Justification for Future Competitiveness
Don't base ROI analysis on past inefficiencies
By John Lenz
CMS Research Inc.
Justification of the purchase of new machine tools by North American manufacturers is becoming more difficult, affecting their ability to invest in the advanced technology necessary to remain competitive in a global economy. Analysis of return on investment (ROI) that is based on the history of manufacturing performance (standard costing) doesn't adequately represent the efficiencies and productivity available from new machine-tool technology.
Standard costs are based on past operations. This cost includes the past utilization of labor, the excess capacity of machines, and market adjustments that impact overhead. For example, the standard cost of labor includes the overtime of paid labor when labor doesn't complete its required production in the planned amount of time. Standard cost includes the excess capacity due to faulty forecasts, paint lines that were underutilized, or failed automation projects—in other words a complete history of the plant's inefficiencies.
Complicating the process of justifying new capital machine tool projects are several trends in machine technology. The magnitude of cycle-time reduction possible through the use of new technologies is diminishing. Reductions in cycle time of 20–25% common as recently as 20 years ago are quoted more nearly at 10% today by machine tool builders. Under standard-cost accounting, the labor component that too often depends on overtime to meet production schedules hides the true cost of labor.
Consider the following example. A Midwestern manufacturer is purchasing a new machine to replace several old pieces of equipment. The project is in jeopardy because the ROI doesn't show the rate of return required for project approval. The reason for the questionable ROI is that the number of total machine hours is decreasing by only 10%, and one operator is still required to operate the machine.
Using standard cost of machine hours and labor hours, there is not sufficient reduction in machine hours and labor hours to offset the capital cost of the machine. A closer look at the ROI analysis reveals that the current process operates at 25% overtime to meet production requirements. The current process performs at less than 50% of capacity.
The new machine, however, would operate at 75% use and require no overtime. Because the ROI analysis is concerned only with standard machine hours and standard labor hours to offset the capital cost, overtime, which is embedded in the old process as a variance, is not considered among the deciding factors.
Standard-cost accounting establishes a cost of labor per standard hour, machine cost per standard hour, and cost of overhead per standard hour. The standard hour is based on the earned or value-added hours from the production process. The number of earned hours, or value-added hours, is determined from the computation of product produced and production time required for each product. These total hours are divided into the total cost of labor to determine the cost of labor per standard hour. This same computation is performed for machine and overhead costs.
Using standard-cost accounting methods, manufacturers that must justify capital investment for an older factory are at a distinct disadvantage to those justifying machines for new factories. The best place to justify machine investment is for a factory that hasn't been built yet. This goes a long way to explain the flight of manufacturing capital investment from existing plants to so-called greenfield sites, from North to South locations, from the US to Mexico, and from the US to offshore manufacturing sites. The trend is clearly seen in the sheer amount of outsourcing of machined parts during the last 10 years.
The advantage won't last that long, because each of these greenfield sites will, in time, become older existing manufacturing sites with their own inefficiencies embedded into their cost-accounting systems. The cycle of ROI analysis based on past performance will continue to impede decisions to ensure adoption of the latest technology unless ROI analysis reflects manufacturing cost based on future performance.
The way to change ROI analysis is to adopt the actual cost method, which uses the annual depreciation of machines, operating cost per year, annual cost of labor, cost of automation, and overhead costs. The sum of these cost components yields the total annual cost of production. This total cost is allocated to all the production to determine cost per part, that is, the actual cost per part is multiplied by the annual volume, summed over all parts produced equals the total annual cost. This cost per part absorbs 100% of the annual cost.
Using an actual cost method to determine ROI, the same data of total parts, annual machine hours, and standard labor hours are used. However, instead of using standard costs of labor and machine, actual costs are used. The actual cost of labor is the wage and benefits cost per hour rather than using standard labor hours. Total paid hours of labor are used, which includes the 50% hourly wage overtime premium.
An important difference with standard costing is how actual costing considers hourly cost of machines and labor. Standard cost is calculated from an hourly cost of machines and labor multiplied by the cycle time of the part. With this calculation, cost absorption is for only that portion of the time when the machine is in use. There is no cost penalty for underutilizing machines and labor. More important, there is no cost benefit for using machines and labor more efficiently. All cost is attached to value-added hours and new machines must show significant reduction in amount of hours to be justified.
In contrast, the actual cost method shows the actual cost of current operations and includes incentive to operate new machines more efficiently. In fact, project acceptance includes a planned level of efficiency that must be met to establish the ROI. The risk of the project is that the machine must operate efficiently or the ROI will not be met. However, operations management now has a reason to manage the efficiency of its processes and not simply use overtime to solve all performance problems.
Here's a prescription that manufacturers can follow for machine tool project justification for future competitiveness:
Know the real or actual costs of your current process. It seems that the only way we know this cost is when the part is outsourced. This actual cost must use the total annual cost to manufacture the part, including all labor costs with overtime, annual machine depreciation, or replacement cost, and allocated overhead costs. Allocated overhead would apply to shared resources and the allocated portion is based on percentage of annual demand.
Know the actual cost of the proposed process. Include the annual depreciation of machines, wage and benefit cost of labor, annual cost of automation, and allocated overhead.
Compare actual cost at various levels of performance. Use actual cost methods to determine the cost per part at 50% use of capacity and 25% overtime. Use actual cost methods to determine the cost per part based on 240-day per year operation and 360-day per year operation. This will establish cost points in business negotiations. If a competitor offers a certain price, you will know what you must do to match that price. If your customer requires periodic cost reductions, you will have a plan to meet these without reducing margins.
Find the least-cost method of manufacturing. This least cost occurs with minimal labor, minimal machine capacity, and minimal use of overhead (shared) resources needed to meet production requirements. In most cases, the minimal use of labor and machines occurs with 24 hours/day and 7 days/week operation. Again, it is not essential that you have to operate under these conditions. It is most important that you know what the cost is at this point and the additional cost when using machines 120 hours per week. The value of this is in knowledge of competition in the market. If the market is willing to accept the excess cost of using machines 120 hours per week, then use the knowledge to secure a competitive position for future business.
Share cost savings with the customer. This is the true test of knowing your actual costs. Expect that a competitor will be willing to accept the operating conditions at the least-cost method and willing to share this cost savings with the customer. Once this occurs, you won't be able to continue to ask the customer to subsidize the under-utilization of machines and labor or pay for excess capacity.
The actual-cost method allows manufacturers to avoid making decisions based on historical inefficiencies that will put them at future competitive disadvantage. It frees them from the consequences of bad decisions made in the past and puts them on an equal footing with new competitors just entering the market wherever in the world they are located. Most important, it enables them to plan for the future based on the performance promised by today's advanced technologies.
Actual Cost vs. Standard Cost Justification
Manufacturers need the most advanced technologies to compete in the fiercely competitive global marketplace. They must look to the future performance that modern machine tools offer as the basis for their analysis of project ROI.
This performance advantage is best represented by actual-cost accounting rather than by historical standard costing. Standard costing is based on a plant's history of performance with existing technology, which incorporates all the embedded inefficiencies, including underutilization of resources and labor rates that ignore the use of overtime to meet production schedules.
An alternative cost system, called actual cost, can accurately measure the impact and benefits of advanced manufacturing technology. The benefits of using the actual cost model are:
- Cost is based on future level of efficiency not on past/historic performance.
- Cost per part is based on 100% absorption of capacity and identifies the cost penalty for excess capacity.
- Cost per part is known at various levels of efficiency for both machine and labor utilization.
- Cost per part accounts for actual production mix.
Examples of Actual Cost vs. Standard Cost justification are available from firstname.lastname@example.org, or by telephone at (920) 235-3356.
This article was first published in the December 2006 edition of Manufacturing Engineering magazine.