Demand is Variable, Costs are Not

Cost Management - Cost Definitions

A Variable Cost is one that is assumed to move up and down in your business relative to demand.

If 100 cases of product takes 3 man hours to make , then you will spend 6 man hours to make 200 cases. This may have been true 50 years ago, but not anymore.

If I asked for a list of variable costs in a factory it would most likely contain the following areas:

Materials - Direct and Indirect

Direct Labor

All Sanitation related costs - supplies and indirect labor

Utilities - Gas, Electricity and Water

All Warehousing related costs - maintenance, operations and indirect labor

Uniforms

Cafeteria

All Maintenance related costs - parts and indirect labor

In order for these all to be variable costs, it is assumed that a 20% downturn in business should result in a 20% reduction in spending in these areas.

The reality is that the only really variable cost above are materials.

Most CFO’s oversee a budgeting process that takes two paths.

Operations budgets their costs on how they project to run the plants in the coming year. Sales teams work on their budgets at a product and customer level and that gets rolled up into a revenue budget. Once the revenue targets are set, the operations budget is bounced against revenue and then operations must react by reducing their budgets accordingly so the profit targets are met. Sound familiar?

Staffing, both direct and indirect are not areas that can effectively be reduced when business slows. You have trained personnel who have an expectation of a steady paycheck who cannot survive with hours that are variable. Replacing highly experienced and trained operators, mechanics and other key department staff will cause future unforeseen costs, inefficiencies and uncertainties.

Direct Labor is Not Variable - click here for more

Maintenance, sanitation and warehousing work must continue as usual when business subsides.

For preventive maintenance, there are both run parameters but also time that if stretched will create future problems with equipment efficiency should savings be sought for here.

Sanitation work needs to happen in order to stay compliant with your regulatory agencies by keeping up with Master Cleaning schedules.

Warehousing work may lag behind production slowdowns due to current sales demand being greater than production demand. There are also inbound material loads that need addressing.

Uniforms and cafeteria expenses follow closely with headcount and work hours. If labor doesn’t adjust, these two expense areas won’t be impacted dramatically.

All of these costs can be impacted over time.

This week and probably this month they can’t be dramatically reduced.

As you look outward, if there are sustained business losses that justify cost reductions then machines can be shutdown, shifts eliminated and personnel released. These actions take some time to decide on and are more permanent moves, therefore not variable.

Business cycles are variable. Week to week and month to month there is variability in demand. There is a normal ebb and flow based on a customer’s internal decision making around inventory levels, business promotions and seasonality. This is something that a manufacturer really has no influence on.

What can we do about fluctuating demand?

1. Work on a method of flattening demand so that in slow times, you can produce and utilize your fixed cost base. In busy times, inventory depletes and fills demand. Concerns over inventory turns and carrying costs can drive decisions that have larger impacts than a company projects from forcing their operations to run in a variable, chaotic manner.

Carrying costs are questionably calculated figures that include many sunk costs such as warehouse space, warehouse personnel and have an expectation that money not tied up in inventory can be put to a better use. Most companies have no short term or more valuable use for this money, unless they can immediately reduce their line of credit.

2. Partner with your customers to provide an allowance to produce to a committed forecast over a 30-60 day period rather than a PO based order pattern. You will have to hold this inventory until the PO’s arrive, but again the cost will be less than forcing stops and starts at your plant with periodic labor reductions.

It is the assumption that a cost is variable when in reality it is not is what keeps companies in a mode of constant disruption.

As we learned in the last newsletter edition, your company was built to a certain capacity, for a certain product line. It must be run to that capacity to be profitable.

Factories are mostly large fixed cost engines. They must have a steady flow of fuel to run efficiently.

That fuel is demand.

They must also have a high grade of fuel to run at its optimum.

Short run, high changeover production will cause your big fixed cost engine to choke and sputter and run poorly.

Branded companies usually don’t have a problem with the quality of their demand. It is the private label and co-manufacturing companies that struggle here.

Put an equal amount of effort to fill up your business with demand as you do to cost cutting and you will find more success.

The proper way to address the overall cost profile of your company is to find better and different ways to get the same work accomplished. Just making cuts is not going to pay in the long run.

Cost cutting in areas than are definitely less variable than your demand will get past muscle and get to the bone, causing systemic damage.

Right now and a few weeks out, with the exception of Materials, all of your costs are fixed.

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