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.
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.
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.
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