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Economics of production and costs

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Director General, UGC
May 29 June 04, 2000

A research report

The economics of production itself is developed periodically-annually, every two years, or perhaps as long as every five years — the period depending in large degree on the nature of the firm’s product line and markets and the pace of its growth. Whatever the period, however, the economics of production must be changed to meet the demands of new production schedules, which rarely stay at the same level as at the time the economics of production is approved by top management. It unfortunately can happen that when a production schedule goes down-shipments to customers are lower than expected retrenchment becomes necessary. On the other hand, increases in production schedules, although certainly a pleasant problem, can be one of production management’s most difficult tasks. It is then necessary to determine the resources in cash, inventory, manpower, and space that are needed beyond those in the existing economics of production and their impact on product cost. Thus, the controller and production manager must engage in what might best be called continuous planning, so that the economics of production can be revised to keep pace with the production schedule.


The primary element in economics of production is the production schedule, which records anticipated product manufacture and shipments each month over the period of the plan. The short-term schedule, of course will be largely controlled by the customer orders already known. Beyond that, the production schedule is based on many factors, including forecasts by the sales department, corporate expansion objectives, and the general business climate. New products are the most difficult to establish production schedules for: first, they are usually the most difficult to keep on schedule, and second, are most likely to undergo schedule changes (hopefully, in the upward direction).

The next major subject of a economics of production is product cost— what it costs to make the product and its components today, and trends that may be expected during the period of the production. Cost reduction and cost effectiveness programmes, which are a continuing activity in any production concern (or at least should be), may be directed at cost goals that are specified in the economics of production. The tendency is to be optimistic in this area, which may cause a production manager to be excessively harsh on himself.

All other elements of a economics of production, including the main planning categories within elements, may be listed as follows:

1. Production schedule

2. Product cost

a. Product cost today

b. Cost trends

c. Analysis of cost for volume changes

3. Manpower

a. Manpower plan by time

a. Manpower plan by function

b. Staffing plan

c. Non-regular Manpower

4. Facilities

5. Inventory

a. Assumptions

b. Data sheet

c. Non-regular Manpower

6. Production expense

7. Procurement

8. Quality assurance

a. Quality assurance plan

b. Production reliability test

c. Failure analysis

d. Early entry

e. Reduced inspection

f. Measurement indicators

9. Industrial engineering

a. Industrial engineering activity distribution

b. Cost engineering

c. Work measurement program-me

d. Total improvement

e. Indices

f. Planned product cost reduction

10. Production engineering

a. Major problems, objectives, and programmes

b. Manpower requirements and plans

c. Financial requirements

11. Cash

a. Cash expenditures

b. Reconciliation of production cost to cash cost

12. Capital

a. Capital plan summary

b. Tooling and test equipment

c. Plant and equipment requirements

Economics of production is normally developed under the direction of the financial controller but is not a financial. It is an overall plant operating plan that integrates and summarizes the plans of all production operations and services. The economics of production then requires a large degree of interaction among all functions involved. Cohesiveness and commitment are two key ingredients of a successful plan.

One approach in initiating economics of production is for the plant manager to call a "kickoff" meeting perhaps six weeks before the plan is due. At this meeting, the controller explains the ground rules, key dates, and broad assumptions on which the plan is to be based. Even though the department managers present at these meetings may have contributed to previous Plans of Operation, many of the ground rules are likely to have changed, and managers may have shifted to other responsibilities. Much of this initial meeting may be expected to be occupied with questions and answers dealing with the details of procedure, such as the key schedule of events and the individuals responsible.

The managers of the various production functions can then follow with their own kickoff meetings. Here, plans are drawn, costs are estimated, and figures may be sharply adjusted and rearranged. The managers may then be expected to have numerous informal meetings with other operating or service managers on budgetary subjects in which both are involved. For example, industrial engineering may propose new processes to achieve product cost reductions. Although the manager of industrial engineering has primary responsibility in this area, he must coordinate with the manager of production engineering with regard to the resulting effects of manpower requirements, one of production engineering’s main planning jobs. The manpower plan is established for direct and indirect labour on the basis of production schedules, and, in building the plan department by department, industrial engineering must review their requirements with all operating and services managers. The controller must be consulted, too, in order to maintain acceptable cash flow.

The staff of the financial department is naturally involved in estimating or cost projections and so may be expected to be frequently involved in inter function planning meetings. Certainly, the cost estimaters in industrial engineering must work closely with cost accountants in establishing product cost targets. To do so, the cost accountant must have some understanding of the product itself, and conversely, the production manager must be familiar with costing and estimating procedures.

Large capital expenditures for process equipment are usually worked out for the capital budget by production engineering. These expenditure must be justified by the existing and projected needs of the production schedule. The controller advises production engineering on development of the most realistic and convincing justification of capital expenditure with respect to cost reductions and returns on investment. Conversely, the finance department must call on industrial engineering for data on utilization of plant space (what production groups occupy what space?) to determine a realistic monthly burden rate.

Cost reductions are customarily considered the responsibility of industrial engineering and yet heavily involve production engineering on process changes, and procurement on contract negotiations and vendor relations. For example, industrial engineering, production engineering, and the materials manager must together work out a budget for automated material handling equipment in a warehouse. In general, however, the role of the financial controller is primarily advisory in the area of cost reduction programmes.

The contributions of the operating, service, and staff functions in the economics of production are shown schematically in Figure 1-1. The flow of activity in developing the plan starts with the market forecast and ends with the market the completed operating plan for approval by top management. The involvement of production functions in budgetary and accounting considerations is demonstrated in the major planning activities given for the various functions.

Note that the review by the general manager is best held off until agreement has been reached by all other functions. Although the general manager may be called on to settle disputes and certainly is willing to contribute informally, the plant manager and managers of the various production functions must feel that the economics of production constitutes their commitments or contracts over the planning period with the general manager. Once the general manager has approved the production plan, which is unlikely to occur without at least some revision, he must then present the Plan to the company president as his own commitment to performance. Approval of the Plan should be confirmed in writing, including any reservations or qualifications.

Plans/operations progress reports: The plant manager and operating and contribution of different functions in developing economics of production service managers cannot realistically be expected to fulfill the economics of production in their areas without periodic progress reports that give them accurate, complete measurements of actual performance in comparison to planned or projected figures.

A plans/Operations Progress Report tabulates the performance commitment of each production group and what was actually done during the period. Although detailed reports in each functional area may be made available to appropriate managers as described below, it is good procedure to distribute the concentrated summary in the P/O progress report to all managers. This summary should include the kind of subject organization shown in the following list.

1. Cost of production highlights

2. Direct labour

a. Direct labour performance

b. Direct hour utilization

c. Direct production improvement trends

3. Factory expense

a. Summary

b. Administrative comparison

c. Manpower analysis

d. Overtime

e. Absenteeism

f. Cash analysis

4. Purchasing and interplant

a. Vender purchase

b. Vender receipt and shipment

c. Interplant shipments