Why most companies have not been able to manage Raw Material Cost Change effectively?Business | March 03, 2023 | By
To the CFO/CIO
Raw Materials are one of the basic ingredients in the running of a manufacturing organization. The conversion of raw materials from their ‘raw’ form to manufactured parts and components constitutes a significant portion of the spending in manufacturing organizations.
Some estimates indicate that up to 70% of the total revenue in manufacturing organizations are ‘spent’ on the Cost of Goods Sold (COGS). The reality is that, in many product manufacturing companies, this could be a higher number. Sometimes as much as up to 85%.
COGS comprises several cost components including materials, labor, consumables, admin, and overheads.
Someone with even a brief experience in the manufacturing industry would point out how managing the cost of labor, consumables, admin, and overheads is critical for the survival of these businesses. In other words, the cost of running the business (Indirect Spend) should be kept as low as possible. In fact, the portion of spend on indirect expenses is about 15% of the overall spend in the company.
That means, up to 85% of the spend is on Direct Materials, which are used to build the products. Of course, the actual percentage of the spending varies from business to business. Thus, on average, businesses spend up to 70% of their total revenue on direct materials.
Why are we discussing these facts? Well, if these are very well-known facts, it would also mean companies have effective systems and tools in place to ensure they manage their raw material costs, right? Unfortunately, the answer is “No”.
From our interactions with so many manufacturing organizations, the fact is that the visibility around the decision-making process related to the Raw Material cost, and integration of the material costs to the global and regional commodity indices don’t exist.
Given this, if the price of copper goes up or down a few quarters for a period, how does your system keep up with the fluctuations? Do you leave it to the buyers to manage the price changes?
Do you have enough people in your organization to manage the impact of commodity rate changes on every single component in your Bill of Material (BOM)?
Is the impact of Raw Material change on an item significant enough for the buyer to justify his/her effort or even to motivate himself/herself to take action?
From our experience in this space, we know why most companies have not been able to manage this effectively – There is simply no software available. The manual process of managing these costs requires significant ‘cost engineering’ and this is a dying trade within the manufacturing industry in advanced countries like the US.
Sometimes, the cost involved in the effort to salvage a dollar far outweighs the benefit gained from the effort on an individual item. So the focus only remains on only a few items where the benefits are obvious.
So, over time, we have completely given up on cost engineering, and all the means of managing costs and optimization are left to the suppliers. We have simply left it to the suppliers and their ‘contractual obligation’ to ensure the “best rates” are provided when the commodity rates go up and down.
I’m sure we’d like to be more in control. If this resonates with you and you’d like to discuss it, write to me at [email protected]