Assigning Cost to Inefficiencies

Business viability is based largely on the gross profit margin of the operation. The difference between gross sales and manufacturing costs needs to be wide and stable enough over time to provide sufficient net profits for successful sustainability of the business, as well as future investments and expansion.

In today’s economic environment, companies are challenged with increasing or even sustaining this essential profit margin. On the input side, a typical approach consists of reducing productive resources to a bare minimum, especially labor, and to squeezing suppliers to the limit. On the output side, many companies have already priced their products at the threshold of what the market will bear, and their production lines are running at or slightly over capacity.

Cost reduction is a part of every strategic planning discussion. Frequently, budgets are submitted and discussed in several sessions beginning with the first submission that includes the wish list, the second submission that has the wish list cut by 20%, and the third submission that is supposed to be 0% or some percent below the previous year. After the budget is finalized, manufacturing optimization initiatives and discussions focus on how to achieve or come in under budget at the end of the fiscal year. This annual rite lends itself to false budget negotiations, which lead to still inflated budgets. Then, over the course of the year, managers try to come in under it at the end of the cycle, which in turn leads to a false sense of achievement and possibly an extra performance bonus for being frugal and successful.

In short, today’s manufacturing optimization talk and efforts tend to limit themselves to cost reductions, such as efficiency and throughput related to minimizing cost of materials, employee reductions, speeding up throughput, or price increases. The one area with a potentially high financial impact on gross margin that is frequently overlooked is the minimization of the costs of manufacturing failures and waste that are often perceived as a “cost of doing business,” and which are incorporated into the sales price of the product.

Some of the program, process, and product failures that add cost to manufacturing and erode the gross profit margin include:

• Rejection of non-conforming raw materials.
• Recycle or rework for quality or food safety failures.
• Repacking or relabeling of finished product.
• Waste due to improper process controls.
• Downtime due to unscheduled equipment stops, and redundant repair or sanitation tasks due to inadequate completion the first time.
• Slowed shipping rates due to unacceptable transportation mode conditions.
• Redundant production due to customer rejects.
• Finished product recalls and withdrawals.

Unfortunately, the “cost of doing business” is automatically added to the cost of goods manufactured, and attempts are made to pass them on the consumer.

The benefits of focusing managers’ attention on the economics of processing, as well as on program, process, and product failures and how these impact business productivity, profitability, and viability can be very significant, are immediately felt, and are key for developing a culture of “zero” failures in the manufacturing and distribution of food products. The method is simple and practical in nature, and includes:

• Determination of program, process, and product failures.
• Development of cost estimates of failures.
• Prioritization of failures in terms of impact on cost of good manufactured (COGS) and gross margin (GM).
• Investment in projects to eliminate avoidable and minimize inherent failures.
• Measuring impact on COGS and GM.

The long-term result of this approach to food manufacturing and distribution is the development and implementation of the culture of food product integrity as a management philosophy in manufacturing facilities. This management approach applies manufacturing optimization techniques to identify and reverse failures and waste that are often perceived as the “cost of doing business.” It provides superior long-term business results, since it focuses attention and efforts of all employees on the practical and measurable task of reducing/eliminating manufacturing failures and waste. This, in turn, provides the means to manufacture food products less likely to have sanitation, safety, and quality problems with higher gross margins than products produced under the typical cost-reduction approach.

The author is Head of Latin American Services, AIB.