Updated: Jan 13, 2022
This article sets out to discuss the ideology of primary product costing and why it is important to know the costs of the product at each stage of the process.
Why is it important to know the cost of a product? A product should be sold at the value it can achieve – not cost plus margin. Why sell a product at less than the market is willing to pay? Selling below market value may be a good idea, if the margins still enables a profit, as it could grow market share. However, not knowing the product cost is comparable to driving blind. Looking at a market price and then undercutting the cost, will inevitably result in sales, but if the product is sold at less than cost, then an enormous sales turnover is not good for business. Understanding the costs of production enables a more comprehensive understanding of all the elements of you business. How can a commercial margin be derived if the cost of the product is not accurately defined? It cannot, so if cost is not understood neither is commercial margin.
In an assembly business, calculating the cost of the material is straight forward. Each raw material will have a procurement price, and a volume will be required of each component. Times the volume with the cost for each component, add the cost of loss, and add it all up to arrive at the aggregated material cost.
Component = c Volume = v Procurement price = p
In the primary meat industry where one unit is disassembled and then becomes several subcomponents, the calculation is less objective, as the price will have to be defined for some of the subcomponents to enable a calculation. If it’s a premium raw material, it must also be decided which components are to recover the premium. One method is to fix the by-product costs at the cost the by-product can achieve in the market and then balance the remaining cost back on the product that is being priced. (Also called return calculation) The by-products are given a price and the prices are then multiplied with the expected percentile outcome of the by-product in relation to total batch size. This is done for each by-product component and the remaining percentage of product will then be the main product. All the by-product values are then subtracted from the raw material cost which will equate to the material cost of the main product per unit* (Example 1). The calculation can also be executed with the total volume prices (Example 2).
*The unit can represent kg, lbs., metric tonnes or whatever measure is relevant for the context of the calculation.
See examples below:
*The meaning of partial product value in this context is that, at this point of the calculation, the knowledge obtained is how much the main product value contributes to the overall value of 1 unit, based on the fixed price of the raw material and the by-products. i.e.: it is a cost proportionate to the raw material per unit.
Written out with words, the mathematics seem very complicated, but they are not. See example below:
Table 1 (note: overheads and labour have been added to the $1.03/unit to get to $1.15/unit)
Raw material volume = rmv, By-product volume = bpv Price = p
Calculating the yield is essentially dividing the individual components, derived from disassembly, with the originating batch weight to identify how large a percentile proportion the component has returned. The difference between the total volume of subcomponents and the raw material volume is the loss. Whether it is a good or a bad yield, depends on the standard and the standard depends on the quality attributes that the product will be measured against.
In the meat industry the volume is, predominantly, expressed in weight when yields are calculated, but which weight do we choose for batch weight? When is the product finished? Where and how should costs be attributed?
The original product in the meat industry is an animal. The animal will go through various stages to become a finished meat product. Each process has a cost associated with it and the process is often defined by the arrival at inventory and the cost is evaluated after inventory to account for any evaporation or drip loss. In the abattoir, the process is completed at the end of the chilling process. Defining the direct cost per unit is relatively straight forward at this stage, despite some disassembly taking place, the unit is still a carcass. Arriving at the cost value* is done by: adding all direct, variable and fixed overheads costs to the product, subtracting any revenue stream directly generated in the abattoir, and then adding the cost of chill and process loss. See example below:
*Cost value, in this context, is product (animal) procurement costs – revenue + process cost (incl. overheads) + cost of chill and process loss. Commercial value is cost value + margin. Cost price ≠ commercial price
Sounds simple enough, but there is subjectivity in the revenue stream from the abattoir as prices will have to be defined. What is even more subjective is the way overheads are distributed which normally involves an internal political decision. From a pure cost perspective, most of the costs can be accurately identified. There will be indirect costs that can be directly associated with the abattoir process. The utilities costs can be obtained by sub metering in the department, so the exact cost of liquid petroleum gas (LPG), electricity, water, or any other utility can be obtained. Depreciation of any equipment that is directly associated with the process in the abattoir is an abattoir cost, any salaries that are directly associated with the abattoir can be directly attributed to the abattoir process cost.
However, there are also costs that are more difficult to attribute directly to a process. E.g., rents and rates, senior management, functions that service the whole of the process from intake to dispatch, depreciation, or the whole of the building and so on.
The distribution of these more general overheads calls for political intervention, as there is a business choice to make. A distribution key based on machine hours, labour hours, square meters, or whatever the chosen metric might be, could be used for the cost allocation. It could be argued that more than one distribution key is required to make sense of the distribution. If the distribution keys make mathematical sense, then they will enable a more accurate approximation of the final cost price.
Ensuring overhead recovery
The disadvantage of distributing the overheads on all the products is that not all the products may go through all the processes. For example, if the product is sold as a carcass and the cost recovery model is recovering the generic overheads in the butchery process, not all the overheads will be recovered. If a carcass is sold, rather than processed within the confines of the original business, then the commercial margin or the cost price has to ensure that the procurement cost that the procuring companies can secure the product at, is high enough for them not to take away business from the originating business’s butchery or further processing.
Some companies load all their costs onto the first point of sale, e.g., a carcass, and some companies just divide their total overheads with the total units sold and then call that overhead per unit. Mathematically neither model reflects the accurate cost of the product, but the former is more likely to ensure that all costs are recovered than the latter. Perhaps, a hybrid of overhead costs directly associated with the process and a recovery of the generic overheads at the first point of sale would make most business sense, though some frozen products may end up struggling to recover their costs on their own. The purest form mathematically would be to show the costs where they belong and then adjust the desired market impacts in the commercial margin. Though understanding the cost of the product will enable shrewder business decision, some costs are inevitable and some political re-balancing of the values is required for it to make sense from a business perspective.
Once an overhead model has been chosen, the costing of the product continues through each stage, and at each stage the entry weight is the volume which the yields are measured against. Standards for labour, yield and overheads, as per the previous example, will have to be established at each process step. Thought there may not be a sale in the department, the understanding of the cost at each process enables a procurement cost price for the following department. The cost needs to include any process loss, so the final product cost price is transferred to the following department at a cost that accurately reflects the value added to the product.
So, to return to the question about which weight is used for batch weight and which is used for finished product; the finished product yield is when it’s sold. The finished units that the customer is paying for is the finished yield. i.e. how much of your original material has been converted to saleable product. Any yields measured between procurement and sales are a cost price value and a process control step.
In theory, the abattoir hot scale weight could be utilised for all the batch weights once standards have been accurately set throughout all the processes. It wouldn’t be very logical to do so, but if the mathematics throughout the processes are accurate, it is possible. However, the more processes there are in between the start weight and the finished yield weight, the harder it would become to identify a process defect. What is a more logical and conventional approach, would be to use the batch weight from exit of the previous inventory. So, for primal break it would be the exit of the carcass chillers, for butchery it would be the exit of primal break*, for packing it would be the exit of butchery, dispatch loss would be measured against finished packing inventory and so on.
Figure 1 Not all ID or inventory steps are strictly necessary. It depends to which extent the measurement of production is required or desired. The logic of inventory loss follows through for each subsequent inventory step.
*There may not be a physical inventory step between all the departments, but to obtain yields a registration of weight between the departments is needed. Where there are no changes to the product, e.g., between butchery and packing, the department yields could be combined, but any loss would then also be combined.
Many factories have their butchery lines in-line with cutting and the inventory step is therefore only a gathering of the primal weights. The gathering of weights at this point is crucial as the different primals will be given different prices, corresponding with market value. It could be argued that the cost of the different primals at the stage of entry to butchery are the same, from a cost per weight unit perspective, which would be correct mathematically and could essentially be used for measuring cost performance, but if the cost price doesn’t reflect market price, it could end up driving undesired behaviours in production. This is where carcass modelling adds further subjectivity to the primary costing process, as the cost of the carcass would have to be distributed between the primals, proportionately reflecting what is believed to be obtainable in the market. What is meant by proportionality reflecting market values is that the cost prices are only to reflect the proportionate differentiation in the market. It’s not a full market price. It is still a cost balancing exercise where e.g., the shoulder, the belly and the leg cost prices are set and the balance of the cost is put on the loin.
Butchery product pricing
Once the price is set for each primal the same costing process is repeated for each individual finished product. Costs are attributed to the product as per example 1 & 2, but as the disassembly now takes place, which products should the cost be attributed to?
Once again, some business choices must be made. All the costs could be distributed onto all components at a level proportionate to the amount they make up of the batch. This would make mathematical sense. However, there will be some components that don’t attract enough premium in the market to be able to carry the cost of labour, overheads and so on. If the raw material is a premium raw material, not all the by-products may be able to attract the premium either. It therefore makes sense to attribute the costs to the target product of the process. If a rare breed animal is bought, the whole of the animal attracts a premium, but once converted into products, it might be hard to attract the same premium for fat, trim or bones in the market. Therefore, loading the costs onto the main product makes sense. There would be no point in processing a premium animal if there is no customer willing to pay the premium for the finished product. As such, the main product can be whatever part of the primal desired, if it can carry the cost. Conventionally it is the larger muscles that attracts the premium and are the target for the production run. Anything that is not the main product will be a by-product and the costs need to be established for each component. If a by-product then needs further processing, for example, a collar has to be butterflied and trimmed to a fixed weight, the collar would then be the raw material for the calculation and therefore will be attracting the additional costs. This cost would be loaded into the product code for the by-product that has been subject to further processing.
Cost of inventory & packing
Once the butchery process has been completed, there are no more changes to the product during primary processing, but the product can still be subject to change if it waits in inventory. 75% of muscle is water and following the butchery process, where muscles have been opened, lacerations and cut surfaces reduce the water holding capacity of the meat, the drip loss (exudate) is exacerbated. It’s therefore important to understand the impact of inventory on the product before it’s packed and sold. Blue leg muscles can lose and average of up to 0.71% of weight for every 24 hours despite being held at a low temperature, and not under compression from the weight of other products. Though decelerated, evaporation will still occur unless the product is frozen so the cost of inventory can have a high impact on the packed yield if not managed.
Picture 1 Leg-joints in meat juice.
If the process dictates that the product must be held in inventory, then the loss should be costed into the finished cost price of the product. The products behave very differently. A bone in loin would lose a lot less than trim. Time, temperature, humidity will all impact on the loss. The most accurate way of representing the loss would be per SKU averaging over a period that includes any extended shutdown periods, as across the weekend.
At the packing stage other elements are added to the direct cost in form of packaging, which would also have to be represented in the final cost price. If the packed product is going to be frozen, the associated overheads would have to be allocated to the frozen products. Transport, shipping, or any other cost incurred before the product is handed over the customer will also have to included in the cost price.
Once the costing exercise is finished, the commercial margin can then be added or subtracted depending on the product.
If the product is going to secondary processing within the same company, it can be handed over to the internal customer at cost price and the costing of secondary processing can commence.
There are several other factors that must be considered before agreeing a non-standard product with a customer. Raw material availability, volume impacts on overhead recovery models, supply chain setup – pipeline timings, cash tied up in inventory or transit, to mention a few. There are also more nuances to primary costing as e.g. carcass selection, carcass genetics, labour modelling, ID points, downgrades, product cross over from premium to standard due to lack of process control etc.
The balance between a hard standard target and the total return of the product will also have to be considered. If the operational standards are unattainable, it will erode the overall product margin but, on the other hand, if they are too easily attained the overall product price will be uncompetitive, unless the commercial margin is sacrificed.
A company may very well be successful without understanding their costs through other factors, as having niche products that attracts a high margin, or have enough volume to dilute overheads to an extent that their product becomes cost competitive inadvertently, but they will never reach the full potential of success without understanding the cost of production.