ECONOMICS OF PRODUCTION AND COSTS
By Dr IQBAL A. PANHWAR,
Director General, UGC
Jun 05 - Jun 11, 2000
A research report
PRODUCTION / PRODUCTION COSTS
It is essential to make realistic forecast of production or costs for a project proposal in order to determine the future viability of the project. One of the major deficiencies encountered in pre-investment studies is the inaccuracy of production cost estimates. This frequently leads to unexpected losses which, if reinforced by low capacity utilization caused by wrong sales forecasts, may quickly push a nascent establishment out of operation. The analysis of cost structures and identification of critical cost items, as well as critical comparisons with si-milar projects, are proper means of im-proving the reliability and accuracy of cost projections and predictions of the financial feasibility of an investment.
Production costs should be calculated as total annual costs and preferably also as cost per unit produced (unit costs).Often pre-inves-tment studies deal only with overall production costs, which is relatively simple for single product factories; but may become rather complicated for certain technologies and the manufacture of a variety of products. For the analysis and justification of an envisaged production programme and for the break-even analysis, it is necessary to determine the main cost items directly related to each individual product. Production costs must be determined for the different levels of capacity utilization and for an operational period corresponding to the planning horizon of the investors and financing institutions interested in the project.
Frequently overlooked in product costing is the fact that fixed costs may be constant within only a limited range of production increases or decreases.
The feasibility study of a product costing in terms of financial costs should be geared towards the use of discounting methods for financial analysis and investment appraisal. All cost elements required for the calculation of total production costs therefore have to be projected and scheduled in line with the projection programme and for the full planning period. Once production costs at full output level have been defined and their breakdown into variable and fixed costs established, it is possible to adjust the variable costs in proportion to the percentage of capacity utilization assuming that fixed costs remain approximately unchanged. All of the cost items entering into production costs should now be assembled in order to arrive at production costs. For this purpose a schedule should be used.
Production costs are divided into four major categories: factory costs; administrative overhead cost; depreciation costs; and cost of financing. The sum of factory and administrative overhead costs is defined as operating costs.
ECONOMICS OF MANAGING PRODUCTION
Cost centres: Cost centre is defined as a unit of dis-integrated system with respect to their functions, for the purpose of determination and analysis of costs, and to evaluate the operating efficiency of each department. The concept of Cost Centre is based on the decentralization process, which divides the organization into smaller units or local centres, for better control of resources, machines, labour and overheads.
Main functions: The main functions of cost centres are:
a) Determination of costs (department wise)
b) Controlling of costs
c) Used for budgeting purposes
d) To identify productive and non-productive cost elements
e) Controlling of resources, machines, labour and overheads.
Classification of cost centres: Cost centres are classified as:
a) Productive cost centres
b) Non-productive cost centres
The main components of cost centres: The functions of each cost centre is defined by considering the following components:
a) Pre-requisite (the pre-require-ment for cost centre to work)
d) Process (es) (production, packing )
e) Output (results)
f) Types of machines
g) Machine capacity
h) Man-power requirements
COSTING FOR THE PRODUCT
Production costs are intended to record those costs which are connected in one or more cost centers of the production sector or the other productive cost centers with the chemical or physical manufacture, formulation (mixing, working up, composition/ assembly), checking of conformity with analyses of measurements (analysis) and inner packing and include the costs for material input, packaging and special individual production costs. The calculation should show the process of production from the raw or input materials to the semifinished or finished product ready for storage, shipment or sale. The cost and results accounting system should be designed in such a way that although production support and supply services (e.g. internal transport, energy supply, environmental protection, factory security, administrative and social management and care of the employees in production, etc.) are to be recorded in the production costs, the other functions of the operational process (research and development, marketing, logistics, general management and administrative functions, including financing) are not to be included in the production costs.
When designed in this way the production costs can also be used to valuate inventories in the balance sheet and to calculate the operational (division) assets.
The content and general structure of production costs are determined in accordance with the following six cost blocks:
I Direct material
II Factory cost elsewhere not yet allocated
III Energies, other utilities
IV Environmental protection
V Analytical costs and
VI Other processes / sundry direct costs
A production cost center covers those parts of the company which are involved in production, in other words with the manufacture of the chemical products and other products and also with the filling and packing. Support and supply services should only be included to the extent that they are directly connected with the production processes. In smaller production department the production cost centers include the analytical departments, including in-process testing, provided they are not amalgamated in central analytical departments.
As a rule all cost categories associated with manufacture and processing are recorded at the production divisions cost center, with the exception of direct material and packing costs which should be allocated directly to the job order, according to the recipe, as separate costs under cost block 1. The remaining cost blocks from the product calculation are charged using calculation rates to the production costs of the products; the relevant production cost center is credited accordingly. It should be emphasized that direct labour is also applied with hourly rates to the products via the charging from the production cost centre.
Job orders are usually debited at fixed hourly rates which are initially maintained in accordance with planning irrespective of the actual costs incurred. As a result, unbalanced amounts arise as the difference between the actual costs incurred and the charging to job orders and these have to be accommodated as production costs not set off.
Content of the production cost centres by cost categories:
Primary cost categories
Social cost and other benefit costs
Cost of leased and other outside personnel (from subcontractors, personnel leasing companies etc.)
Fuel, energies, utilities, fees and charges for environmental protection
Indirect material (booked as overhead)
Technical costs (maintenance and repair etc).
Travel, telephone, other cost of communication
Office supply, books, journals
Leasing equipment incl PCs and / other EDP equipment
Deprecations on apparatuses, machinery, other equipment and buildings
Secondary cost categories
Energies and utilities generated by the company, cost of their distribution
Internal transport, car pool
Central EDP services
Technical cost out of internal services
Central services for environmental protection, fire prevention, factory security, office supply, planning- and management of production, personnel administration, factory catering, medical and social welfare services
Support and supply cost centres: Cost centres which have the task of supplying other cost centres and divisions of the company (for example, energy supply and distribution, internal transport, electronic data processing etc.), are called Support and supply cost centres. Their services are charged within the framework of intra-company charging for services to the production cost centres as secondary cost categories.
The following examples of charging of intra-company services should be used as a guide:
Energy costs, such as electricity, gas, water, etc., where generated by the company itself: a charging price has to be established per unit of quantity from the planned costs at the cost centre providing the service and the planned consumption by the purchaser, which is then used as a basis for charging on, including distribution costs up to the site (place of consumption)
Environmental protection costs: the associated costs for sewer cleaning, waste water treatment, levies for quantities of waste water, disposal of special waste, etc., are allocated to the cost centres in accordance with the characteristic quantities.
Technical workshop costs: allocation / debiting according to the hourly rates of the personnel providing the service
Quality control and other laboratory services: charging on the principle of activity based cost accounting as costs per analysis according to the schedule of tariffs (only to be charged to cost centres where there is no direct debiting of the job order according to the standard allowance!).
Fire prevention and security costs: there costs are charged according to the fire insurance value of the fixed assets or stores (in this case the capacity of the cost centres is decisive, irrespective of the fluctuating utilization of such capacity).
Electronic data processing: in this case services are established according to a process-based schedule or the following keys are applied: cost allocation according to the number of PCs or user Ids, usage times for processors, disk access or print-out lines in computer lists, etc.
Every company, big or small, is concerned about growth. It has been said that a company never stands still for very long; it either grows or declines. A major portion of business owners time is devoted to planning and implementing activities that hopefully lead to their companys growth. The options business owners have for growing their companies include the following:
Expand in their existing markets by getting a share of new business, product or segment.
Expand into new product and service lines that are compatible with existing lines.
Expand into new geographic markets.
Expand into unrelated business products and services.
All of the methods of growth require planning, time, and resources that include people, inventory, equipment and money. Because most business have limited resources, if the wrong decisions are made in the attempts to grow, the results can be disastrous.
One of the more successful methods for growth of companies is through introducing a new product and reducing production costs. This is an indirect way of achieving the principle objective of the company that is profit: which is the difference between the firms total revenues and its total costs. Therefore, among alternative course of action, the companys management will select the one that will maximize the profit of the firm. Attainment of maximum profit worldwide is the natural objective of the multinational companies. The management also focuses on the indirect goal of minimizing cost. For instance, the firm may seek to produce a given level of output at least cost or to obtain a targeted increase in sales with minimal expenditure on advertising. In a host of settings, measures that reduce costs directly serve to increase profits. These host of settings and measures are arrived at by a variety of methods which identify and points directly to the best or optimal decision. These methods rely to varying extents on marginal analysis, Linear programming, decision trees, benefit-cost analysis, feasibilities etc.
As stated earlier management strives to maximize the firms profits, this objective is unambiguous for decisions involving predictable revenues and cost occurring during the same period of time. However, a more precise profit criterion is needed when the firms revenue and costs are uncertain and occur at different times in the future. This more focused managements ultimate objective is known as maximizing the value of the firm. The firms value is defined as the present value of its expected future profits. The term maximizing the value of the firm if applied in a Microeconomics sense depicts the different parameters of operation of a firm, one of which is the economics of production. As we know that production is the process through which inputs (raw material) are transformed into outputs (product). At each stage of the transformation process a firm incurs cost and adds value to the output. This transformation cost of production is the contribution of the production activity to the economic process which taken in a broader economic perspective means contribution as the difference between (output / product price) and the total cost (Samuelson and Marks, 1992).
A dynamic firm will continuously strive to minimize the production cost but at the same time maximize or add value to the product without compromising its quality. This objective can be termed as economics of production (Huda, 1998).
Profit maximisation is the ultimate objective of every company. There are many alternative courses of action available to the management to attain this goal and one of alternative is to introduce a new product and reduce production overheads. The economics of production is concerned with how efficiently one can add value to the output during production processes without compromising on the quality of the product. In this respect one has to exploit the commercialized scientific and technological knowledge most effectively to the companys advantage.
This report basically addressed the profit maximization alternative available to the management, that is, launching a new product and reducing production overheads.
The issue of why it is necessary for a pharmaceutical company to launch a new product was discussed and the conclusion was that high cost of research and development is a major factor in this decision.
A new product for effective treatment of allergy was introduced and the whole process of managing production was discussed in relation to the production of tablets. The concept of cost centres, work centres, cost blocks, accumulation of production cost and their allocations was discussed in detail.
Since feasibility study is an important element in the whole scheme of profit maximization it was dealt with in detail. A feasibility report was prepared for introducing a new carton packing machine which would replace manual packing with automization thus improving productivity with cost effectiveness. This feasibility results show a three year payback period. Introduction of a new product and cutting down overheads gives an investment return of 33.39% to the company. In conclusion, it is hoped that this report will provide some guidance for students to further develop their knowledge on product costing, feasibility, production process and managing production planning in a production company. This will result in profit maximization for the company and benefit the consumers through lower product cost and enhance quality.
In conclusion, the economics of production as applied to a pharmaceutical product was established on the basis of actual cost data and feasibility studies.