by Scott Stratman
Standard costing is a strategy that has been around for years. It has helped distributors realize the greatest return on their inventory investment. While not a cure for strong inventory management practices, standard costing does help recover some of your unanticipated expenses.
Standard costing, in its simplest form, is executed by taking the actual cost of a product paid by you to the vendor, and increasing that cost by a standard costing factor (percentage). That new cost, always higher than the actual cost, is what you then use to calculate your pricing matrix.
For example, if you paid the vendor $10.00 for an item, and you implemented a 3% standard costing factor, then you would use $10.30 as the base cost for establishing your customer pricing. If you wanted to earn a 30% gross margin, then you would price the item at $13.09 instead of $13.00. It may not sound like much, but remember, you are getting the extra few cents every time you sell the item.
Standard costing is a great way to add additional dollars to your bottom line. While it would be nice if every additional penny we added to the standard cost went directly to the bottom line, that, unfortunately is not the case. Think of standard costing as creating a "rainy day" fund. Any additional cash you accumulate can be used to offset those unexpected expenses that continually haunt you. One big one that we often pay for out of net profit is redoing an order that we picked wrong, shipped wrong or possibly damaged. These happen every day, and having a little cash cushion to offset them is nice.
Look at possible areas in your business where standard costing can make you a few extra bucks.
When you are implementing standard costing, you are in effect raising your prices and increasing the base cost of your inventory. In other words, your inventory value will be overstated for all items where you are using standard costing. This requires you to maintain two cost records for those items. The first would be the actual cost paid to the vendor for the item. This is obvious for accounting and tax reasons. The second record is the standard cost basis, where you have decided to increase the cost by a certain percentage. When calculating prices, you would be using the standard cost record as your basis. We have then, in fact, bumped our prices on certain items, and will continue to reap the benefits of a higher cost basis each time those items are received.
The trick is to figure out if the standard costing method is right for you. Some distributors deal in a world of "commodity" items, or "street priced" items, whereas the price for the item is the same no matter which distributor is selling it. In other words, the "price on the street" is $7.00 for this wrench.
There might not be much room to increase the price of commodity priced items. However, look at all the items in your inventory that are clearly not commodity items. There are thousands of them. This is why the standard cost concept can be beneficial to you. In some cases, you can apply a higher standard cost percentage if you are one of the few, or maybe even the only distributor in the market carrying that line.
Standard costing is a great way to set aside a few extra bucks to cover some of your other unexpected expenses. You might also notice an increase in your realized gross margin. Both sound pretty good to me!
Scott Stratman is vice president, business development, for Tech Systems Inc. He has an extensive background in working with distributors around the globe. Many distributors are familiar with Scott from his previous role as founder and president of The Distribution Team Inc.Contact him at Scotts@techsystems.biz.
1)Sales people may see Standard Costing as a tool for screwing with their compensation. If they are paid on gross margin - the margin shrinks.
2)Sales team oriented price pressure still pushes against the margin - only this time it's an artificial number. When the sales team knows a "standard cost" method is in use, they use it as an excuse for further pricing cutting.
3)Standard costing makes no distinction in customer size, customer type or price sensitivity.
Back in the 1980s, standard costing made sense. It is simple, easy and at least a little bit effective. Today's modern business systems allow us to really create a pricing strategy - a process. The computer system does the heavy lifting - you reap the rewards. And, according to David Bauders of Strategic Pricing Associates, "...distributors see a two point increase in gross margin when a process is put in place." That's too big to ignore.