Cost Reduction in Manufacturing Industry
Every company strives to be more profitable by analyzing its costs. Material cost is usually well understood. However, labor and overhead costs are more difficult. Traditional cost accounting tools fail to reveal accurate and actionable insights that product managers and executives need to optimize operations for better bottom line profitability. Activity-Based Cost (ABC) analysis changes this picture for the better.
Cost Reduction in Manufacturing Industry
Hidden Money in Your Business Part 3: Overhead Cost Reduction Opportunities
By Alan Stratton
In my last two articles, I discussed powerful questions to find cost reduction or cost optimization opportunities at an activity and business process level. These questions focus attention on Cost Drivers, the reasons why we do work and get current results. However, these questions are only one portion of the whole picture. They focus on the first stage of an Activity-Based Cost (ABC) analysis. These questions alone are valuable. But, coupled with the second stage of an ABC analysis, they can yield even more profit opportunities.
The second stage of an ABC analysis drives cost accumulated in activities to products or customers or, in some cases, to other useful objects of interest. It is at this point that cost can be compared to revenue to determine an accurate profit. Key to this analysis is using cause and effect relationships in driving activity costs to products or customers.
Early in my career, I worked with several large manufacturing companies. Each used a traditional standard cost system. In each case, most of the companies' overhead was allocated to products based on manufacturing direct labor. From some time, overhead had been increasing while direct labor had been decreasing due to automation and offshoring operations. In these companies, these systems calculated three major components of product cost: material, labor, and overhead.
Material costs received a lot of attention. Nearly the entire purchasing organization focused on finding lower material prices. In addition, much of engineering also focused on raw material costs. Consequently, material costs were usually very accurate.
Another significant chunk of engineering and most of operations focused on direct labor. New automation opportunities were always welcome. When implemented, these opportunities reduced labor but nearly always increased overhead. Once implemented, overhead cost was usually just added to the overhead cost pool and allocated to all products based on the smaller labor basis.
In some companies, it was difficult to keep labor routings up to date. These labor routings were the basis for all direct labor calculations. At times, a product manager would object to a high product cost of an unprofitable product. On cue, all the industrial engineers would scramble to analyze labor routings for the product in question. They always managed to find something to correct that would reduce labor. Further, since overhead was allocated based on labor, overhead cost for that product would be reduced also.
This exercise reminds me of the arcade game, Whack-A-Mole. In Whack-A-Mole, the objective is to smack all moles back into their holes. However, as soon as you whack one mole, more pop up from the other holes. Occasionally, I could really whack one or two, but I could never get them all. Similarly, this labor routing scramble for cost reduction usually only served to push cost over to another product. Rarely did we see any real net profit impact.
The allocation relationship between labor and overhead essentially made labor and overhead vary together. Overhead is dependent on labor. This effectively reduced these three major categories to only two: material and all else based on labor.
With cost derived from Activity-Based Cost analysis, overhead is traced to products individually from activities based on the consumption relationship between activities and products. Now rather than only three cost categories, overhead is split out by each activity. Now, if a product cost is too high, each of these relationships can be analyzed and prioritized. Coupled with cost driver analysis explained in the last two postings gives product managers real ammunition to drive real improvements to bottom line business profits.
With these better cost analysis tools, companies can be in better financial health and more robust to withstand business cycles.
By Alan Stratton
In my last two articles, I discussed powerful questions to find cost reduction or cost optimization opportunities at an activity and business process level. These questions focus attention on Cost Drivers, the reasons why we do work and get current results. However, these questions are only one portion of the whole picture. They focus on the first stage of an Activity-Based Cost (ABC) analysis. These questions alone are valuable. But, coupled with the second stage of an ABC analysis, they can yield even more profit opportunities.
The second stage of an ABC analysis drives cost accumulated in activities to products or customers or, in some cases, to other useful objects of interest. It is at this point that cost can be compared to revenue to determine an accurate profit. Key to this analysis is using cause and effect relationships in driving activity costs to products or customers.
Early in my career, I worked with several large manufacturing companies. Each used a traditional standard cost system. In each case, most of the companies' overhead was allocated to products based on manufacturing direct labor. From some time, overhead had been increasing while direct labor had been decreasing due to automation and offshoring operations. In these companies, these systems calculated three major components of product cost: material, labor, and overhead.
Material costs received a lot of attention. Nearly the entire purchasing organization focused on finding lower material prices. In addition, much of engineering also focused on raw material costs. Consequently, material costs were usually very accurate.
Another significant chunk of engineering and most of operations focused on direct labor. New automation opportunities were always welcome. When implemented, these opportunities reduced labor but nearly always increased overhead. Once implemented, overhead cost was usually just added to the overhead cost pool and allocated to all products based on the smaller labor basis.
In some companies, it was difficult to keep labor routings up to date. These labor routings were the basis for all direct labor calculations. At times, a product manager would object to a high product cost of an unprofitable product. On cue, all the industrial engineers would scramble to analyze labor routings for the product in question. They always managed to find something to correct that would reduce labor. Further, since overhead was allocated based on labor, overhead cost for that product would be reduced also.
This exercise reminds me of the arcade game, Whack-A-Mole. In Whack-A-Mole, the objective is to smack all moles back into their holes. However, as soon as you whack one mole, more pop up from the other holes. Occasionally, I could really whack one or two, but I could never get them all. Similarly, this labor routing scramble for cost reduction usually only served to push cost over to another product. Rarely did we see any real net profit impact.
The allocation relationship between labor and overhead essentially made labor and overhead vary together. Overhead is dependent on labor. This effectively reduced these three major categories to only two: material and all else based on labor.
With cost derived from Activity-Based Cost analysis, overhead is traced to products individually from activities based on the consumption relationship between activities and products. Now rather than only three cost categories, overhead is split out by each activity. Now, if a product cost is too high, each of these relationships can be analyzed and prioritized. Coupled with cost driver analysis explained in the last two postings gives product managers real ammunition to drive real improvements to bottom line business profits.
With these better cost analysis tools, companies can be in better financial health and more robust to withstand business cycles.
While many people have experience with traditional cost systems, few have equivalent experience with Activity-Based Cost systems. Getting actionable information requires both a good system and experience to avoid hidden traps. For better business profits for you, please come to http://www.CostMatters.com for more insights, information, tips, and techniques.
No comments:
Post a Comment