Mahmoud M. Farag : Selection of Materials and Manufacturing Processes for Engineering Design, Prentice Hall International (UK) Ltd., Hertfordshire, 1989. (TA 174 F23 In) Chapter 17 Concepts of Economic Analysis 17.1 TYPES OF COSTS IN MANUFACTURING There are several methods of classifying the different elements of cost that are encoun- tered in manufacturing. A common method is to divide costs into fixed and variable costs. Fixed costs are constant and do not depend on the level of production output, while variable costs change in close proportion with production rate. When fixed and variable costs are combined, the total cost of production is obtained. Deducting total cost from the selling price gives the profit (if any); the selling price as such is determined by the market Fixed costs include: 1. Investment costs, such as interest on cost of the factory buildings, depreciation of production equipment, insurance and property taxes. 2. Administrative expenses, such as share of executive and legal staff and share of corporate research and development staff. Sales and services expenses, such as sales personnel, delivery and warehouse costs, technical service staff and nontechnical service staff. Variable costs include: . Direct labor costs, including fringe benefits Materials, including raw materials, operating supplies, scrap, lubricants, etc. Cost of power needed to operate production facilities. Maintenance costs. Quality control costs, Royalty payments. Packaging and storage costs. a. 4. 5: 6. Ts Some of the above costs, ¢.g. direct labor and maintenance, are sometimes considered as semivariable costs as they do not increase in direct proportion to production rate. At zero production, a portion of the semivariable costs, about 20 to 40 percent of the costs at full production, continues to be incurred. Rather than classifying costs into variable and fixed cost, accountants and finance personnel usually find it more conve: it to think in terms of direct labor cost, material cost and overhead costs. The direct labor cost is the sum of the wages paid to personnel who operate the production facilities and perform the process and assembly operations. The material cost is the cost of all materials used to produce the finished product. Overhead costs are all the other costs associated with running the company. Overhead can be divided into factory overhead and’ corporate overhead.362 Concepts of Economic Analysis Factory overhead includes the costs of operating the factory, other than direct labor and materials, and can amount to several times the cost of direct labor. The share ofa given product in the factory overhead can be allocated in proportion to the direct labor cost, direct labor hours, space, material cost, etc. The elements of cost that are usually considered as factory overheads include: Plant supervision, foremen and security. Maintenance crew, materials handling crew, shipping and handling, and custodial services. ‘Taxes and insurance. Cost of interest on equipment and factory buildings. Cost of depreciation of equipment and factory. Cost of power for machines, lighting, heating, ete. x nua It should be noted that basing the share of a product in the factory overhead on direct labor cost alone could lead in some cases to inconsistencies. For example, a machine operator who runs a small inexpensive engine lathe should not be costed at the same overhead rate as an operator who runs a much more expensive NC machining center. The time on the NC machine should be valued at a higher rate. The appropriate rate can be obtained by dividing production costs into direct labor and direct machine costs. Each of, these costs will then be charged an appropriate portion of the factory overhead. The direct labor cost would consist of the wages paid to operate the machine. The applicable factory overheads include fringe benefits and supervision. The machine cost is the capital cost of, the machine apportioned over its life at the appropriate rate of return used by the company. The machine overhead rate is based on those factory expenses which are directly applicable to the machine, e.g. power, floor space, maintenance and repair expenses. It may be difficult in some cases to separate the applicable factory overhead items given above between direct labor and machine. In such cases, some judgement is needed Corporate overhead cost is the cost of running the company other than its manufactur- ing activities and can be determined in a similar way to the factory overhead. Separating factory overheads from corporate overhead is particularly important in the case where the manufacturing organization operates more than one plant. The elements of cost which are usually considered as corporate overhead include: 1. Share in corporate management. 2. Share in accounting, finance and legal personnel. 3. Share in sales and other support personnel. 4, Share in design and research and development personnel. 5. Share in cost of office space, lighting, heating, etc. 17.2. BREAK-EVEN ANALYSIS Break-even analysis is a method of assessing the effect of changes in production output on costs, revenues and profits. Break-even analysis makes use of the concept of dividing manufacturing costs into fixed and variable costs to calculate the range of production volumes necessary for profitable operation. Figure 17.1 illustrates a simple break-even chart where the semivariable costs are reduced to fixed and variable components. The change in the variable cost per unit change of production volume is taken to be linear in thisBreak-even analysis 363 sreateven po Prot BS) rota Variable ae one 3 hs Sales or production volume Figure 17.1 A simple break-even chart, ing = j_Dveroadh Under Normaltoading —| Second break-even. Income orcost Sales or production volume Figure 17.2 A break-even chart with nonlinear total cost. simple case. However, in actual industrial cases the total Production costs are usually nonlinear functions of production volume, as shown in Fig. 17.2. The least-cost load usually determines the level of operation for maximum economy and profit. Generally, loading production facilities to their full rated capacity corresponds to maximum efficiency of operation. Lack of efficiency when the facilities are underioaded, and the increased364 Concepts of Economic Analysis depreciation and maintenance costs when the facilities are overloaded, contribute to the nonlinearity of the total costs. In such cases it is possible to have more than one break-even point. The break-even chart is an important tool for the analysis of many production problems. It can be used to show how the profits, or losses, will vary for different output levels. The break-even point is the output level at which total costs equal revenues and the profit is zero. Other uses of break-even analysis are in plant capacity planning, equipment replacement studies and make or buy decisions. The break-even chart can also be used to show the effect of changes of output level on the costs of different methods of production. The break-even point in this case is the output level at which the costs for two production methods are equal. In this form, the break-even chart can be of help in equipment and process selection for a given product, as will be illustrated in the following example: A turned part can be produced on an engine lathe, capstan lathe or automatic lathe. Find the most economical volume of production in each case using the information in Table 17.1. Table 17.1 Economics of volume production of a tumed part Engine lathe Capstan Automatic a. Tooling cost ($) 30 30 30 b. Cost of cams ($) ~ ~ 120 . Material cost/part (5) 0.5 os 05 4. Direct labor cost (7h) 80 6.0 3.0 e. Cycle time/part (hi) 03 on 0.05 € Setting up labor cost (S/n) 10.0 10.0 10.0 g. Setting up time (h) 0.2 10 80 hh, Machine overheads (% of item d) 100% 300% 1000% Method of calculation overheads =deh=O0 fixed costs satbt+g(f+0) variable costs/part = (dxe) ++ (O xe) Performing the calculations according to the above procedure gives the results in Table aaTime vatue of money 365 Table 17.2 Results of calculations using data in Table 17.1 Engine lathe Capstan Automatic FC = fixed costs (8) 336 58 350 VC =-variable costspart ($) 53 29 2.5 Break-even quantities can be determined graphically, as shown in Fig. 17.3, or calculated analytically from: (FC,) + (VC\)n = (FC) + (VO,)n (7.1) where nis the break-even point between machine 1 and 2. 1400 a 120 a, 1) 330 i Automatic gine el lathe é | 600 K Capsten 00 200 | hss ° 100 200 300 400 Number of parts produced Figure 17.3 Break-even chart for a turned part, see example in Section 17.2. The break-even results show that the engine lathe is more economical for quantities less than 10 parts, and the automatic lathe is more economical for quantities more than about 390 parts. The capstan lathe is more economical ifthe required number of parts is in the range 10 to 390.366, Concepts of Economic Analysis Another illustration of the use of break-even analysis in selection of tooling materials is given in the following example: A pattern for sand casting can be made from either wood or aluminum. Find the break-even number of castings using the information in Table 17.3. Table 17.3 Comparison of sand casting pattern materials Wood Aluminum Fixed cost (initial cost of pattern) (S) 40 150 Variable costpart (cleaning and preparation) $0.02 0.02 Life of pattern, no. of pans 500 10.000 ‘The costs of the two patterns are shown in Fig. 17.4 as a function of the number of parts to be cast. The figure shows that the break-even number is 1500 parts. 280 200 Aluminum pettern 150 100 500 1000 1500 2000 2500 Numberof castings Figure 17.4 Use of break-even analysis in tool-material selection, see example in Section 17.2.