THE CLASSICAL MODEL FOR DEPICTING FIXED AND VARIABLE COSTS

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.

Copyright © VWG Consulting 2016, all rights reserved

WHAT ARE THE KEY COSTS IN MANUFACTURING?

Understanding the different types of costs encountered in manufacturing helps us to devise strategies for reducing these costs. These strategies must necessarily begin with an analysis of the quantum of each individual cost in order to facilitate the prioritisation of focus areas for your cost reduction programme.

In the final analysis, cost depends on two factors: how much of an item or resource is used or consumed and the price paid for a unit of that item or resource. These two factors are not necessarily independent of each other, and we will explore these relationships in more detail in future posts.

There are two major cost categories in manufacturing:

                  i.     Variable costs, which depend on the level of production

                  ii.    Fixed costs, which are largely independent of production

                 

Variable costs include the costs of raw materials, energy, water, waste management and other costs directly linked to production levels. This is generally where the large cost reduction opportunities in manufacturing lie. It is important to appreciate that even these costs could have a fixed component, and this is one of the reasons behind why factories tend to perform well when highly loaded.

Fixed costs include salaries and wages, rent, rates and taxes, plant maintenance costs, the cost of consumable items and other costs that are generally incurred, no matter what level of production is attained. For the purposes of this blog, we will include financing and asset costs in the "fixed cost" category, comprising costs such as interest payments and depreciation. Financing and asset costs are related to debt levels and the asset intensity of the organisation. These costs also depend on the age of an organisation’s assets, their original cost and the degree of reinvestment pursued by management. Manufacturing businesses generally try to maximise their returns on assets, and it is possible to reinforce this approach by investing in assets which in turn deliver significant savings or provide the business with useful productive capacity.

A healthy balance has to be struck between the frugal use of scarce financial resources and the provision of the capacity required to effectively execute organisational strategy. Skimping on fixed costs can ultimately hurt an organisation's capacity to compete. It is true that while the budget for these costs may be fixed each year, there is a degree of variability to these types of costs. This variability may however be unrelated to the level of production. For example, excessive overtime costs may be a result of problems with plant reliability rather than increased throughput.

The minimisation of overall manufacturing costs requires a balancing act between fixed and variable costs rather than a focus on minimising each category. One of the biggest and most common mistakes is to manage these costs as if they are independent of each other. Deliberately overspending by a small amount against a fixed-cost budget in order to realise a large saving in variable costs is simply good business sense, for example. So is spending more on an asset which is of a design that will significantly improve product quality and/or increase raw material yields, both of which would be positive for variable costs. In future posts we'll examine the different types of costs in detail and explore sustainable cost reduction strategies.

Copyright © VWG Consulting 2016, all rights reserved

WHAT THIS BLOG IS ALL ABOUT

The big savings in manufacturing are in variable costs -
areas such as raw materials, energy, waste and water!

Welcome to our blog, which we hope to turn into your single most important source of information for all things related to manufacturing cost reduction. 

In a world where performance is typically judged by progress against last year’s budget, we believe that many manufacturing organisations are missing a golden opportunity to unlock huge amounts of value through cost reduction. VWG Consulting, based in Johannesburg South Africa, operates proven manufacturing cost reduction programmes, and we would like to use this blog to help manufacturers in our home country and around the world to sustainably reduce their costs. We also want to show that low-cost manufacturing need not be about tightening one's belt. Low-cost manufacturers invest in their businesses and are enabled to do so precisely because of the value they are able to unlock from cost-reduction. We have shown over several years that cost reduction programmes pay for themselves many times over.

Cost reduction in manufacturing is complex. It is however possible to reduce costs without compromising product quality, safety, throughput, flexibility or employee morale. We will explain how in this blog using informative posts, examples, case studies and more. Enjoy the journey with us and please communicate and give us feedback on our posts. 

Copyright © 2016, VWG Consulting, all rights reserved