Chapter 4 and 5

Estimating and Reducing Costs

 Cost Structure
 Reducing Labor Costs
 Workload Balancing 

 Operations Cost = Fixed Cost + Variable Cost
= Administrative Costs + Depreciation and Interest + 
Production Cost + Inventory and Transportation Cost + …
 Operations Cost = Direct Cost + Indirect Cost 
= Direct Materials Cost + Direct Labor Cost + Overhead and 
Utilities Cost + …
 Return (Net Income) = Sales – Operations Cost – Taxes
 Return on Assets = Return/Total Assets 資產報酬率

 Return On Invested Capital = Return/Invested Capital
資本報酬率

1
Reducing Waste to Improve Cost Performance

 Reducing cost is easier than increasing revenue.

 Excess capacity is waste.

 Reducing excess capacity at some process steps 
can improve efficiency and reduce cost.

 Moving excess capacity to rescue the bottleneck 
can increase the overall process capacity.

The Role of Labor Costs in Manufacturing

100%
Other
90% Overhead
Warranty
80%
Quality
70%
60% Labor costs
50% Parts and Parts and
40% material material
costs costs Logistics costs
30%
20%
10% Material costs
0%
Final  Including Including Rolled‐up
Assembler’s  Tier 1 Tier 2 Costs over
cost Costs Costs ~ 5 Tiers

2
Paul Downs started making furniture in 1986, in a small shop in Manayunk. Over the 
years we have outgrown 4 other shops and we now operate a 20,000 square feet 
shop in Bridgeport, PA. 

Much of our work is residential, but we also do a lot of office furniture, including 
desks and conference tables. We complete 125 commissions per year, consisting of 
about 500 separate pieces of furniture. 

Financial Structure of
Production facility
Machines valued about $450k, depreciation $80k p.a.
Overall facility is utilized at 100% right now 

Show rooms and factory: $150k for rent

Indirect costs: $100k marketing, $180k 
management, $60k finish

Inventory: $50,000 WIP and $20,000 raw 
material

Suppliers need to be paid 1 month before 
receiving the wood.

3
Work Force (fixed cost, direct cost)
12 cabinet makers, $20 per hour (220 days @8h/day)

Labor utilization around 90% (idle time resulting from waiting)
Spend 15% of time on set‐ups (build fixtures, program machines)

Actual labor content is about 40 hours per unit of furniture

End Product
Average price is $3000 per unit
Requires 30kg of wood (costs about $10 per kg) plus 25% scrap

Customer pays 50% down and gets her furniture 3 months later

Building an ROIC Tree

Return Return Revenue
ROIC   
Invested Capital Revenue Invested Capital
獲利率 資本週轉率
Throughput
Revenue
Price
Return
Revenue Direct Cost
獲利率
Total Cost
Indirect Cost
ROIC
Throughput
資本週轉率
Revenue
Revenue
Invested Cap. Price
Invested Cap.

4
The Drivers of Process Capacity
Number of
workers
Available
Hours
Hours worked per
year per worker
Process
Capacity 

≈ Throughput Actual production time
activity time
Hours per Wait time
+
piece
Time needed before +
production time
Set‐up time

10

ROIC Tree for Direct Costs

Number of
workers
Available
Hours
Direct  Hours worked per
Labor year per worker
Kg per piece
Hourly wage rate
Direct Wood per  +
Costs +
Material cost  piece
per piece Scrap loss

Direct
Materials Price of wood

Throughput

11

5
 Expanded ROIC Tree
Price Number of workers

Revenue Demand Available

Hours Hours worked per 
Throughput Process year per worker
Capacity Actual production time
Hours per (activity time)
piece Wait 
Return Marketing
Time needed before time
Revenue Management production time
Indirect Set‐up 
Finishing / QA time
Costs
Depreciation Number of workers
Rent Available
Total 
Hours Hours worked per
ROIC Cost Direct  year per worker
Labor Hourly 
Direct  wage rate
Cost Price of wood
Material cost 
Direct  per piece Kg per 
Revenue Wood per  piece
Material
Revenue piece
Throughput
Invested Cap. Scrap loss
Invested Cap.

12

ROIC Tree for Invested Capital

PP&E 不動產與設備
Raw Materials
Inventory +
Invested
Capital + WIP Throughput
+
Total $ spent
Working on wood
Pre‐ Material costs
Capital Payments
Time of pre‐payment
+ Revenues
Unearned
% Down‐payment
Revenue
Time of down‐payment

13

6
Valuing Operational Improvements

How to improve ROIC?
 Cut wages
 Simplify the design to reduce the production time
 Reduce scrap loss
 Reduce setup times
 New payment terms with the supplier or the landlord

Assume there are plenty of demands.
A good approach is to produce more with a fixed workforce.

14

Analyzing an Scooter Assembly Process

15

7
Initial Process Flow

Components Finished Xootrs

Activity 1 Activity 2 Activity 3

13 minutes 11 minutes 8 minutes

Process Capacity of System 1 
= one unit every 13 min.
= 4.6 scooters/hour
= 161 scooters/week

16

Labor Content and Idle Time

 Assume the current demand is 125 units per week.
 The process operates 35 hours per week.

17

8
Estimating Labor Costs

Labor content = sum of activity times with direct labor = 32 min / unit

labor content
Average labor utilization=     
labor content  direct idle time = 63.4%

Total wages per time unit  $1260/week
Cost of direct labor = 
Flow Rate per time unit 125 units/week
= $10.08 / unit

18

Line Balancing Reduces Imbalances

19

9
Recalculating Capacity and Labor Costs
System 2
worker 1 792‐118=674 sec.
worker 2 648+118=766 sec.
worker 3 450 sec.

 Capacity = 164 units/week
 Flow rate = min{ demand, process capacity }=125/week

 Labor costs will not change if the process is demand 
constrained

20

What If the Demand Increases to 200/week?

 System 1 becomes capacity‐constrained
flow rate = 161 units/week
$1260/week
cost of direct labor =  161 units/week = $7.83 per unit

 System 2 is also capacity‐constrained.
flow rate = 164 units/week
$1260/week
cost of direct labor = 164 units/week = $7.68 per unit

21

10
 1 30 1 30 1 30 1 30
2 25 2 25 2 25 2 25
3 100 3 100 3 100 3 100
4 66 4 66 4 66 4 66
5 114 5 114 5 114 5 114
6 49 6 49 674 6 49 674 6 49 623
7 66 792 7 66 7 66 7 66
8 100 8 100 8 100 8 100
9 30 9 30 9 30 9 30
10 43 10 43 10 43 10 43
11 51 11 51 11 51 11 51
12 118 12 118 12 118 12 118
13 110 13 110 13 110 13 110
14 59 14 59 14 59 14 59
15 33 15 33 15 33 15 33
16 96 16 96 766 16 96 635 16 96 602
17 135 648 17 135 17 135 17 135
18 84 18 84 18 84 18 84
19 56 19 56 19 56 19 56
20 75 20 75 20 75 20 75
21 95 21 95 21 95 21 95
22 20 22 20 22 20 22 20
23 43 23 43 23 43 23 43
24 114
450 450 581 24 114
665
24 114 24 114
25 94 25 94 25 94 25 94
26 84 26 84 26 84 26 84
22

Performance of the Balanced Process

 Process Capacity
= 189 units/week
 Average labor utilization 
1890
= 1890  42  63  94.7%

 cost of direct labor 
$1260/week
= 189 units/week  $6.65/unit

23

11
Scale Up to Higher Volume
 Demand reaches 700 units/week

24

Replicating the Line or Adding Workers

1. Four identical lines.
Total capacity = 1894=756 units/week

2. One line with 4 workers at each step.
Total capacity is also 756 units/week

12  35  $12  $7.2/unit
Cost of direct labor = 
700

25

12
 1 30
2
3
25
100
Job Specialization
4 66
5 114
6 49 3. one line, 12 workers
7 66
8 100 The last step is the bottleneck
9 30
10 43  Capacity=700 units/week
11 51
12 118
13 110
14 59 Why does capacity decrease?
15 33
16 96
17 135
18 84 Answer: Since moving a task to the next 
19 56
20 75 worker becomes more significant, the 
21 95
22 20 process is less balanced.
23 43
24 114
25 94
26 84
178
26

Reverse the Trend of Specialization

 Having one worker perform all assembly tasks
Capacity=66 units/week
 Only need 11 workers  726 units/week
 Cost of direct labor=  11  35  $12  $6.6 /unit
700

27

13
Summary

 Labor costs may be very significant for high contact services.
 Labor costs are under the managerial control, while other 
costs are either fixed or dictated by the market.
 Job Design and work balancing eliminates idle time and 
increase capacity and/or labor utilization.
 Proper job motivation is as important as reducing labor 
costs.

28

14