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ones, in the preceding example, is a wholesaler and retail- er. The issues get even more complicated in a manufac- turing environment because there are so many more aspects and categories of costs that mount up as a product moves through a complex manufacturing process. Further rationalizing of those cost analyses and margin calculations can be nearly impossible without the use of a system that is designed to help you keep accurate track of the true costs of each step for each job or product. Fortunately, such activity- based costing (ABC) systems are readily available to track and assign costs accurately.In plants that manufacture only a few similar products, having a single basis rate on which to allocate overhead costs makes sense. Most commonly that basis is labor hours because traditionally that has been the biggest cost element. The greater the number of different products and the greater your manufacturing complexity, the more likely it is that an ABC sys- tem will be a worthwhile investment. The conversion to an ABC system is a big project but one that will help reveal many unsound pricing and other decisions that are currently being masked by simplistic assumptions about assignment of factory overhead costs.
In a more complex environment, with more manufacturing steps, more departments and more products, overhead cost allocation should probably be broken out by each activity involved. ABC systems are really necessary in such cases, where labor rates may vary widely from one department to the next,
and the relative mix of inputs may also vary by department. So in a hypothetical plant, department A may be highly labor- intensive with relatively highly paid specialists. Department B may also be labor intensive but
employ much lower-cost general fac- tory labor. Department C, by contrast, may be highly automated with mini- mal labor. Clearly, labor hours alone are the wrong way to allocate over- head costs in this plant.
In the most complex manufac- turing situations, with many different products, activity-based costing is necessary to develop detailed cost- estimation processes for each activity in each department of the plant. It is important to get this kind of infor-
mation right because if you are using gross margins as a cash driver, you must have confidence that the figures you use in making decisions are reasonable approximations of economic reality. If they are not, the errors will undoubtedly produce sig- nificant negative cash-flow effects.
While activity-based costing is of primary importance in accurately determining gross margins in a manufacturing envi- ronment, management of purchasing and inventory is usually the key in merchandising businesses, whether retail or whole- sale. Timing, a sense of the market, the use of hedging, and knowing when to take markdowns are core issues for main- taining gross margins.
A key to success here revolves around the availability of the right information at the right time in the right form. Pay atten- tion to the design and use of the reports that your accounting, finance and information-technology departments issue. Which ones really get used and by whom? On what do the reports and their readers focus and why? What do the relevant decision makers most want to know, and when? How can you get better information, sooner, in the most usable form, to the right peo- ple? Even partial reasonable answers to such questions will put your company on the road to higher gross margin. At the most
If you are using gross margins as a cash driver, you must have confidence that the figures you use in making decisions are reasonable approximations of economic reality.
If they are not, the errors
will undoubtedly produce
significant negative
cash-flow effects.
basic level, anyone can contribute in this informational way.
Begin simply by taking the time to study and more fully under- stand the content and implications of everyday reports as they exist. Pass your insights about this information along in writing to those who can best use it, and be willing to let them take, or at least share, the credit.
As you analyze your business from a gross-margin perspec- tive, consider both the marketing and the production (or pur- chasing) sides of the firm. If you see a trend of decline in gross margins, it probably means that your company is a price taker—that it does not have suffi- cient power in the marketplace to be able to raise prices enough to cover all cost increases. Alternatively, a downward trend in gross margin when the same margin-erosion problem is not being experienced by the overall industry usu- ally suggests production inefficiencies or poor buying patterns.
If you work in production, produc- tion planning, purchasing or product development, be alert for those things that will add value for your customers.
Improvements in perceived value can help to hold the line on or even increase acceptable pricing lev- els. This would include anything that improves product quali- ty or utility to customers. Anything you can economically do to add value or heighten the perception of value offers possibili- ties for protecting or enhancing gross margin. The same prin- ciple holds true for anything you do in terms of direct and indi- rect customer experiences with your company. These would range from something as fundamental as product design and basic distribution-channel selection to such ancillary factors as packing and shipping. Additional value-creation opportunities abound in most companies. The trick is to motivate and empower people to act on them at their individual levels of influence. Equipping people with cash-driver language is an important early step in that direction.