How To Choose A Right-sized Manufacturing System
Chapter 5 - Reducing Costs
Types of Costs
There are many costs associated with running a manufacturing operation. Some are tangible such as the cost of raw materials and production labor. Others are intangible such as the cost of placing purchase orders too late or expending more production labor than anticipated.
One of the most extreme costs of all is missing a customer ship date. Without a doubt, any system that could eliminate, or significantly reduce, the frequency of missed ship dates could easily justify itself. But who could place a dollar value on such a benefit?
Reducing Inventory Costs
One of the primary sources of cost reductions is the elimination of unnecessary inventory. If through effective planning and foresight, you could indeed reduce your inventory holding cost by 10 or 20%, then the purchase of a manufacturing inventory control system might be justified, depending on your current inventory and finance interest rate.
Imagine that, absent any menu planning on your part, you decided to bring home 4 grocery-carts full of food each week, filling 6 refrigerators, just so you wouldn’t be caught short. Similarly, manufacturing firms with no effective planning tools tend to compensate for their lack of planning by purchasing and storing a large quantity of raw materials. Either is a way to avoid unexpected shortages, but a horrible waste of cash.
Eliminating this waste can be a sufficient justification for purchasing a manufacturing system. In my experience, clients who implement an effective inventory control, purchasing, and production management system can expect to trim 20-30% off their inventory holding costs. Rather than purchasing inventory “just in case you need it” the owner of a manufacturing management system will know what to purchase, and when, in order to meet future customer demand.
To be conservative, a manufacturing firm accustomed to keeping $1M worth of raw materials inventory on hand could free up $200,000 by depending on the manufacturing software to tell them what to purchase and when to purchase it so that customer demands are met on time.
That $200,000 could be used elsewhere (perhaps to purchase a new manufacturing control system) or banked. Assuming a commercial lending rate of 8%, a corresponding $16,000 reduction in debt service – in just one year – could fund the acquisition of a right-sized manufacturing control system, including implementation costs, training, support, and on-going maintenance.
Over the years, I have been amazed at how few clients actually knew what their raw materials and WIP inventory was worth. In an initial client meeting, I always ask what the inventory is worth and make a note of the answer. Later, when the implementation is complete, I always run an inventory valuation report and compare the result with the number recorded in the notes of my initial client meeting. Almost always the actual inventory valuation is double (often triple or quadruple) what its owners had predicted.
The point can be made that inventory stockrooms, like refrigerators and pantries, tend to accumulate materials that have no immediate or continuing need. A system that can identify excess, unneeded, or obsolete inventory can justify its acquisition in just a few months of its deployment.
Now we know that many small- to medium-sized manufacturing firms don’t carry $1M worth of inventory. Depending on the products being produced and their complexity, inventory holding costs may be much lower than the $16,000 cited above. So it may not be possible to justify the purchase of a manufacturing system based on inventory cost reductions alone. But there are other factors that affect inventory and production costs that even the smallest of manufacturing firms must face.
Bill of Material Cost Roll-ups
Ask even the smallest manufacturing firm what their finished goods actually cost, and you will get an answer that is at best a guess.
Especially when finished goods are created from a number of raw material or sub-assembly components, it is difficult to maintain accurate costs for those goods.
The $10 selling price of an item may have been justified when it comprised $7 worth of parts. But when, after several years, the cost of those components has risen to $11, selling the item for its customary $10 cannot be sustained. There is no manual system that can maintain those costs reliably. Automatic BOM-based cost roll-up functions of a computerized system are required.
Labor Costs
For many manufacturers, the labor cost component of assembled items represents more than half of the production cost. And yet few manufacturers have anything more than a wild idea about the actual labor cost of their production.
Determining that labor cost component of your production requires analysis that few manufacturers are willing to perform. It takes time and effort to accurately measure and document the labor required to thread Nut A onto Bolt B – and to do it for every assembly operation – but the pay-off can be nothing less than extraordinary.
A client who recently implemented a manufacturing control system made the effort, somewhat reluctantly, to document the estimated labor component for each manufacturing operation. Much to his amazement, this information showed that his production cost was actually 73% higher than he thought. Using his new software to record actual production times, the client discovered that many production bottlenecks were higher than expected and labor costs more than doubled the actual item cost.
Fortunately for the client, the software was able to identify areas of extraordinary labor cost variance in time to modify production procedures and bring total costs down to within 18% of their estimated levels.
While inventory cost reduction is the primary and most obvious justification for the purchase of a manufacturing control system, enough opportunities exist to reduce total production costs that almost any type of manufacturing firm can justify the acquisition and implantation of a right-sized system.