Before discussing ways to reduce production costs, let’s first understand the concept of manufacturing & various elements of production cost.
A manufacturing concern is a business entity engaged in the manufacturing of tangible articles called goods or merchandise.
Manufacturing an article essentially entails combining some resources to bring into existence a new article. The article so emerged has a distinct name and possesses unique attributes and utility than those of its constituents.
What Is Production Cost & What Are It’s Various Components?
Production cost is the cost incurred to procure raw materials & convert those raw materials into finished products. In other words, all costs related to the factory are included in the production cost.
Production cost = Direct material cost + Direct labor cost + Factory/Manufacturing overheads
Direct Material Cost
Direct material cost is the cost incurred to procure raw materials. It includes material purchase cost & expenses incurred to bring the material from supplier location to your factory location. Tax paid on purchase, being a input tax credit element, is not included in direct material cost.
Examples of costs included under direct material costs:
- Purchase cost
- Carriage inward
- Loading & unloading expenses
Note: Consumables like packing material aren’t included in direct material cost. They’re instead included under manufacturing overheads
Direct labor cost
Direct labor cost is the labor cost incurred to convert raw material into finished product.
Example of labor cost:
- Wages of front-line workers
Manufacturing Overheads are the costs incurred in the factory excluding direct material cost & direct labor cost. Such overhead costs cannot be easily allocated directly to a product. That’s the reason they’re also known as Manufacturing indirect expenses.
Examples of manufacturing overhead:
- Factory rent & insurance
- Electricity & other expenses required to run the factory
- Lubricants & consumable stores like packing materials
- Cotton wastes, small tools & grease oil
- Factory’s supervisors salary
- Gate-keepers & sweepers salary
- Depreciation on machineries
- Machine repair & maintenance
Selling & administrative expenses (falling outside the purview of the factory) aren’t included in the production cost. They’re instead included in income statement as indirect expenses.
John started a new business of manufacturing LED Lights. He incurred the following expenses in his first month while manufacturing 100 LED Lights:
Purchase of raw materials = $ 500
Shipping cost incurred to import raw material from China = $ 150
Import duty paid for custom clearance = $ 50
Transport cost incurred to bring raw material from port to his factory = $ 20
Labor salary engaged in production = $ 100
Salary of factory quality control executive = $ 1000
Salary paid to office accountant & marketing executive = $ 1500
In this case, what will be the production cost for each LED?. Let’s find out.
Direct material cost per unit = ($ 500 + $ 150 + $ 50 + $ 20)/100 = $ 7.2 per LED
Direct labor cost per unit = $ 100/100 = $ 1 per LED
Manufacturing overhead = $ 1000/100 = $ 10 per LED
So, the total production cost comes to $ 18.20 per LED light.
Michael started a new business of manufacuring Furnitures. During the first month, he incurred the following expenses while manufacturing 100 chairs:
Purchase of raw wood = $ 5000
Purchase of glue & paints = $ 1000
Purchase of packing box = $ 100
Transport expenses to bring raw wood from supplier to factory location = $ 200
Labor cost to unload raw wood = $ 50
Salary of carpenters = $ 2000
Salary of factory gate-keeper = $ 500
Office printing & stationary expenses = $ 80
Warehouse rent = $ 750
In this case, what will be the production cost of each chair? Let’s find out.
Direct material cost per unit = ($ 5000 + $ 1000 + $ 200 + $ 50)/100 = $ 62.50 per chair
Direct labor cost per unit = $ 2000/100 = $ 20 per chair
Manufacturing overhead = $ ($ 100 + $ 500 + $ 750)/100 = $ 13.50 per chair
So, the total production cost comes to $ 96 per chair.
WAYS TO REDUCE PRODUCTION COSTS IN A MANUFACTURING BUSINESS
Business being an economic activity runs for maximizing profit.
There are mainly two ways to increase profit, viz. 1. by increasing selling price per unit and 2. by reducing costs. The first one seems a risky and unwise proposition in today’s competitive market conditions.
Thus, most businesses opt for the second one. In a manufacturing concern, total costs can be checked by keeping the manufacturing cost minimum.
The following are some of the ways to reduce the manufacturing cost.
1. Track The Numbers
At the outset, you got to track your key expenses. If you aren’t doing it, then start doing it right now.
You can’t reduce something which haven’t yet recorded. Makes sense?
No, you don’t need an accountant to do that. With the advent of technologies like cloud accounting softwares (Example: Quickbooks), even a non-accountant can track & keep a tab on numbers.
Get started by tracking at least the following key numbers:
- Production capacity
- Actual used capacity
- Direct material cost
- Direct labor cost
- Manufacturing overhead
- Labor efficiency
- Carrying cost of inventory
- Cost of goods sold
- Overtime expenses
- Stock in & out
- Cash in & out
If you don’t want to use an accounting software, then try recording the numbers in a simple excel file. The point is: Do anything but please track your numbers.
If you’ve a big team then share the templates with them (or create users in the accounting software) & instruct them to start feeding the numbers. Do it now.
It’s hard to believe but the fact is– even a simple recording of numbers will give you a lot of idea about what’s wrong with your factory.
For more advanced ideas, continue reading this article.
2. Reduce Direct Material Cost
Direct material cost constitutes a substantial portion of the total manufacturing costs.
There are a number of techniques to control the direct material cost. Let me share a few:
- Invite quotations from as many suppliers as possible
- Consider signing a long-term contract with the shortlisted supplier. That’ll give a quantity assurance to the supplier who in turn can reduce the price accordingly.
- Offer cash payment in return of cash discount. Most suppliers will be willing to trade off discount in return of prompt payment.
- Ask for turnover discount at the end of a financial year. Suppliers are willing to give discounts to customers who’ve contributed significantly to their turnover or revenue.
- Negotiate like a pro.
- Consider sourcing internationally from B2B chinese wholesale websites like Alibaba, Global Sources, Dhgate, etc. Of course, international sourcing comes with a few additional cost like import duty, container shipping, etc. So, do a cost-benefit analysis before commiting to buy from international supppliers.
- Consider re-structuring your product. Can a particular raw material be replaced with an alternative without compromising on quality?. Example: A furniture manufacturer can consider replacing cost raw wood with a cheaper alternatives like plywoods.
- Prepare a database of suppliers with details like name, phone number, email, address. That’ll act like a backup in case you face an adverse market situation like price increase, lack of supply or economic depression.
- Tie-up with a transport company that’ll help you bring stuff from the supplier location to your factory. Invite quotations & enter into a long-term contract with the shortlisted transport company. Even a verbal engagement may work.
- Request the transport company to take care of unloading raw material into your factory. Mention the same in the contract. That’ll save you a lot of money. (Pro tip: Local un-branded transport companies offer cheap rates for transport. Avoid using DHL or FedEx kind of branded transport services)
The direct material is the most significant part of production cost. If you can reduce the same effectively, half of your job is done.
3. Reduce Carrying Cost of Inventory
Carrying cost of inventory is the cost incurred to hold, store & maintain the inventory over a period of time. Inventory also includes raw material & work-in-progress material.
Most components of the carrying cost are included in the manufacuring overhead.
- Warehouse rent & insurance
- Pilfirage & shrinkage cost
- Warehouse staff cost
- Opportunity cost (money blocked in the stored inventory)
- Stock taking cost
- Warehouse electricity & maintenance cost
- Stock insurance
If you’ve incurred $ 40,000 in carrying cost of inventory in a year for 4,000 units of stored inventory on an average. Then the carrying cost per unit comes to $ 10 per unit. Yes, it’s a significant cost. And, therefore demands reduction.
To reduce the carrying cost of inventory, follow these time-tested techniques:
- Set the raw material order quantity using EOQ(Economic Order Quantity) method. EOQ refers to the quantity of material that should be ordered in a single lot. Purchasing at EOQ helps to keep the total of carrying and ordering cost minimum. The formula to calculate EOQ is square root of 2DS/C. Where, D is demand in units & S is the ordering cost & C is the carrying cost per unit.
- Consider using JIT(Just-In-Time) method to avoid over-stocking of inventories. JIT means ordering inventories only when it’s actually needed for production. That avoids unnecessary stocking & thereby reduces carrying cost.
- Prioritize & manage stock using the ABC system of control. The ABC system suggests to classify your inventory into 3 categories: A,B & C. The inventory that’s high in value (comprising at least 50% of the total inventory value) falls under A category. The inventory that’s moderate in value (35%) falls under B category. And, the rest falls under C category. To reduce carrying cost, you need to have a stricter control on A category items, moderate control on B category items & low control over C category items.
- Classify inventory as per the VED(Vital, essential, desirable) method. While the ABC method advocates costing approach, this method recommends a qualitative way to manage inventory. All vital(critical for production) raw materials should be classified under Vital category. The moderate ones should fall under Essential category & the least critical ones should fall under Desirable category. The vital category of inventories requires a stricter control followed by essential category & desirable category.
- Regularly inspect the quality of stock to avoid pilferage & damage.
- Follow the FIFO (First In First Out) method of stock movement to avoid shrinkage cost
- Consider renting a smaller or cheaper warehouse instead
- Sub-let the vacant spaces in warehouse, if possible
- Look if you can get rid of the warehouse staff (the production guys can take care of that stuff)
- Set a threshold limit for the amount of money blocked in inventory. Example: Set an inventory carrying cost limit of 10% on sales. If the cost crosses that level, you need to take a few emergency steps to release the blocked funds.
The idea is to reduce the inventory to such an optimum level that minimizes the carrying cost & at the same time doesn’t affect the production schedule or sale.
4. Increase Workers’ Efficiency
Reducing employees’ remuneration is not a great option because it results in employee dissatisfaction and ultimately in hiring and retaining unskilled employees.
A more wiser approach would be to improve the labor efficiency. It’s not easy but definitely worth the effort.
Let me explain with an example:
Assume you’ve hired 10 labor staff with a combined cost of $ 10,000 per month. At an optimum level, they’re currently producing 1,000 units of finished products. So, the total direct labor cost comes to $ 10 per unit.
Your aim of course is to reduce that direct labor cost of $ 10 per unit. As already explained you can’t reduce the labor salary. So, the other way out will be increase the output which currently is 1,000 units.
If by any means, you can increase the output by say 20% the revised labor cost per unit will be: $ 8.30 per unit. That’s a huge improvement.
Thus, the organization should aim at enhancing employee efficiency by:
- Hiring efficient employees. Use vetted job portals like Monster.
- Providing labor force with adequate training and cost reducing techniques. You can reduce the time taken to produce an average unit by providing specialized training that allows employees to work at a faster rate.
- Offering incentives to the workers who produce an average unit at less than the standard time.
- Using production tracking & scheduling software like BuddyPunch
- Re-schedule production task to match skills. (Example: A worker specializing in packing should only pack & not get involved in other tasks)
- Share a clear production goals with the team
- Motivate the labor force as & when required. Appreciate their commitment.
- Examine & improve your current production process. Eliminate the processes that’re redundant & eat up a lot of time. For this, break down the production cycle into small steps & track the time taken by each step.
Improving labor efficiency is perhaps the most cheapest strategy to reduce production costs. And, the benefits are very rewarding.
5. Control Manufacturing Overheads
Manufacturing overheads are mostly non-value adding expenses & thus can be avoided.
To reduce the same, you may do the following:
- Set budget for these costs and review them periodically. Necessary steps are to be taken to control them.
- Costs such as depreciation are mostly time-based. You have to decide whether to own these assets or to acquire them on a lease basis.
- Reduce headcounts. Look if production supervisor’s role can be delegated to someone else. Whether the gate-keeper’s job is essential?. I know it’s tough to let people go but it’s business & you’ve to sometimes take tough decisions.
- Avoid fancy packaging expenses
- Consider reducing product features that don’t add much of value to the end customers
- Avoid air conditioners or other fancy electric installations in the factory (to reduce electricity bills)
- Regularly check & update machineries to avoid costly repair expenses
These costs can be tough to control. But you got to think about your business first. And, business means profit.
6. Eliminate Non-Value-Adding Processes
Frequent innovations are occurring in the methods of production. Periodical review of manufacturing processes is necessary to diagnose the deficiencies in them. There may be some redundant processes in the manufacturing cycle that are no longer required and are unnecessarily consuming costs.
Hence you should analyze the value added at each stage of production and determine whether that activity is actually required in the present scenario.
Dropping non-value adding activities in the manufacturing cycle can assist in cutting unnecessary costs and keeping the manufacturing cost to minimum.
Here’re a few more steps you can take to improve your manufacturing process:
- Use a tool like ProcessStreet. It helps you to create, streamline & control your workflow & processes.
- Take your factory workers’ feedback. And, make sure you communicate with them regarding the proposed process changes.
- Conduct A/B tests to test the actual improvement of production time. You should approve the new process only if the test results are favorable.
- Take into account the workers’ fatigue & unproductive time while charting a new improved process.
- Use technology wherever possible. In long run, the benefits will pay off the cost easily.
In manufacturing, you got to take tough calls. Of course, no process is done without a reason. But if the reason is non-value-adding, it can be avoided.
7. Leverage Automation
The automation of processes makes them more efficient. It gives more opportunity to save in terms of cost.
Human beings are more prone to mistakes than machines. Hence, with the use of technology, it’s possible to bring down errors. Further, you won’t have the liability in terms of warranty or refunds to customers who’ve been served with defective products.
Thereby the customers will be satisfied and the reputation of the business will improve due to the low error rate.
You’ve to use sophisticated machineries which will process the products at a faster rate and minimize the firm’s manufacturing cost in the long run.
Here’re a few examples of processes that can be automated:
- Painting, etc.
Of course, automation comes a huge upfront cost. So, study the cost & benefits before taking a decision in this regard. Alternatively, you may also try leasing the automated machines if it makes sense.
8. Optimize The Production Output Level
Optimizing output level means figuring out a quantity at which the production cost (per unit) is the minimum.
Example: Michael started a new factory & observed that the production cost per unit for first 3 days differed as follows:
Day 1: Qty produced = 100 units, Production cost per unit = $ 3.50
Day 2: Qty produced = 150 units, Production cost per unit = $ 3.25
Day 3: Qty produced = 180 units, Production cost per unit = $ 3.40
So, for Michael, 150 units per day is the optimal level of production where his production cost per unit will be minimum. Anything more or less will result in additional cost.
Since all costs are not directly proportional to production level, we have to determine a level at which the per unit cost of production reaches the minimum. Making various cost analysis can help to arrive at the optimum level.
So, how does one arrive or predict the optimum output level?
Here’s the formula.
The optimum level of output is reached when the marginal cost(MC) is equal to marginal revenue(MR) or the market price.
Marginal cost (MC) is the additional cost you incur by producing one extra unit.
Whereas, the Marginal revenue(MR) is the additional revenue you earn by by selling one extra unit.
John produces 100 units (per month) of a certain product with a total production cost of $ 300. That means his cost per unit comes to $ 3.
Now, to increase production beyond 100 units, he installed a new machinery. The next month he produced 101 units at $ 304. His selling price is $ 10 per unit.
So, his MC to produce an extra unit comes to $ 4.
Since the demand didn’t increase, his selling price falls to $ 9.75.
So, the MR comes = $ 15.25 [(101*9.75) – (100*10)]
Since, MC isn’t equal to MR therefore 101 units isn’t an optimum production level.
Now, let’s say that John produced 103 units instead of 101 units in the second month. The MC & selling price remain the same i.e $ 4 & $ 9.75.
The MR comes to = $ 4 (Approx) [(103*9.75) – (100*10)] which is equal to the MC.
So, to reduce production cost to the minimum & maximize profit, John should produce 103 units every month.
Simply putting the formula on graph, marginal cost curve should be cutting the marginal revenue cost from below(as shown in the picture). At this point, a manufacturing firm minimizes it’s production cost & maximizes it’s profit.
9. Reduce Waste
Wastes may be in different forms such as
- Early production– producing products before they are needed leads to unnecessary blockage of funds and also some of them may get damaged by the time they’re required.
- Waiting– products, people, and machinery waiting unnecessarily during the manufacturing cycle due to avoidable reasons delays the production process.
- Overstocking– Maintaining inventories in excessive quantity than required also leads to unnecessary blockage of funds.
- Motion – Unnecessary movements of people and products during production cycle delays it.
- Defectives – As already discussed, these are the finished units that rank below the standard quality and need repair even during the warranty period.
In order to reduce such wastes, your business needs to have a strong internal control system. Conduct periodical checks should be conducted to minimize wastes. As we know prevention is always better than cure.
Thus, you should detect the areas of waste and implement measures to prevent them. Tighten the quality control measures, so that only those units are offered to the market that meet the quality standards.