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Make It or Buy It? Part 1: Manufacturing Overhead Costs
What types of products does your company make? No
matter what your industry, manufactured goods have two types of costs: direct
and indirect. Direct costs, such as labor and materials, are expenses that you
can attribute to the production of specific items. Indirect costs, such as
management salaries and property taxes, represent all of the other costs of
doing business. These overhead costs can be fixed or variable, and include
manufacturing overhead costs (MOH) that some companies underestimate.
Until you capture all of your MOH or factory
costs, your company may price its products too low - and fail to turn a profit.
Your technical buyers and production managers may also make the wrong decisions
about outsourcing the production of parts such as rubber gaskets. Although some
companies claim it's cheaper to produce these components in-house, their true
factory burden indicates that outsourcing is cheaper. So how can you determine
whether it's better to outsource your gasket fabrication?
What Are Your Costs?
Every company is different, and manufacturing
overhead costs vary by industry, location, plant size, and sales volume. By
expressing overhead as a percentage or proportion - a rate - instead of a
dollar amount, you can compare indirect costs to direct costs and calculate
total expenses. According to Grant Thornton, one of the world's
largest accounting firms, overhead rates can vary from 20% to 130%. Often but
not always, these rates are lower at larger companies because these firms can
spread the cost of indirect expenses across higher volumes of manufactured
units.
Years ago, the Harvard Business Review studied the challenge of reducing factory costs
and concluded that "across the spectrum of U.S. industry, manufacturing
overhead averages 35% of production costs." The RAND Corporation, another well-respected
institution, reported that general and administrative (G&A) costs in one
industry alone (defense) could exceed direct labor costs "by a factor of two or
more". An EPA study of the automotive
industry puts the ratio of direct costs to indirect costs at 1:1 or 1:1.5.
Only your cost accountants know your company's
MOH costs, so let's apply a range of overhead rates to an example of in-house
gasket fabrication. In this way, even if you can't pinpoint a percentage, you
can see for yourself whether outsourcing is more expensive.
Some Examples
In North America, the average hourly
wage for a factory worker is about $25. According to the U.S. Department of Labor, workers earned $24.93 (USD) in August 2014. In Canada, the last available
data is from May 2014, when workers earned
an average of $22.80 (CSD). Canadian manufacturing soared
in August, however, so it's likely that number
is now higher. Even considering the U.S.-Canada exchange rate, it's reasonable
to put manufacturing's hourly rate at $25.
Let's say you need gaskets to complete
a project, and that a custom
fabricator can supply them for $20 each. Your
alternative is to buy standard rubber profiles at $5 each, and then cut and
splice the parts in-house. If per-unit production takes 30 minutes, you'll
spend about $12.50 for labor and $5 for materials (not including waste). That
$17.50 is less than what you'd pay for outsourced, fully-finished $20 gasket.
Remember, however, that $17.50
represents only your indirect costs. Now let's apply a range of overhead rates
to see what your total per-gasket costs could be.
Direct
Labor |
Direct Materials |
Total
Direct Costs |
Overhead
Rate |
Overhead
Dollars |
Total
Gasket Cost* |
|
12.50 |
5.00 |
17.50 |
25% |
4.375 |
21.88 |
|
12.50 |
5.00 |
17.50 |
50% |
8.75 |
26.25 |
|
12.50 |
5.00 |
17.50 |
75% |
13.125 |
30.63 |
|
12.50 |
5.00 |
17.50 |
100% |
17.50 |
35.00 |
|
12.50 |
5.00 |
17.50 |
125% |
21.875 |
39.38 |
|
12.50 |
5.00 |
17.50 |
150% |
26.25 |
43.75 |
|
12.50 |
5.00 |
17.50 |
175% |
30.625 |
48.13 |
|
12.50 |
5.00 |
17.50 |
200% |
35.00 |
52.50 |
*Total gasket costs include rounding
Some Conclusions - and Questions
Across every scenario, it's cheaper to
outsource your gasket fabrication than it is to produce these parts in-house. Why
can the custom fabricator produce these components more cost-effectively?
Instead of using a cardboard cut-out and a utility knife, the gasket fabricator
uses a state-of-the-art waterjet cutter. Instead of splicing profiles by-hand,
the specialist uses a splicing machine. Ultimately, this means that
outsourcing's per-unit costs are lower, both in terms of labor and materials.
When you calculate the cost of
in-house production, do you include the cost of re-work, too? Unless your
production team cuts profiles all the time, they won't have the experience of a
custom fabricator. Also, are you still "saving money" since each worker
requires training, and quality assurance personnel must check each fabricated
part for defects? Your tooling costs may be as inexpensive as a utility knife
and an adhesive, but how much longer does it take to use them?
There are material
costs to consider, too. Do you track waste from
in-house production? If so, how much rubber is wasted? Whenever a worker makes
the wrong cut and throws away a profile, those costs are absorbed by your
business. As the complexity of cutting and splicing increases, so does waste -
or muda, as it's known in lean
manufacturing. Seals for five-sided doors, and profiles that require 30° or 35°
cuts are challenging. So are rubber
floor mats that must fit cabs precisely and
account for bolts and pedals.
Thanks for reading my latest CR4
blog entry. I look forward to your comments, and to learning about your own
experiences with manufacturing overhead costs.
About the Author: Doug Sharpe is the
President of Elasto Proxy, Inc. (Boisbriand, Quebec, Canada), supplier of sealing solutions
and custom-fabricated rubber and plastic parts to a variety of industries,
including automotive, defense, mobile specialty vehicles, and mass transit.
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