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Knowing Your Costs May Hurt You!

Copyright Thomas P. Crouser, October 10, 1995

The following was first published in The Crouser Report of April 1, 1990. It is sent to you today for it is still valid.April 1, 1990

Dear Friends. . .

Know your costs. That's been preached in the printing industry for decades and still many people do not know their costs of production. Everyone agrees with that. Only problem is: knowing your costs exclusively as a pricing philosophy can work against you.

Huh? When we know our costs and exclusively price from them (cost plus markup), we automatically pass through the production efficiencies obtained by our investment in modern equipment and even production management efficiencies and techniques.

Example: Assume allocated overhead and direct wages for a single small format press is $62,400 per year and within that amount one press operator is paid for 2080 hours per year (52 weeks x 40 hours). The other money is for rent, heat, and other total costs allocated by you to this cost center. When we deduct vacation hours (80 hours per year) and holiday hours (56 hours per year), we have 1944 salable hours per year. So, a simple division of $62,400 by 1944 salable hours gives us $32.10 per hour of costs assuming all hours are sold (charged) to specific jobs. Of course, that doesn't happen because it is impossible to sell 100% of the time. So, if the shop has a job cost system (most don't) then it would be known that on average 70% of the total time of this press operator is sold or charged to specific jobs. (70% is not meant to be considered an average for the typical shop. The actual percentage among shops can vary greatly depending mainly upon product mix or in this case, run lengths of jobs and the quantity of jobs.) In order then to convert the 100% rate of $32.10 to a 70% rate, we simply divide the $32.10 by .70 (70%) to derive $45.86.

So far, we have described the standard method of deriving a budget hour rate. By multiplying the budget hour rate by the amount of time spent on a specific job and then adding to that the direct materials which are used (paper, plates, etc.), then we have determined the total cost of the job. What happens next is that many will multiply the cost of the job by some predetermined markup to derive the price. This is a cost plus markup approach to pricing.

So what's wrong with that? By exclusively using cost plus markup we too many times leave a lot of money on the table. How? Assume this same shop with the same press operator finds itself doing a lot of two color work. The owner thinks, rightly so, that to improve production an investment in a second color head would be a good idea. After all, it would improve the turn around time, improve quality in most cases, and generally make life easier for the press operator because holding the registration is generally easier. All of which are true.

But look at a specific job. The printer has been producing a two color job for $500 using the previously described cost plus method. What impact does the addition of the second color head have on the job? After the addition of the equipment which cost, say $10,000, a change in the cost formula is made. It goes something like this:

$10,000 investment in equipment depreciated for costing purposes over 5 years (straight line to keep it simple) is an additional $2,000 per year ($10,000/5 years). Allowing 50 weeks per year for the use of the equipment (again to keep it simple) we find the equipment cost is $40 per week ($2,000/50 weeks). At 100% chargeable time, there would be 40 hours available, so $40 per week divided by the 40 hours is $1 per hour. Now, just as in the case of the press operator, the equipment will not be used 100% of the time. In fact, it won't even be used as much as 70% of the time since that is the total amount of time the press operator is charging to jobs. More realistically, and again to keep it simple, say it is only used 25% of the available hours or about 10 hours per week. How does this fit into our budget hourly rate calculation? Take the $1 per hour 100% chargeable time cost and divide it by 25% ($1/.25 = $4). So, the cost difference in adding the equipment is $4 per hour in this example.

So what? If we use an exclusively cost plus pricing formula, we would add the $4 per hour to our 70% cost rate of $45.86 per hour for a new budget hour rate of $49.86. What we have accomplished is that we have invested $10,000 of our money in a piece of equipment, incurred the risk of the investment, improved the turn around time to the customer and generally improved the quality. And then, by using cost plus, instead of selling it for the $500 we use to sell it for, we would find ourselves selling it for something like $280!

That's what we mean when we say that exclusive use of cost plus many times results in us passing along our production efficiencies to the customer. What should we do? Actually we should probably be increasing our price to the customer beyond the $500.

There are also other ways in which we can pass along production efficiencies to the customer. A printer told me of how he was able to purchase a large quantity of paper from an odd lot broker in Texas for $8 per thousand. Of course, he had to buy a considerable quantity and thus had a significant investment but the plus side was that the paper would normally have cost some $20 per thousand. My question to him, as I am sure your question is, at what price did he charge the customer for the paper? $8 or $20? He said $8. In this case, his buying efficiency worked against him. He would have been better off not taking the risk of the investment, paying the local paper house $20 and end up making more money. How? By using cost plus markup his markup on the $8 was not nearly what it would have been as if it were $20 and he would not have incurred the risk. Additionally, he would have saved the time and aggravation of finding and buying the paper in the first place. More appropriately, he should have passed the paper cost through at $20 or at least at a more appropriate price. But, one might say, what if this were some sort of bid job? He might not get the job at the $20 paper price. Right. Bid jobs are a little different, but that wasn't the case as this paper was for his normal stock.

Another way of passing along production efficiencies is similar to our first example. It's where the print shop runs a job cost system and simply marks up the cost at the end of the job to assure a profit. Most of us have had the experience of having two press operators, one of whom is better/faster/etc. than the other. The actual cost of the job may be a function of which operator actually prints it. The faster operator charges less time, thus the job is marked up less than if the slower operator printed it.

Another example comes from a seminar I did in Atlanta this month. One attendee indicated he has different hourly rates on different presses. The same 50,000 impressions could be more if it is on the smaller press which he said would take longer than running more up on a larger press. He would estimate the cost plus markup on both presses and then charge the lower of the two. My point is that the value of the 50,000 impressions does not change because the way the job is produced. What we are doing, once again, is passing along production efficiencies.

So what is the answer? Am I saying to throw cost plus markup out the window? Absolutely not. I am a firm believer in developing budget hour rates and knowing what it cost you to produce a job. On the other hand, however, I am saying that pricing is not a function of cost. Pricing is a function of the market or what you can get for the job.

Does that mean you would charge the same customer different prices on the same job depending upon when the job comes in the shop? If you are real busy you would charge more and less if you were not? No, although that does play into many estimates.

My answer is that cost plus gives to us a floor for pricing. We should not go below this floor in pricing. But it is a floor. It is not a maximum. Many times we sell a job for a fair amount, then by investing in better and more modern equipment, we end up selling the job for less. But, this makes you a more efficient producer, so doesn't this mean you get more work? Theoretically, it doesn't (for a discussion of this, message me for a copy of our Crouser Report on Monopolistic Competition). But it also means that theoretically the more we invest in the business and the harder we work, the less money we make. And that's not our purpose in life. Cost plus is not always the answer. Do take into consideration market levels in your structured pricing program.

ADDENDUM: I happen to believe that many small press shops can greatly benefit from the addition of a second color head to their equipment inventory.

Sincerely,

Tom Crouser

P.S. Be aware of strong drink. It can make you shoot at tax collectors and miss. Anonymous

And just to prove our point, here is an excerpt from the Crouser Report OnLine of December 21, 1995.

Letters: Prices
Ran across a fantastic piece from the Printing Industries of Illinois-Indiaa on how a web printer lost money by increasing productivity. Just had to include it for you in this batch of letters.

First, how did that printer lose money by increasing productivity?

The Classic Giveaway
We heard a presentation by a long run web offset printer who has installed a gapless press which saved 1/4 of paper on every revolution of the press. He noted that this didn't sound like much but that it amouted to $250,000 worth of paper every year. This was a great story in production efficiency, but there was a problem. As in most plants, the foundation of the pricing system was the estimates ad the estimators had found out about the quarter inch. Without even thinking about it, the savings wound up in the hands of clients (because they were charged for less paper). Worst still, since paper was marked up an average of 10%, prices were actually reduced by $275,000 producing a negative return of $25,000 per year on the substantial investment in productivity. We can't think of a better example of the damage you can do to yourself by making the estimate the basis of your price. It's unthinking pricing policies such as this that give our industry such a lousy return on investment.

Hum, at least that situation couldn't occur in Quick Printing. Right, guys?
Right? Er, maybe it does. Hum.

Happy Trails. . .Tom Crouser Crouser & Associates Performance Group program includes two on-site evaluations by Tom Crouser each year along with two group meetings. Management training is held during the group meetings along with participation in a meeting with non-competing printers. Join others who have decided to run their business instead of the business running them. Reply to by Email to Tom Crouser for more detailed information or call Clark Workman at (304) 342-5100. Or fax (304) 342-5187 or contact crouser@ibm.net. Return to Crouser Index
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