Many of our clients over the years have been manufacturers, makers of the products they sell – cosmetics, automobile parts, aerospace components, etc. Some of those manufacturers, notably in the aerospace field, make products to meet the design specs of their customer, generally on a negotiated cost-plus-markup basis.
One of the biggest challenges they encounter in making someone else’s product is knowing what price to charge for a component, perhaps one they’ve never made before. Given enough details they can determine the process of making it, and if they add the direct labor cost, materials used, subcontractor add-ons, and a decent markup, they make a profit when they deliver. If they do it well and deliver on time, they become a trusted supplier and might make that same component for their customer for years.
A corollary to that scenario might be a re-order of a product that was made in the past, trying to determine what price to charge for a re-order in today’s world of rising costs, supply shortages and all the rest. Charge the same price for the same product while their costs continue to rise? Not a great idea.
The answer in both situations is in having a firm grasp on today’s costs, and being able to translate them into a formula that captures them and is easily updated as circumstances change. The best manufacturers have learned that the best practices method of doing that is to maintain a current Labor Shop Rate, the amount they will charge a customer for each hour of direct labor that goes into making the product. Keeping that one metric current, bidding with it, and sticking to it in contract negotiations is key to the profitability of countless manufacturers, from small machine shops to major aerospace giants.
So what to keep in mind as you develop a labor shop rate that will reasonably assure you a profit – if you can make the product in the number of hours you estimate? Here’s our recommendation:
- Have a proven calculation process that captures the actual cost of direct labor
This is a really important piece of arithmetic. Using the direct labor hours that go into making each product, lay out a template to make sure you recalculate your labor shop rate the same way every time. That way you will know you’ve covered everything that should be included. Then re-calculate often – we suggest at least quarterly. Then compare your newest calculation with the prior ones for variances that may indicate a boost in costs that could hurt your margins or the need to exercise better cost control. Tip: if you’re not closely tracking labor costs for each product you produce, the result will be largely meaningless.
- Don’t forget your non-manufacturing costs, and your markup
When you use your labor shop rate for bidding, the rate you base your bid on has to cover everything. So your calculation process should include your cost of doing business. That means not only direct costs of manufacturing, but also overhead, marketing, selling, general and administrative expenses. AND your markup! Think of it this way: your labor shop rate is the price tag on your products, and your customer is going to pay what’s on the price tag. No add-ons or extras. If you don’t build a profit into your price tag, you’re subsidizing your customer’s profits instead of yours.
- Labor Shop Rate X the number of direct labor hours per piece X the number of pieces in the order
That’s your bid. Now quote your customer with confidence, knowing you can deliver what they want and make a fair profit doing it.
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