial inputs must be understood. Utilizing a cost accounting model is important because it can help companies determine the factors that drive costs and subsequently how to manage those factors to keep costs down. It can also be used to compute the profitability of each product line, be used when bidding on new contracts to determine the most competitive price the company can offer, and be used to understand whether or not a customer is profitable. Understanding and keeping track of costs can also help a company identify that there is a problem, while there is still time to fix it.
The process starts with listing all of our costs. These should be separated into two categories, fixed costs and variable costs. It is important that managers know and understand both of these concepts as well as what category every expenditure falls into. Fixed costs, which are also called overhead costs, are ones that do not change regardless of how many pallets are produced or recycled. These include rent, insurance, office staff salaries and utilities. Variable costs are the costs whose amounts vary in direct proportion to changes in levels of production, such as labor and materials. For example, the more pallets you build, the more wood and nails you need to buy. Differentiating between the fixed and variable costs is important because the total cost per pallet actually decreases as the number of pallets produced and sold rises. This is because the more pallets that are produced and sold, the less the sale of each pallet needs to contribute to help cover the fixed costs. For example, if total fixed costs on a monthly basis are $20,000 and 10,000 pallets are produced and sold, $2 from the sale of each pallet would be needed to cover the fixed costs. However, if 40,000 pallets are produced and sold, only $0.50 from each would be needed to cover fixed costs.
To just break even, your sales must equal your fixed costs plus your variable costs. To make a profit, your sales must exceed your fixed and variable costs. If your sales are less than your fixed and variable costs, you will have a negative profit, or a loss. This can be viewed in the following mathematical equation.
Sales minus (Fixed costs + Variable costs) equals Profits
Consider the following example:
• A company’s fixed costs are $30,000 per month, which includes rent, maintenance, insurance, utilities, office staff, forklift driver, truck driver, and fuel.
• For each pallet, the company buys $2 of pre-cut wood, $0.30 in nails, and pays two workers $0.35 each for assembly. That makes the variable cost of each pallet $3 ($2 + $0.30 + $0.35 + $0.35 = $3).
• Therefore, any price above $3 can be contributed to covering the fixed costs. So if the pallets sold for $6 each, than each pallet would contribute $3 to cover fixed costs.
• Based on these numbers, the company would need to sell 10,000 pallets per month to break even. All pallets sold beyond the first 10,000 contribute to the company’s profit, once the variable costs (materials, labor, etc.) are subtracted.
• Therefore, if 20,000 are produced and sold for $6 each, the total profit, after all costs have been subtracted, would be $30,000.
While all of the above is fairly basic accounting, you would be surprised how many people have never actually stopped to calculate their true cost for a particular customer or order type. This basic information provides a framework for deeper insight.
Jim pointed out that this type of model is especially suited for use within the pallet industry for several reasons. Many pallet assemblers or repairers are paid on a piece rate, making it easy to calculate labor costs per pallet, fixed costs tend to be rather low, most equipment is low-tech and does not require increased sophistication, and most companies only have a few product lines.
The previous example was a very simple, yet effective method of cost accounting. However, for some companies a more detailed accounting procedure may be helpful. “Cost accounting models can be very simple,” Jim said. “But you can add layers of complexity to help you manage your business, depending on what your needs are.”
Beyond the raw materials, other cost factors that could be added to a more elaborate accounting model include transportation, sorting, sawing, dismantling, maintenance, utilities, sales and office costs. The differences between a simpler and more complex method is apparent if a manager used both to determine the cost of a repair board for a GMA pallet. When using the simple method, only the average price of a used pallet, the average number of usable boards yielded, and the tear down labor is considered. In contrast, a more detailed method would also have portions of inbound transportation costs, forklift time for unloading and moving around the plant, sorting labor time, and maintenance costs.
Assigning fixed costs is straightforward for companies that produce only one product line. But for those with multiple product lines, as most pallet companies do, allocating the overhead costs to the appropriate product line takes a little more effort. “If you start to produce multiple product lines, the focus and intensity of resources against those product lines is going to be varied,” Jim said. “You’ve really got to be careful and thoughtful about how you put this together.” Jim suggested asking the following questions for each cost factor to estimate what costs should be assigned to each product line
• Maintenance: What processes or product lines consume time?
• Materials handling: Where is forklift time being consumed?
• Rent: How much floor space is devoted to each product line?
• Utilities: Which processes and products are energy intensive?
• Management time: What processes or product lines consume time?
The essential idea is to take the time to consider which product lines these costs are going toward. “These are just a few examples of questions to ask in order to think about everything you’re spending money on and try to track it back to product lines or customers,” said Jim.
A common way of reducing the amount of estimating needed to allocate overhead costs to product lines is a method called Activity Based Costing, which uses the activities each product line requires to assign costs. This can be done by dividing each worker’s time between the different tasks that they perform. If employees use a paper-based time card this is easy to do. Instead of entering just start and end times for each day on the time card, have employees enter start and end times for each activity they perform, or what product line they are working on. Salaried workers and companies that have employees electronically clock-in could have workers fill out a more detailed paper copy as well. For example:
• Pallet sorting: 9:00am – 10:00am
• GMA assembly: 10:00am – 1:00pm
• Kiln Loading: 1:30pm – 2:30pm
• Nailer maintenance: 2:30 – 5:00pm
This will especially yield useful information at companies where many of the employees do multiple tasks throughout the day. “When you go through these logs and look at how people are spending time, it gives a lot of insight into what is consuming resources in your company,” Jim said.
There are number of areas to watch to ensure that costs don’t creep up on you and alter old matrices. Changes in the level of “full cost” of inventory can create swings in profitability that are sometimes difficult to explain or understand. Or an increase in inventory can “absorb” costs of production and increase profits, while a decrease in inventory level will decrease profits.
Smart pallet veterans know the seasonality of their business and keep this in mind when trying to determine the amount of inventory to have on hand as well as the potential cash flow challenges posed by various market changes. Overall, cost models need to evolve as your business becomes more complex.
Now all of these costs can be worked out the old fashioned way with a pencil and paper, but there is software available to help managers calculate these costs. Utilizing one of these can save companies a lot of time, and allow them to easily analyze multiple hypothetical scenarios to assist in making decisions about changes to the productions process, expansion plans, or bidding on a new contract. Two options designed specifically for the pallet industry which include cost accounting processes are PalletTrack from Innovative Data Systems (IDS) and PalMate from Automated Machine Systems (AMS).
Pallet Track provides easy-to-use bar coding, scanning and touch screen kiosks to gather data on inbound raw material, saw line production and inventory, new and recycled pallet production and inventory and more. This enables companies to accurately track all purchases from pallets to components, by purchase order or pre-set pricing. The costs then follow products for use in new or remanufactured pallet production. It can also track production by employee and run numbers as well as material purchased and used during production runs. The software uses this information to calculate profit margins based on true cost or products, labor and overhead. More information on the Pallet Track systems is available at www.pallettrack.com.
PalMate is an Enterprise Resource Planning (ERP) software that can be used in conjunction with the Pallet Track system. Cost monitoring is just one of the many office functions that PalMate provides within a centralized system. It also has an extensive list of predefined and customizable reports that can be easily printed or shared. When using the fully integrated system, raw material costs are entered when they are purchased, allowing managers to find the cost of each product line with just a few clicks of the mouse. ERP allows company leaders to make smarter decisions using real-time information. For more information visit www.palmateerp.com
A free pallet cost accounting program was also developed by the U.S. Forest Service several years ago. The Pallet Costing System (PCS) is a computer-based, Microsoft Windows application that computes the total and per-unit cost of manufacturing an order of wood pallets. The major cost factors addressed by PCS are raw materials, labor, machine, and manufacturing overhead. It also has a function that allows pallet producers to evaluate the impact of changes in labor cost, species, processing steps, and other factors. The program can be downloaded at www.nrs.fs.fed.us/pubs/5936.
The most important thing to remember about cost accounting is that one exact method of cost accounting is not going to work for every pallet company. Whatever cost accounting method is chosen by a company needs to work for that company. It needs to yield information that can be used by the management to make educated decisions for the company. Once implemented any effective cost accounting model, whether simple or complex, will give management the information it needs to identify ways to improve operational performance and boost profits. But this information is meaningless if it is not put to good use. Whatever system you use, it must have management support to ensure accurate data collection and execution of any strategy developed out of this newfound information.
How much does a repair board for a GMA cost?
• Average price of a teardown/machine/odd size pallet is $0.50
• Yield is 7 usable deck boards and 2 usable stringers per teardown pallet
• Pay $0.22 in labor for tear down
• Therefore my cost per board is ~$0.08 per board
More complex method
• Build in a portion of inbound transportation
• Build in a portion of forklift time for unloading and handling teardown pallets
• Build in a portion of maintenance time and materials for the tear down machines
Best Practices for Pallet Cost Analysis
• One Size Does Not Fit All: Tailor your approach to fit different plans, maybe even different order types or customers.
• The right method will give you actionable data to make smarter business decisions.
• Don’t over complicate things if not required. Cost accounting can be as simple or complex depending on your needs and the scope of your operations.
• Challenge Assumptions: The thing that can cost you the most money may be overlooked if you refuse to challenge your typical assumptions as your business changes.
• Work with a CPA to determine compliance with generally accepted accounting principles.
• Look for business winners and seek to maximize this type of business. You can’t do this if you don’t know where you make your money.
• What you measure is what you get. You can’t know what is going on in your operation unless you observe and measure it.
“We should start by knowing the profitability of at least the top 20% of our customers, 20% of our customers often give us 80% of our revenues/profits. Once you have a methodology – getting to 100% is easy.” — Jim Schwab
Consider the Following Example
• Buys 5 loads of B grade pallets per week, one load a day, M-F, in the morning same dock time
• $4.15 per pallet
• 5 miles from your plant, in a van. Drop and hook 1 drop trailer
• Issues a blanket PO at the beginning of the year
• Never calls unless you miss a shipment
• You can set your watch to their payment reliability
• Buys 5 loads of B grade pallets per week. Orders are inconsistent and often last minute (2 on M, 1 Emergency on Wed evening, 2 Friday – next week looks different)
• $4.25 per pallet
• 40 miles from your plant, flatbed, live unload with sporadic wait times
• Issues separate POs for each load
• Pay late, constant re-faxing of invoices
Which Customer is More Profitable?
Is all the headaches of serving Customer B worth the additional $12,000 per year in revenue? It all depends on your perspective. That is why you conduct real cost analysis. Understanding the variation in cost in serving different customers was the greatest benefit of this kind of analysis.
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