Business Turnaround Basics – Understanding the Real Cost of Your Materials and Components

In the previous article on June 1, 2009, we explored the large negative impact that poor product and service costing can create. As I stated before, product costs are made up from three elements and they are material, labor and overhead. In this article, we will cover material costs and how to insure these costs are accurate.

In most cases today, material and component costs are often the greatest portions of product costs. When we consider materials and component costs, we need to factor in other items that can have an impact on the accuracy of these costs. Listed below are some areas that need analysis with respect to these costs. The recommendations used would be based on an Activity-Based Costing approach which ties all costs to the driving behaviors.

Timing of cost analysis

The time in which costs were established can have a big impact on validity of the cost data. For example, if standards are only rolled once per year or are averaged or some other leveling method is used, the costs reflected in the system may not reflect today’s costing reality. This scenario can also impact the inventory valuation method used and either be under or overstating inventory valuation. At a minimum, purchasing can be acting on incorrect information when it comes to negotiating pricing and the current product cost rollups can be questionable.

Inflationary or Deflationary Market

This is really a subset of the timing issue mentioned above. If costs are rising or falling in the market, a business must review the frequency of costing updates and see if a more-frequent rolling of costs is necessary. In either the inflationary or deflationary situation, the latest costs could be substantially different from the standard and these differences need to be understood.

Freight and Handling Costs

If components come from overseas or they require special handling, there can be a substantial cost associated with these individual components. For example, if an item costs $10.00 and the amortized freight impact to ship these in from China cost $3.00, then the costs of the item need to reflect the FOB cost of $13.00 each. If these costs are tied to the part, and not thrown into a general incoming freight account, the true impact is shown on the product. Also, given this true cost, Purchasing can use this as a baseline to price out other sourcing options.

Lead time and Inventory costs

Building on the previous section, when a long lead time item is sourced offshore versus a much shorter lead-time domestic item, there are additional inventory carrying costs associated with the lead-time increase. For example, if the offshore supplier takes 90 days to respond versus a domestic supplier taking 30 days, the implication is that there will need to be at least an additional 60 days of inventory coverage to source from offshore. If this is a material or component that takes up a great deal of space, the facility requirements to store the product can be quite expensive, along with the added inventory carrying costs. For example, industry experts in materials management believe that it costs about 30% of an items inventory value just to store it and pay for handling damage and obsolescence risk each year. In comparing the two options mentioned before, we should include the carrying costs of the additional 60 days of inventory costs as well as any other additional overhead associated with this particular item. When these costs are factored in, it could make more sense to use a domestic supplier for these components.

Quality and Yield costs

This is an area where any process or inspection fallout should be factored into the cost of each item. For example, a client company was buying a large component from China at the lowest cost supplier they could find, a third tier supplier. However, they were experiencing quality fallout of up to 40% on these items. This fallout required substantially more inventory to be on order to backfill the fallout. In addition, due to last minute failures on the line, there were ongoing misses in shipping commitments, creating customer service issues. The fallout also included the need to pay air freight on some items to cover the shortages. When we factored all of these costs into each item, it was much cheaper to source these components from a higher cost and more-reputable supplier and we initiated a program to systematically move all of this capacity to a Tier 1 supplier.


Some of the recommendations addressed in this article will require work on how to assign these unique costs so they roll up properly in the costing system. In any case, it is critical to understand these and factor them into the product costs as well as factor these impacts into both strategic and tactical business planning.

Posted in Blog Post, Restructuring Businesses and Struggling Businesses


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