In an earlier post we explored
the major categories of costs in manufacturing, and discussed fixed and variable
costs. This blog will investigate opportunities to reduce those costs, with
particular emphasis on variable costs. It is useful to have a picture in our
minds of how these costs relate to each other and to total manufacturing costs,
all as a function of the level of production.
Fixed costs, variable costs and
total costs are as outlined below. Fixed costs remain constant regardless of
the level of production, which is as we have defined. Variable costs increase
as the level of production increases. This makes sense, as each additional unit
of production requires additional resources, such as raw materials, energy and
water, and leads to the production of increased quantities of waste. In the case of fixed costs such as labour costs, we incur these regardless of how much product we produce. Total
costs are simply the sum of the two.
Something that is important to
appreciate is that as the level of production increases, the cost per unit of
production decreases. This is because the fixed costs become “diluted” as
production increases. This is one of the reasons that manufacturers can offer
customers reduced prices for large orders.
Reducing fixed costs reduces
total costs by a fixed amount, regardless of the level of production. A
reduction in fixed costs therefore has a smaller impact on the cost per unit at
high levels of production than it has at low levels of production. This is why,
when manufacturers come under pressure with volumes due to poor sales, the
temptation is to reduce fixed costs. Sadly, the first place many manufacturers
look when attacking this cost category is the wage bill. The cumulative impact
of a reduction in fixed costs increases as time passes, regardless of
production levels.
Reducing variable costs reduces
total costs by an amount that increases as the level of production increases.
The absolute impact on the cost per unit remains constant regardless of the level of
production. The cumulative impact of variable cost reduction increases with
total cumulative production, regardless of time. Variable cost reduction
therefore adds significant benefits during peak production periods.
The largest cost reduction comes
about when both fixed and variable costs can be reduced. This leads to the lowest cost per
unit of production. It is important when trying to do this that the action taken to reduce one cost category does not result in an increase in the other cost category overall.
This model is a little simplistic. Fixed costs are seldom completely fixed, and variable costs never behave in a perfectly linear fashion. This is however a useful construct when seeking to understand the fundamental differences between these two cost categories.
In future posts we will explore how
we can achieve sustainable cost reduction in each cost category and the risks
involved.
