Services > Manufacturing Consulting > The Cost of Complexity

In today's competitive marketplace, many manufacturers have designed their production processes to handle a wide variety of products, sizes, packaging and volumes to accommodate the demand from an ever-increasing number of market niches and needs. This demand has created a more complex production environment and has put increased pressure on manufacturers to manage production runs, raw materials, packaging, and changeovers more efficiently. This complexity, if not managed well, can cause substantial losses in efficiency and output, resulting in sub-optimal production runs, higher manufacturing costs, lower asset utilization and lower profits. In order to deal with this problem, several companies have turned to HMC to analyze the cost of complexity and provide a solution for managing it.

Complexity comes from a variety of sources. And while there is a need for some complexity, much of it is not essential. For example, some manufacturers don't eliminate old or unneeded SKUs. This will tend to slow down the production process because of unnecessary changeovers. They may also be able to combine SKUs in order to generate longer, more productive runs. A careful analysis of the production process will often reveal opportunities to combine packaging forms that reduce changeovers and lower package material costs. A thorough analysis may also show other areas in the production process where complexity exists, but is not required.

Analyzing the production process provides some tangible benefits but often it only scratches the surface in terms of reducing complexity and generating significant cost savings. HMC has developed an innovative tool that gives its clients a better perspective on understanding complexity in the production process. Most companies today use an allocation technique to assign costs to various parts of the manufacturing process, also known as Traditional Cost Accounting (TCA). HMC consultants, however, apply an Activity Based Costing (ABC) technique, which more accurately reflects the true cost of producing various products. This is extremely important because if the costs are not applied correctly, manufacturers will make production decisions that are not efficient or cost-effective.

At HMC, we use software tools developed by ABC Technologies (now SAS), a leader in the field of activity based costing. These tools enable us to allocate our clients' manufacturing costs to the activities that produce them, and then analyze more accurately how those costs flow through their production process. This analytical technique will produce a more accurate assessment of production costs and the cost of complexity, and yield a better and more reliable solution to the complexity problem.

Let us show you an example of what we mean. Let's consider XYZ Manufacturing, who produced products A & B. They made 100 of product A and 1000 of Product B, and it took 1 hour of direct labor to produce product A and 2 hours of direct labor to produce Product B. At $20 per hour for labor, the direct labor cost for Product A was $20 and the direct labor cost for Product B was $40. Total overhead costs were $100,000, and it consumed 2,000 hours of labor.

Under TCA, the overhead allocation costs for Product A and B are as follows:

Product A Overhead: ($100,000/2,000 hrs. = $50 hr. x 1 hour) = $50 per unit Product B Overhead: ($100,000/2,000 hrs. = $50 hr. x 2 hour) = $100 per unit

If we look at how the costs break down by activity, we see a different picture:

Activity: Total (Hrs. / Cost) Product A (Hrs. and Cost) Product B (Hrs. and Cost) Set-Up 100 / $10,000 25 / $2,500 75 / $7,500 Machining 800 / $40,000 100 / $5,000 700 / $35,000 Receiving 50 / $10,000 10 / $2,000 40 / $8,000 Packing 50 / $10,000 10 / $2,000 40 / $8,000 Engineering 1000 / $30,000 500 / $15,000 500 / $15,000  Total 2000 / $100,000 645 / $26,500 1355 / $73,500

Using this ABC methodology, the overhead cost allocation would be as follows:

Product A Overhead: $26,500/100 = $265 per unit Product B Overhead: $73,500/1000 = $73.50 per unit

Now let's compare the total per unit production costs using each methodology:

Product A Cost: TCA ABC Overhead: $50.00 $265.00 Direct Cost: $20.00 $20.00 Total: $70.00 $285.00

 

Product B Cost: TCA ABC Overhead: $100.00 $73.50 Direct Cost: $40.00 $40.00 Total: $140.00 $113.50

As this chart clearly shows, using activity based costing produces a significantly different product cost, which will have a substantial impact on production planning decisions. By allocating the costs based upon the activity that produced it, we can get a better fix on what is driving production costs and how to manage them more effectively. We can also get a more accurate picture of the profitability of each individual SKU.

What we have also found is that marketing decisions that increase the manufacturing complexity have typically been based on the traditional accounting method, which as we've noted above can seriously misrepresent the true production cost, and ultimately, the true product profitability. As a result, some companies add SKUs thinking there is added profitability when in reality, there could be added loss. Only by using Activity Based Costing can the true profitability of each SKU be determined. Armed with that knowledge, it is then possible to make more effective production planning decisions that yield maximum output at minimum cost in a complex manufacturing environment.

At HMC, we believe in giving our clients the best tools and methodologies that help them understand their manufacturing process and environment. Utilizing activity based costing, we help our customers determine true production costs and product profitability, which in turn enables them to identify the cost of complexity and, with our assistance, find ways to reduce it or manage it for maximum performance.

If you would like our assistance in solving your manufacturing complexity problems, or would just like more information on our Cost of Complexity Service, please contact us.

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