Arguably one of the most important components of a manufacturer’s financial well-being, manufacturing cost management is the practice of analyzing and driving down the costs to produce manufactured goods. The visibility afforded by strong manufacturing cost management feeds into profitable pricing strategies, and the discipline of continually improving process efficiency and sourcing practices lends itself to better business decisions and bottom-line performance.
What Are Manufacturing Costs?
Manufacturing costs are the costs associated with creating a finished product. Typically, manufacturing costs are divided into three major categories:
- Direct materials, which are the costs for the raw materials that will go into the product.
- Direct labor, which are the staffing costs for paying those who directly produce or supervise production on the factory floor.
- Manufacturing overhead, which are the indirect costs associated with supporting production, including everything from indirect labor costs in the back office to equipment depreciation.
Various costing methods exist to determine manufacturing cost inputs, and manufacturers can use them to calculate a total cost per unit or inventory valuation. For example, when using variable costing, also known as direct costing, a manufacturer excludes manufacturing overhead from the calculation. Meanwhile, absorption costing factors in overhead to the price per unit. While absorption costing is preferred for external financial reporting under accounting frameworks, such as Generally Accepted Accounting Principles (GAAP), variable costing can be valuable for internal analyses that help drive business decisions around margin and break-even points.
Other costing methods for manufacturing include process costing, which tracks costs of specific processes during one or more stages of manufacturing; target costing, which starts with a targeted sales price of a product and works backward to determine costs; and activity-based costing, which aggregates costs across a production run based on the activities that go into that run, ideally creating a clearer picture of the indirect costs associated with production.
What Is Manufacturing Cost Management?
Manufacturing cost management is the practice of establishing visibility into manufacturing costs and using this data to make better-informed business decisions to more effectively source, transport and store raw materials, streamline manufacturing processes, manage manufacturing workforces more effectively and reduce waste. Effective manufacturing cost management isn’t solely about driving down manufacturing costs — it’s also intricately tied to pricing management and can help drive business discussions about the performance and feasibility of current and proposed products. When done well, manufacturing cost management makes it possible to perform sophisticated analyses of margins and ultimately maximize profit for the business.
- Manufacturers depend on manufacturing cost management to maximize their profitability.
- Manufacturing costs consist of direct materials costs, direct labor costs and manufacturing overhead.
- Manufacturing cost management tracks costs across these three categories and seeks ways to incrementally drive down costs.
- Some common areas manufacturers focus on to manage costs are supply chain management, inventory management, workforce management, waste reduction and process efficiency.
- Manufacturing cost management informs pricing decisions and can help business leaders decide which products and features to prioritize over time.
Manufacturing Cost Management Explained
Manufacturing cost management is a cross-disciplinary effort that includes the accounting function for tracking costs that go into producing items, as well as the active management of the materials sourcing, workforce and processes that contribute to manufacturing costs. Leading manufacturers continually seek out improvements in their end-to-end manufacturing processes that help them more effectively manage their costs without adversely affecting the quality of finished products. Some of the common best practices in manufacturing cost management tend to revolve around the following activity categories:
- Vendor and supply chain management for raw materials
- Inventory management
- Energy efficiency and sustainability
- Process management
- Workforce management and scheduling
- Waste reduction
These activities are often highly interconnected and complex in their relationships to each other, which is why organizations use management frameworks such as lean manufacturing or total quality management to orchestrate a symphony of cost efficiency, visibility and incremental changes to the way things get done.
Additionally, organizations depend on strong data collection, accounting and analytics to monitor cost inputs in real time, forecast how potential changes can impact costs and track how changes to processes ultimately impact costs over time. These analytics and accounting capabilities are also integral to leveraging manufacturing cost management to make better business decisions about pricing, production timing and volume, and whether or not to produce a particular item based on market demand and profitability targets.
Importance of Manufacturing Cost Management
Manufacturing cost management is essential for sophisticated manufacturers to make knowledgeable business decisions that will maximize their profitability. Effective manufacturing cost management can help organizations with the following tasks:
- Identify wasteful practices and maximize the use of raw materials.
- More actively manage vendor relationships and stabilize the cost of raw materials over time.
- Minimize over- or underproduction.
- Avoid storage costs for raw material and finished inventory.
- Appropriately hire and schedule workers based on production demands.
- Make pricing and quote decisions based on data rather than gut feelings.
- Maintain quality and customer satisfaction while lowering costs.
In times of economic headwinds like inflation or inconsistent availability of raw materials or labor, cost management may not necessarily lower costs, but it can definitely help a manufacturer maximize its margins.
Examples of Manufacturing Costs
As mentioned above, manufacturing costs can be classified under three distinct categories: direct materials, direct labor and manufacturing overhead. These costs are built into the cost of the inventory and ultimately flow through cost of goods sold. The following are examples of the types of costs that fall under each category.
Direct materials are the component that are converted into finished goods, can be linked to the product, and are assigned based on the actual materials used. This could include scrap and spoilage that occur during production. For example, a clothing manufacturer would include cotton, wool and thread in its direct materials costs. A car manufacturer would incur direct materials costs for material like steel, rubber and leather. Supplies used in manufacturing but not converted into finished products — for example oil to lubricate manufacturing equipment — aren’t included in direct materials but are instead considered part of overhead.
Direct labor costs are the wages and associated payroll taxes paid by manufacturers for production crews on the factory floor, including machine operators, assembly line employees and factory supervisors working on a product. In some calculations, these costs include benefits paid out to these direct labor employees. Direct labor does not include costs for a manufacturer’s supporting workforce, such as industrial engineers, designers and so on. These indirect labor costs are included in manufacturing overhead.
Manufacturing overhead is the catchall expense category for all costs associated with manufacturing operations that aren’t considered direct material or labor costs. This includes indirect labor costs for workers who manage manufacturing functions, such as quality control and industrial design, as well as for back-office personnel, such as accounting and legal. This would also include indirect materials, like small components and supplies. Manufacturing overhead also encompasses facility and equipment costs, so this category would include facility rentals, equipment depreciation, parts and maintenance. Also included in this category are utilities, insurance and taxes, as well as factory supplies used directly in a finished product.
17 Manufacturing Cost Management Best Practices
Manufacturing cost management can be achieved through a number of avenues. The following are 17 best practices that manufacturers commonly use to gain better insight and control over their manufacturing costs.
1. Implement Lean Manufacturing
Lean manufacturing and lean inventory management provide guiding principles for reducing waste and increasing efficiency in manufacturing processes. Lean manufacturing can help companies curb unnecessary manufacturing costs by limiting overproduction, slashing idle time and cutting costs of raw materials over time by limiting how much is wasted on defects or purchasing mistakes. Some of the hallmarks of lean manufacturing production patterns are careful demand planning, process standardization and an emphasis on just-in-time inventory and production management.
2. Embrace Total Quality Management (TQM)
The primary goal of total quality management (TQM) is to increase customer satisfaction through an approach that emphasizes continual improvement and quality discipline that’s carried out by all employees at a manufacturing company. Along the way, TQM’s systematic methodology for quality management can reap significant manufacturing cost savings as well. TQM manufacturing shops tend to focus on process thinking by breaking manufacturing into a series of functional steps or processes that work together as part of a broader business-wide system. Processes are tracked meticulously, and performance data is continuously used to identify opportunities for improvement and to assess whether changes resulted in favorable outcomes.
3. Use Activity-Based Costing (ABC)
Activity-based costing (ABC) makes it easier for manufacturers to track and analyze indirect costs against specific manufacturing business processes in greater detail than traditional cost accounting techniques. Using ABC, manufacturers can identify and tie costs of cross-departmental processes that support a specific line of production. This can increase visibility into indirect costs that could still be increasing the total cost of units even as efforts are made to drive down direct costs for material or labor through methods such as lean manufacturing or TQM.
4. Implement Just-In-Time (JIT) Inventory Systems
A key component of lean manufacturing, just-in-time (JIT) inventory management is a process designed to bring in raw materials as close to production time as possible and to manufacture the minimum amount of finished inventory to meet market demand. When done right, JIT inventory management reduces waste and improves cash flow by avoiding overproduction, minimizing excess stock and storage costs and ensuring that cash isn’t tied up in excess raw materials or unsold inventory. Effective JIT inventory management requires an inventory system that can support JIT processes with real-time inventory visibility, strong demand management capabilities and strong connections to suppliers for well-orchestrated coordination of material delivery.
5. Optimize Supply Chain Management
The optimization of supply chain management can dramatically boost manufacturing cost management, from sourcing and procurement all the way through warehousing and distribution. Fundamental to a supply chain optimization strategy are improved monitoring and analytics, as well as increased automation. On the analytics side, this means keeping close tabs on metrics, including raw material and inventory turnover, warehouse capacity, storage costs and transportation efficiency — and given the scale and velocity of data involved, it also means using big data analytics techniques to glean insight from those metrics. Meanwhile, bolstering automation in areas such as order processing, warehouse operations and transportation scheduling can greatly increase efficiency in the supply chain ecosystem.
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6. Invest in Modern Technology
Whether they call it digital transformation, Industry 4.0 or the fourth industrial revolution, manufacturing leaders making concerted investments in modern technology are driving huge financial gains for their companies. According to one recent study by McKinsey, a typical machinery and equipment manufacturer is achieving cost savings of between 5% and 20% through cloud-enhanced digital transformation investments. These investments run the gamut and include widespread investment in industrial internet of things (IIoT) sensors in manufacturing equipment for improved visibility and lower maintenance costs; robotic automation on the factory floor; the use of digital twins to spur process and design improvements; and investments in machine learning and artificial intelligence to enhance analysis of manufacturing data.
7. Regularly Review and Adjust Product Pricing
Manufacturing cost management should never happen in a vacuum as it is closely connected to pricing management. In order to get the most out of cost management practices, manufacturers should use their increased visibility into cost considerations to make better pricing decisions. This means regularly reviewing and adjusting product pricing. Obviously, costs aren’t the only factors that go into that, but they play a big part in the overall price optimization strategy.
8. Foster a Culture of Continuous Improvement
There are only so many tactics that companies can use to tamp down the costs of raw materials in manufacturing. But there are innumerable measures that can be taken to improve operational efficiency in the manufacturing process and drive down waste, labor costs and other indirect expenses over time. Big-bang, revolutionary changes bring a lot of risk to the table, which is why so many of the winning manufacturing management frameworks, such as lean manufacturing and TQM, focus heavily on consistent, continuous improvement. Fostering a culture of continuous improvement can help a manufacturer increase communication, reduce silos and bottlenecks among departments and respond to performance metrics with ideas for incremental changes that can drive down costs.
9. Embrace Energy Efficiency and Sustainability
Manufacturers’ efforts to lower carbon emissions, improve energy efficiency and bolster sustainability are not just good for burnishing the environmental, social and governance (ESG) narrative for investors and customers. These sustainability efforts can also go a long way toward optimizing costs in manufacturing environments. Industry-leading manufacturers that install more energy-efficient equipment and implement processes to conserve energy and promote sustainability can tie these investments to cost management by tracking against the right goals and metrics. One way to do this is to build sustainability goals and activities around the SMART acronym, which stands for specific, measurable, attainable, relevant and time-bound.
10. Benchmark and Analyze Regularly
Engaging in regular cost benchmarking across common cost input categories is a good way for manufacturers to compare their costs with those of industry peers. Engaging in regular analysis and benchmarking can help manufacturers get a proverbial temperature check on how well they’re doing in cost management and identify areas for improvement. Some common metrics used for analysis and industry benchmarking include capacity utilization, schedule attainment, throughput, purchase costs, wages and total cost of manufacturing per $1,000 revenue.
11. Cross-Train Employees
Employee churn and brain drain can dramatically increase manufacturing costs over time. Recruiting and training highly specialized manufacturing employees is an expensive endeavor. Manufacturing companies can optimize costs in the long run by cross-training employees. On the retention and workforce management front, this builds a cadre of employees who are more flexible to fill immediate vacancies. Beyond that, cross-training can promote greater collaboration among roles that can minimize departmental friction, increase communication and smooth out processes in a way that reduces indirect costs not necessarily apparent on the balance sheet.
12. Consider Outsourcing Non-Core Activities
Effective outsourcing can be an extremely valuable tool for manufacturers to manage labor costs and bolster efficiency. By bringing in third-party specialists to handle roles and processes that are outside of their core competencies, manufacturers can focus on their strengths. Outsourcing non-core activities also makes it possible to more flexibly scale up manufacturing operations with fewer capital expenses.
13. Enhance Preventive Maintenance
Preventive maintenance is an important facet of cost management for any business, but it’s paramount for manufacturers. Establishing effective preventive maintenance procedures and using predictive analytics and other advanced digital systems to manage maintenance are crucial to not only bolster the efficiency and life span of expensive manufacturing systems, but also avoid unplanned downtime. Maximizing uptime is an important part of manufacturing cost management, which makes preventive maintenance a key component of any cost management strategy.
14. Review Product Portfolio
Manufacturing cost management is important not only in driving down costs, but also in helping a manufacturer make sound business decisions about which products make sense to produce in the first place. Companies should feed manufacturing cost management data into ongoing reviews of their product portfolios in order to inform decision-making on production volume, timing, product design, pricing and end-of-life planning for their products.
15. Adopt a Zero-Based Budgeting Approach
Often controversial and sometimes wielded with too heavy a hammer, zero-based budgeting is nevertheless an approach that some manufacturers use to great effect to drastically bring down manufacturing costs. The idea behind zero-based budgeting is that every expenditure must be justified from scratch, line item by line item, at the beginning of a budget cycle. Expenses are justified based on a rationalized need and industry norms. This is in contrast to traditional budgeting, which typically sets line items according to previous budget cycles. Zero-based budgeting forces companies to critically evaluate and justify every expense, which can lead to more efficient resource allocation and cost reduction. This approach ensures that budgeted funds are allocated based on current needs and priorities rather than simply continuing past spending patterns.
16. Foster Open Communication
One of the fundamental tenets of lean manufacturing is the idea of cross-enterprise collaboration, where teams work closely together using shared data, insights and decision-making. Establishing more open communication channels can help manufacturers reduce the kind of organizational friction that increases indirect costs through bottlenecks, wasteful mistakes and inefficient processes. When it comes to actively managing costs, part of open communication is busting data silos. Relevant teams should have insights into real-time data from enterprise resource planning (ERP), customer relationship management (CRM) and sales systems, among others, to help them forecast and plan appropriately.
17. Use Predictive Analytics
Predictive analytics is often a primary driver for digital transformation initiatives in manufacturing companies. Manufacturers can use predictive analytics to help them strengthen cost management on some very important fronts. For example, predictive analytics can analyze historical demand patterns, market trends and seasonality to predict future demand for products. It can also help optimize inventory levels by forecasting when and how much raw material or finished goods should be stocked.
Manufacturing Cost Management Challenges
Putting the full range of these best practices into place is no trivial task. Even under the best conditions, manufacturers can find it challenging to discover and track their manufacturing costs accurately and identify where to prioritize adjustments for the strongest financial impact. Further complicating matters are a number of other challenging factors, including the following:
Changing Market Dynamics
Whether wrought by the shifting sands of geopolitical turmoil or macroeconomic trends, market dynamics are always changing. Some of the current challenges manufacturers are grappling with include workforce talent disruptions, shortages in critical raw materials, supply chain logistics difficulties caused by port gridlock and a tenuous economic outlook. All of these factors impact manufacturing costs and require careful consideration and active management to navigate.
Supply Chain Disruptions
Supply chain disruptions have become a looming issue for manufacturers and consumers alike in today’s post-pandemic global economy. A recent Deloitte study notes that 80% of manufacturing executives reported experiencing heavy or very heavy impact from disruptions in their supply chains in the last 12 to 18 months. As manufacturers navigate a challenging supply chain environment, inconsistent availability of raw materials is wreaking havoc on well-oiled, JIT inventory management approaches that bolster cost management practices and causing logistics inefficiencies that inevitably impact costs.
Fluctuating Raw Material Prices
Whether up or down, fluctuating raw material prices can hinder manufacturers’ ability to appropriately plan and manage the direct costs of manufacturing over time. Real-time analytics can help them keep track of variable materials costs and manage sourcing in response to changing costs.
Maintaining Product Quality While Cutting Costs
While it might be tempting to slash costs to the bone, manufacturers must always manage costs with a lens toward customer satisfaction. This means managing costs in tandem with quality, which is why lean manufacturing is such a favored approach to manufacturing cost management.
Future Trends in Manufacturing Cost Management
Manufacturing cost management is already a highly specialized financial niche that’s typically led by qualified manufacturing cost accountants who hold certified management accountant (CMA) or certified public accountant (CPA) credentials. As manufacturing processes continue to grow more complex and feel the impact of digital transformation and automation, manufacturing cost management will have to keep pace. Manufacturers that effectively utilize artificial intelligence, data analytics tooling and automation will be better prepared to measure cost performance in real time, establish more sophisticated forecasting and more effectively manage the supply chain at scale.
These kinds of capabilities will be crucial because manufacturing cost accountants will likely face economic headwinds in the near term as they manage JIT inventory. Inconsistent raw material pricing and availability, along with labor shortages and other supply chain constraints, will add variables into the cost equation that will require flexibility and contingency planning best served by accurate and timely data flows, as well as strong analytics capabilities.
Optimize Cash Flows and Minimize Costs with NetSuite Accounting Software
From supply chain disruptions to economic tightening, manufacturers are being called to manage their costs in an increasingly volatile environment. NetSuite Cloud Accounting software provides a solid accounting foundation for manufacturers to implement automated financial controls and reporting to support manufacturing cost management activities. This cloud platform offers manufacturers real-time insights into the financial metrics that feed into cost analysis. Meanwhile, industrial organizations can augment the power of NetSuite Cloud Accounting with NetSuite for Manufacturing, which is purpose-built for manufacturers seeking to optimize cash flows and minimize costs from a single platform. This manufacturing cloud ERP solution provides tools that make it easier to manage procurement, plan production and direct manufacturing processes in a unified fashion.
Manufacturing cost management is a crucial capability for manufacturers to maximize the profitability of their operations. When done well, manufacturing cost management doesn’t just drive down costs. The practice also informs pricing and enables better decision-making when prioritizing the most profitable goods for production over time.
Manufacturing Cost Management FAQs
How do you manage costs in manufacturing?
Manufacturers tend to use a combination of strong accounting practices, data analytics and management frameworks, such as lean manufacturing, to both track and manage costs in manufacturing.
What are the basic manufacturing costs?
The basic costs that go into manufacturing a product include the cost of raw materials; the cost of both direct and indirect labor in designing, producing and shipping products; and the cost of manufacturing overhead.
What are examples of manufacturing costs?
Some examples of manufacturing costs are the costs to buy raw materials, wages for factory workers, rent for factory facilities, equipment costs, supplies other than raw materials, technology and IT costs and insurance and taxes.
What are the three components of manufacturing costs?
The three components of manufacturing costs are direct materials, direct labor and manufacturing overhead.