Bidding 101 for the metal fabrication job shop in "new now"

Costing estimates what a job costs; pricing is about determining what the customer is willing to pay. Accurate costing and smart pricing create a sustainable business. Getty Images

The past six months have been difficult and trying for most fabricators. The pandemic and subsequent economic ramifications have left many small and midmarket fabricators reeling. Some have had to realign core business functions in the front office and on the shop floor, considering new health guidelines for social distancing or the desire for employees to be able to work remotely.

During times of economic uncertainty, it is vital to get the business fundamentals right. One of the fundamentals of a successful business during the “new now” is ensuring that you are estimating and pricing your services at a level that ensures the company maintains positive cash flow (as much as possible) and is covering the cost of doing business.

Costing and pricing are different but complementary concepts. Cost is the expense a company incurs to make a product or deliver a service. The cost of fabricating a part typically includes direct materials, direct labor, and a provision for other fixed and variable expenditures directly related to manufacturing operations. Pricing, on the other hand, is the amount of money that a customer is willing to pay for the product or service. The difference between the two is the gross profit, which the business can then use to pay other normal and usual business expenses.

Two things are critical to run a profitable operation. First, you need to understand the manufacturing costs incurred and how to apportion them to the parts that you produce correctly. Second, you need to understand how to price your work effectively, based on what your customers are willing to pay, and ensure a positive inflow of new orders.

Determining Manufacturing Cost

Some fabricators find it difficult to develop a framework or approach to allocate manufacturing costs to specific parts or orders—especially those costs not directly attributable to particular parts or production runs. The traditional standard costing approach used by some legacy enterprise resource planning (ERP) or accounting systems will not meet the costing requirements of a custom, make-to-order, or mixed-mode manufacturer.

Standard costing assumes that parts are repetitively manufactured, often in high volumes, with minimal variation in the labor or material consumed and the cost of those resources. In many fabrication shops, however, where the price of the material may fluctuate significantly or the employee involved may vary either based on manufacturing process or skill set, standard costing typically falls short.

Say you’ve received a request for quote (RFQ) for a part that you have never fabricated before. The part requires several internal operations, an external subcontracted service, inventory that will be pulled from stock, and special material that will be sourced directly for the order. To understand the cost of the part, you need to know the employees who will fabricate the part and the cost of operating each machine. You select what cost should be used to cover the inventory required for the part, then determine the cost of ordered material and outsourced services.

Direct and Indirect Labor Costs

Direct labor costs are directly attributable to the employees manufacturing the part. Because the direct labor costs may vary based on the operations required to produce the part, it is important to consider them by manufacturing process or activity. And if one employee will set up a machine before another employee operates it, you may want to segregate direct labor setup costs from direct labor run costs.

To correctly determine direct labor costs by operation:

1. Consider all employees that may do the setup for a specific manufacturing process. Average their hourly wage to determine the average setup cost per hour.

2. Consider all employees that perform production for a specific manufacturing process. Average their hourly wage to determine the average production cost per hour.

3. Consider all additional direct labor overhead costs for the past year across all employees for that process or work center. These costs should include any company-paid expenditures such as payroll taxes, 401(k) matching, employer-paid insurance, and vacation/holiday/sick pay. Once you determine the total overhead cost, divide the result by the total direct labor hours expended during the same period to arrive at the direct labor overhead cost for the operation.

Indirect labor costs may not be attributable to a process but are required for the efficient operation of the factory or shop floor. These costs might include wages for supervisors or other operational support personnel. A simple allocation of their cost would be to divide the total labor and overhead cost for the year by the total direct labor hours in the shop for the year to arrive at a single hourly cost that is then added to each work center.

Direct Machine Costs

Direct machine costs are directly attributable to the machines used for each fabrication step. Machine resource costs should include all the costs associated with efficient operation, including the cost of the machine, lubricants, maintenance and repair costs, and depreciation.

Hourly machine cost calculations vary across the industry, but most share some common threads. First, they incorporate the “real” costs that wouldn’t be incurred if the machine weren’t on the shop floor. This can include electricity consumption, lubricants, and expected maintenance and repair costs. Machine cost calculations also incorporate accounting items like depreciation or “investment payback” costs, with rates based on the desired return on investment (ROI) for a particular machine.

Again, all this depends on the shop, the types of jobs it processes, and the technology it uses on the floor. Regardless, most operations account for machine costs in some way in every estimate. And much like direct labor, the total machine cost for the period should then be divided by the total machine hours expended for the same time to arrive at an hourly machine rate.

Direct Purchase Materials or Subcontract Services

Any material purchased directly for the order or any subcontracted service used to manufacture the part should be costed based on the actual purchase price. Keep in mind that this cost should include not only the cost for the actual material or service used, but also expenditures incurred to source and transport the material.

Stock Inventory

The final cost consideration is what cost to use when the material is pulled from the existing stock inventory. Again, many legacy ERP and accounting platforms were not designed to support different costing methods for inventoried material. Some may only support standard costing. Typically, standard inventory costing should be considered only if the material is bought under a long-term contract, and the costs remain fixed or fluctuate infrequently.

Stock inventory should be evaluated based on how many inventory turns occur over the course of a year. Based on the frequency of those inventory turns, the associated costing method should be chosen. For fast-moving inventory, last cost or last-in/first-out (LIFO) is likely the best choice. For slower-moving inventory, standard cost or first-in/first out (FIFO) is probably the best choice. For any material that is lot- or serial-controlled, the actual cost of that specific lot or item is likely the best choice. Many modern ERP platforms today now support the ability to specify the costing method at the individual-item or item-family level.

Determining the Selling Price

When determining how a part should be priced or quoted to a customer, fabricators often resort to a “cost-plus” approach. In other words, once the cost is determined, the result is “marked up” by a certain percentage across the board or by individual cost element.

That said, markup and margin are not the same, though both are calculated using profit, or the difference between the selling price (revenue) and cost. Markup percentage is profit divided by cost, while a margin is profit divided by revenue.

Say you sell an item that costs $100 to make for $115 (your revenue):

So here, a product marked up 15% makes a 13% margin. To reach a 15% margin, you’ll need a higher selling price:

Say you sell an item that costs $90 for a price of $100. That 11% markup ($10 profit divided by $90 cost) achieves a 10% margin ($10 profit divided by the $100 price)—a seemingly small difference that, combined with razor-thin profits on numerous jobs, can brutalize a P&L statement and wreak havoc on planning. At the other end of the spectrum, if you sell an item that costs only $30 to make for a price of $100, that 233% markup achieves only a 70% margin. Yes, most fab shops would kill for an “only” 70% margin. Regardless, it shows how different markup and margin calculations are.

When pricing, you need to decide whether you want to aim for a specific markup or margin. In the markup method, cost is in the driver’s seat. You squeeze as much cost out as you can, aim for a specific markup, then price accordingly. However, is pricing based solely on a markup the most logical approach, especially in tough economic times?

What the Market Will Bear

In challenging economic times, knowing the competitive landscape is more critical than ever. Knowing how your competitors are pricing similar (or the same) products and services should be another data point when determining the selling price of your product. Pricing using a cost-plus approach without considering what the competition is doing can be a recipe for disaster. You may be spending significant time and resources only to lose the quote because you overpriced for what the market will bear.

In uncertain times, it is especially important to analyze how your prices for similar products compare against your competitors and take corrective action when necessary to win more business, if prudent. Of course, the challenge is always to not merely meet your competitors’ prices and become known as the low-price alternative. In fact, fabricators should never fall victim to being the low-price alternative to the competition. It can be a difficult and potentially dangerous position to maintain. Customers need a reason to buy from you, and it should never be solely about the price.

Value-based Pricing

Establishing a quoted price should not be based just on the cost to manufacture the product or the level at which the competition is selling it. Instead, it should be (at least equally) about the value that you deliver to your customer.

Before you submit a bid, ask yourself these critical questions:

• What is my unique value proposition, such as high quality, outstanding customer service, on-time performance?
• What is the customer willing to pay for that value?
• Does the price quoted reflect that value?
• How can my company communicate that value on this quote (and for every other opportunity)?

This is where margins-based pricing can play a key role. Again, when you bid with markup-based pricing, cost is in the driver’s seat. But when you bid with margin-based pricing, the value you give the customer is in the driver’s seat.

You start with defining your unique value proposition, weigh it against what you think the market will bear, price accordingly, and only then evaluate costs to see if you can achieve your desired margin. If you can, you move forward with the bid. If costs are too high, and there’s no alternative way to fabricate the product at a lower cost, you increase the proposed selling price to achieve your desired margin and see if the market will bear it.

In one sense, all this helps fabricators test their unique value proposition. A company can offer something unique; margin-based pricing tests whether customers are willing to pay for it.

Pricing With Eyes Wide Open

Of course, there’s an art to all this, and it’s truer now than ever before. Margin-based bidding can be ideal—if, that is, it produces prices customers are willing to pay. But even in good times, price-conscious customers might negotiate the price down to what you’d get using the cost-plus method. The key is to be aware that a quoted markup is not the margin that ultimately feeds into the P&L.

The challenges of the new now have placed increased pressure on those people and departments within the organization responsible for costing, estimating, quoting, and pricing goods and services. Having a clear understanding of operational costs, but then considering all the other essential aspects of establishing the right sell price for your products, will help ensure you can weather the existing storm and come out on the other side stronger and more resilient.

Technology to support more accurate costing continues to be developed, which will make it easier to understand the baseline costs. And best practices continue to evolve regarding how to price your products and services appropriately. In the end, neither will likely completely replace the human element in effective product pricing.

Dave Lechleitner is a senior consultant with Ultra Consultants.