Previously, we talked about how to predict cost of goods sold. In this article, we discuss how to predict direct material cost in a product business. Specifically, we will be using a bakery as our example.
As we learned from the previous article cost of goods sold consists of:
- Direct material
- Direct Labor
- Applied overhead
I will take each of these components and discuss them in more details below.
Direct Materials
Cost of goods sold forecast is directly related to the forecasted sales units. Once you know how much you plan to sell, you can begin to forecast the units you need to fulfill your sales requirement. However, there are other factors that affect the actual quantity bought besides the number of units you plan to sell as discussed below
Determine the standards for making your product
Before you can effectively forecast the cost of your inventory, you need to start by forecasting the quantity you need. A good way to do this is to create standards as to what it takes to make one unit of your product or service.
I will be illustrating my point by using examples from my sample bakery shop. In my bakery shop, I sell only one product, my famous cake relished by every one in my little town called “Themiddleofnowhere”. To make my cake I need the following ingredients: (for simplicity I am limiting my ingredients to only 2 items):
- 10 cups ready to bake flour
- 5 cups of cooking oil
Prep time for one cake (depending on skill level): 35 minutes
Bake time for one cake: 45 minutes
Include an allowance for normal waste
One of the biggest causes of stress in life, is people don’t add buffers to their schedules. In the same way not adding a buffer in life can be stressful, not adding buffers to tasks or materials needed could increase stress.
An allowance should be added for normal wastage. For example: time can be allocated to increased time needed for new staff. Or for unforeseen difficulties in carrying out their tasks. Or for the parts of the flour that is wasted if unusual shapes are needed. Whatever it is, it is important to think of what type of wastage is normal in your line of business and incorporate that into your standards: No business has perfect processes.
In my cake business, I decide to increase the quantity needed by 5% to allow for normal wastage.
Determine quantity to purchase for direct materials
Continuing with my example from above, at a minimum I will want to purchase what I need to bake the 1,000 cakes as shown below:
However there are some other factors to consider before deciding what my purchasing behavior should be for the upcoming here.
Deciding quantity to purchase: External factors
Knowing how much material I need for my cake is not sufficient. There are other external factors I should consider that will affect my final budget. There are two (2) main reasons I want to consider external factors in deciding how much quantity to purchase.
- Firstly, I will need to know how much inventory I need on hand besides what is needed for production.
- Secondly, I want to know whether my market has enough products to meet my sales forecast.
The external factors we consider are reflected in our quantity equation:
Market supply
Analyzing market supply, allows me to answer the question, “Are there any crisis going on in my external environment that could hamper my supply of flour?” Flour is derived from wheat. Are there any issues being faced by resource owners (wheat farmers) that might affect my supply of wheat down the line.
On the other hand, I may want to see if there are any substitutes for wheat that could be cheaper but provide the same or better results. The number of substitutes available reduces my risk of limited market supply.
If after my research I find nothing, then probability is I will be able to get the supply I need for the cake. Thinking about this beforehand, helps me become proactive rather than reactive to circumstances.
It’s good business practice to be aware of what is going on in your industry.
If I predict market supply is low, I might want to increase the quantity I buy at time. In other words, in addition to the amounts I am ordering, I will always want to have a sufficient ending inventory on hand to make sure I meet my forecasted sales need.
Besides, considering the national/ international supply, I will want to consider my local circumstances. In my case, my bakery is located in a small town called Themiddleofnowhere. Supply in my small town is very limited and goods sold tend to be marked up at least 30% above market because of the high cost of transportation. So this means, I often have to travel at least 50 miles to get my supply of flour at normal market price. As a result, I like to carry at least 40% more inventory than I need for non perishable items. This bring my new quantity forecast to:
Business capacity
The next question I should ask myself is: “What will it take to sell 1,000 cakes?” In other words,
- Do I have access to the financial resources required?
- How much ingredients can I store at a time, etc?
Taking into account your limitations does not mean you cannot go ahead with the sales forecast, it just means you need to address them as you move forward. Admitting limitations is not a form of weakness but rather a sign of wisdom.
It might be that my business is capable of handling 200 units of flours at a time so I have to order in batches of 200. When inventory falls below 100, I order a new batch.
Also, I have to take into account the lead time between the date I order and the date I am likely to get my inventory. When a bigger lead time is anticipated, I will need more inventory on hand.
For my cake shop, I have both the financial resources and storage capacity to handle the inventory.
Quantities at which economies of scale occur
In my example above, I plan to buy 14,700 units of flour over a year. What if after talking to my supplier he promises a discount of 50 cents a pound if I agree to buy 800 more units. This decreases my cost of goods sold by 50 cents. This also means that I am tied into a 12 month contract with the vendor. 15,500 units is the minimum quantity at which the vendor enters contracts with customers.
The first thing I should do before accepting an offer like this is adjusting my sales forecast to see if I am able to sell the extra units. My little town can only eat so much cakes and raw materials only have so much shelf life. It is important to know if I can sell the extra inventory before it expires. Also, I do a quick check to see if I have the financial resources and business capacity to handle the demands required by those extra units.
For example, extra inventory might mean:
- I have to increase marketing by another 5% to sell the excess products.
- Have more cash tied into inventory (Do I have the financial resources?). ,
- Increase the amounts of items I have to store (Do I have the storage capacity?)
It is important to be aware of the consequences of our decisions. While they may not stop you from taking action, being aware of alternative uses of resources is very wise.
I decide going into a 12 month contract to buy 15,500 units of flour makes more sense than not having a contract and buying the 14,700 units required by my sales forecast. A contract also works in my favor, because I can be assured of what my inventory will cost during the year. This keeps my cost stable. Also, I decided not to increase my sales forecast but keep the extra as ending inventory. Since flour has a long shelf life, it will reduce the number of units I need to purchase in the following year. My new quantity forecasted is as follows:
Quantity Purchased Summary
Now that I am done analyzing elements of my quantity equation. I ended up buying 15,500 units of flour and 7,350 units of oil.
You will have to undergo the same diagnosis for every significant item your purchase as inventory. If an item makes a very insignificant fraction of your cost, then going through this analysis might not make sense. You have to weight the cost against the benefits.
Price per unit
Once I have decided the quantities I need for my budgeting period, I can now forecast my price per unit as follows:
The purpose of thinking through this elements is to help you think through factors that could increase or decrease your cost. By taking proactive action, you stand a better chance of minimizing your cost and maximizing your profit.
Industry value chain cost
The value chain analysis is the cost of the (resource owners + all convergent agents) * their markup
(Resource owner cost * Resource owner markup) *(Markup for the number of touch points in the industry value chain before the goods gets to you)
It is important to evaluate the value chain for the product you buy. Sometimes cutting one link to the chain can significantly reduce your cost. For example, the oil I need, comes from the corn farmers, who sell it to the oil manufactures, who engages a distributor or wholesaler, before it finally it gets to the retailers. Each business in the value chain adds their own markup.
The higher you go up the chain, the more it will cost you in investment to reduce your cost. Sometimes business owners get so accustomed to buying from retailers because that was their only option when they began. But as you grow in size, you gain more power to go up the value chain. And if you become really big, you can even acquire your resource owners or convergent agents.
After analyzing my value chain for my bakery, I decide at this point my business is small enough and I am limited to buying from retailers. Nationally, the average retailer sells the oil I need at $1.83 per unit based on the quantity I am purchasing.
On the other hand, the price for my flour is under contract so my price is fixed at $4.50 per unit. This is actually better than the industry value chain cost of $5.00. Unless circumstances changes, further analysis of future price will do little good when I am on a contract.
Markup for scarcity/ markdown for surpluses
Since I reside in the middle of no way, the materials I need are usually scarce in my local area. This affects what I will be paying for oil. Since I buy lower quantities for oil, I could not secure a contract like I did for flour. Moreover, assuming oil has a lower shelf life than flour, the quantity I can carry at a time is very limited. So, I know majority of my supply will have to come from the local vendor who marks up his inventory by 30%.
In my case I will have to add a 30% markup due to the scarcity of the product in my area.
On the other hand, if I live in a city with tons of businesses that sell my product, my item will probably be on sale a lot. I can markdown my cost and plan to stock up when sales price goes down.
As said, thinking about these factors as individual items in determining price, forces you to think of alternatives rather than just accepting your normal.
Markup for inflation
Overtime the price of goods go up, you can use historical data to predict what percentage price might go up. Or you can just use the current inflation rate of 1.06%.
Price Estimation
After my analysis I come up with a unit price for flour of $4.50 and $2.40 for oil as follows:
The Direct Material Budget
Again, the point of this exercise is not to attain perfect accuracy but to help you think of factors that affect your business and where you can reduce cost. The lower your cost the higher your profitability. In the next post, I will discuss how to predict labor cost for my cake business.