Most owners of a manufacturing business know their gross margin without looking it up. Ask which customers and which parts earn that margin, and which ones lose money, and the answer usually comes from memory. The cost system was never built to say.
If you ask the owner or chief executive of a private company whether all of the company's customers are profitable, most will respond "yes."
The company margin is an average. It is a fair number for a banker and a poor one for deciding which orders to take, because the work underneath it varies far more than any average can show.
How standard cost hides the loss
Standard costing does a real job. It values inventory, and it lets a sales team quote in an afternoon. To do that, it takes the overhead of the plant (supervision, maintenance, setups, inspection, scheduling) and spreads it across every part at one rate, per labor hour or per machine hour. Plante Moran’s phrase for it is costs “peanut butter spread” across the entire factory.
The spread flatters some work and hides the cost of other work. A part that runs twice a year in lots of fifty carries the same overhead rate as a part that runs every week in lots of five thousand. The short run used a setup, a first-piece inspection and an hour of somebody’s schedule, and the long run paid for them. On the margin report, both earn the plant average.
The standards also age. They carry the material and labor rates of the year they were set, so it is worth asking when yours were last updated. Raw material costs were manufacturers’ top business challenge in each of the last two quarterly surveys by the National Association of Manufacturers, and the latest one looks ahead:
Manufacturers expect costs to continue rising, with raw material and other input costs projected to increase 5.0% over the next year.
A standard left alone for a year will price next year’s work at this year’s cost, and every quote built on it carries the same error.
What the real shape looks like
When each customer is charged for what it uses, profit rarely comes out as a gentle slope. The accounting firm Kreischer Miller cites a 2001 study by Harvard Business School professors Robert S. Kaplan and V.G. Narayanan that found this:
Generally, the top 20 percent of customers generate 150 to 300 percent of the total profits, whereas the middle 70 percent of customers break even and the bottom 10 percent of customers reduce firm profits by 50 to 200 percent.
For an owner, that means a fifth of the customers earn more than the whole company does, most of the rest break even and the bottom tenth give a large share of it back. A healthy company margin can sit on top of all three. Parts tend to follow the same shape, for the reason above: the short runs are carried by the long ones.
Start before the cost data is perfect
A common reason owners do not look is that the data is not good enough. The system holds standards rather than actuals, and a full re-costing project sounds like a year of spreadsheets. So the question waits for a better system, and new orders keep getting quoted on the old numbers.
You can start with numbers you already trust, in two passes.
- Sort by what the system already knows. Revenue by customer and by part, and the hours each one takes on the machine or line that limits your output. Neither number depends on how overhead was spread.
- Re-cost the top of the list. Take the customers and parts that carry most of the revenue and cost them on what they use: setups, run length, scrap, expedited freight and special terms. That is a short list, and the rest of the catalog can wait.
The first pass shows where your scarcest hours go, and the second shows what they earn. That is enough to act on, and it gets more exact as better cost data comes in. What we would not do is run an 80/20 on the standards as they stand and act on it, because it inherits every distortion described above. That is why a Profit Survey counts the cost to serve each customer before it ranks anything.
Keeping the answer current
One read answers the question once. Prices, material costs and the mix of orders move every month, so a read done in the spring is out of date by the fall unless someone on your team owns it. That is a separate problem, and we wrote about it in Why cutting one item at a time fails, and what to do instead.
Where to start
The Growth Check takes about fifteen minutes. Two of its questions ask which customers and which products make up two-thirds of your gross profit. If you cannot answer them from a report, say so. That answer tells us where to look first, and we read every response ourselves and reply by the next business day with what stood out.