The Real Cost of Production

Manufacturing costs include more than just material, labor and overhead.

Possibly it’s because inflation has ticked up over the past year or so, or possibly it’s because despite a long career in manufacturing, and I am still not sure all stakeholders from production, sales, customers, suppliers – and especially accounting – really understand or agree, but I find myself now more than ever trying to identify and come to grips with the “real cost” of what I produce. 

I am hardly the first to ponder this question. Truth be told, I spent too many years early in my career performing standards engineering and being responsible for product costing. All that experience, I fear, has left me more a skeptic than an expert on product costing. Too many companies in our industry have ended up foundering, in no small part because of their leadership not understanding the real cost of their product.

Cost accounting 101 will teach you to consider material cost, labor and overhead. Yet it is the “other” costs that, in my experience, are far more significant and usually either not considered or undervalued as part of the costing equation. Supplies, required services, benefits and most of all, risk, all seem to get rolled into one of the basic three (materials, labor, overhead) rather than being understood and properly valued. So, let’s quickly run through all seven of them.

Materials. To fabricate a circuit board, laminate is needed, as is surface finish, processing films, etc., and these usually make it onto the bill of materials because they are relatively easy to quantitate and are needed to produce product.

Supplies. Now the slope begins to get a bit slippery. Yes, everything from chemicals to drill bits to rags and filters and other “stuff” is consumed while producing the product. And yes, most people in manufacturing understand that these items are needed. What is almost always missed, however, is that there are typically lax controls on managing these often low-cost items and, therefore, the actual cost of these supplies is almost always higher than costed into a product. My experience tells me they are too often woefully underestimated in product costing. However, as they are collectively supposed to be a relatively small percentage of total cost, managers typically just look the other way when costing supplies.

Services. Another slippery slope. Services mean everything from an outside service used when in-house capability is not available, to the support services, such as calibration, that are “assumed” to be minor. With the ever more complex capital equipment and demand for more detailed verification and validation of processes, they are an ever-increasing component of cost in manufacturing.

Labor. One of the basic three costs. Despite automation and thanks to a combination of decreasing interest in manufacturing careers and rising inflation, labor represents both a talent sourcing concern and a more expensive piece of the costing equation.

Benefits. Typically lumped with labor or thrown into the overhead cost, benefits are becoming a cost category of their own. Offering better benefits can often mitigate some of the problems in attracting new hires, but it comes with a cost. Some states also have requirements for benefits that add costs. And finally, some benefits are “soft” costs that sound inexpensive when initially offered, but when employees take advantage of them, the true cost becomes apparent.

Overhead. Whether the company’s facility appears more like the Taj Mahal or that of a slum, they will most likely end up costing the same. The Taj Mahal will hit the depreciation account while the slum will hit the repair and maintenance account. Regardless, they are both real costs, regardless of where in the budget they are listed. And more often than not, the real cost of each is more than what is accounted for.

Risk. This cost is never adequately considered and includes the trifecta of expenses that can do real damage to a company’s financial picture. When a company takes on a job that is risky, they will consider the yield and add cost (read: price) to compensate for it. So in a simplistic world, if yield “risk” is 50% then they expect to produce two for every one they ship and get paid for. That’s great until the trifecta is taken into consideration. The trifecta is 1. loss of capacity; 2. cost of reputation; and 3. collateral damage including impact on on-time delivery. Two of the three costs are soft costs while one is real, very real.

If a facility has unlimited capacity, which is never the case, then costing out the risky low-yield job will work fine. If too many risky low-yield jobs are taken, however, the capacity is consumed by scrap at the expense of building good (and profitable) product. This impacts on-time delivery, which suffers as staff tries to get the low-yield job through now capacity-stressed processes at the expense of other jobs in the queue. Low on-time delivery in turn impacts the manufacturer’s reputation as customers lose confidence in a supplier with poor delivery and quality.

What is the “real cost” at your company? How well are each of the cost drivers really being managed? Are any cost areas putting your business at financial, operational or reputational risk? After all these years, I continue to grapple with balancing all these and staying hyper-focused on improving in every cost-driving area. 

Peter Bigelow is president and CEO of IMI, Inc. (imipcb.com); pbigelow@imipcb.com. His column appears monthly.