Misleading allocations and how to fix it–Part 1

Two things about which I warn my clients who buy manufacturing software are these:

1. Manufacturing software is capable of capturing, storing and reporting on reams of data
2. If you are not careful, you will find yourself taking “as fact” the data produced by the system and being mislead in your decision-making

Why is this so?

Because ERP systems allow the users to create allocations of overhead based on manufacturing “drivers.” In Sage 500 ERP’s case (as shown in the screen image below), the chosen driver is “labor hours”—for run time and set-up time.

In the Sage 500 ERP Set Up Work Center screen there are places for “Fixed Setup” costs and “Fixed Run” costs. The values placed here are used to absorb “Fixed” overhead costs at the rate supplied based on each hour of “Setup” or “Run” time calculated for production utilization of the Work Center.

The problem is that these “absorption rates” must be calculated based on historical (or prognosticated based on expected future) utilization rates of each Work Center. These calculations must make assumptions about product mix, work center utilization rates and operating expense levels. As soon as any of the these factors change

• Product mix
• Work center utilization rates
• Overhead expenses

The data supplied by the calculations will be wrong.

And, since either the product mix or the total of operating expenses will certainly be different than the numbers used in the calculations, the data resulting from the calculations will (virtually) always be wrong.

A simplified example

We are going to look at two different allocation methods and the decisions that might be derived from such calculations.

• Standard overhead allocations by Job (equivalent to allocation per work order in a manufacturing operation)
• Activity-Based Costing (ABC) allocation based on production hours

In order to make the allocations easy to follow, you will see that the company is a service company and that the firm has three partners (administrative overhead) and some relatively fixed overhead in the form of vehicle leases, maintenance and so forth.

The direct labor (production labor) comes from five employees who—to make it simple—all work exactly 200 hours per month and all make exactly the same rate—$10 per hour. This also gives “production” a known capacity—1,000 hours per month.

The partners have kept good track of their history over the last six months and have also done enough market research to have a good handle on the size of the market they are serving. They know, therefore, how many of each kind of job they have done each month (on average), as well as the market potential for the kinds of jobs they do.

STANDARD COST ALLOCATIONS (by Job)

In an attempt to leverage what they have learned by capturing data about past performance and, of course, to improve profitability, the partners do an analysis that includes a standard allocation of overhead to each job.

From this analysis, they discover that their most profitable jobs are landscaping jobs ($35 per job), followed closely by window cleaning jobs ($30 per job). So, they decide to satisfy the market demand in that order, using the resources they have (1,000 hours of production time).

Before we move on, note that with their present product mix, the company is producing a profit of $4,100 per month ($49,200 per year).

The results of this action are shown here:

Upon first glance, it appears that this has been a great move. Based on the calculations in the table, profit has moved from $4,100 per month to $7,200 per month!

Again, the problem is that since NO plumbing or gutter guard jobs were done, some of the overhead (allocated at $90 per job) was not absorbed in the calculations. The total overhead is $18,000 plus $9,000, or $27,000. But the 220 jobs only absorbed 220 times $90, or $19,800 in overhead. That leaves $7,200 in overhead NOT absorbed. Take that $7,200 away from the calculated profit of $7,200 and the company is actually worse off (zero profit) after having reallocated its resources to what appeared to be the “most profitable jobs.”

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[To be continued—be sure to watch for Part 2!]

The Dangerous Dichotomy - Part 1

Far too many business executives have created an artificial dichotomy within their own organization that is potentially dangerous to their firm's survival and almost certainly destructive of profits. What is that artificial dichotomy, I hear you ask?

The answer is simple: Businesses all too frequently put the responsibility for increasing revenues into the hands of one part of their organization, while putting an entirely different group--usually most of the rest of the organization--in charge of reducing costs.

While, on the surface, this may seem to make sense; it really does not.

Here's why.

The Revenue-Increasing Group
The folks in the organization put in charge of increasing revenues--usually the sales and marketing departments--generally are measured only on the things pertaining to revenues. Because it is not a part of their reward metric, the folks in sales and marketing are, therefore, wont to make decisions that may:

1. Increase the costs of production
2. Drive inventories up
3. Increase operating expenses
4. Reduce output

Now, they don't do these things intentionally. They are just trying to do what they have been mandated to do by management and senior executives.

But, if increases in revenue are stymied or shrunken by, say...

1. Failures to meet delivery-time promises
2. Out-of-stock conditions on finished goods or components
3. Lay-offs or cut-backs in production, warehousing or elsewhere

Then, the revenue-increasing group has an "out" for not performing up to expectations or forecasts. Their excuses are generally based on the performance of the other part of the organization.

The Cost-Cutting Group
The other part of the organization is, as I said, usually all the rest of the organization. These folks have all been instructed and, frequently, are being measured based on "keeping costs down." There interest is in doing everything they can to...

1. Keep the costs of production down
2. Holding inventory levels as low as possible
3. Making sure that operating expenses are minimized

These parts of the organization's management also want the organization to succeed. But they are not being measured based on the organization's (the "system's") success. They are being measure on their performance against budgets for costs and expenses.

The folks working in these other departments have no malice of intent, but when sales and marketing brings a request to engineering or production that is going to increase the costs of production, they are not likely to look too kindly upon the idea. When sales tells these folks that they could sell more if they just had more inventory, they may nod their heads in affirmation, but the are not likely to take affirmative action because they aren't rewarded for that effort. To the contrary, they are more likely to be rewarded for holding inventory levels down and increasing inventory turns.

So, the battle rages
And, of course, the battle does not end there. When cost-cutting fails to make the firm more profitable, this group is just as willing and able to point fingers at the "sales guys," and point out how their frequent interventions, their calls to change production or shipping priorities, and their demands that end-of-period orders "get out the door" prevent serious cost-cutting by...

1. Driving overtime expenses up
2. Increasing requirements for both raw material and finish goods inventories
3. Reducing production by breaking up shop floor production runs with new priorities on a daily basis

 Hence, these two separate factions--who should be working toward a single end--are first formed by management and then each becomes the excuse for the other for non-performance. Meanwhile, the firm as a whole suffers reduced profits, higher operating expenses, and--generally speaking--too much inventory (made even more unbearable by having too little of the things that the customers want when they want them).

To be continued...
If your organization is not presently experiencing this warfare--even if subtle or boiling just beneath the surface of a "mask" of "team work"--then you are a fortunate one and, more likely than not, you know a firm or have worked in a firm where this is or was true.

This internal conflict is evidence of the lack of "system thinking." When executives give different directives to different parts of the organization--in the hope of squeezing some profit out of "local optima," rather than global metrics that encompass the goal of the whole system--the whole organization--this is what one must expect.

There is an answer.

[Continued next post....]

Taking the Easy Way (Down and) Out

In a LinkedIn group discussion today, many people were offering advice regarding how to save a small business that has been struggling due to the recession.  There has been no shortage of advice.  However, one comment today really stuck out to me. Here is what the contributor had to say:

A company is making 1 million a year.
From that it makes 10,000 profit (1%).
Each sale yields 25% return - i.e. if you sell 1,000 250 is profit.
To double its profit it can:
1. Reduce costs by 10%
2. Increase sales by 40%
Do the math(s). Which is easier?

Now, perhaps this example was intended to demonstrate what a clearly bloated and, likely, wasteful company really looks like. After all, the firm is grossing $250,000 on $1 million in revenues, but net profits are only $10,000 (1%).  That means that the firm is spending $240,000 (99%) on “expenses.”

If this is true – that the company really is bloated and wasteful – then, by all means, the quick and easy way to making more money is to “reduce costs by 10%.” It may even be likely for a $1 million revenue company that is spending $240,000 in expenses that $24,000 could be cut out and not do a bit of damage to the firm’s ability to survive and thrive.

The real state of things

For better or for worse, most small businesses today do not have a profit-and-loss statement that looks anything like that – at least not in terms of being bloated and wasteful. Most of the SMBs (small-to-mid-sized businesses) that I encounter are already running a pretty tight ship. There is no extravagance left in the firm’s operating expenses and, typically, they have already cut back on staffing so that many of the folks in the organization are working long hours and have taken on multiple duties so that fewer people are needed to keep things running. These organizations do not have any “fat” left to trim away. If they seek to cut expenses by even five percent (5%), it would mean cutting away “muscle and bone” – the strength that has allowed the organization to survive until today.

Cost-cutting may have gotten here

If management in such organizations are trapped in cost-world thinking, it could be that cost-cutting is what helped bring them to the brink of destruction, as it is. Here is how cost-world thinking can take a executives and managers astray and lead them to make decisions that are damaging to the organization:

Misleading allocations of overhead expenses

Using the figures offered by the contributor to the discussion (above), this company believes it has a gross profit of 25% ($250 for every $1,000 in revenues). Let us say that this is being calculated in the following (traditional) manner:

Cost Classification	Cost Amount
Raw materials	$250.00
Direct Labor	$100.00
Allocation of indirect costs and overhead	$400.00
Total Calculated Cost of Product	$750.00

For the sake of simplicity, let us say that each “widget” sells for a price of $1,000, so we have the following:

	Amount
Unit Revenue	$1,000.00
Unit Cost (incl. allocations)	$750.00
Calculated Gross Profit per Unit	$250.00

Also, let us assume that, due to the recession, this company also has excess capacity at this time.  (Otherwise, how could their operating expenses possibly be $240,000 on revenues of $1 million?)

Opportunity knocks

Now, one of this firm’s salespeople comes back from a long discussion with a potential new customer in Europe. This firm wants to buy up all the remaining capacity at the firm. That means 1,200 units. However, they are only willing to pay $650 per unit.  What should the company do?

Far too many executives caught up in cost-world thinking would turn this offer down. They would say, “We can’t take a loss of $100 per unit and ‘make it up’ in volume! That’s crazy!”

But, let us look at what is really happening. The company already has excess capacity. It could produce the additional 1,200 units without investing in any new facilities or equipment. Furthermore, it would not add to operating expenses, because no additional back-office staff would be required and no overtime is expected to meet the new demand. So, here is a contrast between cost-world thinking and reality:

COST-WORLD THINKING	Amount
Unit Revenue	$650.00
Cost-world Cost	$(750.00)
Gross Margin per Unit	$(100.00)
Number of Units Sold	1,200
Gross Profit from Offer	$(120,000)
Gross Profit from Current Operations	$250,000
Total Gross Profit	$130,000
Operating Expenses	$(240,000)
Net Profit	$(110,000)

Throughput Thinking

THROUGHPUT THINKING	Amount
Unit Revenue	$650.00
Truly Variable Costs (TVCs) (Raw Materials)	$(250.00)
Throughput per Unit	$400.00
Number of Units Sold	1,200
Change in Throughput from Offer	$480,000
Throughput from Current Operations	$250,000
Total Throughput	$730,000
Operating Expenses	$(240,000)
Net Profit	$490,000

Escaping from cost-world thinking

Here is a simple formula to help rescue firms from making the error we have illustrated above:

Where ROI = Return on Investment,
delta-T = Change in Throughput, where T = Revenue less Truly Variable Costs (TVCs),
delta-OE = Change in Operating Expenses, and
delta-I = Change in Inventory or Investment

In this case, we have determined that the change in OE = zero, and for simplicity’s sake, we have also assumed that the change in Inventory or Investment is zero (or negligible).

Essentially, when looked at properly this offer to “sell below cost,” actually increases the firm’s net profit by $480,000 with virtually zero investment. (In a real situation, some change in inventory is likely, but the effects would still be small.)

I trust this sheds new light on your business situation. Contact me at rcushing@GeeWhiz2ROI.com if you’d like to have help getting a better view of your business and how to make more money.

©2010 Richard D. Cushing

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

Getting more of what you want - Part 1

Most of my clients are small to mid-sized businesses when I meet them. Many of them have already achieved a significant level of success. These firms have proven themselves and grown -- many of them have grown rapidly -- and frequently they are on the precipice of making the leap from entrepreneurial to enterprise.

Generally, what makes an entrepreneur successful is something of a sixth sense that communicates to them an almost instinctive connection between opportunities (or revenues) and truly variable costs (TVC).

Entrepreneurs thrive and grow on this instinct and worry about the "cost accounting details" later. However, two things begin to change as their organization begins to grow:

1. The entrepreneurial individuals in the firm -- the founder and his or her closest associates -- may become less connected to each opportunity the firm may encounter and similarly disconnected from a sense of the TVC involved.
   
   
2. The more disconnected these, now, executives become from the details surrounding opportunities and TVCs, the more they begin to rely on standard "cost accounting methods" to guide their organization's decision-making.
   

Interestingly, the more "sophisticated" the decision-making process becomes in their organization, the more profits and profitability growth may tend to decline. The entrepreneurs find it increasingly difficult to make that leap from entrepreneural to enterprise capabilities.

What's keeping entrepreneurs and firms in this position from getting more of what they want? What's stopping them from making more money tomorrow than they are making today?

[To be continued...]

Contact me.