COST MANAGEMENT: Squeezing the (NON)VALUE Out of Overhead – An Activity Analysis Approach

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 at the dawn of the twenty-first century and actually around the middle of the twentieth century, 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 materials 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 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/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/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 in direct proportion necessarily) 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 discernible 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.

Part one – categorize the costs

The first thing to do in discerning value or non-value is to slot both natural expenses and departmental costs into one of the above value categories. Let’s take some examples.

In the “exploit/enhance” category, 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 “eliminate” category, we would note such really non-value added activities/expenses such as inspection, material handling, kiting and the like that we want to eliminate as rapidly as possible.

Moving to the “reduce” category is where we slot the activity intensive overhead items. 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 “consolidate/redeploy” category. 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 slotted in “reduce and eliminate categories,” the search for actual activities and cost “drivers” is the first task at hand. For these activities, we will want to discover that which the underlying cause of them is. 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 significant overhead cost is indirect labor and perhaps the plant could get along with less people if shipments from this department decline. 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. Such functions as accounting, materials and production planning, purchasing, human resources, once thought to add managerial value as part of a plant management team are now often being more efficiently and effectively deployed in corporate “centers of excellence.” Such centers of excellence provide the professional critical mass so that the highly trained and educated people who staff these functions can associate with their peers and can still interact with operations management at the plants for which they have responsibility through modern communications. Professional critical mass is the value component of center of excellence deployment and the value is enhanced by the economies of scale realized from having professional manufacturing staff work spread across more than one plant. It is of questionable value to have numerous purchasing professionals overworking local procurement issues by being physically and organizationally located on a plant site. Similarly, much of on-site plant accounting (accounts payable, cost accounting, general ledger), once believed to be the financial counsel to the plant manager, may hardly be relevant in an era of MBA plant managers.

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 deployment of resources.

Part four – exploit and enhance

Finally, we come to “exploit/enhance.” 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 contradictory 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!

3 Fun And Productive Activities For Your Teenager This Summer

It is summer time and your teen has been waiting for this holiday season! For most girls, hanging out with their friends and having sleepovers is what they really cannot wait for. While the boys are all about “doing their thing”, which in most cases is never a good thing. You need your teen to always follow the right path, even if you are not around and below are some ideas that will do that and more, as he enjoys this summer time.

· Sports

If your teenager is a couch potato, things are about to change! Their bodies are most active at this age and so are their minds. If you as a parent do not get involved in your kids growth, you might miss on a lot, which is the current problem parents are having. Your teen will only end up being a social misfit and this could greatly affect him in future. A sport is not only about being physically fit, but it also teaches them on discipline, perseverance, respecting one another and teamwork.

· Charity events

If there is a good way to teach your teen about thanksgiving and being appreciative, it is through charity events. Charity work is not for old people, in fact, most of them are for needy kids and teens. The good thing with such events is that they are very involving, with various activities and competitions which a teen should have no reason not to participate in. What better time to grow their confidence and also learn to communicate with new people? At the end of the day someone else will gain and your teen will learn so much as well; something he could never learn at home watching video games.

· Teen retreats

This could go in either one of two ways; your teen may actually learn something valuable or it might be a learning experience in the wrong way. The bad thing about it is that you are not going to be there as a parent (unless you feel the urge to follow them and snoop around), but the good thing is they are supervised. There are different kinds of retreats; religious, high school retreats, holidays like summer retreats etc. Your teen has a variety to choose from and he/she can team up with friends to make it an even better and worthwhile experience. You never know; your teen who is a loner, might actually make a friend or even better, two.

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