Managing costs - a focus for the future - Part 1

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Introduction

Competition in all manufacturing sectors is constantly increasing and there is continuous pressure to drive costs down and increase cost management (generally by employing another accountant!). Indeed cost management is still seen as vital to the success of any manufacturing company in any sector. But are we really managing costs or are we just playing at it?

Realistic cost management for the future is not about ignoring huge chunks of cost (such as overheads) but is about trying to understand what we are really doing. Unrealistic costing systems can distort the reality of the business so much that good profitable products are killed whilst unprofitable products are produced. The management of costs is critical to survival and if you want to stay alive then you had better start thinking about it soon or you may not be around to regret it!

Cost structures and efforts

The cost composition of products and the rise of overheads

A major factor that is changing in manufacturing is how we need to approach the costing of products. This is because of the rapid rise in overhead costs relative to other costs. Most manufacturing industry recovers the overheads - the indirect costs - by increasing the direct cost of the products by some factor. In the simplest form the total overhead cost for the company is divided by the total number of available direct labour hours (or machine hours) to give an "overhead rate". This overhead rate is multiplied by the number of direct labour hours (or machine hours) required for the individual product to give an overhead allocation. This overhead allocation, the cost of direct labour and the cost of direct materials involved are all added up to give the "cost" of the product.


Overheads are rising, labour content is reducing. Tell me about it!


These costing methods grew up in the first half of this century when direct labour was a high proportion of the costs and overheads were lower. Increased investment in machinery has reduced direct labour costs and simultaneously increased overhead costs. The need for "Customer Service", Quality Management, Health and Safety and compliance with other regulatory requirements has also loaded overhead costs. Despite these changes, the costing systems and our efforts have not changed to reflect these facts. The model we have all grown used to is no longer valid.

In fact, the problem is getting worse as time goes by, the direct labour base continues to shrink and overhead costs continue to rise. This is making the older style cost accounting formulas even more inaccurate. They are ripe for both change and management. The approximate change over time in the distribution of the costs is shown below.

Cost Category

1960

1986

1996

Overheads

15%

30%

35%

Direct Labour

25%

12%

10%

Direct Materials

60%

58%

55%

The cost basis of most manufacturing operations has changed over the past 40 years and the process is continuing. The cost of direct labour is now much less than the cost of overheads yet we continue to use direct labour hours as the most common benchmark for cost allocations.

Note: These figures may not be exactly right for your company but they won't be far out.

Even when we did look at "overheads" we concentrated on the staff (or labour) element of overheads and delayered, made redundant or RIFfed (Reduction in Force) management teams so that there is nobody left to do any of the work that can really save us money. Meanwhile our production people are frantically trying to meet the production targets, to complete the new initiatives started by the management (with too few people to complete them) and the real cost contributors are left unchallenged and out of control.

The management efforts

If we accept that the cost basis has changed then where do we currently allocate our efforts at cost reduction? The traditional Work Study Department measures and controls direct labour, the Purchasing Department attempts to control direct materials purchases after the product has been designed and nobody controls the overhead costs. The efforts of most manufacturing companies is shown in the diagram below.

The biggest costs have the least efforts to reduce them - are we trying to get it wrong?

The labour costs in the UK are among the lowest in Europe (productivity may be another story) and yet we constantly worry about this aspect when we discuss competitiveness on a European scale. We spend most of our time and effort on the smallest component of the cost and largely ignore the other huge chunks of the costs that we ought to be managing. Reducing the overheads by only 10% translates into a product cost reduction of about 3.5% - the same as a labour cost reduction of 35%. Logic tells us that if we want to make reductions then we should start with the big numbers because that is where we can make some big savings. Yet this is not where we start and we wonder why our cost reduction efforts are not as effective as we would like. Whatever happened to Pareto analysis?

In plastics processing the labour costs represent only about 10% of the cost of the product but the overwhelming amount of effort still goes into reducing labour in the process - 75% of the effort is in reducing labour costs and only 15% in reducing overhead costs. This misdirection of effort continues to cost money and waste resources throughout our industry. Our efforts are badly or incorrectly focused because we still operate instinctively on a model that is wrong and sends us in the wrong direction when trying to manage costs.

What are the new rules?

Having spent most of this article discussing cost management and hopefully convincing you of the urgent need to re-examine how you look at costs, it is perhaps fitting to end with a simple statement to prepare you for the weeks ahead - Cutting costs is not the same thing as becoming a low-cost producer. OECD reports on productivity show that American manufacturing workers are 45% more productive per head than Britain's, Germany's are 19%, Japan's are 17% and France's are 7%. The real difference is not in the labour cost but in the productivity - it is perhaps not a coincidence that all of the major competitors invest substantially more capital per worker than does Britain. Cutting investment to reduce costs is a short term measure.


Managing costs can make you a low-cost producer, simply cutting them will not!


The "Managing Costs" Series.

"Managing costs" is designed to give you direct and clear information on some ways of looking at the way we generate cost information in our companies and some ideas for managing them. The series has been written specifically for plastics processors but most of the information is equally relevant to general business. The series is:

Part 1: Introduction - This article

Part 2 - Overhead cost management

Part 3 - Materials cost management

 

Last edited: 11/03/10

Tangram Technology Ltd. 1998

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