In the Pleistocene era of manufacturing cost accounting (actually, only about one hundred years ago – it just seems longer), product costs were classified as: Labor, Materials and, Overhead – in that order. The order was not haphazard; it connoted the relative importance in dollar size of each. Labor was then the highest cost component, materials was next and overhead was a poor third. Well, now the order is reversed. Overhead is the most expensive component of the cost equation. In fact, as labor declines to third in the cost hierarchy and material costs begin to stabilize in some of the mature manufacturing companies, the management of overhead spending can be the strategic management element in the profitability success equation. Knowing that overhead is the major component of manufacturing spending and putting aside the arcane methods for its accounting and allocation, how then can the senior management of manufacturing companies discern value in overhead in relation to its cost? Let’s take a look at some of the options and combine them into an overall program to find the value and reduce the costs.
What really is manufacturing overhead?
In plain managerial terms, manufacturing overhead is that agglomeration of expenses that don’t “add value” to the products made by the enterprise. Non-value-added activities, now the bogeyman of the era of Lean Manufacturing, are those activities that customers wouldn’t pay for if they knew the extent to which they existed. The most commonly cited example of non-value-added activity is a quality inspection function. The customers would be saying to themselves, why would I want to pay for this when you the manufacturer should have been able to get it right the first time? The strategic implication being, of course, that if we were able to reduce or eliminate non-value added activities; the customer would not have to pay for them through lower prices. The potential for lower prices is largely a near term marketing issue but, in the long run, the costs incurred for products have a structural impact on a company’s and an industry’s prices and profitability. Recognizing that all non-value-added activities can’t be eliminated, some are placed in the category of “non-value-added, but necessary.” These are typically those that are driven by regulations (e.g., GMP, OSHA, FDA, SEC etc.). Other non-value-added activities, despite not being regulation driven, are tenacious in their seemingly innate ability to survive because people believe that if they weren’t incurred, dire consequences would follow.
From a micro-economic perspective, manufacturing overhead is a large component of the break-even point of the enterprise and therefore part of squeezing out value lies in minimizing it. It is the fixed period cost base that the enterprise must cover with incremental gross margin. Accounting gives us numerous expense classification and departmental views of overhead in the detail needed to analyze and reduce or contain this strategically important manufacturing cost component.
Manufacturing overhead has a time and variability dimension
Critical to the comprehension of value and the potential for manufacturing overhead reduction or containment is an understanding as to the behavior of individual natural expense classifications. Virtually all period costs are driven by one or another variable, some of which are static and others dynamic. For example, the variable that drives depreciation is the dollar amount of fixed assets which in turn is driven by long term investment decisions – a value decision that has already been made and absent a sea change in perceived value the cost associated with the decision is fixed. On the other hand, indirect labor in a large shipping department might vary, not necessarily in direct proportion with shipment cubic footage. Of these two examples, one is driven by a static decision and the other by operating circumstances. The difference in time with which a change may be effected in these two expense classifications is dramatic. So, it is wise to view natural expenses for value and optimization in the following groupings:
Fixed in the long term. Those related to a long term decision – depreciation, real estate taxes, property insurance –for which there are cost reduction opportunities in the next long term decision cycle.
Fixed and controllable in the short term. Those that have no discernable connection to a numerical variable – travel expense, outside services – for which value and magnitude judgments may be made on a monthly/quarterly basis.
Variable with activities. Expenses that may be connected to the occurrence of measurable production volume or non-production activities – indirect labor, manufacturing supplies, utilities – which may be controlled by management of the underlying cost driving activities.
Purely Variable. Expenses that vary in direct proportion to the production or sales curve. There are not many of these. Utilities and consumable tools in a machine intensive shop come immediately to mind.
The departmental dimension
There is a departmental dimension to analysis and control of manufacturing overhead as well. Overhead in manufacturing and manufacturing support departments is more easily related to activities on the shop floor and is susceptible to industrial engineering analysis. For example, the “indirect labor” and other expenses of a metal shearing department may be related to lineal feet of incoming sheet metal or the number of strokes of the presses. In contrast, expenses in administrative departments are principally related to management imperatives (that may not be relevant any longer) and may be analyzed and controlled through value/discretionary analysis and zero-based budgeting.
A new dimension - value
The watchwords of the lean era are “value-added” and “non-value added” so it seems that a discussion of value in manufacturing overhead would be a contradiction in terms. If value added is found only in those activities that actually alter the product to suit the customer’s needs, then how can a shipping department confer value upon the product and the enterprise? Perhaps we need to take a closer look at these notions of non-value added and value added to answer this question.
Much is said about how much time and effort is expended on control and reduction of the manufacturing activities that add value and how little is spent on the non-value added side of the shop. The popular estimates are that ten percent of shop activity is in value added activity and ninety percent is found in non-value added activity on the shop floor. The natural consequence of this revelation is to suggest that the “waste” inherent in such shop floor activities as inspection and material movement ought to receive the lion’s share of attention in reduction of non-value added work. Little is said in the same context about such “indirect” labor in manufacturing departments and administrative labor in the offices of a plant. So, in understanding value or its lack, we need to re-categorize activities and expenses according to a value dimension that overlays the time/variability and departmental dimensions. A value dimension goes beyond the simple assumption that all overhead is non-value added and will suggest that some “overheads” really aren’t that at all. The value dimension adds the following overlay categories:
Elimination potential: Those overhead activities and related expenses that represent inherent waste and should be eliminated. Improvement here is not an option; nothing is more useless than improving the way you do something you shouldn’t have been doing in the first place.
Exploitation/enhancement potential: This category covers those activities that might be considered “non-value added but necessary” and present an opportunity to improve the way they are done and to exploit them to squeeze value out of them. The numerous regulatory body proscriptions – ISO, FDA, GMP, Sarbanes-Oxley – that can’t be eliminated come under this heading.
Reduction potential: Expenses and activities that can be reduced correlate well with the time/variability groupings called fixed and controllable in the short term and variable with activities.
Consolidation/redeployment potential: Here we will find the many administrative functions that have grown up in the organization in ways that either seemed to make sense once upon a time or were patched on to the organization when the need arose.
For simplicity, we can view these value dimensions on a matrix with the time and variability dimensions.
|
Controllability |
Reduce/control in the short term; potentially eliminate in the long term
|
Consolidate/ Redeploy |
|
Eliminate as soon as possible
|
Exploit/ Enhance |
|
|
Variability
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Part one – put the costs in the boxes
The first thing to do in discerning value or non-value is to categorize both natural expenses and departmental costs into one of the boxes on the previous matrix. Let’s take some examples.
In the lower right hand box, we might find the departmental expenses associated with an ISO effort - there are two basic ways to exploit this overhead grouping: minimization of the costs by controlling activities and by using the program as an adjunct to a quality at the source initiative.
In the lower left hand box, we would note such really non-value added activities/expenses such as inspection, material handling, kitting and the like that we want to eliminate as rapidly as possible.
Moving up the controllability side of the matrix to the “reduce” box is where the activity intensive overhead items are slotted. These are the expense classifications that while variable with an activity, must be consciously managed when the activity level changes.
Finally, those overhead costs that don’t have much real variability but can be controlled go in the upper right hand box. Typically, these are administrative departmental costs which may need to be reconsidered from an organization standpoint to make sure that the managerial value desired is being received in relation to their cost.
Part two – perform the activity analysis
For those costs in two left hand boxes – the reduce and the eliminate boxes - the search for actual activities and cost “drivers” is the first task at hand. For these activities, we will want to discover the underlying cause of them. The best way to do this is by drawing a value stream map of the entire manufacturing process. Value stream mapping is a subject unto itself but for our purposes, we can simply say that such a map is a diagrammatic and narrative picture of the human, material and information movements that comprise each operation in the sequence of the operations plotted against time. Such a map enables us to see the non-value added steps in the process and identify their root causes. Through further investigation, we can also quantify the drivers and activities that comprise the root causes and plot such quantities over time and identify their trend line. For example, after the value stream mapping and quantification of activities has been performed for a shipping department the data might look like this:
|
|
2004 |
2003 |
2002 |
2001 |
2000 |
|
Cost Driver – Full time equivalents (FTEs) |
32 |
32 |
31 |
35 |
33 |
|
Associated activity – loads shipped |
8,287 |
8,566 |
8,840 |
9,305 |
9,210 |
|
Loads per FTE |
259 |
268 |
285 |
266 |
279 |
|
FTEs required based on prior averages |
30 |
|
|
|
|
|
(Overage)/underage |
(2) |
|
|
|
|
In this example, the overhead cost is indirect labor and it appears that the plant could get along with two less people as shipments from this department have declined. The shipping department would have been identified on a value stream map as non-value added yet reducible in short run with the potential to re-engineer the process and eliminate the entire shipping operation in the long run. There are usually numerous cost drivers and related activities like maintenance supplies expense would be driven by the quantity of small parts utilized which in turn is related to machine hours. The driver and activity can be plotted over time as in the indirect labor example above and a similar overage or underage computed.
Costs that come under the “eliminate as soon as possible” category are those which are susceptible to engineering analysis. Materials kitting or inspection on the shop floor, which may have drivers and activities, ought to be subjected first to industrial engineering analysis to determine how they may be eliminated and only be viewed as a reduction opportunity if elimination must be delayed.
Part three - redeploy
The growth of local administrative functions over the previous quarter century has added between fifteen and twenty percent to total overhead expenses. Once thought to add value to the enterprise, many of these administrative functions may now be outsourced to specialists who, given their scale, can perform them at a lower cost and more effectively. In the last fifteen years we have seen the consolidation of such functions as purchasing and planning in materials management departments. Not only does such consolidation contain costs, but it enables the planner/buyers to be more effective by having a broader view of the materials for which they are responsible.
Consolidation of administrative functions does not represent doing more with less. Rather, it represents doing the same with less and doing it better through superior organization and deployment of resources.
Part four – exploit and enhance
Finally, we come to the lower right hand box of the matrix. Here are located the overhead costs that can be classified as “non-value added but required.” These costs primarily represent an opportunity to cast them in the light of value. Most obvious, for those companies that have ISO programs in place, is the chance to utilize the ISO documentation for quality enhancement. More subtle but equally as valuable are the Sarbanes-Oxley business control requirements as they translate to accurate inventory records or accurate bills of material for cost of sales reporting. These “SOX” control requirements, while part of a mandate, can enhance the way manufacturing is managed and can contribute to lower costs (of physical inventory, accounting errors, etc,) in the future. Rather than bemoaning the cost of such apparent non-value added costs, they should be embraced and exploited for their business value.
No one would argue that these costs should be not be subject to cost controls while value is being sought. A quality department subject to FDA regulations could maintain a traditional program to contain the cost of the regulations and simultaneously pursue a program of lean practices to make compliance efficient and less costly over time.
Overhead and value are not necessarily contradictary terms. A program that categorizes overhead according to behavior and value keeps a focus on this all important cost component and permits management to ascertain that it is getting value for its money.
