Financial Decision-Making Tools for Industry

“The ability to learn faster than your competitors may be the only sustainable competitive advantage”

— Arie DeGeus, Royal Dutch Shell


Financial Engineering

When we install a new pump, we wouldn’t think of guessing about what size pump is required, what pressure is desired, what size suction and discharge pipes are required to deliver the fluid to its destination.  We wouldn’t let the electrician use just any old electrical cable for the motor.  We would carefully calculate the size of overload  protection required, and make sure that the pipe was properly specified and supported.

However, when we make financial decisions for our plants, too often we resort to guesswork.  How much does Downtime cost? How much should we invest to reduce downtime? Should we outsource and pay overtime to get the job done in 24 hours, or save the overtime and finish the job in three 8 hour days? If we buy a new machine, will it pay for itself?

Management is almost always focused on reducing costs. How can you convince your boss (and yourself) that spending more money is the best way to generate value for the company?

In the following sections, I will present a few simple tools that I find very useful for making good plant management decisions.  For all of these examples, data for your calculations is best obtained from your operating budget or from your actual accounting statistics.

Variable and Fixed Costs

Fixed costs, also known as Period Costs, are expenses that are relatively constant over a period of time and do not significantly change with changes in throughput. Factory rental / lease costs, equipment depreciation, and insurance are examples of fixed costs.

Variable Cost, also known as Direct Cost, is the value of expenses directly identified with your product, such as raw materials, packaging materials, production utilities, etc.

For the purposes of valuing incremental changes in plant throughput (such as increased or reduced plant downtime), I do not include Direct Labor as a Variable Cost. Accountants generally do treat Direct Labor as a Variable Cost, and rightly so, because they are looking at overall company averages, and considering long term trends. An Accountant might observe that if Production increases by 20% next year, we will need to increase the number of employees accordingly. However, at the operational level, we must recognize that if we have 2 hours of downtime today, we cannot cut staff compensation by 2 hours, thus for operational planning purposes Direct Labor is effectively a fixed cost.

Most accountants are very cooperative, and would be pleased to provide you with a breakdown of Variable and Fixed costs, adjusted to be meaningful at the operational level, once they understand your requirements. Alternatively, these costs can often be extracted from the plant operating budget workbooks.

Marginal Cost per Unit

If you gain or lose a few units of production, how much do those units cost? Probably all organizations know very well the manufacturing cost of their products, but there is a big difference between the average manufacturing cost of product and the incremental (also know as marginal) cost of product.

If you normally produce 1,000 units of product per month, the cost of these 1,000 units is the value of all fixed and variable costs during that month incurred to produce those units. A simple and logical concept. Now, perhaps you have a machine failure and lose 1 unit of production, or alternately, you avoid a failure and prevent the loss of 1 unit of production. How does this loss, or loss avoidance, impact your operating costs? Your factory rent doesn’t change, employee salaries stay the same, and depreciation costs are unchanged. Hence, for valuation purposes the lost unit has no fixed cost, only variable costs such as raw materials and packaging. For small changes in production, Marginal Cost = Variable Cost (with variable cost as defined previously).

Contribution Margin

So, we had a machine failure and lost a few units of production. What is the value of that lost production? The value of the lost production is the value that the lost units would have contributed to the business had they not been lost. This is known as Contribution Margin. In general, Contribution Margin is the amount of money available to cover Fixed Costs and generate income.

When we sell a unit of production, we generate Revenue, which is the money we receive from the customer.  Often there are some selling expenses, so I prefer to use Netback Revenue which is the money we receive from the customer after selling expenses are deducted. This is the money available to pay for producing our product.

Hopefully by this point we agree that the incremental (or marginal) cost of a unit of production is its variable cost, not including labor, because labor is fixed for incremental changes.

Thus, we can calculate the Contribution Margin as the Netback Revenue minus the Variable Cost.

Contribution Margin = Netback Revenue – Variable Cost

Prepare to be surprised. For most companies, Contribution Margin is much larger than managers might otherwise expect. Imagine that each unit of production generates revenue of $1000, and has a fixed cost of $400 and a variable cost of $400. Many organizations would thus calculate that each unit costs $800 to produce, so if we produce 1 extra unit, or fail to produce 1 unit due to a problem, we gain or lose $200 of income. This is typically called Gross Margin. However, this calculation would only be true if we are talking about the value of all of the units produced during the period. In reality, the incremental value of a single unit of production is $600 (60% of sales price compared with 20%). Thus, if we spend less than $600 to achieve this incremental production increase, we generate value for the business.

Cost of Downtime

Continuing with our example, we normally produce 1,000 units per month, or approx. 6 units per hour. A machine fails, and you suffer 1 hour of downtime. What is the value of this downtime?

If you have excess capacity and lots of inventory, this downtime incident probably didn’t cost you any money, other than the cost to fix the machine. You didn’t lose any sales. However, if your sales demand is equal or greater than your production capacity, or if you are reluctant to accept additional sales orders because your plant reliability isn’t good, then this downtime incident cost the company money. How much money?

We know the Contribution Margin for each unit is $600, and at 6 units per hour we lost 6 units of production. Thus, we lost $3,600. Had we not suffered our downtime, we would have produced and sold 6 additional units of production. Fixed costs for the year wouldn’t change, employee salaries wouldn’t change, only the amount of raw materials and other variable costs would have increased. Thus, our 1 hour of downtime cost us $3,600 of income, not including the cost to repair the machine.

On average, each unit of production generates $200 of income (i.e. Gross Margin), when fixed and variable costs are included. Had we used this value, instead of Contribution Margin, we would have mistakenly calculated the value of our downtime event at only $1,200. The truth is that downtime is much more costly than we usually realize, and the value of plant improvements is therefore much higher. Managers often fail to make improvements because they underestimate the value of such improvements.

Downtime Decision Example

Our plant is operating at maximum capacity. We are planning an outage to clean and inspect a machine. We have the option of doing the work using our in-house staff, or outsourcing to a skilled and experienced contractor. We are confident that both options will provide good quality work. If we use our own staff, the work will require 8 hours of plant downtime, but we won’t have any significant costs, because all of our staff is already available in house. If we outsource, we will need to pay $7,000, but since they have specialized equipment and abundant manpower, they can complete the work in only 4 hours.

From our previous examples, we know that actual downtime costs us $600 / unit. At 6 units per hour, our downtime causes lost contribution margin of $3,600 / hour.

For the inexpensive in-house option, we incur virtually no expense, but lose contribution margin of $3,600 / hour, for a total downtime cost of $28,800. For the outsource option, we lose 4 hours of contribution margin, or $14,400, plus incur contractor expense of $7,000, for a total of $21,400. By using the “expensive” outsource option, we will be able to reduce the cost of the downtime event from $28,800 to $21,400, a savings of $7,400. Thus, the cheaper option actually costs the company $7,400 in incremental income.

CM Case Table

Note also what happens if we mistakenly value our downtime using Gross Margin, which we have calculated as $200 / unit, or $1,200 / hour. In this case, we think our in-house option costs us $9,600 in lost margin. The outsource option costs us 4 hours of lost production, or $4,800 in lost margin, plus $7,000 in expense, for a total of $11,800. In this case, we will choose to do the work in house, because we think we will save $2,200.

GM Case Table

Reality Check: At the end of the year, if we had selected the oursource option, we would have had only 4 hours of downtime, instead of 8. Thus, we would have produced (and sold) 24 additional units of product. In both cases, total payments for employee salaries, plant depreciation, other fixed costs such as plant maintenance and spare parts, would have been identical. The only cost differences for these two options is $7,000 expense for the outsource contractor, and the cost of the raw materials (our definition of variable cost) to produce the 24 additional units. The outsource option therefore generates $24,000 in incremental revenue ($1,000 / unit), at a cost of $9,600 ($400 / unit), plus $7,000 of expense. Again, we recognize that this has produced additional income (i.e. margin) of $7,400.

Reality Check Table

Breakeven Point

Not all companies operate at full capacity. Some companies have too much capacity. In such cases, it is important to understand how many units must be sold to allow the plant to breakeven.

From our Contribution Margin calculation, we know how much each unit of product contributes towards fixed costs and income. If our monthly fixed costs are $400,000, and our Contribution Margin is $600 / unit, we can divide fixed cost by contribution margin to determine that we must sell 667 units to cover our fixed cost. This is our Breakeven Point. We start earning income when we sell unit 668.

Important Note: When doing Breakeven Point calculations, you need to again consider the proper treatment of Direct Labor. The Breakeven Calculation assumes a longer time horizon than our Downtime calculations. You are looking to the future to determine the minimum output required to cover all costs. Whereas over a short time horizon all labor is essentially fixed cost, over a longer time horizon some labor may be truly variable cost.

If your production is labor intensive, and your labor force is flexible (you can add and subtract labor as production demand changes), then you should value Direct Labor as a Variable Cost for Breakeven calculations. Be careful – even in this case, not all labor is variable. Whether you produce 1 product or 1000, you will still need a Plant Manager, Accountant, Supervisor(s), etc. These people are fixed costs. However, at least some of your factory labor may be truly variable, and their cost would increase / decrease as your plant output changes.

To be most accurate (since even Direct Labor rarely varies in a linear relationship with output), you might consider holding all labor as fixed cost to calculate an initial breakeven point, then manually adjust your labor costs to match that output level and repeat the calculation. This iterative method will allow you to properly match labor to output, giving a most accurate estimate of the true Breakeven Point.

Gross Income / Loss

We can also estimate Gross Income or Loss by using Breakeven. If we sell 700 units, our Gross Income will be the number of units sold above Breakeven multiplied by Contribution Margin. (700 – 668) x $600 = $19,200. If we only sell 650 units, (650 – 668) x $600 = —$10,800.

What to do if our sales are uncomfortably close to Breakeven? One option is to do some “what-if” calculations to see if operating performance can be improved. Can we reduce our fixed costs? Sell the MD’s BMW to reduce depreciation expense? Reduce staff to lower labor costs? Reduce sales price (reduced contribution margin) to capture significantly greater sales volume? We can calculate the Breakeven point for different cost scenarios, and estimate the effect on income.

When considering different cost scenarios, be careful to include all cost changes. For example, by using these simple tools to value downtime, calculate breakeven point, and evaluate different operating scenarios, you are sure to earn a much larger salary and bonus. Don’t forget to include your higher fixed salary costs in your future cost scenarios.

Frank T.

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