top of page
Search

Standard Margins - Management Tool for Operations Effectiveness Management and Pricing.

Most of the time when we hear about margins, we hear about Gross Margins. I’d like to talk about Standard Margins. These are mostly applicable in manufacturing or production type businesses across various industries.

Standard Margin – is based on “standard input costs”, other words what it takes to produce a product based on a bill of materials (i.e. your product recipe) and inputs of known and estimated figures. For example, wage per hour is known, but how long it may take to make or pack a unit is an estimate.


Think of a Standard Margin as your ideal margin on a product sold when everything went according to plan under nearly full capacity utilization.

The notion of estimates vs. knowns is one of the two underlying differences between Standard and Gross Margins.


The two underlying are as follows:


(I) Estimated cost based on history and making assumptions – what becomes your bill of material (BOM) or a list of STANDARD input costs needed to build a product. These cover you labor, raw materials and packaging.


(II) Variances associated with your assumptions in (I) and what actually happened, i.e. how much of material was used, how long it actually took workers to produce, pack and ship product.


Gross Margin – is your Standard Margin less any variances associated with estimates and what actually happened.

Gross Margin – is your Standard Margin (always higher than Gross Margin) less any variances associated with estimates and what actually happened. Think of a Standard Margin as your ideal margin on a product sold when everything went according to plan under nearly full capacity utilization.


Why is this important? Standard Margin, is used for 2 main reasons – (A) Pricing and (B) Operations management.


So, how are these used?


(A) Pricing –knowing your standard input costs, helps you to maximize the price per unit aligned with the demand of your product category.


(B) Operations Management – think of it as setting a “standard margin” or what should happen if everything goes according to plan vs. what actually happens. The variances analysis helps management determine areas and degree of improvements needed to run operations as efficiently and effectively as possible.


It must be noted that setting standard costs needs to be done only once a year. Best practice is end of year analysis and revisions leading to standards reset on January 1st. This sets an expectation for performance that will be measured against actuals in the months to come.


Lastly, we should discuss different types of variances. At a high level, there are three types of variances: Materials, Labor and Overhead. Without getting into the definitions of direct vs. indirect costs, let’s see why these three variances matter.


- MATERIALS Variance: helps you determine whether you’ve considered all of the raw material and packaging cost increases, AND as well as how much of it was actually needed to produce 1 unit. Your assumptions of scrap and yield loss goes here as well.


- LABOR Variances: similarly to materials variance, labor variance helps to see if the management passed all of planned and potential compensation related increases, AND consideration had been given to how long it takes to produce and pack 1 unit.


- OVERHEAD Variance: otherwise known as FMO or Factory Manufacturing Overhead variance, refers to the use of plant and production capacity. There will always be an allocation of a standard overhead use per unit within the standard cost. FMO variance would tell you (1) the degree of plant/production capacity utilization and (2) what volume you’d need to maximize the capacity.


It is important to point out that inventory valuation (average cost, standard, LIFO/FIFO) although is related to this discussion, has a different purpose for accounting and reporting.


Standard vs. Gross Margin analysis is used as a management tool to analyze the performance and areas of improvement of a manufacturing facility.


-A.G.

61 views0 comments

Recent Posts

See All

תגובות


bottom of page