“You must understand the impact of the known unknowns and the unknown unknowns onyour gross profit. Unless you capture all costs in your gross profit measure, you will not be in a position to reduce these costs”
Measuring your gross profit is not just about measuring the known costs relating to the supply of goods or services. This can be very misleading unless you also measure the unplanned costs of sales as well. By “unplanned” costs, I mean those costs that you have not included in your costing models.
Most businesses will be aware of the “known unknowns”. Examples of these include equipment failure, set up times or waiting on materials to arrive (e.g. electrical contractor on-site waiting for lighting products to be delivered). The unknown aspect of these costs is their magnitude.
But as Donald Rumsfeld stated in 2002 “… there are also unknown unknowns – the ones we don’t know we don’t know”. These are often there but the business is just not aware of them. These are a disease in the business operations and, if not addressed, may get much worse and more difficult to remedy.
The best method for measuring the “known unknowns” and the “unknown unknowns” is to use a recoveries model for measuring the cost of sales. A simple explanation of this is explained below.
Let us assume that a business manufactures one product. The costing model states that there is 5 hours of direct labour required to make each unit of production. The business manufactures 10,000 units for the month of April. According to the costing model, 50,000 man hours of direct labour would be recovered from the production volume (as per the bill of materials). However, the payroll data shows that 62,000 hours of direct labour were used for the month. This means there was 12,000 hours of additional labour paid for in the month. This is the cost of the “unknowns” that relate to direct labour.
What caused this. Apart from productivity or efficiency issues, there are many reasons. Staff may spend a lot of time not producing due to equipment breakdowns, shortages of raw materials, power outages, waiting on set up, waiting on key staff to arrive, communications meetings, waiting for production plans to be updated, training, waste levels, additional cleaning, and many more reasons.
There is an old saying, “if you can’t measure it, you can’t manage it”. A much more insidious danger for business managers is “if you don’t know it even exists, you will do nothing about it!”
For those businesses who do not have the resources or skills to achieve this type of analysis they should speak to an experienced gross profit consultant who can provide this level of support. The members of the Association of Virtual CFOs is a great place to start if you wish to speak to someone about gaining control of your gross profit margins.