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Mistakes Manufacturing Companies Make

Mistakes Manufacturing Companies Make

Job costing, cost accounting, manufacturing costs, what does all of this mean? Oftentimes, job costing, cost accounting, and manufacturing costs are used interchangeably. As a manufacturer, it does not matter what you call it. But it is critical that as a manufacturer, you capture all of your conversion costs. Simply put, you are taking raw material and converting it to a finished good that is ready for sale. You need to capture 100% of those cost of converting the raw material. Most small companies start with the most basic bookkeeping, and that’s okay. But there are two huge mistakes manufacturing companies make that you need to avoid.

 

Eventually, you need to have proper accounting transactions and systems to capture all of those manufacturing costs to have accurate margins. Accurate financial statements and margins will allow you to correctly price your product and will allow you to make adjustments to your business. This is helpful when you have a change in prices of materials or labor, or if your volume throughput changes for whatever reason.

Mistakes Manufacturing Companies Make

In my career, I have seen two recurring mistakes manufacturing companies make that are related to accounting process, procedures and systems.

First, a company may not want to spend the time and money to improve their cost accounting and systems. As a result, this company will struggle forever. The managers of that business will not have accurate financial reports, and they will likely feel the pain when markets turn or are in a high growth situation. Remember, cash gets tight when in either a growth or decline pattern, especially if it’s not managed well.

Second, a company wants to improve the manufacturing cost accounting, but they overdo it. They want a report that tracks every penny and part, and they install a massive expensive system. Many times, they install the wrong system for their company because it was marketed as the best accounting system. This happens when companies do not spend the money to go through a system selection process. They all end up spending much more than the cost of the professional system selection and bust their budget.

Best Practices for Manufacturing Companies

As a manufacturing company, please consider the following as a best practices for your leadership to abide by.

Analysis Paralysis

You DO have to capture 100% of your costs to take raw material and manufacture a finished good. However, this does not mean you need a separate dashboard or KPI for every cost item. If it is not material and the outcome of the cost is not going to change your mind or cause you to make a business decision, then you may reconsider trying to measure it. Remember, everything you want to measure has a cost itself of measuring it. Not capturing 100% of the costs can be devastating to your company.  Remember the quote from Benjamin Franklin, “A small leak will sink a great ship.

Many business owners and financial leaders want to measure everything. But you should limit your key  performance indicators to those that will lead to business decisions! Click here to access our KPI Discovery Cheatsheet to identify those indicators that really drive value.

Margins

When you manufacture a product, you have your obvious direct materials and direct labor – measuring Cost of Goods Sold. This is absolutely crucial in a manufacturing company. But there are other costs that you need to measure. I am referring to your indirect expenses, especially your sales, general and administrative expenses. You also want to measure your gross margin and/or contribution margin and your Earnings, Before, Interest, Tax, Depreciation and Amortization (EBITDA). Consider the implementation of analyzing trends based on a trailing twelve months (“TTM”). This will help you spot trends in your business and financially lead your company. Do not forget your balance sheet. Everything ultimately affects cash and working capital.  Without cash and working capital, you will create a financial disaster. Do have KPIs for your balance sheet items that you want to measure.

Systems

Systems are an important part of having a productive and efficient accounting department. It seems that every year there is a new operating system that comes in to the market, and it seems that the developers of these systems want to expand into every market – beyond manufacturing and accounting. With all of these choices and with all of the talented sales people, you need to understand what the choices are for your business. It is worth spending the money to go through a system selection process.

Timing

Timing is everything in manufacturing. Consider the following timing of:

  • Throughput
  • Delivery of the finished good
  • When you modify your standard costs
  • How quickly you close you books and generate financial records that are accurate and serve as a tool to help you run your business
  • Collections so you have cash to place that next order of raw material

Employee Turnover

I recently quoted in a past blog that employee turnover in the U.S. has an average cost of $65,000 per year per employee lost. The number in a manufacturing environment is actually higher because there are often specialty skills that need to be acquired in manufacturing. So keeping a close watch on employee turnover is crucial in a manufacturing company.

Inventory

For whatever reason, inventory seems to be the “Achilles Heal” in many manufacturing companies. Companies either do not properly manage inventory, they have bad practices, or it just seems that it is never right. Once you establish a good process and reconcile inventory, it should be more of a maintenance routine if your people know that they are doing.  Consider the following for inventory:

Be Realistic About Inventory

Be realistic about what is obsolete inventory and good inventory. I know that companies, especially public companies hate to write off inventory.  But you are just kicking the can down the road by not dealing with it now.

Clean Up

Get rid of the junkyard! So many companies I have seen have a junkyard behind the manufacturing facility.  It has been there for years and all it does is accumulate rats, snakes and rust.  Liquidate it and get a scrap dealer to take it off of your hands. You can use that cash for door prizes at the next company party!

Stay Focused

Stick to your business and stay focused. Especially in closely held companies, some business owners waste money on the craziest things. I have saw hundreds of old mopeds (remember, these are bicycles with a weed eater motor) in the back of a large industrial manufacturer. The owner got a “great deal” on them, so he purchased them to resell. The problem is that the initial transaction happened 7 years ago. I also saw a massive specialty machine that cuts steel in the back of a pipe manufacturer because the owner thought he could open a new line of business cutting huge pieces of steel. This machine was two stories tall and weighed thousands of tons. Still to this day, I have no idea how they ever moved it. In addition, the owner never got the new line of business started because there is not a building big enough on his property. The machine has not run in 10 years.

Physical Count

Establish strict physical counts quarterly or at least annually. Have the right team of people conduct the physical count.

Adjustments

Make adjustments to your inventory, and get it over with. Write it up or down in your accounting records.

Segregate Inventory

Segregate your inventory. There is something beautiful about walking into a manufacturing facility and seeing exactly where the raw material, work in process, and finished goods are. Keep obsolete inventory in a separate area that is clearly marked off. Tag and count everything!

Hire a Good Cost Accountant

Cost accounting is a specialty area within the accounting profession. Unfortunately, not every accountant or controller knows cost accounting. Yes, hopefully most accredited accounting programs at universities cover cost accounting, but that does not mean the person you are hiring is a cost accountant. Someone with good manufacturing experience and understands cost accounting is worth his weight in gold. This person will add value to your bottom line.

In the meantime, start measuring and tracking your KPIs. Download our free KPI Discovery Cheatsheet and start tracking your KPIs today!

Mistakes Manufacturing Companies Make
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Mistakes Manufacturing Companies Make

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Brexit: Why should you care?

Britain’s exit from the EU, commonly nicknamed Brexit, is one of the most discussed issues over the past week; particularly when it comes to the financial implications of Brexit and how it impacts business.

financial implications of brexitFor the first time in its existence, the European Union (EU) has lost a country from its (previously) 28-country politico-economic union.  News reports have been answering the most Googled questions: What does Brexit mean? What is the EU? Should Great Britain leave the EU?

Truth is, there are dozens of financial implications that businesses are going to have to contend with, regardless of whether they are based in the US or other countries. With Britain as the 5th largest economy in the world, it is bound to have a direct impact on the United States. The US currently has the largest economy in the world. Because it can be slightly overwhelming to understand what Brexit means for business (with the term “Brexit” returning over 213 million Google search results and counting), we’ve narrowed it down to 4 macro issues.

  1. Labor
  2. Stock
  3. Trade
  4. Regulation & Innovation

We’ve chosen to examine these issues because, regardless of whether you’re a domestic firm or a multi-national corporation, they could have either a direct or indirect impact on your company.

Labor

It’s a no-brainer that you need people (labor) to run a business. With labor, comes skill. In a recent article, The Guardian analyzed what the financial implications of Brexit are and, more specifically, how the talent pool is anticipated to shrink in the coming months or even years. The United Kingdom (UK) is experiencing a skill gap in many professional positions, such as IT. GB has failed to produce skilled workers or laborers internally. Many of the roles that require these types of skill are held by immigrants from other countries in the EU. The Guardian quoted Bhuwan Kaushik, CEO of Spectromax (an IT-based company), saying:

“The impact of the Brexit will be sizeable and long term. There’s a huge IT skills gap in the UK. It’s going to take a number of years to close it. Leaving the EU at a time when the UK is in need of skills will be a huge blow to UK businesses, let alone the commercial opportunities that may be lost and could consequently stunt UK startup growth.”

So why does this matter?

Because labor matters regardless of what industry you’re in and what type of labor you require (skilled or unskilled labor). Even if you’re an American company who does not do business with other countries, it’s time to start digging a little deeper. Research the origins of your suppliers and their suppliers. Find out where your customers and their customers are located. You will likely find that somewhere in your supply chain there is someone who will be affected by Brexit and the effects will make their way to you.

Like I always say, pick your head up and take a good look at the world around you.  Just like the bullwhip analogy in a supply chain, one small ripple in the whip can cause huge results.

financial implications of brexit

Woodford Investment Management’s Report on Brexit

Immigration

With Europe experiencing the worst refugee crisis since World War II, this splintering of the EU is going to shock their already frail economy. In addition, they will continue to grow unemployment rates (The Independent). The Treaty of Lisbon (originally created in 2007) created stronger immigration policies to regulate those immigrating from “third countries” or in other words, countries outside GB. This treaty also set the procedures for countries who decide to leave the EU.

Now that GB has voted to leave the EU, they will start to transition into a third country position. This can result in immigration policies being enacted by the British Parliament. Travel between GB and EU may not be as easy as once before.

Stock

With any political action that causes major uncertainty and doubt in the market, it’s reasonable to expect that investors are going to react. Most investors are willing to take calculated risks, but when the final vote for Brexit tallies at 51.9% Leave vs. 48.1% Stay, the market becomes a scary place.

The day after voting day on Brexit, the pound fell to the lowest value in 3 decades. Oil dropped on Friday as well. Almost a week later, the stock market is only slightly bouncing back.

With the financial implications of Brexit panning out, London’s title as a global financial hub is being threatened as many investment banks are considering moving their headquarters to Frankfurt or Paris. This will not only impact GB’s stock market, but increase unemployment. The Financial Times has already reported that some of the major US banks (JPMorgan Chase, Goldman Sachs, and Morgan Stanley) are moving their operations to other financial hubs within the EU.

We expect Foreign Direct Investment (FDI) to decrease as the GB renegotiates its relationship with the EU. Assuming that Britain comes out with favorable terms, we expect FDI to rebound and recover the loss during this time period.

(During these uncertain times, it’s critical that the CEO has a wingman. Download our How to be a Wingman Guide to learn how to be a trusted advisor your company needs.)

Trade

Out of the many financial implications of Brexit, trade is most likely going to be the most important macro issue addressed.

Let’s talk a little about tariffs on imports and exports. If you have a facility in the EU and need something from GB, then you’ll now have to accommodate tariffs within your selling price. EU tariffs on exports were cut about 50% since the 1990s. Great Britain is in a good position at this time with exports.

Manufacturing

Going back to our conversation about labor, take a look at the manufacturing connections between GB and the EU. This division may result in higher manufacturing costs not only to cover new export/import tariffs, but costlier labor in GB as well.

Caterpillar, a heavy machinery company, owns a manufacturing facility in GB that employees over 9,000 employees. GB was a strategic location for them to optimize GB’s free trade relationship to the rest of the EU and their close proximity to customers in Europe, Africa, and Asia. What once was a competitive advantage is now in question. The Independent illustrates that this decision to approve Brexit has a ripple effect that will impact companies across the world.

Capital Economics contracted Woodford Investment Management to research the possible impacts that this separation of Britain from the EU would cause. They found that 63% of Great Britain’s exports are tied with EU members. While this most likely will not turn into anything more than an increase of tariffs, GB has 2 years under the Treaty of Lisbon to negotiate their withdrawal agreement. This is similar to a divorce followed by custody agreements.

Regulation & Innovation

There are no strong theories of how regulations might change. But it is important to be aware of changing regulations, especially when it comes to manufacturing facilities, imports, and exports. Expect security to strengthen in GB. As a result, it may result in new taxes or security measures to compensate.

Great Britain, as the 5th largest economy in the world, is not in a position where all of its innovation and brain power has disappeared with their split from the EU. GB may come to a stage where they will partner with the US and other countries to create a pool of innovation and ideas.

What impact does Brexit have on you? 

As everything unfolds within the next two years, look at your projections. Understand that if you have any international connections, you may be facing financial implications.  Be sure to adjust them as needed while keeping an eye on the economy.  Now more than ever, solid future planning can be the difference between weathering the storm or getting swept away.

Just like during any period of uncertainty, it’s important to recognize the opportunities presented.  Take stock of your operations. See if there are things you can do to strengthen your business while everyone else is chasing their tails.  The uncertainty caused by Brexit is similar to that we discussed in the Trump Effect Part 1 and Part 2 and many of the same strategies can be employed to deal with or take advantage of it.

Conclusion: Financial Implications of Brexit

By addressing these 4 macro issues, you’ll be better prepared to reduce the impact of the unpredictability of big events. Some of these big events include presidential elections and the 5th largest economy leaving the only fully economically-integrated union in the world.

In any event, try to narrow possible areas of influence down to 4-5; then start drawing out all the consequences.  This will not only leave you feeling more prepared for the battle. But it will also reduce the stress the people in your company may be feeling.

After being in the financial sector for over 25 years, I’ve learned that stuff happens in the world and we always find a way to move on. Times are tricky and the future is murky, but fortunately, it’s not the end of the world. As the financial leader, it should be your priority to guide your company during this process of analyzing how economic decisions like Brexit will impact your business.  Acting in this way, you become your company’s wingman.

It’s vital for you as the financial leader to be the trusted advisor your company needs. If you’re uncertain about where to start, I’d like to offer you a free white paper on How to be a Wingman.

HOW TO BE A WINGMAN

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financial implications of brexit

With all the drama caused by Brexit, we wanted to give you something to laugh about! Here are a few of our favorite jokes and memes that have come out of #Brexit.

financial implications of brexit

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Work in Progress

What is Work in Progress?

In accounting, a work in progress (WIP) account is an inventory account that includes goods that are in the process of being produced but are not yet finished. This account represents the costs of resources used but not yet turned into completed products. Also refer to the work in progress account as work in process. It is one of the inventory accounts commonly used to track the flow of costs in a production process. Other common inventory accounts include raw materials and finished goods. Inventory accounts are reported as current assets on the company’s balance sheet. Use these accounts for internal analysis as well as external financial reporting.

Cost of Goods Manufactured Calculation

Compute the cost of goods manufactured in a fiscal period using cost data relating to the work in progress account. Simply start with the beginning balance of the work in progress account. Then add the costs of resources transferred into the account during the relevant period. Finally, subtract the ending balance of the work in progress account for that period. As a result, you will get the cost of goods manufactured for that period.

Cost of Goods Manufactured = Beginning Balance + Transfers In – Ending Balance

Flow of Costs

Costs that are represented in the work in progress account include direct materials, direct labor, and manufacturing overhead. As work proceeds in a production process, costs flow from the raw materials inventory account, into the work in progress inventory account, and then into the finished goods account. Represent all of these costs as current assets in inventory accounts on the balance sheet. Once you sell the finished goods, transfer the associated costs to the cost of goods sold account on the income statement.

Raw Materials → Work in Process → Finished Goods → Cost of Goods Sold

Just-in-Time and WIP

The work in progress account represents a cost to the company. These costs are storage costs and obsolescence costs. But holding inventory is costly – it takes up storage space and requires supervisory monitoring. The longer a company hold goods in storage, the higher the risk of these goods becoming obsolete. Therefore, they will decrease in value. Just-in-time inventory system strives to minimize the amount of inventory held in the work in progress account. Therefore, it reduces the costs associated with holding inventory.

work in progress

Source:

Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008.

See Also:
Balance Sheet
Working Capital
Working Capital Analysis
Income Statement
Throughput
Inventory Shrinkage

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Vertical Integration

See Also:
Horizontal Integration
Business Cycle
Business Segment Reporting
Mergers and Acquisitions (M&A)
Business Intelligence and Finance

Vertical Integration

What does vertical integration mean? Vertical integration is the process or a company’s domination of every aspect of the production line or process for a particular product. This includes the extraction of raw materials to manufacturing, and the sale of the finished product.

Vertical Integration Explained

Vertical Integration was first used in business practice when Andrew Carnegie used this practice to dominate the steel market with his company Carnegie Steel. It allowed him to cut prices and exhuberate his dominance in the market. Currently, this is considered a vertical monopoly and is illegal as an entity.

There are currently three types of vertical integration in the marketplace. The first known as backward integration means that a company possesses control over the first parts of the production process. These can range from raw material possession or production to the manufacturing process. The second form of vertical integration is forward integration where a company maintains control over the forward parts of the production process like distribution and selling of the finished goods. The last of the types of vertical integration is balanced integration. This type of integration contains all parts of the production process, and is also referred to as a vertical monopoly.

Vertical Integration Example

Chris owns a wooden furniture company which is responsible for the manufacture of wooden furniture products to several retailers around the United States. Recently Chris’s company has undergone some strains on its profit margins from the timber companies that supply the company to the retailers who are trying to cut their own costs. Chris has thus decided to vertically integrate to try and enhance his profit margins because if he doesn’t he sees his company going out of business. Thus Chris buys one of the larger retailers so that he can immediately use the large distribution and selling centers around the nation. By doing this Chris can charge a higher price because he is now selling directly to the customer. He can also see a reduced cost for his distribution points.

Learn how you can be the best wingman with our free How to be a Wingman guide!

vertical integration

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vertical integration

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Why Don’t I Have Cash?

See Also:
Cash Cycle
Cash Flow Statement
Free Cash Flow
External Sources of Cash

Why Don’t I Have Cash?

I was involved in a meeting with a prospect a few weeks ago who we will call Don. Don owns a manufacturing company which is presently experiencing a growth rate of thirty percent annually. He is showing a profit, but his bank will not increase his line of credit. As a result, Don’s company is having cash flow problems. He told me that he has to extend payments to his suppliers, but they are not happy with him. Don also told me he is unable to call most of his customers for payment, because they are within their credit terms; he feels he would be harassing them. He asked me “Why don’t I have cash?”

Operating Cycle Trap

I told him he was caught in what I call the operating cycle trap. Don looked at me and said “What is that?” I told him his operating cycle is; 1) the time from when he first purchases raw materials, 2) converts the raw materials to a finished product, 3) sells the finished products, 4) converts the accounts receivable to cash. I continued by saying your problem arises when the operating cycle is greater than the credit terms you receive from your suppliers.

The operating cycle problem is increased when your bank, being a historical lender, bases your line of credit on what your company has done in the past, not the opportunities in front of you. They will not increase your line of credit. Finally, your profit margin is not large enough to fund your current growth rate. Don looked at me and said “Is there anything I can do?”

Alternatives to Improve Cash Flow

I said, “Yes, Don you do have some alternatives.” If possible, the way to solve this problem, at no additional cost to the company, is to get your suppliers to give you longer credit terms. Then, give your customers shorter credit terms. This will shorten your operating cycle, and a goal for any business should be to minimize their operating cycle. Don said “I know that will not work because my creditors are asking me to pay faster and the competition within my industry will not allow me to shorten my credit terms to my customers.”

Another way to solve your company’s needs is to consider approaching another bank that may take a more aggressive approach to increasing your line of credit. He then told me that he has been to three different banks. They all said they think they will be able to increase his credit line. The end result has been every bank has either a) they want Don’s business, but the line would be the same as his current line of credit, or b) the increase was so small it really wouldn’t solve his problem. I told him that is what I would expect. Bankers’ underwriting policies for lines of credit are similar.

A third solution would be to get an equity partner. A person or entity would invest the amount of cash to pay the bank off and to fund your projected growth for three to five years. He looked at me and said “The last thing I want is a partner.”

why don't I have cash

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Semi Variable Costs

Semi Variable Costs Definition

Semi variable costs are costs that include both a fixed and a variable component. They are also called mixed costs.

Semi-Variable Cost Example 1

For example, let’s say you subscribe to a phone service that charges $40 dollars per month, plus $0.10 per minute for each additional minute beyond 500 minutes per month.

If you talk for less than 500 minutes per month, then the cost is $40 dollars per month. Beyond 500 minutes, the cost increases. This is an example of a semi variable cost. The flat rate of $40 dollars for 500 minutes is the fixed cost component. The additional $0.10 per minute for each additional minute beyond 500 minutes is the variable cost component.

Semi-Variable Cost Example 2

Here is an example of a slightly different type of semi variable cost. For example, let’s say a manufacturing company has an electric bill that uses semi variable cost, including a fixed cost component and a variable cost component.

The electric company charges the manufacturing company a flat monthly rate of $300 dollars per month for basic electricity service. Then they charge $0.015 per kilowatt hour (kwh). In this example, the flat rate of $300 dollars per month is the fixed cost component. And the variable cost component is $0.015 per kwh.

If the manufacturing company uses 50,000 kwhs of electricity in a particular month, then its electric bill would be $1,050 dollars. ($1,050 = $300 + ($0.015 x 50,000kwhs)). And if the manufacturing company uses 100,000 kwhs of electricity the following month, then its electric bill would be $1,800 dollars. ($1,800 = $300 + ($0.015 x 100,000kwhs)).

Accounting Treatment

Cost accountants typically separate semi variable costs into their two distinct components – the fixed cost component and the variable cost component – when dealing with semi variable costs. Treat the fixed cost component separately as a fixed cost. Then treat the variable cost component separately as a variable cost. This may cause a differentiation of cost that does not reflect economic reality, but it makes it easier to handle and examine the effects of semi variable costs.

semi variable costs

Source:

Barfield, Jesse T., Michael R. Kinney, Cecily A. Raiborn. “Cost Accounting Traditions and Innovations,” West Publishing Company, St. Paul, MN, 1994.

See Also:
Variable vs Fixed Cost
Absorption vs Variable Costing
Product Costs vs Period Costs
Sunk Costs
How to Estimate Expenses for an Annual Budget

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Standard Cost

Standard Costs Definition

Standard cost accounting is a goal or budget costs that is associated with variable costs. They are also used to measure the cost that management believes that it will incur over a period.

Standard Costing Explained

In short, standard costing takes the direct labor, direct materials, and manufacturing overhead, and estimates the cost over a quarter, year, or whatever the period may be. This is similar to budget costing, but is different in that budget costs account for a total cost while a standard cost estimate is on a per unit basis. Therefore, if a standard cost estimate turns out to be correct, then the total cost would turn out to be equal to the budget cost. But, this sort of thing never happens.

Standard Cost Formula

The standard cost method can be broken down using the following formula:

Standard Costs = Direct Labor * Direct Materials * Manufacturing Overhead

Where:
Direct Labor = Hours Worked * Hourly Rate

Direct Materials = amount of materials * market price

Manufacturing Overhead = Fixed Salary + (Machine hours * Machine rate)

Note: All but the fixed salary component of overhead must be predicted given the market conditions on demand and cost of the materials. It should also be noted that this is the same formula for the manufacturing costs, but the difference lies in the fact that Standard costs accounting is done on a predictive basis.

Standard Cost Example

For example, Jenny is an accountant that was given a task by her boss, Craig, the CFO to calculate the standard cost of the company for the upcoming year 2010. The following past information for Wawadoo Co. was given to her to try and calcualte the standard cost for Wawadoo’s product called the widget.

Direct Labor-2009
AVg. Labor Hours= 1,960 hours per employee
Avg. Hourly Wage – $10
Number of employees = 47
Total Costs= $92,120

Direct Materials-2009
Material Units=20,000
Avg. Market Price= $20
Total Cost= $400,000

Overhead-2009
Fixed Salary per Manager= $80,000
Number of Managers= 5
Number of Machine hours= 1,000
Hourly Machine rate= $2
Total Cost=$410,000

Jenny’s Boss, Craig, believes that the overall demand for widgets will increase by 5% and the price and number of units needed will increase by the same amount. He also believes that there will be a need for 8 new employees as well as a new manager.

Jenny finds the following:

Direct Labor= 1,960 hrs.* $10/hr* 55 employees= $1,078,000
Direct Material = $21 mkt price* 21,000 units= $441,000
Overhead= ($80,000* 6) + (1,000 hrs.* $2/hr* 6) = $492,000

Total Standard Cost= $2,011,000 cost for the year

standard cost

See Also:
Manufacturing Cost
Cost of Goods Sold (COGS)
Overhead Definition
Direct Cost vs. Indirect Cost
Variable Cost

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