The Problem with Manufacturing Software

Maybe I am just too cynical. It is likely that I am. However, whenever I work with clients who are implementing (or thinking about implementing) ERP software that includes a manufacturing suite and further, when this client is implementing the manufacturing suite because they "need to get a better handle on manufacturing costs," I warn them: "The problems with implementing software that helps you calculate your cost of manufacturing are two-fold: first, the system will produce a lot of numbers and reports for you and, second, you will believe the reports!"

"So, why is this a problem?" I hear you ask.

In order to answer that question, let me take you through the steps that a client is going to go through in order to implement their new manufacturing suite before they are going to start getting reports and numbers coming out of the system.

In even a relatively simple manufacturing suite, there are dozens of parameters involved. These parameters are used in various places. However, for our purposes, we will just concern ourselves with the few parameters that might be found on a typical "routing" or "router" – the part of the data that tells the system what steps must be executed – and in what sequence the steps must occur – in the manufacture of any given item. Consider the following table:

	Parameter	Purpose	Source and Comments
1	Move Hours	Used by APS (advanced planning and scheduling) to calculate the time it will take to move a unit of production (piece) between operations	Most organizations have never tracked this, nor even given much consideration to "move time" in their operations. Therefore, this is usually a very round "guess-timate" provided to the new manufacturing suite from "tribal knowledge."
2	Queue Hours	Used by APS to calculate the time a unit of production will sit in its queue waiting for the pending operation to actual work on this particular piece	Again, this is usually a very round "guess-timate" provided to the manufacturing suite from "tribal knowledge."
3	Set Up Hours	Used by APS for scheduling purposes, but also used by manufacturing costing to calculate the labor costs and fixed overhead that should be allocated to a production run for the time spent setting up to run a particular operation	The values provided to the new manufacturing suite for the time it takes to set up for a particular operation will probably be pretty close, even if they do come from "tribal knowledge" with no formal calculations underlying them. Likewise, the dollar-costs for the variable labor will also probably be pretty close to the dollar-amounts per set-up. The problem area is going to be fixed overhead absorption rates. These are problem because the actual amount of fixed overhead dollars that should be absorbed will be dependent upon the number of set-ups that occur. If there are more actual set-ups than the number of set-ups used to make the calculations, fixed overhead (and variable labor) will be over-absorbed, and if there are fewer actual set-ups, fixed overhead (and variable labor) will be under-absorbed. One thing of which you may be pretty certain – the number will never be the right number. That is, the actual number of set-ups and the actual duration of the set-ups will virtually never coincide precisely with the numbers used to set the parameters in the software.
4	Reset Hours	See Set Up Hours above	The problems with Reset Hours are precisely the same as with Set Up Hours above.
5	Pieces per Reset	Used by APS and manufacturing costing to determine how many "resets" were performed during each reported production run	This is just one more parameter that contributes to the calculation of manufacturing costs. The relative accuracy of the calculated cost versus the true cost will be entirely depend on the following factors: Was the number of "resets" actually performed exactly as estimated in the creation of the routing? Did the "resets" actually take the precise number of hours allotted for each "reset"?
6	Scrap Pieces	Used by APS and manufacturing costing to determine how many pieces had to be "processed" in order to produce the number of usable pieces required	This parameter also is based on averages. Therefore, if the actual scrap was different from the averages, incorrect costs will be assigned to WIP and, ultimately, to finished goods. If methods are provided by the manufacturing software to capture actual scrap by production run then, most likely, the differences will show up in variances – yet another confusing data point to unravel for decision-making.
7	Production Rates (pieces/hour or hours/piece)	Used by APS for scheduling purposes, but also used by manufacturing costing to calculate how much labor and fixed overhead should be calculated into the manufacturing cost of each operation	Even if the averages used for this parameter are pretty accurate, they are just that – averages. This means that, while they may be reasonably accurate on average over a large sampling of data, the factor will be actually wrong (inaccurate) for virtually every actual production run (which will almost never hit precisely on the average used to set the parameter in the software).
8	Production Effective Rates (percent of "standard" rates)	Companies frequently have "standard" rates per manufacturing operation based on some (frequently unknown) factors. However, they realize that in the process of actual manufacturing the operations generally do not hit this rate. As a result, they may apply a "effective rate" factor to the "standard rate." This factor is used by both APS and manufacturing costing.	Since this factor is taken into account in the calculation of manufacturing costs, it is subject to the same weaknesses previously listed for other parameters.

So, let me get this right…

All right. Let us start with this sampling of eight data points in a typical routing for manufacturing. Remember, these eight data points are repeated for each labor step in the routing. So, if a complex item has, say, 30 labor steps, that means that these data points are going to be used in 240 calculations associated with determining what will appear on reports and may be affecting the value of inventory, as well.

These eight data points – most of which are "guess-timates" or averages to begin with, will next be mathematically compounded against other data points related to:

• Variable labor absorption rates
• Variable labor overhead absorption rates
  
• Fixed overhead absorption rates
  

Since these absorption rates must be calculated based on other "averages" or "guess-timates" as to production quantities per period (e.g., month, quarter, year), we may safely assume that these absorption rates themselves will never be correct. We may say this in a mathematical sense that, in order to be mathematically correct the actual production during the period must match precisely the estimated production during upon which the absorption rates were calculated for the whole organization. Furthermore, the actual fixed overhead or variable labor expenses destined for absorption must match precisely the estimated fixed overhead or variable labor expenses used to calculate the absorption factors. The statistical likelihood of this occurrence is so close to zero as to be the statistical equivalent of zero. Therefore, we may properly say, these calculations will never be "correct" in actuality.

Unfortunately, having populated their new manufacturing suite with "averages" and "guesses," when the official-looking reports come out the other end, far too many executives and managers actually believe what the reports say. Worse! They actually begin taking action on the results presented by their costly manufacturing software as though the data reported is "God's truth" in print.

A simpler solution

Before you invest from $100,000 to $1 million or more in the purchase and implementation of a manufacturing suite of software, allow me to suggest some calculations that you and your management team can do simply in a spreadsheet (or on a napkin at lunch).

Try this simple formula for any item in your system:

T = R – TVC
where T = Throughput,
R = Revenue, and
TVC = Truly Variable Cost

Now, for almost any item in your manufacturing operations, you – or someone on you management team – can come pretty close to calculating the Throughput (T) value without getting up from the table. Many times this calculation can be done with reasonable accuracy without ever going to your present accounting system to get "costs."

Forget about all those "allocations" and "absorptions" of fixed overhead! They don't really happen and they can make you believe things that aren't true. Your payroll and fixed overhead do not vary directly with each unit of production – even though that's what most manufacturing software wants to make you believe in their costing and variance reports.

The previous formula is good for looking at a individual product or product family, but how about looking at overall operations?

Here's another simple formula to help you do that:

P = T – OE
where P = Profit,
T = Throughput, and
OE = Operating Expenses

Operating Expenses are, essentially, everything that you pay out that is not TVC.

We will look into this further in another post. Stay tuned.

©2010 Richard D. Cushing