## Cost Calculation – introduction

Posted on: October 12, 2017, by :

Cost calculation within companies and procurement is always a difficult item, especially when talking to finance colleagues or management. Finance colleagues see costs difference than “we” from procurement do. On the discussions with management: make sure you don’t get trapped in the pitfall of potential mix-up between cost calculation and price of the products.

## What is cost calculation for procurement

First of all: cost calculation determines the actual production costs of a manufactured item or a purchased item. However, the cost calculation does not determine the price of the product. The price of a product is:
Price of product = Actual calculated costs + leverage of customer. We will come back to this later.

Cost calculation can be made very complex, but here follow the basic principles:
Cost = Price of raw materials + processing costs + overhead + profit-leverage of customer.

Sounds easy enough. But then comes the tricky part.

## How do you determine the price of raw materials

How do you determine the price of raw materials? A few idea’s that might help you:
– Find out the direct costs with the raw material manufacturer and benchmarks. They might give you the information or at least a bandwidth.
– Use (paid) indices and databasese, such as for example the LME for metals, or ICIS for plastics.
– Ask open costing from your supplier and make your own database: use the knowledge you have from the supply base

Then, finally: use common sense to compute the input. Make sure that you know what you are talking about: in sheet metal for example, there is a difference in the usage of gross and net. This difference can be re-used (scrapped with a scrap return). In plastics, you might lose the injection sprue. These losses need to be accounted for.

## How do you determine the processing costs

Processing costs are much more difficult to assess, but are made up of the following items:
– Cycle time
– Machine rate (hourly costs, which in itself deserves its own chapter)
– Number of cavities / number of products per cycle
– Set up time
– Human labor content

This accounts for all the processing costs, but clearly has some difficult items. Cycle times are given, but not necessarily reliable. I would always recommend to make a clause with your suppliers that you can check cycle times at any time and revert the costs backwards.

The machine rate depends on many items, such as the energy consumption, value of the machine, depreciation of the machine, maintenance of  the machine, square meters or feet used and the fill rate of the machine.

As well, there is a huge difference in shift-pattern. Machine rate should drop considerably when adding multiple shifts. More on this will follow in other articles.

The number of cavities is a no-brainer, but requires some calculations. A business case needs to be made with a careful consideration whether multiple cavities will pay itself back within the expected lifespan.

Set-up time should be limited, but not at all costs. You can make injection molding machines which can change dies in 3 minutes. But the payback period must be considered. Many other things however can and should be done, so that the idle time between products (the change-over time) is limited as much as possible. After all, you pay for it and you get nothing for it.

The cost of human labor depends on the geographical location and what type of personnel is needed. Does the supplier need highly skilled labor, or less skilled operators? Can human labor be limited and at which costs?

All of these items combined make the processing costs.

## How do you determine overhead and profit

To what extent do you feel comfortable with your supplier in terms of overhead and profit? What are fair numbers? Obviously, these numbers are different per industry and per situation. An industry with high risks and large investments which are necessary, generally provide a higher profit. I always tell to my suppliers that profit is a return on risk-taken. Less risks means less profit. This is very different compared to how financial people see profit.

Overheads can be tricky: which indirect costs are there and how much of this is attributable to you as a customer?

Bear in mind that when your volume goes up (considerably), the overhead percentage should go down, until further investments in fixed costs are necessary and needs to be covered.

## Price= cost – leverage of customer

What is meant with the above? We’ve seen the basics of cost calculation. So we can make a beginning with the costs. How is this different from the actual price? The power position of the customer versus supplier determines the leverage: urgency, capacity, scarcity. This determines the end-price.