Organizational Performance Part 51: Understanding Direct Labor Costs | Operational Excellence Quick Hits
Quick Hits share weekly tips and techniques on topics related to Operational Excellence. This week’s theme relates to direct labor costs. We hope you enjoy the information presented!
In today’s session, we’re going to continue on the mindset necessary to achieve breakthrough improvement. Today, I want to talk about cost reductions and labor savings and how that translates into improved company performance. Lot of companies I work with do process improvements, and then they calculate based on the cycle time how much labor was saved and they convert that savings into a dollar amount and sometimes apply overhead to that and say, “Okay, by just changing the process, reducing the cycle time, we’re actually going to save direct labor costs.” A lot of justifications are done based on that labor cost savings, so I want to challenge that assumption today.
First, I want to talk about different cost classifications and we can take costs and classify them into three categories, fixed cost, variable cost and mixed cost. I’m going to talk about the first two, fixed and variable, because that’s what I see most in organizations. How does fixed cost behave in the organization? Fixed cost by nature is fixed obviously because as the number of units sold increases, the cost for that service or that expense doesn’t change over time. Examples of fixed costs would be, okay, I’m paying so much for a lease payment on a piece of equipment or a lease payment for a building and it’s the same payment every month. That’s a fixed cost, and it’s irrespective of the volume that’s being produced through that building or through that resource.
The second is a variable cost, so the variable cost changes would be output. As the output goes up, the cost also goes up in a linear fashion. In this case, we have increased outputs and cost increase as a result of the increased outputs. The best example here is if we buy materials that go into our product, then as I produce more and more units, the total cost of material purchase goes up. Or tooling costs can act in this manner, the more I use the machines to produce product that are going to ship out the door, the higher the tooling cost.
We can look at these two types of costs and then we can understand how they behave in the organization. I’ve seen two types of cost behaviors. One is a step cost behavior, and one is more of a linear cost behavior. What’s the difference in the two? A step cost is fixed for a short period of time. Then as the activity increases, the cost steps up in a stepwise function like you see here on this graph.
If you look at material, materials are variable cost, but it acts in a stepwise manner because I have so much material for X number of units I’m producing. Then if I do X plus, I have to buy more material. Then, that cost goes up in a stepwise manner. Where tooling expense might act a little bit different, that’s a function of how long I run the machine, so the longer I run the machine, the tooling cost is going to go up more, probably in a linear fashion. If we understand this, that the cost is fixed in a short period but as the activity increases, it goes up in a stepwise manner.
We can also look at linear cost behaviors. Linear cost behavior, the cost goes up linearly as the activity increases. As I mentioned in tooling cost, tooling cost, as the activity of machining goes up, it probably goes up in a linear fashion. If we understand cost and how it behaves, whether it’s variable or fixed, linear or step, we can start to understand the effects of changes on the performance of the company’s financials.
Let’s talk about direct labor savings. If we look at direct labor savings from a macro perspective, direct labor costs are fixed. That means we have so much direct labor that we’ve hired for the organization to function and we’re not hiring and firing people every week. If we look at the direct labor cost, that’s fixed, that acts in a stepwise function. As we increase labor, labor goes up in a stepwise manner. Or if we decrease labor, it goes down in a stepwise manner.
If you don’t believe that direct labor cost is fixed, take your payroll expense, your direct labor payroll expense for the last maybe 15 periods and plot it on a graph. What you’re going to see is a pretty straight line going horizontally. Direct labor costs only change by when we lay off people or we hire people and otherwise they’re fixed in the short horizon. Reducing cycle time on a process reduces the labor content for the work being completed, but does not reduce the total labor cost that the company is paying through payroll.
This is an important concept to understand. We can reduce the cycle time, but unless we’re going to lay off people, there’s actually no direct labor savings. What we don’t want to do is allocate costs to the product. We’re going to look at labor as a total cost to do business for the organization. If we reduce cycle time on our process and it reduces labor content, the work being completed does not reduce the total labor cost or overhead cost to the company’s payment to keep the organization functioning. Therefore, reducing cycle time on our process have no effect on the overall labor or operating costs of the organization.
What does affect performance of the company is if we reduce the cycle time, what effect does that have on the overall company performance? First of all, if we reduce cycle time on the constraint operation in the organization, then it’s going to translate into improved output of the organization. If we look at productivity, our definition of productivity, we’re getting more units out with the same level of input. Reducing cycle time on a constraining operation will actually increase the throughput while maintaining the same level of cost, so productivity or profitability goes up.
The second way is to free up capacity on a non-constraint and be able to transfer that capacity to another area to improve the total output. We can do this by two ways, using that capacity that we free up… That labor capacity that’s freed up and move that to a constraining operation or have that labor support other functions, non-constraints, that are in danger of stopping the flow on the constraint. That’s the only way that we’re going to get improved output or increased productivity with the same direct labor.
Our lesson here is don’t allocate cost to the product. Don’t calculate savings based on direct labor savings, unless you’re laying people off. We know laying people off is going to hurt the overall continuous improvement effort, so look at what is the increased throughput as a result of your process changes? You’ll be surprised how many process changes have no impact on throughput for the system. They might make improvement in one area, but if it doesn’t get more out the door, then it’s not an improvement.
That’s our lesson for today. Our lesson next week, we’re going to be talking about problem solving. When I go into companies, they look at problems as being equal and they say, “All problems that are created are equal and should get the same level of attention.” I’m going to challenge that assumption in next week’s session.