The Cost of Inefficiency

Anyone with experience managing a business knows that improving profits requires one of two actions: prices must be increased or costs must be cut. In the manufacturing world, the first of these options has become all but impossible. The struggling economy has caused many customers to ask for price breaks or even consider risking the sacrifice in quality that can result from sending work overseas. This has left many shops in a rush to find ways of cutting costs. Shops have reduced their workforces, narrowed or broadened the focus of their target markets and turned to less expensive equipment and materials. The success rates of cost-cutting efforts have been as varied as their widely differing approaches. Steps that increase the net income of one shop may just as easily lead to the failure of another. Even amid such uncertainty though, certain principles remain applicable across the board.

 

The Danger of Decreasing Prices

To deal with the pressure of remaining profitable while delivering products at static or decreasing prices, many shops have attempted to trim the fat through their consumables. Some common examples of this would include implementing cheaper tooling or switching to less expensive, lower quality raw materials. At first glance, this appears to be a logical starting point. The apparent relief is felt immediately and the savings are realized without the massive overhaul that can accompany efforts to reduce larger, fixed costs. Unfortunately, those who choose this option often are not mindful of all the effects such steps can have on overall profitability.

Many times, a decrease in the cost of consumables can actually increase the total costs allotted to a product. For machine shops, the root of this phenomenon can be found in productivity and the effects of working below true capacity. The profit turned on a single part can be broken down simply as the price received less the combination of fixed and variable costs. On the surface, a decrease in variable costs inevitably results in a larger profit-per-part. This approach fails to appreciate the effects of fixed costs on profits.

 

Fixed and Sunk Costs

Fixed costs are often overlooked in profitability analyses. Expenditures such as rent, maintenance, salaries and machinery fall into this category and are frequently left out due to their sunk nature. In other words, once an expense is committed to and the money is spent, such as with the purchase of a machine, its effect on part cost is easy to forget. To do so is committing a serious error.

While fixed or sunk costs are somewhat in the past, they have a direct effect on the profitability of an individual part. A portion of fixed costs must be attributed to each piece produced. The size of this allocation depends upon how many parts are being manufactured. The greater the quantity produced, the smaller the fraction of fixed costs dedicated to each part. In short, growth in volume results not only in greater overall profitability associated with a higher quantity of sales, but also serves to decrease the cost and increase the revenue derived from each individual unit produced. If cutting corners on consumables decreases productivity, the money saved can easily turn into a less profitable product. On the flip side of that coin, in many scenarios, increasing the amount spent on consumables can actually decrease the overall cost of a part.

 

Three Scenarios

To adequately analyze the situation, three scenarios were considered as they applied to the machining community: (1) a decrease in cutting tool cost, (2) an increase in cutting tool life and (3) an increase in cutting tool cost coupled with the resulting increase in productivity (see Figure 1).

In the first situation, a 30 percent discount was taken on the cost of cutting tools. With all other variables held constant, this action does obviously result in some savings. Unfortunately, total cost is only reduced by a small amount. As cutting tools typically only account for 3 percent of total cost, the price reduction results in just below 1 percent of savings for the part.

The second scenario yields results very similar to those found in the first. Increasing tool life, in effect, merely spreads the variable cost of the tooling over more parts without reducing the amount of fixed cost allocated per part. Again, with the negligible percentage of total cost accounted for by tooling, the overall savings only amount to around 1 percent.

Improving productivity by far had the greatest impact on revenue. An increase in cutting speed of 20 percent, the average gain in a Productivity Improvement Program (PIP), increased capacity significantly. While the cost of cutting tools per part increased by 50 percent, this was easily negated by the drop in fixed costs. As these fixed costs originally comprised 80 percent of the total cost per part, their reduction resulted in a savings of approximately 15 percent. The increase in productivity and capacity clearly provides a stronger economic benefit than cutting the cost of consumables.

 

Looking at the Whole Picture

In today's marketplace, raising prices is rarely a viable option. To compensate for this limitation, manufacturers are often tempted to go for a quick fix to lower costs. While such actions may appear to have immediate benefits, it is vital that businesses recognize the detrimental effects of not considering the whole picture. Those who keep this lesson in mind will stay ahead of the competition and at the forefront of the industry of tomorrow.