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Cost Accounting In The Shop

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Do you feel that your shop has the type of
control over costs, expenses and productivity that it needs to
survive in today’s market? Do you understand how to calculate
the actual cost of each job that you do and the efficiency that
each of your employees achieves on a daily, monthly or annual
basis?

Unfortunately, most shop owners do not. In
fact, shop owners need to realize that there are few, if any,
businesses that have an exclusive hold on any particular product
or service or market, and who are free to charge as much (or as
little) as they want for those products and services.

As one of the three owners of Midwest Crankshaft
and Midwest Engine Parts Warehouse, Harvey, IL, we realized about
five years ago that we needed to address the issues of accurately
determining our costs per hour so that we could obtain the profit
margins required to adequately pay ourselves and our employees,
provide our customers with the type of product quality and performance
they expected, and to continue to invest in our business over
the long term.

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We began looking for a software program that
would help us gather all the necessary information we needed.
We knew we needed to track labor revenue and billed hours, employee
productivity, scheduling, P.O.S., warranty, sales ranking, the
ability to create purchase orders, inventory control, profit margins
and more.

I initiated our search by first writing a three-page
wish list of what I would like a business software program to
track. After looking at 11 or 12 different software programs,
we decided on PTM (Part Time Manager), Inc.’s, Columbia, MT, software
program and computer system for our machine shop. The purpose
of this article is not to recommend one manufacturer’s software
over another’s. However, you should compile a list of requirements
that any software you purchase must meet. Then evaluate every
supplier’s software in terms of meeting those requirements.

We chose PTM for a variety of reasons including
its hands-on experience in automotive and heavy duty shop ownership,
and its ability to address issues specific to our industry. The
company has also been selected as the preferred software vendor
by the Engine Rebuilders Association (AERA) as well as several
other major engine parts suppliers.

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PTM’s software has been integrated with AERA’s
Prosis software, which is used by many machine shops across the
country to provide technical and identification specifications,
and with electronic cataloging of automotive and heavy duty engine
and chassis parts, and price and part number updating for inventory
control, which is available from several parts suppliers.

We had never been computerized at our machine
shop, so it was a new experience for all of us. In implementing
the software program, virtually every procedure changed from how
we formerly did them. Each employee had to adapt to new procedures.
However, their transition was facilitated by their increasing
understanding of how we could improve the many processes and procedures
required to reach our goals. As a result of these changes our
warranty returns have never been lower, and employee moral has
improved dramatically.

Use of appropriate shop software has taken
much of the stress away from our employees in terms of scheduling
work. We now know how much backlog there is and can accurately
schedule the next job. This took us from operating in an almost
constant "rush job" status on virtually every work order,
to being able to plan the work load to achieve the most productivity
from each employee.

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We have what I believe are some of the best
machinists in the country. But what we now also have is the knowledge
of how much revenue they generate per billable hour, and if there
is a warranty problem, who to talk with about it.

Our employees are now able to ensure (with
little supervision) that they get the job done on time and with
the highest quality. With the market demanding that we maximize
our efficiency, implementing the changes that we did was one of
the best decisions we ever made. We where able, for example, to
look at specific labor operations, and the time required to do
them, and realize that we simply could not charge enough to cover
our costs. So, in some cases, we stopped offering those services.
In other cases, instead of giving away our labor, we began charging
for it.

We were also able to see exactly where more
than 90% of our warranty problems were taking place, i.e., when
we were doing partial jobs. Some customers would tell us to "just
resurface the cylinder head only," or "don’t repair
the valve guides," or "don’t replace the cam."
They would plead, "I just don’t have the money."

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Well, any and all of these situations cost
both the customer and us many times more money than if the job
had simply been performed correctly the first time. We abruptly
stopped doing all partial jobs. Our warranty returns declined
immediately, our customer satisfaction improved, and for the most
part, we didn’t lose much of the work we formerly had been losing
money on. We did, however, in many cases "lose" the
right customers.

We now take the time necessary to explain to
our customers the mutual benefit of providing the highest quality
work. Our employees know without a doubt, that they are expected
to provide only the best service, and they now do exactly that.

Know your break-even

You should know what your break-even point
is. You should know what your cost per hour is. You should know
what gross margin you need to average on your parts sales to make
a profit.

You must know what you need to charge per hour
in labor to make a profit. We must all realize that the difference
between making a profit, or not, is very slim. To make a profit
we must know what our cost per hour is.

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If you read this article (and those that will
follow in subsequent issues) you will come to believe, as I now
do, that you can obtain the overall profit margins that you, your
employees and your company require. Whether you are the sole owner,
have one employee or 50 employees, your shop can be profitable.

For the past few years I have tried very hard
to improve my skills at reading financial statements by taking
classes at the local college, going to financial training seminars
(one put on by a company called Skill Path was the best), and
by reading books on accounting and bookkeeping.

However, even with all of this information
I still could not look at an income statement or balance sheet
and know what to charge in hourly labor, and what average gross
margin we needed on parts sales. However, as I worked with spreadsheets
more and more, I started writing a program that would take all
the totals from the PTM software, e.g., billed hours, revenue
from labor and parts sales, warranty rate, efficiency rating,
payroll, operating expenses, and combine it with hours worked
and our profit goals.

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I found that I could see precisely what effect
giving a 3% raise to employees actually would have on our hourly
rates if we were to maintain or increase our desired profit margins.
Or, if my real estate taxes went up 5%, I could see how much we
would have to adjust our hourly rate to compensate for it.

Now, for example, if we want to give employees
with "X" amount of years of service three weeks vacation
instead of two, we know exactly how this would change the hourly
rate our company needs to charge to pay for it. Unfortunately,
having this information doesn’t always enable you to begin charging
for it. Sometimes, it’s simply more than the market will bear.

But, although you may realize that you can’t
make up the difference by adjusting your hourly rate to maintain
your gross margin, you may see that those margins can be sustained
with a lower price increase combined with an "X%" improvement
in efficiency. The information obtain through my software program
can also be used to justify hourly rate increases for each employee,
providing bonuses based on actual revenue generated, operating
expenses, efficiency ratings and reaching specific profit goals.
This software program ñ "Profit & Expense What
If Tool Kit" was introduced at the AERA Tech Show ’98
last month in Nashville, TN.

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We all know the basics of what goes into our
cost of doing business. Wages, utilities, rent or lease payments,
principle and interest payments on notes, real estate taxes, insurance
payments, telephone expense, advertising, building maintenance,
machinery repair/maintenance, shop supplies, company vehicle maintenance,
wages, employment taxes and employee benefits, are just a few.

But there are other areas, just as important,
that many shops overlook. These areas also need to be considered
when evaluating your costs of doing business. No one has a crystal
ball to tell us exactly what the future will bring. However, to
the best of our ability, we must try to prepare for it. The five
"other" areas that shops often neglect are:

  • The actual hours available to produce
    revenue.
    Whether you are a one-man
    company or employ 50, you must know the net hours after holidays,
    vacation days, personal days, morning or afternoon breaks, etc.,
    that you provide to your employees. You must also estimate the
    lost time for employees coming in late in the morning or leaving
    a few minutes early at the end of the day. Also, after breaks
    or lunch time, how long on average does it take everyone to actually
    get back to producing revenue? This number should be calculated
    for each of your employees, it represents the maximum hours available
    in which revenue can be generated.
  • The number of billed hours per employee.
    If you pay an employee 40 hours on his or her paycheck, how many
    hours of revenue did that employee actually bill out. It is not
    uncommon to bill only 50% to 75% of the total hours that an employee
    works.

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Many factors can affect why an employee would
bill less than 100% of his or her actual hours worked. A few reasons
might include: the day-to-day operations of the company are simply
inefficient; the teardown area and the degreasing area are too
far apart, i.e., work flow efficiencies need to improve; work
orders are not being filled out precisely enough, so the machinist
must walk back to the counter person and ask exactly what the
customer wants; your employees start-and-stop on jobs in-process
on a regular basis due to schedule changes or other reasons.

There are many factors that contribute to inefficiency.
It could be that your employee must routinely look for the tools
necessary to complete each job. Improving efficiencies in various
areas of your company will be the fastest dollars to reach your
bottom line. A 1% increase in your company’s efficiency rating
will add 1% of profit to the bottom line.

  • Your company’s warranty rate.
    Every company has some warranty issues it must pay for. We are
    all human, therefore there will always be some mistakes made.
    But, the less we make the better our bottom line will be and the
    better our customer’s satisfaction in our products and services.

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For example, you may have a company policy
where if a customer has a complaint, it will be taken care of
to the customer’s satisfaction, regardless of who is at fault.
Many shop owners feel that if a customer has a complaint, that
customer needs to walk away feeling he has not been taken advantage
of. Customer satisfaction, overall, usually leads to new business.
The shop owner is usually time and money ahead satisfying existing
customers compared to the expense of finding new business.

All that being said, we still must have control
on our paid warranty rate and must figure this into our overall
expenses. Whether your warranty rate is 1% or 5%, calculate that
dollar amount into your overall cost of doing business. The next
time a warranty issue comes up, simply take care of your customer.
You will know that you have already budgeted the dollars required
to cover your warranty expense.

  • How much bad debt do you have?
    If you allow any of your customers to charge their purchases,
    it is very likely that some of them are not going to pay you.
    If customers are paying you slow, this will definitely put a strain
    on your cash flow when it comes time to pay your own bills.

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If your customers are not paying according
to your credit terms, then you must react. It is likely those
customers who cannot pay you on time, do not have a handle on
what they need to charge for their products or services. If you
look at the customers in the 31 to 60 day column for past due
payments, work with them to pay you sooner, or put them on COD.
If you have customers past due more than 61 days, you should be
concerned that amount is bad debt. You need to calculate into
your expenses an amount for this estimated bad debt.

  • What does the owner want to make in
    salary, and what do you want to pay your employees?

    Pick a number in annual wages that would make it worthwhile for
    you, the owner, to earn (if you are not already making that amount).
    Would you like to pay your employees more than they are currently
    making? Would you like to provide health or other benefits? Planning
    for these items is an important step towards achieving your profit
    goals.

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Operating expenses directly affect what you
must charge for your products or services. And the efficiency
rating of your business directly impacts your operating expense.
Your available hours to generate revenue dictate what you must
charge per hour. Consider the following likely scenarios: you
pay an employee 52 weeks pay per year, but two of those weeks
are vacation pay; you pay for six holidays per year; some employees
take off one or two days per year because of illness or other
necessity; some employees come in five to 10 minutes late twice
a month.

All of these factors (and more) impact what
you may need to charge per hour for labor, or what you need to
average per hour in parts sales. Take 52 weeks times 40 hours
per week and you have a total of 2,080 hours. These 2,080 hours
minus 80 hours vacation time, 48 hours holiday pay, 16 hours absent
because of illness, and four hours per year due to being late
to work now equals just 1,932 hours available to generate revenue.

To achieve your profit margin goals, you must
know your cost per hour, and you must know your available hours
to generate revenue. Let’s say that the average hours available
per employee is 1,932 per year. Let’s say you have three employees,
and your annual operating expense is $230,000. Three employees
times 1,932 hours available per employee, equals 5,796 hours per
year (your maximum available hours to produce revenue). Now take
the $230,000 and divide it by 5,796 hours (your total available
billing hours). Just to meet operating expenses, your cost per
hour would equal $39.68, and that’s if you were 100% efficient.

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You can see from this exercise how important
production efficiencies really are. You should never be satisfied
with them; you should always be trying to improve your efficiency.
Your employees can be a great source for those ideas to improve
efficiency. Let’s say that you only bill an average of 5.6 hours
out of every eight-hour day, in other words you are 70% efficient
(5.6 divided by 8). That means you need to charge $56.69 per hour
based on your efficiency rating just to cover your expenses.

But you must also figure in profit. Profit
is what will pay for your business growth, the maintenance and/or
replacement of machinery, and salaries and benefits. If you are
conservative and figure a 10% return on actual investment of $230,000,
that would be a $23,000 profit goal. I don’t think 10% is a very
large number when you consider that the local bank would pay 4%
to 5% as a passbook saving’s rate. So, 10% profit would translate
into an hourly rate of $62.36, which would also cover shop expenses
at your present efficiency rating.

When examining operating expenses, the five
items we’ve just listed should also be a line item expense when
you calculate what you charge per hour for labor and the gross
margin you need on parts. Of course, there are other items to
look at too, such as inventory shrinkage, underestimating your
expenses, updating or replacing shop tools and supplies, employee
safety, and workman’s compensation rates (if an employee files
a claim your rates can double).

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Always plan for the unexpected; expect the
unexpected. In business there is always something that was not
planned for but that occurs and you must pay for. Don’t let those
items come out of profits; let them come out of planned expenses.
Estimate their cost and figure them into your cost of doing business.

By including "all" expenses, or at
least all that you can possible foresee, you’ll be in a better
position to charge an hourly rate that ensures that you’ll reach
your profit goals. With this information in hand, you may realize
that you must reduce your operating expenses (we will talk about
watching vendor prices and other costs in a following article).
You may realize that you need to operate more efficiently. You
may realize that you need to raise your margins on labor and parts
sales. Or you may realize that you need to do a combination of
all of these, or more. But, it will be worth the effort!

Look at the mechanic or electrician who has
10% of the investment in tools, equipment and overhead as we do,
and who also has a $60 hourly labor rate. We must cover our expenses,
and we must realize the profit margins we need to continue in
business. Not to do so is to admit that we are working towards
going out of business.

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I believe passionately in the fact that we
in this industry must do anything and everything that is necessary
to price our work at the level necessary to make a true profit.
In order to set our prices properly, we must know what our costs
are. To set our prices properly, we must know how many hours are
available to produce revenue. To set our prices properly, we must
know how efficient our employees are. To set our prices properly,
we must have a profit goal in mind.

Each of us has different levels of operating
expenses and different efficiency levels. We also may have differing
views as to how much profit is enough. These are the primary reasons
we cannot look at the competition to see what they are charging
to set our own prices. Don’t misunderstand. You should know what
the competition is doing. But it is dangerous to set your prices
based solely on what they are charging.

Your competitor, for example, may, as an owner,
be drawing $20,000 a year as a salary. Your competitor may not
be disposing of his hazardous waste according to state and federal
regulations. You, on the other hand, may be drawing $50,000 in
salary and spending $10,000 per year in hazardous waste disposal
cost. Consequently, your operating expenses will be higher.

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If you set your prices to match your competitor’s,
you could be on a long road, maybe even a short road, to going
out of business. At the very least you are likely to struggle
continuously to pay your bills. One person may feel that to make
$40,000 per year in wages as an owner is good. Another person,
however, may think that $80,000 is okay, while a third may feel
that $120,000 is what it requires to take on the responsibilities
of being the boss.

But to have an achievable goal you must know
what your cost of doing business is. With this information you
can make precise decisions concerning your business.

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