cost and profit

What are you trying to do?

The obvious answer is, make some money. Since we are talking about lean manufacturing and not lean market research, the next questions are:

  1. How do you make a profit?
  2. How do you control your costs?
  3. What are your costs?
  4. How do you provide faster lead time to the customer if needed?

Assuming that you are using the same equipment as your competitors and equally skilled people, how do you take work away from them and grow your company?

Let’s talk about profit in a manufacturing firm. You have a great product that everyone wants to buy. All you have to do is buy some material, rent a factory, hire and train some employees, start making your product and selling it to customers, and start accumulating some profit.

In order to make a profit, you need to establish a couple of things:

  1.  What is your cost?
  2.  What is your selling price?

Your profit (or loss) will be the difference between your cost and your selling price. That being said, where do you begin—with the horse or with the carriage?

Let’s start with the horse—that is, cost.
You would think that as your cost goes, so goes your selling price. However, this is not really the case. Unless you have no competition, your selling price is actually set by the marketplace. If you care to test this hypothesis, identify a competitor who produces the same product as you, with comparable quality and lead times, and raise your
price to twice that competitor’s. Then track market share. You should have plenty of time to do this, since you will probably be sitting at home, in your boxer shorts, drawing unemployment. You’ll have lots of free time.
So the operative relationship here is really, as your cost goes, so goes your profit.

Let’s start with the obvious stuff: taxes, lights, gas, water, real estate, Steel, copper—whatever it is that you need in order to operate and make your product.

Can your company buy materials and components more cheaply than other manufacturers competing for the same business?

Are there any suppliers that are willing to sell material X to your company at a lower price than they sell it to all of their other customers?

If your answer is yes, please contact me with the name of your HR manager so that I can fire off a resume in the morning (do you have profit sharing and dental?). I digress. If your answer is no, then we can assume that your company buys its raw materials, processed material parts, electricity, water, and so on at the prevailing market value. So far, so good.

Next, let’s look at what the average company considers to be the actual (real) cost to produce a product.
When you walk through the typical manufacturing plant, you usually see everything moving very fast. People are working; there are batches of material and parts in front of every station and batches of parts after every station; forklifts are busy taking parts from one area to the next area; expeditors are moving and tracking materials—
everything is busy, busy, busy. This is good, right?

There are two primary rules of (non lean) production:

  1.  Everybody needs to be busy.
  2.  All of that expensive equipment needs to be running all the time.

If we are measured primarily on direct labor efficiency and machine utilization, this is what we focus on. We’ll discuss standard cost systems and metrics later. So, how does this relate to cost?

Here’s the question: If you add up all of your current costs and obtain a total, is this your true manufacturing cost for a certain product?

In order to make one item of a certain product (let’s call it a gizmo), a person must work a certain number of hours and process a certain amount of material. This is close to the true manufacturing cost to produce one gizmo.

The Cost of Overproduction

I’ve built the five gizmos that are due to ship today, and I still have three hours left on my work shift. What am I to do? My 300 assembly and machining people have built all the customer orders that I have for this month, and I still have four working days left in the month.

What am I to do? If direct labor efficiency and machine utilization are considered your most important operating goals, you will keep everybody busy and keep the machines running. How exactly do you do this?

First, you need to figure out what to make. So you talk to your sales guys and have them try to guess what your customers will want to buy in the near future.

We’ll call this your sales forecast. Now you need to buy some materials, schedule the product from your forecast into production, and get your people to make these items.

Your product is built, and since you built it to forecast—that is, nobody has ordered any of this stuff yet—you need a place to store it until the orders for these particular items come flooding in. If you leave this product on your manufacturing floor, it will get in the way of future production, so let’s add a stockroom to your operation. Now you need a way to get the product to the stockroom and someone to put it away.

Let’s hire a person to move materials and buy him a forklift. And on and on. If the amount of inventory in your storage space increases, you will need to hire people to count it, track its location, add systems and computers to manage the information, and so on.

The people involved in these newly developed tasks need to be paid, you’ll have to buy the machines, and in the end, the additional costs for space, people, and equipment will be counted as part of the cost of these products. In addition, the materials used are already paid for. If you paid cash, you are losing the opportunity to invest
this money where you would receive a return. If you borrowed the money, there is an interest charge accumulating on this idle product.

What else could happen? You get a leak in your storeroom roof, and some of your product becomes rusty. Your material handler drops skid, and a product is broken. When you pull some product to ship in future, you have three left units, but you can find only two right units to make the pairs. Your customer changes his product style to a newer version, and the stock you have becomes obsolete. You could probably add a few what-ifs to this list. The bottom line?

Your accounting department adds all of this waste into the cost of your product. In reality, when they take inventory, many companies discover that they have inventory and supplies sufficient for one or two months sitting idle in storage. It is not uncommon for a company to have several months’ worth of supply of some items.
An enormous amount of additional cost has been created by doing what lean experts would call overproduction.
Overproduction is building something before you can ship it to someone in exchange for cash. Overproduction and excessive inventory are the two most critical areas of waste in the lean philosophy.

In Lean Manufacturing, we try to reduce the losses that occur in industries and help them to be more profitable.  Lean manufacturing will help you to remain ahead of the market & you can bit your competitor.

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