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Help to Production
2.1 What is the production process? In order to find out what costs (labour, raw materials and overheads) are involved in production, it is useful to follow the whole production process and to identify how the raw materials are received and gradually, step by step, transformed through various processes (e.g., cutting, mixing, assembling, finishing, packaging, etc.) into a finished product. Description of the process need not be a lengthy explanation, but should cover all the major operations. A process flow chart (see Table 2.1 for example) is a useful tool to depict the production process. This will also clarify how many workers are required at each stage and what skills are needed. 2.2 What building and machinery (fixed assets) are needed and what will be their cost? Identify these items carefully and estimate their cost accurately. If the requirements are over-estimated, the results can either be: a) too much production occurs and stocks are built up - this costs money and ties up capital uselessly; b) excess capacity means that you are investing in some assets or paying interest on building and equipment that are not giving you any return. This will also increase cost in the long run by having higher depreciation than necessary (in our example we are assuming that Mr Rainero owns the land and constructs the building); c) there is also the possibility that the project may not be financed at all because it appears too expensive. In general, it is better to start on a very modest scale with a small building, or even a rented space, and the minimum essential machinery. Remember, if the demand for your product exceeds the 8-hour capacity (one shift) of the equipment, an extra shift can be added at a later stage, or you can operate on overtime after the regular shift. Especially when starting a business, proceed with capital purchases with extreme caution, and only when the market is secured. Regarding machine capacity, the supplier should give the right information to the entrepreneur. In many cases, suppliers tend to over-rate the capacity and efficiency of their machinery; so do not count on the machines working at 100% rated capacity. By determining the realistic capacity of each machine, it is then possible to estimate accurately the proper balancing of the machines and men, i.e., how many of each tools or machines are required, and correspondingly the workers and skills required to operate the machines, to ensure a smooth and efficient production operation. Determining the costs of building and machinery should be relatively easy since every entrepreneur can find out this information from machinery suppliers. Again, you should be cautious not to build fancy buildings or obtain equipment which are too modern or too sophisticated to operate and maintain. Machinery salesmen usually try to sell the most expensive or most modern equipment first, so be aware of what you need and can afford, and do not be taken in to purchase equipment which may not be essential or even suitable to your scale of production, especially in the initial stages of your operation. Be aware that there may be a wide range of technology options ranging from labour-intensive (more labour is required relative to the number of machines or investment in machines) to capital-intensive (more machines are used or higher investment in machines relative to the labour required). If quality labour supply can be assured, it is often wise to use labour-intensive technology since your factory will be less dependent on its machines which can break down at any time, suffer from power failure, and be idle for lengthy periods. If, on the other hand, labour is troublesome and unreliable due to seasonal availability, a more capital-intensive approach on a modest scale may be more practical. However, if workers are properly motivated, they can be encouraged to become more reliable. Finally, list all the land and improvements, building, furniture and fixture, machinery and factory equipment including installation cost, giving their size, capacities and cost, to arrive at the total cost of fixed assets. 2.3 What is the useful life of the building and machinery? The answer will depend on the make of the building (i.e., whether made of wood, concrete structure, etc.) and machinery and on how much you use your fixed assets. To arrive at an annual depreciation charge, deduct the scrap value at the end of its expected life, and then divide the value of the asset by the number of years of its productive life. If it has no scrap value, simply divide the value by the number of years. In your country, the Tax Office publishes general rates of depreciation. In many countries, the general practice is as follows, although some variations may exist:
2.4 How will maintenance be done and are spare parts available locally? It makes little sense to import equipment which, although it may be more dependable, may result in long work stoppages while you wait for the arrival of spare parts from abroad. Maintenance service and spare parts should be available locally to ensure continuous production. Do not forget to estimate the cost of maintenance and spares as this will form part of production cost. Maintenance cost is part of factory overhead expenses. 2.5 When and where can the machinery be obtained? It is necessary to check with machinery suppliers. Estimate accurately the delivery time of the machinery as this is vital in preparing your pre-operating schedule. Also, do not forget to include in the cost of the machinery, the transport cost to the factory, the import duty (if imported), insurance up to the point of installation, and installation charges, if any. 2.6 How much capacity will be utilised? 100% capacity utilisation normally means that the equipment is working eight hours a day, six days a week. Most factories work on an 8-hour on one shift basis and many of them use their equipment for only a portion of this time. Seasonal fluctuations in capacity utilisation should be accounted for. A good example is a brick factory where operation may run continuously for 24 hours a day during the construction season and may be shut down for six months due to monsoon rains. 2.7 What are the plans for using spare capacity? Machines and equipment should be used as much as possible. This keeps the workers in a steady rhythm and the equipment in good running order. During periods where low capacity utilisation is foreseen, attempts should be made to ensure that other works (e.g., product improvement and development) are undertaken which may not at first be directly related to the main production but which later on may develop into a new product. 2.8 When and how will the machinery be paid for? Some machinery suppliers are prepared to sell their equipment on hire-purchase scheme. This spreads the cost of the machinery over a longer period of time, resulting in higher total costs, but it enables the business to have greater cash liquidity or lower investment requirement during the start up period. Before purchasing the equipment, find out the terms of sale, i.e., whether cash, credit, or hire-purchase, the length of payment and other conditions like guarantee, after-sales service, training of operators, etc. 2.9 Where will the factory be located and how will the factory be arranged? Almost always in small industries, the factory has the same location as the business address. Equally important is to determine the floor space required by the business (for production, office, store room, toilet, etc.) and more importantly, how the factory space is going to be laid out in terms of the arrangement of the machines and equipment. To answer this question, it is essential that you must know the production process and the machines/equipment needed for each process so that, as much as possible, you can arrange the machines according to the production flow. You can also determine the size of the machines and the space it will occupy (including allowance for movement). A plant layout will be very useful for this purpose. You can arrange your machines in a straight line or a U-shape. 2.10 How much raw materials are required? Now that you have a good idea of the production level you want to achieve, find out the type, quality and quantity of raw materials needed. Find out the input-output ratio or conversion ratio, e.g., how many kg. of oil would be required to produce 120 kg of soap per day. These should be specified according to square meter, kg, ton, pieces, etc., which will be used per month. 2.11 How much will the raw materials cost? After determining the quality and quantity of raw materials needed, find out their unit costs (i.e., LC2,000 per ton, LC15 per square meter, etc.) and list these costs next to the material and prepare a list of average monthly raw materials requirement and their costs. Include duties and relevant taxes, if raw materials are imported. 2.12 What are the sources of raw materials? Are they available throughout the year? In sourcing raw materials, at least three factors are critical. Firstly, the price should be as low as possible. Secondly, their source should be as close as possible to the production site to reduce transport costs. Thirdly, the source should be reliable. If raw materials are not available throughout the year, at least two alternatives are possible - either the factory will have to reduce production, or it must build up a stock of raw materials when they are plentiful so that production can be continuous. If the latter is chosen, additional working capital is required and should be included in the calculation of your cash needs and determination of your project's investment requirement so that the business can cope with this situation. For example, think of the problem to obtain fruits for a fruit processing plant during off-season! 2.13 How many direct and indirect labour are needed and what skills should they have? Labour in a factory is divided into direct and indirect. Direct labourers are those who are directly or intimately involved in production. Indirect labourers are all those other workers who facilitate production such as utility men, foremen, maintenance workers, among others, who are not directly involved in production. To determine the number and type of direct labourers needed, break down their skills into three categories: skilled, semi-skilled and unskilled. Their salary scales should be calculated accordingly. 2.14 What will be the cost of labour? Estimate how much each worker (from the production supervisor/foreman down to the production worker, maintenance man, utility man, for example) should receive on a monthly basis. Labour cost should include effective total labour cost to cover basic salary, wage, fringe benefits, paid leaves, free meals, social and medical insurance, etc. In some cases, direct labour will be paid according to piece work. If this is the case, estimate the production output of the worker and multiply this number by the piece rate (LC). 2.15 Are workers available throughout the year? If not, what effect will this have on production? Many factory workers in small businesses receive low wages and, therefore, supplement their income with agricultural or other extra jobs outside. If this is the case, the business must be ready to cope with such a situation and, either pay its workers competitive or a higher wage/salary/piece rate, or recruit new or temporary workers during this time, or even be prepared to reduce production. Whatever course of action is decided upon, it must be accounted for in determining the production schedule. 2.16 How will the workers be motivated? Workers can be motivated in a number of ways: humane treatment, good working environment, increased responsibility, other incentives (e.g., profit sharing, awards for deserving workers, bonus and providing facilities, such as meal and snack allowance, transport allowance, medical allowance, lodging, etc.) If these are given, their costs should be calculated and included in computing actual labour cost or as overheads. 2.17 What factory overhead expenses are incurred? Factory overhead expenses include such costs as rent of factory space, maintenance and repair cost, depreciation of factory machines and equipment, cost of utilities (water, electricity, salary of supervisors, cleaners and maintenance men. In the case of electricity, if it is used in large quantity and the amount used depends directly on the level of production, it should be treated as a raw material rather than as an overhead. But if electricity is only used for lighting and general purposes, then treat it as overhead. Only the costs, such as those listed above, which do not change or vary much according to the level of production, are treated under overheads. 2.18 What is the production cost per unit? Production cost includes the cost of direct raw materials, direct labour and factory overheads. Two methods are mentioned here to calculate production cost per unit, as follows:
To arrive at the production cost per unit, add the monthly cost of direct raw materials (step 2.11), direct labour (step 2.14), overhead expenses (step 2.17), then divide this amount by the number of units produced during the month (step 2.6).
It is unfortunate that in real life costing is not quite as simple as given above. The complication arises from the fact that few small industries produce only one item for sale. Whereas it may be easy to identify the raw material cost in any one item, estimating the labour content or allocating a portion of the overheads to a particular item presents another problem. Allocating Labour Costs: To assign direct labour cost to any product, follow this simple rule: Multiply the hourly direct labour charge (LC) by the number of hours of direct labour that goes into manufacturing the product. The hourly direct labour charge is derived by dividing the total direct labour cost by the number of hours of direct labour available. For example, if 8 direct labourers work 8 hours a day, 6 days a week, for 4 weeks, then the total hours of direct labour available per month is: 8 workers x 8 hrs/day x 6 days/week x 4 weeks = 1,536 hrs If the total cost of these direct labourers is LC4,000, then the hourly rate (LC) is: Total direct labour cost of LC4,000/1,536 hours available = LC2.60 per direct labour hour (Hourly rate) Example: If a chair requires 6 hours of direct labour to make, then the direct labour cost of that chair is: Hourly rate of LC2.60 x 6 hours = LC15.60 Allocating Overhead Expenses: There are two ways of allocating overheads. These are: a) by relating overheads to labour hours, b) by allocating them in relation to sales. The first and preferred way is to relate overhead expenses to the hours of direct labour involved in making the product. This can be done by dividing total overhead expenses by direct labour hours available and then multiplying this amount by the number of hours it takes to make the product. Example: If total overhead expenses is LC3,000 and total direct labour hours is 1,536, then the hourly overhead rate is: Total overheads of LC3,000/1536 total hours = LC1.95 per direct labour hour (Hourly overhead rate) Then, multiply the hourly overhead rate by the number of direct labour hours used to make the product: Hourly Overhead Rate of LC1.95 x 6 hours to make one chair = LC11.70 This figure can then be added to the raw material and direct labour charge to arrive at the unit production cost of the product. The second method of allocating overheads is according to % of sales of that particular product in relation to total sales. If, for example, a furniture maker produces the following products:
Total sales is LC20,000 of which 20% is chairs, 20% beds, and 60% tables. Therefore, 20% of overheads could be allocated to chairs. The overhead charge per chair can then be calculated as follows: Total Overheads for 20 chairs is: Total Overheads per month of LC3,000 x 20% = LC600 The overhead charge for each chair is, therefore, LC30: LC600/20 chairs = LC30 Similarly, for beds, it is: LC600/10 beds = LC60 And for tables: LC600/12 tables = LC150 After having determined the raw material cost per unit, the direct labour cost per unit and the overhead rate per unit, the unit production cost can be calculated by adding all of these three cost components: +
Unit Raw Material Cost Alternatively, unit production cost can be derived from the following calculation: +
Total Raw Material Cost = Unit Production Cost
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