Authored By: Michael Sassano & Antonio Guedelha
When you look to the future of your company’s life cycle, financial health in planning your exact production costs will help inform important decisions pertaining to profitability. Much of this financial planning was developed in your ERP stages and general decision-making was covered in GMP #9. As time goes on, developing these individual models for production costs is a precise product-by-product series of equations. Additionally, each different GMP product facility has individual calculations of inputs and concerns.
As a basic example of why we need to calculate production costs correctly, let’s use an example. You are a GMP pharmaceutical company that just closed a contract to supply a pharmaceutical product for 2 years with a sales price for contract manufacturing of $2.30 per box of 20 tablets. Unfortunately, after revising the production costs, you found an error and the real cost of the product was $2.50. This means each box of 20 tablets is losing $0.20 of the expected income per unit. This is something that is avoidable by preparing estimates better.
Production cost calculation systems are critically dependent on having the right information and data. An error in your starting data sets will compound errors throughout the system. GMP is about providing strong control of all changes in the records and information used to calculate the production cost. There are several systems to calculate the production cost of a product, which range from simple to incredibly complex. And the more detailed the data, the more intricate and costly the system becomes.
Let’s start with the basic three systems: a budget for the next year, a forecast of sales by product for the next year, and the Bill of Materials (BOM) for each product. Then depending on the detail, you may want to attach specific costs to the calculation system like labor time in the production process or process equipment time in production. For even more detail, you may attach information like compressed air quantity used in each batch, electricity, purified water, water, sewage treatment, and other individualized costs of production.
The main three systems are often divided into three groups: equivalent units, labor time and machine time, and the bill of activities. All these systems will be implemented in your ERP.
Common data for all three financial planning systems include:
- A Budget is necessary for the management of the company. All areas will have an approved budget for the year which they will use and control their processes. Budgets will include the total facility operational costs and overheads. Notably, the actual production costs and marketing costs are not normally included.
- A Forecast is necessary to understand the future of each product that will be for sale. This is always an estimate but should be as close as possible to reality. GMP rules will define which products can be produced in your facility and will define procedures to evaluate each possible product to manufacture.
- A Bill of Materials (BOM) for each product is necessary to have well-defined and correct. Sometimes is necessary to make several batches to get the right quantities to use in the BOM. Loss should be defined properly. There will always be some loss of product either by sticking to the equipment or lost in washing. All the quantities used and lost must be included in the BOM. As defined in the previous series, GMP rules apply and all BOM needs approval by Quality Assurance before they can be used in the production.
Equivalent Units System
The Equivalent Units System is the simplest system to use. We can use a single product equivalent unit to be produced. The more products, the more complex and equivalent values of more than 1 can be estimated on the proportional value of complexity, time, and production stability. The procedures of a production calculation will be:
- Estimate Budget
- Estimate Forecast
- Based on the BOM calculate the cost of the raw materials
- Define for each product of the forecast an equivalent unit
- Multiply the number of boxes of each product in the forecast by the equivalent unit for each product and calculate the total of equivalent units
- Divide the total of the budget by the total number of equivalent units, and get the equivalent unit cost
- Based on the equivalent unit for each product multiplied by the unit cost of the equivalent unit, which gives the operational cost part of the production cost
- Add the cost of the raw materials with the equivalent unit part and get the production cost of each product
See a sample example in the table for Equivalent Units Systems. Although GMP does not direct the equivalent specific systems, GMP rules will verify that the data used are correct and controlled. This system is normally used in small manufacturing units.
- Reference Managerial Accounting, Susan Crosson and Belverd Needles, 9th Edition
Labor Time and Machine Time System
The Labor Time and Machine Time systems are a bit more complex. They split the costs depending on the process equipment and their uses to calculate the unitary cost per hour as a function of equipment. You will also calculate the number of hours of labor to run the equipment. Besides these extra segregated calculations, the rest of the equations follow the previous calculations in the previous example. This system is normally used in small to mid-size companies.
Bill of Activities System
The Bill of Activities System is a more complex system in which data is collected from the shop floor. In this system, you can detail as much as you want, but you will need equipment to collect information. For example, if you want to know the quantity of compressed air used in the production of one batch, you will need to install a compressed air counter in each piece of process equipment. The same will apply to many other inputs like electricity or water. Other activities can be input based on relation to the batch number, or any other unit to be measured as defined by the activity you want to calculate. This is a complex system normally used in big pharmaceutical companies. Not all ERPs are ready to use this production cost calculation system.
Whatever system you decide is best for your company and the future, the key is that you are always evaluating data and improving the accountability of your reporting. Data capturing from all over your facility helps to make these future estimates more precise. After all, the profitability and solvency of your company depend on tight controls like creating product cost systems that are accurate and useful.