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Me 134

ACTA
POLYTECHNICA
SCANDINAVICA
MECHANICAL ENGINEERING SERIES No. 134

Engineering Cost Functions in Make-to-Order Production with Applications

ESKO NIEMI

Laboratory of Production Engineering

Helsinki University of Technology
P.O. Box 4200
FIN-02015 HUT
Finland

Dissertation for the degree of Doctor of Technology to be presented with due permission for
public examination and debate in Auditorium K216 at Helsinki University of Technology (Espoo,
Finland) on the 12th of February, 1999, at 12 o’clock noon.

ESPOO 1998
2

Niemi, E., Engineering Cost Functions in Make-to-Order Production with Applications. Acta
Polytechnica Scandinavica, Mechanical Engineering Series No. 134, Helsinki 1998, 139 pp.
Published by the Finnish Academy of Technology, ISBN 952-5148-81-5. ISSN 0001-687X.

Keywords: Engineering cost function, Economies of scale, Make-to-order production, Plant

location problem

ABSTRACT

Make-to-order manufacturing technology is analyzed using an engineering approach, in order to

express the production cost as a function of production volume. The long-run cost function, i.e. the
minimum production cost as a function of output volume and input prices, is determined. It
typically requires that different technologies are applied at different volumes.

Technology-based cost functions and their approximations are formulated. It is found that
economies of scale in a manufacturing process which uses alternative technologies are strong at
lower production rates due to indivisibility of manufacturing resources. After the initial decrease
the average costs may decrease further, if efficient technologies are available, although more
slowly at higher production rates. The continuing economies of scale can also be produced by use
of long-lived tools or other resources shared by several manufacturing units. The more capital-
intensive the manufacturing process, the higher the economies of scale generally are.
Consequently automation, especially unmanned operation, tends to increase these.

The main application of the cost functions presented here is the plant location problem, which is
analyzed by means of operations research methods. Inclusion of the economies of scale into
solution of these problems was found essential.

© All rights reserved. No part of this publication may be reproduced, stored in a retrieval system,
or otherwise transmitted, in any form or by any means, electronic, mechanical, photocopying,
recording, or otherwise, without the prior written permission of the author.
 3

PREFACE

The interest in economies of scale in manufacturing expressed by the present thesis originated
from an experience in the management of a continuously expanding industrial production
operation. After a preliminary search had revealed that in spite of the importance of the subject,
surprisingly small amount of analytical research had been carried out on it, the research reported in
this thesis was conducted at the Helsinki University of Technology.

Several persons have read and commented on drafts of the thesis. I want to express my gratitude to
Professor Veijo Kauppinen who has supervised my work and provided me the opportunity to use
the facilities of the Laboratory of Production Engineering at Helsinki University of Technology. I
also wish to thank Professors Ilkka Lapinleimu and Tauno Olkkonen who have reviewed the
manuscript. I am indebted to several previous and present colleagues not mentioned here by name,
for inspiring discussions and friendly working atmosphere.

I acknowledge with great pleasure the financial support which I have received from Imatran
Voiman Säätiö, Tekniikan edistämissäätiö and Suomen Konepajainsinööriyhdistys.

Finally, I want to thank my parents and Elisa for their continuous encouragement during the
course of the work.

Helsinki, December 1998

Esko Niemi
4

CONTENTS

SYMBOLS .........................................................................................................................................7

1 INTRODUCTION ...........................................................................................................................9
1.1 Background of the study .........................................................................................................9
1.2 Research problem .................................................................................................................10
1.3 Objective...............................................................................................................................10
1.4 Scope of the study.................................................................................................................10
1.5 Analytical method.................................................................................................................11
1.6 Structure of the thesis ...........................................................................................................12

2 PRODUCTION AND COSTS ......................................................................................................14

2.1 Theory of production and costs ............................................................................................14
2.2 Capacity utilization ...............................................................................................................17
2.3 Statistical cost function studies.............................................................................................18
2.4 Engineering cost function studies .........................................................................................19
2.5 Economies of scale ...............................................................................................................21
2.5.1 Sources of economies of scale in production .............................................................22
2.5.2 Sources of diseconomies of scale in production ........................................................24
2.5.3 Firm-wide and external scale effects..........................................................................26
2.5.4 Non-real economies of scale ......................................................................................26
2.5.5 Economies of scale studies.........................................................................................27

3 MANUFACTURING PROCESSES AND COSTS ......................................................................28

3.1 Labor cost .............................................................................................................................28
3.1.1 Labor cost function in the long run ............................................................................28
3.1.2 Labor cost function in the short run ...........................................................................30
3.1.3 Labor indivisibility.....................................................................................................32
3.1.4 Long-run labor cost function with unmanned night shift...........................................34
3.2 Long-lived process equipment capital cost...........................................................................35
3.3 Other manufacturing process costs .......................................................................................37
3.4 The individual manufacturing process..................................................................................38
3.4.1 Long-run cost function of a single technology and single unit of equipment............38
3.4.2 Long-run cost function of a single technology and single unit of equipment
with unmanned night shift...................................................................................................42
3.4.3 Long-run cost function of machining using a given machine tool.............................43
3.4.4 Long-run cost function of a single technology with multiple units of equipment .....49
 5

3.4.5 Long-run cost function of a process with economies of scale due to more
efficient technologies ..........................................................................................................53
3.5 Common mechanical engineering manufacturing processes ................................................59
3.5.1 Manual work...............................................................................................................60
3.5.2 Mechanized parts manufacturing with constant machine operator presence.............61
3.5.3 Mechanized parts manufacturing using multiple units of similar equipment,
expensive tooling and constant machine operator presence................................................69
3.5.4 Mechanized parts manufacturing with partial operator presence, i.e. automation....71
3.5.5 Mechanized parts manufacturing with different levels of operator presence
at different hours of the day, i.e. automation without operator presence............................74
3.5.6 Continuous processes .................................................................................................77
3.5.7 Economies of scale with increased unit labor cost and decreased fixed cost ............79
3.5.8 Conclusions on the cost functions of mechanical engineering manufacturing
processes..............................................................................................................................80
3.6 Cost of capital employed in the work-in-process .................................................................80
3.7 Total manufacturing process.................................................................................................83
3.7.1 Long-run cost function ...............................................................................................83
3.7.2 Random simulation of the long-run manufacturing cost function .............................83
3.7.3 Approximation of the long-run manufacturing cost function ....................................87
3.8 Example of long-run manufacturing costs............................................................................89
3.8.1 Elasticity of capital-labor substitution .......................................................................91
3.8.2 Process utilization ......................................................................................................93

4 COSTS OF MATERIAL SUPPLY, ORDER HANDLING AND PRODUCTION

MANAGEMENT .............................................................................................................................94
4.1 Material supply .....................................................................................................................94
4.1.1 Ordering costs ............................................................................................................94
4.1.2 Holding cost ...............................................................................................................96
4.1.3 Purchase cost ..............................................................................................................96
4.1.4 Example of total material costs ..................................................................................98
4.2 Order handling ......................................................................................................................99
4.3 Production management......................................................................................................100

5 EXAMPLE OF A TOTAL PRODUCTION PROCESS .............................................................101

6 APPLICATION OF LONG-RUN COST FUNCTIONS TO THE PLANT LOCATION

PROBLEM .....................................................................................................................................102
6.1 Introduction.........................................................................................................................102
6.2 Production location problems .............................................................................................103
6

6.2.1 The simple plant location problem...........................................................................103

6.2.2 End point optimality.................................................................................................105
6.2.3 Single assignment property ......................................................................................105
6.2.4 Solution techniques for the simple plant location problem......................................105
6.3 Plant location problems with economies of scale due to technological specialization ......106
6.3.1 Cost-minimizing plant location model with fixed demand......................................106
6.3.2 Profit-maximizing plant location model ..................................................................110
6.3.3 Cost-minimizing and profit-maximizing plant location models with fixed
constraints on transportation time .....................................................................................111
6.3.4 Cost-minimizing plant location problem with market share constraints
depending on transportation time......................................................................................112
6.4 Validity of the results..........................................................................................................116
6.5 Conclusions.........................................................................................................................117

7 VALIDITY OF THE RESULTS.................................................................................................119

8 CONCLUSIONS .........................................................................................................................120

9 SUMMARY ................................................................................................................................123

REFERENCES ...............................................................................................................................125

APPENDICES ................................................................................................................................128
 7

SYMBOLS

Those symbols that are used only in one Section are explained as they appear. The following
symbols are used throughout the study:

AFEC average capital cost

AFECm average capital cost of process machinery
AFECt average capital cost of tools, fixtures etc.
AFECf average fixed capital cost of rent, heating etc.
A, b, C, d parameters
C cost or annuity, used also as parameter
aj number of machines that a worker can use in labor cost category j
Dj demand at market j
f economic production function
IRAVC intermediate-run average variable cost
LRAC long-run average cost
LRALC long-run average labor cost
LRALCI long-run average labor cost with indivisible labor
LRAVC long-run average linear variable cost
LRLC long-run total labor cost
LRMC long-run marginal cost
SRALC short-run average labor cost
SRALVC short-run average linear variable cost
SRTC short-run total cost
pi price of input i
q output
∆ti annual working hours in labor cost category i
t time
tj maximum possible total annual working hours up to and including cost category j
tr function returning the largest integer that is smaller than or equal to the argument
Tu workpiece processing time
wi hourly labor cost in labor cost category i
x number of units produced
zi input i
8
 9

1 INTRODUCTION

1.1 Background of the study

Since the early days of industrialization it has been well known that large factories tend to be more
efficient than small ones. In addition to their larger output, they also manufacture products at a
lower unit cost. An important reason for the phenomenon called ”economies of scale” is the
distribution of higher investments in technology over a more than proportionally larger number of
manufactured products. There are also many other reasons for decreasing costs in large volume
production, such as superior techniques of organizing production and faster learning due to a
higher rate of production.

If the capacity of a factory is further increased, the increase in benefits of size usually decelerates
and a point may be reached after which these benefits start to decrease and diseconomies of scale
appear. This can be due to both technical and organizational reasons.

Knowledge of the best way of establishing any output level allows one to calculate the minimum
production cost as a function of output volume and input prices - i.e. the cost function. Firms can
use cost functions for judging the attractiveness of businesses, finding profit-maximizing output
levels, judging the optimal factory size and method of organizing production, price-setting,
determining factory location and many other important issues. Knowledge of the dependencies of
costs on production volume is essential for almost all basic strategic decisions made by a firm
operating in a market.

Econometric production and cost functions have previously been studied extensively. These
functions have been derived statistically from historical data and describe dependencies between
inputs and outputs. The data is usually aggregated from information related to several firms. The
models obtained have no direct connection with the reasons leading to the behavior they describe.
Such econometric cost functions have normally little practical value as the cost function of an
individual firm or factory.

The most accurate way to determine the cost function of a factory is a thorough technological and
economic examination of the production process. This is called the engineering approach. It
implies a large amount of detailed and synthesizing work. Introductions of practical tools in
support of such a process have not been found in the literature and appropriate case studies are not
available. The present study accordingly concentrates on explaining the relevant factors behind the
costs and determining the long-run cost function of make-to-order manufacturing of products in
the mechanical engineering industry. Applications to optimal use of resources, in order to
minimize costs at any production rate and to find the overall cost-minimizing production rate, are
presented in the study.

The make-to-order mechanical engineering industry is characterized by standard product types that
are usually customized according to customer requirements. Such production is typical in the
mechanical engineering industry, e.g. in Finland. The products are made in small lots and often
under severe pressure for short delivery times. Consequently the production is generally labor
intensive and consists of a number of specialized resources. These characteristics result in a high
practical usefulness of cost function analysis.
10

Plant location optimization is examined in the study as another application of cost functions.
Economies of scale support a concentration of production in just a few factories. On the other
hand, delivery time requirements and a firm’s multi-regional presence favor decentralization of
production into different market areas. The long-run cost function of a factory, logistics costs and
markets affect the efficient allocation of production. If these are known for a certain product, the
cost-minimizing factory location problem can be formulated as a mathematical programming
problem. Although it may not be possible to take all factors into account, those most directly
affecting costs can be modelled and their effect calculated. Such optimization supports the
strategic planning of firms operating in global markets.

1.2 Research problem

The core problem of the study can be stated as follows:

”What is the form of the long-run cost function of a factory manufacturing mechanical engineering
products to order and how are the values of the parameters of this function determined?”

Related problems are: what is the optimum production volume for minimizing unit cost and what
factors affect the cost behavior?

In addition, the plant location problem, which is presented as an application of cost functions, is
set out and can be stated as follows: what is the production allocation that minimizes costs, when
markets are served in given market shares? Problem formulations subject to constraints on
delivery times are also presented.

The point of view taken is strictly microeconomical, i.e. the point of view of an individual firm or
a factory.

1.3 Objective

The study examines the dependence of production costs on production volume in make-to-order
production of discrete mechanical engineering products. The objective of this study is to determine
the form of the long-run cost function. The function will thereby be formulated so that its
parameter values can be calculated from estimated or known operational data of production plants
of the type in question.

The usefulness of the cost functions will be demonstrated by applications concerning optimization
of shift working arrangements, machining optimization and factory location optimization. These
problems are formulated and solved using appropriate case data.

1.4 Scope of the study

The scope of the study is limited to cost functions of make-to-order production in the mechanical
engineering industry. The types of products in focus are discrete components and assemblies that
are variations of the same basic construction or members of the same product family. The product
variability is taken to be so large that it is not rational to produce the parts or end products to stock
in large batches. However, the products are assumed to be similar to such an extent that they can
use the same production resources and the same type of raw materials. On the other hand, the
 11

resources are considered so specialized that they are not shared by products which do not belong
to the same family.

The manufacturing process normally consists of several serial and parallel subprocesses which
represent various technologies. It is assumed that the manufacturing resources are not
interdependent, and that the technology of each subprocess can be chosen separately. When
alternative technologies for the different subprocesses are considered, it is assumed that the
number of these technologies is limited. It is also assumed that economies of scale exist between
these technologies in order for them to be relevant.

In this study, mostly fixed proportions manufacturing technologies are assumed. That is, once the
technology is chosen, the capital input is fixed and the output is directly related to labor input. An
exception to this is the application to machining, where the cutting tool wear is characterized and
taken into account by a nonlinear function.

Make-to-order production and a low level of standardization are accompanied by large factory
load fluctuations and need for a large amount of manual set-up work and human process
supervision. Consequently the dominant technologies applied are fairly labor intensive. This
background assumption characterizes the analysis throughout the study, while the technologies
used for manufacturing components are usually more mechanized than those used for assembling
final products.

Production is considered to cover all order handling activities within a factory up to the delivery of
the product, including manufacturing, material supply, and supporting functions. Significant scale
economies may also be present, among others, in research, marketing, cost of capital, firm
management and distribution. These are firm-wide issues and will only be discussed in a
summarizing fashion. Distribution of products is treated separately in connection with the plant
location application.

The assumptions derived from the limitations of the scope of this study are presented in more
detail as needed.

All the case data presented in the study originates from Finnish mechanical engineering firms,
whose production fits within the scope described above. Products typical to such firms are, for
example, large pumps, valves, diesel motors, electrical motors and transformers.

1.5 Analytical method

The engineering approach to production and its economy is based on an analysis of the technology
applied at the plant floor level. It can be compared with the statistical or econometric approach
which deals with overall economic data at various levels in business and industry, but does not
involve their technological background.

The method based on technological analysis implies construction of the cost relationships of the
product and process in detail and their combination in appropriate ways. The result is a
mathematical cost model that is based directly on the technological and economical dependencies
of the production process.

Numerous cost models of individual processes are formulated during the construction of the cost
model of the total production process. Their characteristics are examined analytically and
numerically.
12

Usually the engineering approach of process analysis is applied to specific products and processes.
In order to increase the practical usefulness of the complex model constructed in this study, other
simpler cost models containing only a few parameters are searched. Numerical random simulation
is used to generate pseudo-cost data with the original cost models, and the simpler models are
fitted to this data. The validity of these models is evaluated using statistical methods. The
generality of the models is verified using different parameter values in the simulations. The
parameter values are chosen so that a wide range of mechanical engineering production processes
of different natures is covered.

One real-life application of cost models to a total production process is presented. In this example
engineering estimates of the process parameters are used and the characteristics of the obtained
cost function are analyzed.

One main application of the cost functions presented, the plant location problem, is analyzed using
operations research methods. Different variations of the problem are formulated as mathematical
programming problems. These problems are solved for example input data using existing standard
software.

1.6 Structure of the thesis

The research report consists of seven chapters. Their contents are as follows:

Chapter 1 introduces the study, giving an overview of its background, objective, scope and the
research method.

Chapter 2 reviews the relevant theoretical background of the cost functions including capacity
utilization aspects. The related literature and previous studies are surveyed.

In Chapter 3, the economies of capital costs, and labor costs and other variable costs are examined
for individual technologies. The cost function of an individual technology is formed and its
characteristics are analyzed. The relationships between the alternative technologies for a
subprocess are formulated. The cost function of a subprocess is examined in the cases of different
process types common in mechanical engineering industries. The cost function of the total
manufacturing process is formulated and its shape is analyzed using numerical simulation and
statistically fitted models. A real-life example of engineering estimate of a total manufacturing
process cost function is presented.

This chapter also examines machining parameter optimization as an application of the cost
functions obtained.

Chapter 4 examines the material inputs and supporting functions of a factory’s production process.

Chapter 5 presents the total production process of a product in the light of an example.

Chapter 6 analyzes the plant location problem as an application of the production process cost
function. The effects of transportation time constraints on the cost-minimizing solution are
studied.

Chapter 7 assesses the results’ validity and practical relevance.

Chapter 8 presents the major conclusions of the work. Subjects of future research are proposed.
 13

Chapter 9 is a summary of the main points of the study.

14

2 PRODUCTION AND COSTS

This chapter briefly reviews the basic concepts of production and costs relevant to this study. The
point of view is mainly that of an individual manufacturing plant and the focus is on the factors
affecting the costs of such a plant. The engineering approach to cost analysis is emphasized over
the statistical or econometric one. Where applicable, attention is paid to characteristics relevant to
mechanical engineering production. A survey of the existing literature on the subjects discussed
accompanies the presentation.

2.1 Theory of production and costs

The concepts briefly presented in this Section are explained in more detail for example in Gravelle
and Rees1, Jehle2, Varian3, Ferguson4 and rigorously in Shephard5.

Production

The production function f(z) shows the maximum output of products that can be produced from
any combination of inputs, or factors of production, zi, (i = 1,2,..). It gives the technological
constraint for a manufacturer so that he or she can choose to produce an output q:

0 ≤ q ≤ f (z) . (1)

The single output quantity q and the inputs are considered flows and are expressed in units per
time period. The average product of an input is the output of products per unit of that input, and
the marginal product of an input is the increase of output for one additional unit of the input.

It is usually assumed that the production technology in use or choice of the production technology
allows factors of production to be substituted with each other to some extent. If maximum output
q0, is produced from two inputs z1 and z2, the production is output efficient and the constraining
isoquant q0 = f(z1,z2) can be drawn as a contour in relation to the inputs; see Figure 1.

The slope of the isoquant gives the marginal rate of technical substitution, which is the rate at
which z1 must be substituted for z2 to keep output constant when moving along the isoquant. The
marginal rate of technical substitution is equal to the ratio of the inputs’ marginal products. The
slope of the isoquants is negative when production is technically efficient. That is, the marginal
products of the inputs are positive.

1
Gravelle, H., Rees, R. 1992. Pages 180 - 229.
2
Jehle, G. A. 1991. Pages 218 - 236.
3
Varian, H. R. 1978. Pages 1 - 51.
4
Ferguson, C. E. 1971. Pages 1 - 166.
5
Shephard, R. W. 1970.
 15

q1
z2 qL qF
EP

q0 σ=0

σ≈1
zi*
σ=∞

C0

z1

Figure 1. Isoquant map of production of one output by two inputs. q0, qL,q1, and qF are isoquants of
different kinds of technologies and σ‘s their elasticities of substitution. C0 is the isocost line corresponding
to cost-minimizing output q0 and inputs zi*. EP is the expansion path.

Elasticity of substitution is a parameter generally used to summarize the substitution

characteristics of the production function. Elasticity of substitution σ for two inputs is defined as
the ratio of the proportionate change in factor ratios to the proportionate change in the marginal
rate of substitution of the factors of production:

d ( z1 / z2 ) ( z1 / z2 )
σ= . (2)
d ( dz1 / dz2 ) ( dz1 / dz2 )

The elasticity of substitution describes the curvature of the isoquant so that the higher σ is, the less
bowed-in toward the origin the isoquant is. A fixed proportions technology has an elasticity of
substitution of zero. A linear technology has infinite elasticity of substitution; see Figure 1.

Cost

The cost of production is ∑ p z , where prices of inputs pi are assumed to be fixed. When all
i i

inputs can be varied, the firm’s long-run cost minimization problem is to minimize the cost C of
producing output q, i.e.

min C = ∑ pz i i so that f(z1,..,zn) = q, zi ≥ 0 . (3)

In a two input case the isocost line shows the combinations of inputs that have the same total cost:

p1z1 + p2z2 = C0 (4)

The lowest cost isocost line is tangent to the isoquant for the required output and the slope of the
isoquant and the isocost line is the ratio of the prices which equals the ratio of marginal products
of the inputs. The input combination representing the tangency point is the cost-minimizing one
for that output and the production is economically efficient. A line combining the cost-minimizing
input combinations for different levels of outputs is the expansion path; see Figure 1.
16

The cost-minimizing input levels which solve Equation 3 are the conditional input demands, zi*,
which are functions of the prices of the inputs and the output level required. The cost function
relates output, prices and the minimum of total costs:

Cmin = ∑ p z ∗ = pizi(pi,q) = C(pi,q).

i i (5)

The cost function is useful because it contains all economically relevant information about the
production technology of the producer.

The long-run average cost per unit is simply the total cost divided by output, LRAC = C/q. The
long-run marginal cost is the rate at which total cost increases as output increases, LRMC = dC/dq.

The elasticity of cost with respect to output is defined as the proportionate change in cost divided
by the proportionate change in output:

dC / C dC / dq LRMC
Eqc = = = . (6)
dq / q C/q LRAC

The cost function has economies of scale when Eqc < 1 and diseconomies of scale when E qc > 1 .
The LRAC is decreasing when there are economies of scale and the LRMC is smaller than LRAC.
Correspondingly the LRAC is increasing when there are diseconomies of scale and the LRMC has
higher values than LRAC. The reasons for economies of scale and diseconomies of scale are
discussed in Section 2.5.

The short-run cost minimization problem is obtained from Equation 3 by fixing the value of one of
the inputs, here z2 to z20 . The cost is minimized by minimizing the variable input, while producing
the required level of output. The short-run total cost function SRTC for two inputs is of the form

SRTC = p1z1 + p2 z20 . (7)

The short-run average cost function is tangent to the long-run cost function at the production rate
where the value of input z2 is z20 . At all other production rates the short-run cost values are higher
than the long-run costs. If the production function f(z) is continuous, z2 can be fixed to different
values, and different short-run functions are obtained. The envelope of the average short-run cost
curves generated is the long-run average cost function. Figure 2 shows typical long-run and short-
run average cost curves.

The effect of factor prices on costs depends on the form of the production function. A
proportionate increase or decrease of prices of the inputs affects both total and average costs in the
same ratio. A change in the ratio of the input prices causes the more expensive input to be
substituted by the less expensive one by an amount determined by the change in prices and the
elasticity of substitution. In fact, assuming cost minimization, the elasticity of substitution can be
redefined as the ratio of the proportionate change in factor ratios to the proportionate change in
relative factor prices.
 17

C/q
SRAC1
SRAC2
LRAC

Figure 2. Long-run average cost curve LRAC as the envelope of short-run average cost curves, SRACi.

The effect of change in the price of a factor on the total cost depends on the factor’s share of the
total cost at the particular output level. The effect of a factor price change would represent the
same percentage of total cost at all outputs only if the proportions of inputs would be the same at
all outputs. In such a case, production function would be homothetic and the expansion path would
be a straight line from the origin.

2.2 Capacity utilization

The cost functions presented in the previous section assume that the input prices are fixed and that
the inputs are fully utilized for economic efficiency. In practice, firms may want to plan for a
lower than maximum utilization of their equipment. Firms may know at the time of investment
that the product market will vary and demand will fluctuate or increase over time. Marris6 showed
that optimal idle capital is also justified by rhythmic input prices. The cost rhythms mean that it is
optimal to build extra capacity in order to be able to avoid running the production process during
time periods of high input costs. The most common input with such price characteristics is labor.
The cost of labor is typically high at inconvenient hours during the day and during weekends.

Winston7 lists the determinants of optimal utilization under rhythmic input prices as follows:

1. Relative factor prices and factor shares. The higher the capital costs relatively are the more
important is their reduction by high utilization.

2. The amplitude of the input price rhythm. The more the input price at different periods differs,
the greater is the incentive to operate only during the low cost periods.

3. The elasticity of factor service substitution. If the elasticity is less than one, it pays to increase
utilization if the relative cost of capital is increased or if the amplitude of the input price rhythm
is decreased. If elasticity is greater than one, the effect of the capital cost increase is reversed.

6
Marris, R. 1964.
7
Winston, G. C. 1974. Page 1306.
18

With an elasticity of unity, relative factor prices do not affect the optimal utilization of capital.
The factor service substitution is normally likely to be between zero and one8.

Betancourt and Clague9 point out that high capital intensity is often both a cause and an effect of
high utilization. Highly capital intensive technology favors high utilization, which lowers the
relative cost of capital. This in turn favors the substitution of labor intensive technologies by
capital intensive technologies.

The same authors also discussed the effect of economies of scale on shift work. They assumed a
homothetic production function and concluded that economies of scale make the technology used
for producing a given daily output economically less efficient if more shifts are worked. This
conclusion implies that higher capital utilization is not included in economies of scale. Normally
higher capital utilization is considered one of the main reasons of economies of scale .

2.3 Statistical cost function studies

Studies of statistical or econometric cost functions are based on the idea that a production process
can be described using a suitable production function, the parameters of which are determined
statistically from the input and output data of the process. The details and functioning of the
physical process do not need to be known, and the production function is not directly based on
them.

Statistical cost function models are based on what has actually happened. The data used in such
studies is usually collected from public statistics and concern entire industries rather than
individual firms or factories. This kind of data is macro economical, and studies of statistical cost
functions are usually more macro than micro economical.

These statistical studies may be based on the production function or the corresponding cost
function. The most common production functions to appear in such studies are briefly listed
below.

The Cobb-Douglas production function10 for two inputs has the form

q = Az1α z2β (8)

where A, α, and β are parameters. The elasticity of substitution of this function is unity at all
outputs. The relative factor proportions are equal at all outputs, i.e. the function is homothetic, and
the elasticity of total cost to output is always constant and equal to α + β. It is homogenous of the
degree α + β.

The Constant Elasticity of Substitution (CES) production function11 is a more general form in that
it allows the elasticity of substitution to be other than unity, but still constant.

8
Winston, G. C., McCoy, T. O. 1974. Page 425.
9
Betancourt, R. R., Clague, C. K. 1981. Page 18.
10
Cobb, C. W., Douglas, P. H. 1928.
11
Arrow, K. J., Chenery, H. B., Minhas, B. S., Solow, R. M. 1961.
 19

The Translog production and cost functions12 allow the elasticity of substitution and elasticity of
cost to output to change with output and with factor proportions.

A good example of a statistical cost function study is the one done by Robidoux and Lester on
Canadian manufacturing13. They use a homothetic Translog cost function and data from the
Canadian Census of Manufacturers. The results of the study are statistics of, e.g. the potential cost
reductions in different industries with an optimal scale of operation.

2.4 Engineering cost function studies

However flexible and mathematically elegant the econometric cost functions may be, they always
require the data to be fitted to. It is practically impossible to construct accurate statistical micro
cost functions for given products, because it is unlikely that useful data for different sizes of
factories and different factor prices exist. This is especially true of new products.

The engineering approach to constructing production and cost functions for production processes
is based on the technological relationships of these processes. The engineering production function
model proposed by Chenery14 is based on engineering variables that are the physical properties of
the inputs or of the process itself: “For example, if the principal element in a process is an
automatic machine, the relevant engineering variables may be its speed, size, continuity of
operation etc. The analysis of machine operations is likely to be more complicated than that of
fluid operations, and less exact.”

The engineering production function e relates engineering variables, xj, to output:

q = e(x1,...xn). (9)

Assuming that we have m economic inputs zi, the total solution of maximization of output q

max q = e(x1,...xn) so that zi = hi(x1,...xn), i = 1,..,m, (10)

where

hi = input functions that determine the use of economic inputs as functions of engineering
variables,

is the economic production function q = f(z). This can be transformed further into a cost function.

Chenery applied the engineering approach to an analysis of pipeline transportation. This is a

simple process, the engineering production function of which can be easily formulated.

A survey of engineering production functions by Wibe15 lists 21 different studies, four of which
are related to the mechanical engineering industry. His survey includes three of the five studies
reviewed below.

12
Christensen, L. R., Jorgensen, D. W., Lau, L. J. 1973.
13
Robidoux, B., Lester, J. 1988.
14
Chenery, H. B. 1949.
15
Wibe, S. 1983. Page 4.
20

Kurz and Manne16 studied capital-labor substitution in metal machining based on data collected by
Markowitz and Rowe17. They fitted the data on observations of the value of different machine
tools, labor input and daily output of certain well defined tasks to Cobb-Douglas and CES
production functions. They found the elasticity of substitution to be close to unity. It was later
pointed out by Furubotn18 and Lave19 that the procedure used to eliminate inefficient machine
tools should have been based on the present value and not the investment value of the machines.

Boon20 analyzed single metal working processes: turning and facing. He calculated break-even
output rates for different technologies and different wage rates. His cost function is simple, for
example shift arrangements are considered given.

Uhlig and McBain21 carried out least-cost calculations similar to those of Boon, for bolt and nut
manufacturing. The study was different from Boon’s in the sense that the alternative
manufacturing processes consisted of a series of subprocesses. Their main conclusion was that the
factor prices alone are relatively unimportant in determining the least-cost solution. According to
their study, the critical determinants in bolt and nut manufacturing are output, batch size and
product dimensions.

Lamyai22 studied capital-labor substitution and scale elasticities in the production of a minor part,
the bicycle head lug. He examined three different process options, each consisting of different
subprocesses with alternative technologies. Two alternative assumptions concerning the
indivisibility of machine capacity were considered: that of full sharing or full divisibility, where
machinery is always fully utilized, and that of no sharing or full indivisibility, where capacity
utilization is determined by the specific production operation. He assumed one shift operation of
2000 hours per year and full divisibility of labor. The main conclusions were:

1. The production function for the head lug is non-homothetic. The sensitivity of choice of
optimal technology to relative factor prices is greatest at the intermediate scales of output.

2. The production exhibits a high degree of economies of scale. The sources are the set-up times
of production batches, special fixture indivisibility and in his no-sharing case, machine
indivisibility.

3. Economies of scale are far more pronounced in the case of indivisibility. The choice of
technology is influenced by the assumption of indivisibility so that the optimal technology is
equal or less capital intensive in the case of indivisibility than in the case of divisibility.

His proposals for further research included the recommendation that labor indivisibility should be
somehow taken into account. He stated that an assumption of full divisibility is not realistic, and
referred to experiments using data, which indicate that the labor cost completely dominates the
choice of technology if full indivisibility is assumed.

16
Kurz, M., Manne, A. S. 1963.
17
Markowitz, H., Rowe, A. 1963.
18
Furubotn, E. G. 1965.
19
Lave, L. B. 1966.
20
Boon, G. K. 1964.
21
Uhlig, S. J., McBain, N. S. 1977.
22
Lamyai, T. 1978.
 21

Inman23 studied the use of shiftwork in automotive assembly. He simulated labor cost curves
under demand uncertainty taking into account the employment guarantee provisions in the labor
contract used by the U.S. automobile industry. The marginal labor cost curve was neither U-
shaped, increasing or even convex. The short-run cost model used concerned one assembly shop
as a single unit and, in addition to the labor cost, it consisted of a fixed cost and a linear variable
cost. The main conclusion was that there may be more than one production volume in which
marginal revenue equals marginal cost. These points have to be evaluated separately in order to
find the maximum profit output. - Although Inman’s study does not consider alternative
technologies and as such is not a long-run study, it is summarized here because of the realistic
approach it exhibits.

All the engineering cost function studies reviewed lack generality in their results, since the
empirical research carried out has concentrated on the manufacturing of particular, simple
components or products. At most only a few processes and alternative technologies have been
considered in them.

Four16,20,21,22 of the five studies focus on the choice of optimal technology and factor substitution.
The economies of scale and the shape of the average cost curve are paid less attention, although
these are the issues of most importance to industrialists. Only Inman’s study23 specifically
concerns the shape of the cost curve, but exclusively that of the short-run curve. The shape of the
long-run cost curve for a total factory producing a product or product family has not been
examined in any of the studies.

The cost models used in the studies are oversimplified, for example none of the long-run studies
take into account the effects of shiftwork on optimal utilization. In addition, the assumptions
concerning indivisibility of labor and equipment appear unrealistic. Neither issue can be nor is
neglected in least-cost calculations performed by engineers who plan real investments.

2.5 Economies of scale

Economies of scale is the characteristic of cost functions that is usually expected and the
magnitude of which is the main interest of most parties. In this chapter, the general issues relevant
to economies of scale are discussed and some of the numerous previous studies on the subject are
taken up.

The principal indicator used to measure the magnitude of economies of scale is the extent to which
the costs increase at 50 % below the minimum efficient scale. This practice was suggested by
Bain24 because the degree of economies of scale may vary at different outputs. The minimum
efficient scale is the output at which the long-run average cost curve levels out so that a doubling
of the output leads to an insignificant cost reduction, typically 5 %25.

23
Inman, R. R. 1995.
24
Bain, J. 1956. Page 54.
25
Pratten, C. F. 1971. Page 26.
22

Dimensions of scale

Output is the main dimension of scale in this study. Issues related to production technology and
scale are discussed in detail in the following chapters. There are other dimensions besides output
rate to which economies can relate. According to Pratten26 and Silberston27, these are:

− Total output of production at the chosen rate. The total cumulative output, i.e. how much of a
particular product is manufactured over time, affects the choice of technology and equipment.
− Cumulative output of production. Due to learning production of the same products with the
same equipment becomes more efficient over time.
− Product variation. In order to be able to judge the required flexibility of the production
equipment and the possibilities for batch formation, product variability has to be known.
− Batch size. The number of parts or products manufactured in the same batch with the same set-
up affects the unit cost through the set-up cost distribution and learning within a batch. The
choice of machine type also depends on the degree of importance of a short set-up time.
− Vertical integration. Vertical integration means the extent of a firm’s own manufacturing in the
direction of process flow. The reasons determining the depth of vertical integration have been
discussed by e.g. Froenmueller28. For comparability, the extent of vertical integration assumed
when determining a cost function has to be constant. However, the cost-minimizing depth of
vertical integration may itself be a function of scale.

2.5.1 Sources of economies of scale in production

The sources of economies of scale are closely related to each other, and the following is just one
possible classification. For a more detailed discussion of the subject, see the previously mentioned
studies of Pratten and Silberston and also the study by Haldi and Whitcomb29.

− Indivisibilities. There are costs that are at least partly independent on the scale of production.
Typical examples are: development costs, tools and fixtures, machinery, purchasing orders and
other batch-specific costs.

− Increased dimensions. Increased size may produce cost advantages for natural reasons. For
example, the capacity of a tank increases in the third power of the diameter whereas the area
increases in the second power. The area mainly determines the cost of the tank, at least if the
thickness of the material is not increased. This kind of cost advantages have been analyzed in
detail by Bruni30.

− Specialization. Specialization is one of the basic ideas of industrial production. If an employee

specializes in one job, work becomes more efficient if the worker does not have to switch
between tasks. Specialization also concerns machinery. Since a machine can always be
duplicated, different technologies are used in larger factories if these technologies are more

26
Pratten, C. F. 1971. Page 6.
27
Silberston, A. 1972.
28
Froenmueller, M. P., Reed, R. 1996.
29
Haldi, J., Whitcomb, D. 1967.
30
Bruni, L. 1964.
 23

economical. In mechanical engineering production, specialization can be exploited in most

manufacturing processes. An important advantage can be achieved by specialization according
to size. It may be possible to reduce workpiece variability per process machine by an increase
of production volume. If machines are dimensioned closely according to the size of the
workpieces, the speed of production may increase considerably.

− Organization of the system. Large volume and specialized methods may allow a different
arrangement of the whole manufacturing process. A typical step in this direction is the move
from job shop layout to cell organization. Product specific flow workshop is currently a
common layout solution in large volume mechanical engineering factories. If the process flow
is made more continuous and even, it may be possible to reduce the need for buffers between
the process steps.

− Massed resources. Costs associated with risk are a special type of indivisibility. Typical such
items are spare parts for machinery, randomly needed specialist skills, spare capacity, and
safety stocks. For example, if a factory has two machines of the same type, it is far less likely
that the same component will break down at the same time in both machines than in one. Thus
only one spare part may be sufficient. The same logic also works for planned abnormalities. If
maintenance breaks can be balanced between several machines, the product flow to the
subsequent process can be kept more uniform.

− Learning. Learning, or the experience effect, refers to labor productivity improvement

materializing with cumulative production - not with scale. With larger scale these effects are
reached faster.

Learning, and especially the learning curve deserves a closer look in this context, because it is
often used to model economies of scale as well as the actual learning phenomenon.

Learning curve

The learning curve describes the connection between labor hours per unit and cumulative number
of units produced. The basic form of the learning curve equation for repetitive work is simply:31

Yx = Kxn (11)

where

Yx = number of labor hours required to produce the xth unit,

K = number of labor hours required to produce the first unit,
x = cumulative number of units,
n = log10 b / log10 2 = learning index < 0, where b = learning percentage or rate,
1 - b = progress ratio.

In the form shown above the unit production time is reduced by a fixed percentage each time the
cumulative production doubles. According to the equation, only the initial starting level and the
progress ratio have to be known in order to draw the curve and forecast future development.

31
Yelle, L. E. 1979. Page 302.
24

When used to model labor learning, the starting level obviously depends on the product, process,
and the preparation beforehand. The rate of learning of an individual is influenced by various
factors related to the type of work, training, output rate etc.32 Although the model of Equation 11
approaches zero asymptotically, it has been found out in several studies that the learning usually
ceases at some point and the curve becomes flat33. This phenomenon is called plateauing. It seems
logical to consider these labor rates in engineering estimates that are made in long-run cost
function studies.

The learning curve function is often used to model the connection between capacity and output of
machinery, especially in process industries34,35,36, or even total economies of scale37,38. However, it
seems that in these contexts this simple function is used more as a rule of thumb, since there are no
better models to be found in the literature.

2.5.2 Sources of diseconomies of scale in production

In principle, total diseconomies of scale should not appear in the long run, because production
plants can always be duplicated and the same average costs preserved, if more capacity is needed.
However, individual factors causing diseconomies can still exist within a production system
exhibiting overall economies of scale. Such factors, often referred to in the literature, are listed in
the following.

− Limited supply of a factor of production. Factor costs may rise disproportionally if the supply
of a factor of production is limited. Typical such factors are skilled labor, land and material.
This phenomenon is external to a factory and is not normally taken into account in engineering
cost function studies.

− Technical diseconomies. There are at least two types of technical diseconomies of scale in
mechanical engineering production. The more important one is the problem of increased
distances and shortage of space, and the other is environmental problems.

If larger capacity increases the space needed for processing units, the distances between them
increase. This increases transportation costs, confuses process flow and makes visual
production control difficult.

Environmental economies or diseconomies are not so obvious. Tightly packed high volume
factories release a lot of heat and impurities into the air. Smaller units may cope with a fan and
an open door, but at some volume proper ventilation is necessary and air conditioning may even
be required during the warm season. The reason again is the natural volume-area relationship.
More space produces more heat for the outer area to dissipate. On the other hand, large
ventilation units are more cost effective than small ones.

32
Chase R. B., Aquilano, N. J. 1992. Page 587.
33
Yelle, L. E. 1979. Pages 310 - 311.
34
Bruni, L. 1964. Page 177.
35
Haldi, J., Whitcomb, D. 1967. Page 376.
36
Ostwald, P. F. 1989. Page 268.
37
Cao, D., Installé, M., Nino de Zepeda, A., Maino, M. 1994. Page 258.
38
European Commission. 1997. Page 78.
 25

− Labor efficiency. Labor efficiency in large organizations is a soft issue that is usually
disregarded in engineering cost function studies. Although it is a rather common opinion that
the work morale is lower in large companies than in small ones, practical means of modelling it
are hardly available.

− Management efficiency. Management efficiency is another soft issue, which is often claimed to
cause diseconomies of scale. Beckmann39 has theorized it from a meaningful point of view. His
main results are reviewed in the following.

Cost of management hierarchy

There is a wide belief that company hierarchies cause two kinds of diseconomies: delays in
decision making and the increasing cost of administration per worker. Beckmann has shown that
in an organization where each administrator has not less than a immediate subordinates the total
number of administrators per worker is no more than 1 / (a-1) no matter how large the
organization. The bound for total labor cost per worker, including workers’ and administrative
labor costs is

Cn W
En ≤ 1 − b , (12)
a

where

Cn = wage and salary bill of an n-level firm,

En = number of workers of an n-level firm,
W = wage of a worker,
b = upper bound of the ratio of the salaries of an administrator and an immediate subordinate,
1 < b < a.

The result is that the average administrative cost per worker remains below a definite bound no
matter how large the organization is. Beckmann has also shown that with realistic constant values
of a and b attained at all levels of the hierarchy, the deviation from the bound in Equation 12 is
negligible in medium or large firms.

He also studied the delay in passing decisions between levels in the hierarchy. Assuming that each
administrator makes an equal number of decisions, he concluded that the average delay of all
decisions is very close to the upper bound of t / (a-1), where t is the time taken to communicate a
decision. This is claimed to apply to any organization where the number of subordinates per
person is never less than the constant a.

He summarized that it is by no means true that the marginal cost of administration increases
indefinitely with size of organization, rather it is likely that the cost of administration per worker is
practically constant.

39
Beckmann, M. J. 1960.
26

If the size of organization relates to number of workers rather than to production volume, there
might even exist economies of scale in direct management costs due to economies of scale in
manufacturing.

2.5.3 Firm-wide and external scale effects

The scope of the quantitative analysis in this study is limited to production. There is a number of
functions external to it where scale dynamics are also important factors. To get a fuller picture of
economies of scale, some of these are mentioned in this section.

− Research and development. The research and development cost is an initial cost where
economies of scale can be achieved by spreading it over a large production volume. This is a
substantial advantage for large companies that can afford more money for developing better
quality products or for redesigning them more often.

− Marketing. According to Kotler, the marketing effort has to exceed a minimum threshold to be
efficient40. Above some limit, it becomes more difficult to attract new customers and the
efficiency decreases. This leads to an S-shaped sales response function and some profit-
maximizing optimum. Investment goods are often sold to a small number of customers, and it is
not obvious that this reasoning can be applied to such markets. Large companies can spread the
cost of marketing material over a relatively larger volume.

− Distribution. A factory may have to reach more distant customers in order to sell more. This
leads to longer transportation distances and higher transportation and packing costs.

− Cost of capital. There are economies of scale involved in raising capital. These are related to
two reasons: issue cost and risk. The issue cost for raising equity or debt can be much lower for
large amounts than small ones41. Statistical investigations show that profitability varies less for
large companies than for small42. The risk is lower leading to a lower expectation of return by
investors.

− Management. When companies increase in size, the hierarchy of the organization becomes
higher. The quality of information that the top management receives may deteriorate.
Correspondingly the decisions made may become distorted and it may take more time for them
to reach the operational units. The cost of poor management of course is the losses caused by
wrong decisions. There are many other interesting issues related to company size and
management43.

2.5.4 Non-real economies of scale

Besides real advantages based on natural reasons, i.e., less inputs producing more output, large
scale can produce other advantages for companies44. They may e.g. be able to charge higher prices

40
Kotler, P. 1991. Page 85.
41
Higgins, R. C. 1992. Page 165.
42
Scherer, F. M. 1980. Page 104.
43
Ibidem. Pages 85 - 86.
44
Pratten, C. F. 1971. Page 17.
 27

in monopolistic situations than in competitive markets. Large companies may also be able to
influence authorities to adapt legislation or use public money to their advantage. They may even
use their strong position to artificially raise market entry barriers by influencing suppliers or by
lowering prices when an entrant is trying to get a foothold in the market.

This type of economies of scale are not considered in this study.

2.5.5 Economies of scale studies

Research on economies of scale has received extra interest in Europe in the 1980’s and 1990’s due
to the further integration of the European Union. New studies have been published, but little new
information has been reported45,46,47. The most comprehensive and cited studies on the subject are
still those of Pratten48, Scherer49 and Weiss50. These are usually considered engineering studies,
but they are not such in the sense of Chenery’s original engineering production and cost function
study; see Section 2.4. They are, however, engineering studies in the sense that they are based on
estimations about the production costs of hypothetical production plants. The estimations carried
out rely mainly on interviews and consensus statistics.

According to a summary compiled by Pratten51 of the results of the latter three studies the cost
increases in mechanical engineering industries at 50 % of minimum efficient scale vary between 4
% and 7.7 %. These numbers and other similar results are not discussed here in further detail,
because of their infirm background.

45
Pratten, C. F. 1988. Pages 11 - 152.
46
Junius, K. 1997.
47
European Commission. 1997.
48
Pratten, C. F. 1971.
49
Scherer, F. M., Beckenstein, A., Kaufer, E., Murphy, D. R. 1975.
50
Weiss, L. W., 1976.
51
Pratten, C. F. 1988. Pages 84 - 85.
28

3 MANUFACTURING PROCESSES AND COSTS

In this chapter, economies of scale are analyzed and cost functions developed for labor, equipment
and other costs of the type of manufacturing studied. These functions are combined in order to
obtain cost functions for individual manufacturing processes. They are further aggregated in order
to obtain the cost function for the total manufacturing process. Examples are presented for all
types of functions discussed.

Although the focus of this study is on manufacturing, the costs of other functions of a make-to-
order production plant are also briefly examined later in Chapters 4 and 5. This is necessary in
order to obtain a more complete picture of production costs and to be able to estimate the cost
function of a complete factory, which is needed in order to solve the plant location problem
discussed in Chapter 6.

3.1 Labor cost

In addition to wages and fringe benefits, other issues have to be taken into account when the total
labor cost per unit produced is calculated. These are the quality of the labor force, calendar hours
during which the production process is manned and indivisibility of the workforce.

Wage and benefits

The labor cost consists of the actual total wages paid to the employee and of benefits such as
social security, pension and insurance payments paid by the employer. In this study, all these costs
are considered to be allocated according to the working hours spent at work irrespective if the
work is actually performed or not. A typical breakdown of labor costs in the Finnish mechanical
engineering industry in 1996 is presented in Appendix A.

Labor quality

The quality of the labor force depends on education. Normally basic education is taken care of by
society, and extra training acquired by the employee is assumed to be included in the rent paid for
the labor, i.e. the wage. Investments in training by the company are assumed to be included in the
investments in new process equipment. Additional training of new and old employees which is
paid for by the company is considered a fixed cost per employee and year.

3.1.1 Labor cost function in the long run

It is assumed in this study that each production operation is performed so that the productivity of
labor input, all other things being equal, is constant unless otherwise mentioned. However, the
labor unit cost generally depends on the hours of work, which has important consequences for the
optimal utilization of fixed factors of production.

A high utilization of the production capacity by keeping the process running more hours per year
is beneficial for several reasons. The fixed cost per unit produced is reduced if there is more
production over the same calendar period. The production equipment is always subject to the risk
of becoming obsolete due to changes in products or production methods. This risk is reduced if the
equipment is made to reach the end of its useful period of operation more quickly and thus become
 29

substituted by more modern devices which are normally more efficient due to technological
progress. - Through-put times are inversely related to the utilization rate of the process. Short
through-put times are especially important for make-to-order businesses in order to achieve an
advantage in the market place. The other important benefit of short through-put times is the
reduced capital employed in the work-in-process.

The trade-off for all the advantages stated above is the uncomfortable working hours required.
According to the general agreement between employers and employees in the Finnish metal
industry in 1996 an extra compensation of 4.25 FIM/h was paid for working in the evening shift
and 7.85 FIM/h for working in the night shift. The average basic wage at that time was about 58
FIM/h. Work on Saturdays was compensated by an extra 7.85 FIM/h and work on Sundays by a
bonus of 100 % of the basic wage. In addition to the higher wage per hour, the total annual
working time was shorter for regular three shift work than for one and two shift work, and even
shorter than that for uninterrupted three shift work.

Any hours of operation with a unique marginal labor cost is called a labor cost category in the
following. However, since long run is in focus, overtime is not assumed to be used. It is assumed
that all cost categories of lower cost are fully occupied. Only the annual manning hours in the next
category above them are adjustable and all higher categories are empty. If the manning hours can
be freely adjusted to the desired level, the total labor cost as a function of annual process manning
hours is:
i = j −1 j −1 j −1
⎛ ⎞ j
LRLC(t ) = ∑
i =1
wi ∆ ti + w j⎜ t − ∑
⎝ i =1 ⎠
∆ti ⎟ , when ∑ ∆ti ≤ t < ∑ ∆ti ,
i =1 i =1
(13)

where

LRLC = total long-run labor cost as a function of annual process occupation hours,
j = the number of full and partial labor cost categories in use,
wi = hourly labor cost in labor cost category i, wi+1 > wi,
∆ti = maximum possible annual working hours in labor cost category i,
t = total annual process occupation hours.
The first summation term in the equation is the total labor cost in the fully occupied labor cost
categories. These are accumulated as far as, but not including, the cost category tj. The second
term is the total labor cost accumulated in cost category tj. This labor cost category may be
partially occupied.

The average hourly labor cost is simply the total cost divided by the cumulative hours:

LRALC(t) = LRLC(t) / t, (14)

where in addition to previous notation

LRALC = average long-run hourly labor cost as a function of annual process occupation hours.

The resulting function is monotonous and non-decreasing. The derivative of the LRALC function
is non-continuous. In each cost category j, the value of the LRALC function in theory
asymptotically approaches the marginal hourly cost of that cost category. However, in practice it
does not even come close to the marginal cost, wj, before t reaches the upper limit of the hours,
30

∑ ∆t
i =1
i , in the cost category j. The total effect of the extra compensations stated above with the

appropriate benefits is demonstrated in Figure 3 . The lowest continuous line in the figure shows
the minimum average hourly labor cost as a function of annual process occupation hours. Here it is
assumed that all process manning hours can be reached without idle working time or overtime.
This is difficult to organize in practice even in the long run. More realistic assumptions are
considered below in the section on labor indivisibility.

170 172 Day shift

Average labor cost, [FIM/h]

160 162 Evening shift

150 152 Night shift
140 142 Saturday included
130 132 % Sunday included
120 122 1 worker
110 112 2 workers
3 workers
100 102
4 workers
90 92 5 workers
80 82
0 1500 3000 4500 6000 7500
Annual running hours

Figure 3. Hourly labor costs as functions of annual machine occupation time. The lower line consisting of
segments referring to shifts and weekdays is the long-run curve. The V-shaped curves are the short-run
functions using indivisible labor. The overtime compensation used is 200 %. Compiled by the author from
the 1996 contract between labor and employer unions in the Finnish metal industry.

One may argue that it does not matter what agreement is made between unions on shift
compensation, since people cannot be forced to work at inconvenient hours. However, practical
experience has shown that the agreement’s conditions satisfy the workers’ and employers’
expectations about sufficient compensation quite well. Thus the cost levels for the different shifts
and the form of the aforementioned curve in Figure 3 can be considered realistic for an average
long-run labor cost curve, taking into account the assumptions made about process occupation.

3.1.2 Labor cost function in the short run

In the very short run process occupation can be increased by overtime work. Overtime
compensation usually increases progressively as more overtime hours are worked. In the Finnish
metal industry, the compensation for the first two overtime hours per y is 50 % of the basic wage
and 100 % thereafter according to the 1996 union agreement. There are also rules concerning
overtime compensation for work in addition to the regular weekly working time., i.e. usually on
Saturdays and Sundays. When there is no possibility of a continuous 36 h rest per week, another
100 % per hour is paid for work during the missed rest time. In the case of a low work load, the
unit labor cost rises since the labor is fixed in the short run. The short-run average labor cost
function as a function of value-adding working hours is formulated in Equation 15:
 31

⎧⎡ i = j −1
⎛ i = j −1
⎞⎤
⎪⎢ LRLC(t C ) + ∑ w i ∆t i + w j ⎜ t − t C − ∑ ∆t i ⎟ ⎥ t ,
⎪⎣ i =1 ⎝ i =1 ⎠⎦
⎪ i = j −1 i= j
⎪
SRALC(t ) = ⎨ when t C + ∑ ∆t i ≤ t < t C + ∑ ∆t i , (15)
⎪ i =1 i =1
⎪ LRLC(t C ) / t, when t < t C
⎪
⎪⎩

where

SRALC = short-run average hourly labor cost function as a function of annual process
occupation hours,
LRLC = total annual long-run labor cost as a function of annual process occupation hours,
j = number of over-time labor cost categories in use,
tC = number of annual process occupation hours with regular working time,
wi = hourly labor cost for overtime cost category i, wi+1 > wi,
∆ti = maximum possible annual working hours for overtime cost category i in the examined
period,
t = total annual process occupation hours in the examined period.
The function consists of two segments on opposite sides of the regular working time hours tC. The
upper part of Equation 15 represents the overtime segment. It is similar to the long-run average
cost function in Equation 14, except that the starting point of the curve is LRALC(tC) and the
values of parameters wj and ∆ti are different. The lower part of Equation 15 represents the low
work load segment. It is simply the labor cost at the long-run average output divided by the
number of hours worked.

The period examined above refers to the short run. During such a period the number of employees
is considered constant. The short-run labor cost function is illustrated in Figure 3 by the V-shaped
curves. The lowest points of these curves indicate the annual occupation hours and average labor
costs attained with different numbers of workers and a regular working time. The upward turning
right hand side of the curves shows the average cost with additional overtime at 200 % overtime
compensation. The left hand side of the curves shows the average labor cost if the worker is left
under-utilized during a low load period. In practice the situation is normally somewhere between
the short-run and long-run curves.

The maximum number of annual overtime hours is 350 per worker, which is about 20 % of the
total regular working hours. Although the extra compensation makes overtime work lucrative to
the worker, it is voluntary and not all workers are willing to accept it. Thus the average number of
annual overtime hours would remain well below 350 even in situations where it would be
profitable to use all the overtime hours permitted. The number of overtime hours in the different
cost categories is not limited by the contract. However, the number of hours is limited for natural
reasons and the employer may impose any limitations he considers reasonable. The examples in
Figure 3 are based on a 200 % increased wage. Regular overtime would be required at a rate of
about 40 % of the standard working time to reach the level at which it becomes more economical
to hire an extra employee. Cost-equalizing levels of utilization between two manning levels are
shown in Figure 4 at different overtime cost rates. The hourly costs are shown for one worker
32

working overtime and two workers being under-utilized. It must be noted that the benefits paid by
the employer for the over-time hours are only about 23 % of the hourly wage. This covers social
security, pension and other payments that are directly proportional to the wage. Other costs such
as holiday wages are already covered by the regular working time benefits; see Appendix A.

170
160 overtime / 200 % wage
increase, 1 worker
Cost per hour, [%]

150
Overtime / different
140
wage increases, 1 worker
130
Overtime / 100 % wage
120 increase, 1 worker
110 Overtime / 50 % wage
100 increase, 1 worker
90 Under-utilization, 2
workers
30 40 50 60 70 80 90
Weekly labor hours

Figure 4. Critical points between low load and high load short-run labor cost curves.

The possibility of utilizing overtime work depends on the average utilization of fixed resources.
Thus the cost distribution of overtime hours changes depending on the shift system in use. One of
the curves in Figure 4 is a combination of 44 % of overtime hours at a 50 % increased wage, 25 %
at an increase of 100 % and 31 % at an increase of 200 %. Based on experience, this relationship
between the cost categories is typical for two shift work. The total number of overtime hours per
worker tends to fall as more shifts are occupied.

In addition to normal overtime work, such flexible working time arrangements are possible where
overtime hours during high load periods are traded directly with absence during low load periods.
Thus the hourly labor cost remains at a basic level in the long run. Since these arrangements are
voluntary, a necessary condition for them to work is that the worker values the opportunity to
reschedule his or her free time higher than the overtime compensation. Such an arrangement is
beneficial for both parties if their timing preferences match.

3.1.3 Labor indivisibility

Under normal circumstances, workers work regular hours. The total annual working hours have to
be adjusted in indivisible lumps. The total annual working time per worker was limited in Finland
in 1996 to about 1710 in one and two shift work, to about 1640 hours in three shift work and to
about 1600 hours in uninterrupted three shift work. The short-run curves in Figure 3 are drawn at
process occupation levels representing full utilization of the different manning levels and one
worker per machine.

In order to achieve lower costs in the long run at any rate of utilization, the machines have to be
operated by fewer workers than the full utilization of machines would require. The relationship
between machine hours and man hours has to be changed so that workers operate alternative
machines in turn rather than remain idle. This means that the number of workers is adjusted
 33

accordingly, in addition to using them at different machines. The skill level and flexibility of the
labor force limit the maximum number of alternative machines that an operator can run. For
example, if the machine operator can run three different machines serving different purposes, full
labor utilization is achieved at three steps between zero and one full shift of three workers. If there
are two parallel sets of machines, the number of full labor utilization steps becomes six.

Increasing the process occupation above the level of uninterrupted three shift working hours
involves further complications. The time the process is left unoccupied mainly consists of the
summer and winter holidays. The summer holidays, which are about a month long, are
concentrated over a three month period, which means that at least 50 % excess manning on
average - or 600 % marginal at annual level during two months - is required to keep the machines
running full-time. The winter holiday and other absenteeism substitution improve the situation
somewhat, but nevertheless the cost is high. A 500 % marginal cost as compared to the basic wage
rate is therefore used in the calculations.

The long-run average labor cost curve is modified to take into account the effect of labor
indivisibility as follows:

⎪⎢ j ( j (
⎧⎡ LRLC ∆t tr a (t − t ) / ∆t / a + t
j −1 j ) j )
j −1 +
⎤
⎥
⎫
t ,⎪
⎪⎢
⎣ ( ( ) )
LRALCI (t ) = min ⎨⎢w j t − ∆t j tr a j (t − t j −1 ) / ∆t j / a j − t j −1 ⎥⎥
⎦
⎪
⎬,
⎪ ⎪
( ( ) )
(16)
⎪ LRLC ∆t j tr a j (t − t j −1 ) / ∆t j + 1 / a j + t j −1 t ⎪
⎩ ⎭
j i = j −1 i= j
if t j = ∑ ∆ti , ∑ ∆ti ≤ t < ∑ ∆ti , j = 1,.. n,
i =1 i =1 i =1

where in addition to previous notation

LRALCI = long-run average hourly labor cost as a function of annual process occupation hours
with indivisible labor,
tj = maximum possible total annual process occupation hours up to and including cost category
j,
∆ti = maximum possible annual working hours in labor cost category i,
aj = number of machines that the worker can use in labor cost category j,
tr( ) = function returning the largest integer that is smaller than or equal to the argument.

Function 16 is a set of the smallest values of two functions. These functions are similar to the
short-run cost functions in Equation 15. The main difference is the division of each long-run labor
cost category into aj segments. Labor is fully utilized at the upper and lower limit of each segment.
Each segment consists of an overtime and an under-utilization period. The manning level is
increased at a point during each segment when the running hours are increased, i.e. at the point
where the cost of under-utilization becomes lower than that of the use of overtime. The function
( )
∆t j tr a j (t − t j −1 ) / ∆t j / a j + t j −1 yields the lower limit of such a segment. This limit is used as
( )
the starting point of the overtime period. Correspondingly ∆t j tr a j (t − t j −1 ) / ∆t j + 1 / a j + t j −1
yields the upper limit of the segment, which is used for the calculation of the under-utilization
period’s cost curve.
34

Figure 5 shows the long-run average labor cost curve with the values used in example of Figure 3
and with aj = 9 except for the last - “the holiday category” - where it is 3. A lower figure for the
holiday period is used because it is likely that machines that justify double manning require
specialist operators that can not be shared with many other machines.
Average labor cost, [FIM/hour]

180
170
160
150
140
130
120
110
100
90
0 1000 2000 3000 4000 5000 6000 7000 8000 9000
Annual running hours

Figure 5. Long-run labor cost curve taking into account labor indivisibility. The lower continuous line
represents the lower limit assuming annual total working hours per shift in the Finnish metal industry in
1996. The saw-tooth line represents the labor cost assuming that manning can be increased in nine steps per
shift and in three steps if uninterrupted three shift operation hours have been fully used.

3.1.4 Long-run labor cost function with unmanned night shift

Automated technologies may allow the machine operator to leave the production machinery
running unattended for a full shift. In such cases it is customary in mechanical engineering
industries to process the difficult parts during day time and load and prepare the machinery for the
unmanned night shift. Flexible manufacturing systems (FMS) are a typical example of a
technology often operated with an unmanned night shift.

The labor cost function for unmanned night shift operation is obtained simply by setting the
marginal labor cost to zero during nights. A labor cost curve comparable to that of Figure 5 for
continuously manned operation is shown in Figure 6. In the curve of Figure 6, the average labor
cost decreases hyperbolically during the night shifts. Since this labor cost function requires that
appropriate technology is used, the implications involved are left to a later section.
 35

Average labor cost, [FIM/hour]

160
150
140
130
120
110
100
90
80
70
60
0 1000 2000 3000 4000 5000 6000 7000 8000 9000
Annual running hours

Figure 6. Long-run labor cost curve with unmanned night shift. The other parameter values are the same as
in Figure 5, except that the indivisibility parameter ai = 2.

3.2 Long-lived process equipment capital cost

Long-lived process equipment employs capital that is assumed to be originally paid in one lump-
sum. This capital is depreciated during the life of the equipment. At all times, the remaining value
is charged with an opportunity cost. These costs are described in this section. - The efficiency of
the equipment determines the number of units produced that can be charged with these capital
costs. The different technologies and related efficiencies and scale effects are discussed later in
this chapter.

The constant annual rental of equipment can be calculated using the annuity factor, i.e. the
expression in square brackets in the following equation52:

C = PV / 1 / r − 1 / r (1 + r )τ , [ ] (17)

where

C = annuity,
PV = present value of investment in the beginning of the first year,
r = discount rate,
τ = number of payment periods, here years.

The economic lifetime of a machine is variable, in the sense that depreciation covers the wear-out
and that wear depends - here linearly - on use. On the other hand, even if the machine were
otherwise useable for a longer time period than originally planned, it might become obsolete due
to its technical inefficiency. Such obsolescence may be due to the general technological progress
of production equipment or of the products manufactured or even due to environmental effects
such as rust. Thus the lifetime τ in Equation 17 becomes:

52
Brealey, R. A., Myers, S. C. 1996. Page 40.
36

τ = min {age to obsolescence, time to wear-out} (18)

where

age to obsolescence = lifetime before technical obsolescence,

time to wear-out = durability in units / annual production volume.

Taking τ as defined in Equation 18 the average annual equipment capital cost per unit produced is:

AFEC = C / x, (19)

where in addition to previous notation,

AFEC = average annual (fixed) equipment capital cost per unit,

x = annual production volume in units.

A graphical interpretation of Equation 19 is shown in Figure 7. If the production rate is so low

that obsolescence alone is the only factor limiting lifetime, the function is hyperbolic. At higher
rates, if these are possible, the equipment is worn out in a shorter time than its obsolescence age.
Here the function is still decreasing, but only due to the lower opportunity cost per unit. The
opportunity cost is of course lower because the equipment is worn out more quickly and less
interest is accumulated.
Average capital cost, [FIM/unit]

1000
Durability 15 000 units
900
800 Durability 20 000 units
700 Durability 25 000 units
600 Durability 30 000 units
500
400
300
200
100
0
0 200 400 600 800 1000 1200 1400 1600 1800 2000
Annual production volume, [units]

Figure 7. Average annual equipment capital cost as a function of production volume. In this illustration, the
durability of the equipment is limited to 15 000, 20 000, 25 000 and 30 000 units. The maximum
economical lifetime of the equipment is 15 years and the investment is 3 000 kFIM in each case. The
interest rate is 7 %.

In order to minimize costs, the durability of process equipment should be the same as the
obsolescence age at the planned utilization rate. Otherwise the equipment is unnecessarily wear-
resistant and consequently expensive - or it wears out too early. Here it is assumed that more
durable equipment is more expensive than less durable equipment, but less expensive in relation to
the capital costs per unit produced. Otherwise it would be more economical to buy short-lived
 37

machinery and replace it more often. It is also assumed that operating costs are equal, and
durability is the only difference between the two cases.

Due to the indivisibility of equipment, the planned utilization rate may be different from the cost-
minimizing utilization rate. In any case, it is assumed here that the process equipment
manufacturer constructs the equipment under the assumption that it will be utilized at the cost-
minimizing hours of operation and operation speed. Thus the durability of the equipment is the
same as the obsolescence age at that rate.

A consequence of the above reasoning is that the ex-post capital cost is fixed below the cost-
minimizing process utilization rate, but is variable at higher average production rates. With a
fluctuating load, the capital cost is of course fixed per unit as long as the planned production
accumulates fully before obsolescence.

3.3 Other manufacturing process costs

Costs linearly variable in the short run

The use of some factors of production is practically linearly variable in relation to the production
rate in mechanical engineering production. The returns to scale for the related costs are constant as
long as the technology is fixed. In the long run their use is also dependent on the technology, that
may change. However, even the long-run elasticity of scale often stays close to unity for these
inputs. Such factors include maintenance, process energy, compressed air, cutting and heating
gases, and overhead materials such as cutting fluid, oil, cleaning material etc.

A fixed cost is always involved in the supply of energy and gases, but it is assumed to be covered
by the rent of the building.

Cutting fluid and machine lubrication oil are changed at calendar time based intervals, if the
utilization of machines is low enough. However, their share of total costs is usually small, even at
such low utilization rates. Therefore one may consider that they are only consumed during the
process.

Based on what is said above, the short- and long-run average variable cost for a given technology
as a function of units produced per time unit, SRALVC, is considered constant per unit, Is , for
these inputs:

SRALVC = Is. (20)

Costs non-linear in the short run - cutting tools

Not all factors of production respond linearly to changes in production rate which affect them.
Tools used for the cutting of metals are such a factor, which is of importance for mechanical
engineering industry. These tools are exposed to severe wear. The wear rate increases
progressively with the cutting speed. The effect of this phenomenon on manufacturing costs is
complicated. It is examined in detail in a separate section later on.
38

Costs variable in the intermediate run

In the intermediate run labor is considered a variable input, but the process equipment is still fixed.
Costs of indirect labor, work supervision, human resources development, cleaning, and electronic
data processing belong to this category. Indirect labor means the production process support
personnel whose input is not directly connected to the production rate of a specific unit of process
equipment. Quality control and internal transportation are examples of such tasks.

Some of these costs depend on the number of workers and may thus exhibit economies of scale if
the technologies change. Other costs may also show positive scale effects, but for most of them the
overall importance of scale effects is likely to be small.

For a given technology the intermediate-run average variable cost, including those process specific
costs that can be adjusted over the lifetime of the long-lived process equipment, IRAVC, is here
considered constant per unit, Ii:

IRAVC = Ii. (21)

Costs variable in the long run

The costs - other than long-lived equipment capital cost - considered variable only in the long run
include rent of facilities, insurance, heating and guarding. Normally rent of facilities is by far the
most important one of them.

All these costs are dependent on the technology used in the long run. Thus it is not meaningful to
analyze the economies of scale in terms of these costs alone, but rather together with the other
factors involved in the particular manufacturing process. Most of these costs are linearly related to
the factory floor area or to capital employed in the process.

3.4 The individual manufacturing process

In this section, the major manufacturing cost elements presented above are combined to form the
average cost function of the individual process. Cost functions of common manufacturing
processes are discussed as representative examples.

The cost of capital employed in work-in-process depends on the through-put time of the total
process. Thus it is not taken into account here, but is discussed later in Section 3.6 preceding a full
discussion of the total manufacturing process.

3.4.1 Long-run cost function of a single technology and single unit of equipment

The long-run total cost function is the sum of the cost functions of the individual cost elements
explained in the previous sections. The parameter values of these cost functions are specific to the
particular technology used. The total cost equation below concerns one individual technology
appearing alone in one unit. The costs included are those directly related to the manufacturing
process and those indirect manufacturing costs that can be directly allocated to the particular
process. This allocation can be driven for example by the number of working hours, the number of
workers, value of the equipment or the floor area.

LRAC = LRALCI + AFECm + ∑ AFECt + AFEC f + LRAVC (22)

 39

where

LRAC = long-run average cost per unit as a function of units produced per year,
LRALCI = long-run average labor cost per unit using indivisible labor. The argument is from
now on understood as the variable number of units produced annually, which is equal to t/Tu,
i.e. the total annual process occupation hours divided by the constant processing time Tu of
one unit,
AFECm = average annual equipment capital cost of process machinery, as in Equation 19,
AFECt = average annual equipment capital cost of process tools, fixtures etc., as in Equation
19,
AFECf = average annual fixed capital cost for rent, heating etc., as in Equation 19,
LRAVC = long-run average variable cost, considered constant per unit for a given technology
as a function of units produced per year, total of Equations 20 and 21.

A provision is made by the addition of a set of AFECt terms corresponding to the use of several
significant long-lived tools or fixtures.

All linear variable costs are considered constant per unit produced in Equation 22. Machining and
its non-linear variable cost are treated separately in the next section.

The LRAC function has the U-shape traditionally assumed typical of short-run cost curves as
functions of annual production. The function shows increasing returns to scale as long as the
increasing returns due to equipment capital cost indivisibility overcome the rising labor cost.
Figure 8 shows a graphical representation of the curve and its cost components with realistic
parameter values.

500 Total
Machinery
450 Labor
Cost per hour, [FIM/h]

400 Variable
350 Rent
Fixture
300
250
200
150
100
50
0
0 10 20 30 40 50 60 70 80 90 100
Units produced per year, in percent of maximum capacity

Figure 8. Average manufacturing costs for a single technology. The parameter values are as follows: capital
investment in machinery is 2.5 MFIM, interest rate 7 %, obsolescence age 10 years, minimum labor cost
100 FIM/hour, indivisibility parameter a = 3, constant variable cost 70 FIM/hour, rent and equivalent fixed
costs 43 000 FIM/year, tools last 200 units and their purchase cost is 170 kFIM. The maximum total annual
process hours are assumed to be 8500.
40

The fact that the LRAC curve has a minimum can be seen by studying the derivative of the
function in relation to the number of units produced annually. Since the minimum points of the
sawtooth-shaped indivisible long-run labor cost function lie on the corresponding function with
fully divisible labor, the latter is used for simplicity. The processing time per unit, Tu, is taken to
be constant so that the number of units produced, x, can be used directly in the labor cost term
instead of total processing time, t. Other variable costs are not relevant in the following
examination and they are ignored. It is assumed that tool and fixture costs are linearly variable or
have the same life-time as other equipment. It is also assumed for now that the time to wear-out of
the equipment is equal to the obsolescence age.

Under these assumptions LRAC is reformulated by substitution of labor cost and capital cost from
Equations 13, 14 and 19 into Equation 22. The LRAC is shown here for one labor cost category
only:

LRAC = wi x i / x + wi − wi x i / x + Ce / x (23)
where

x = number of units produced, xi < x < xi+1,

wi = average labor cost in the beginning of labor cost category i,
xi = number of units produced in the beginning of labor cost category i,
wi = labor cost in cost category i,
Ce = annual fixed equipment and other capital cost.

The derivative of the LRAC in relation to x is:

dLRAC / dx = − wi xi / x 2 + wi xi / x 2 − Ce / x 2 (24)

The LRAC function has no analytical extremum in relation to x. The sign of the derivative
determines at which limit of each labor cost category, lower (x = xi) or upper (x = xi+1), the
minimum cost is reached. The value of LRAC is constant, if

(wi - wi ) xi = Ce. (25)

Thus Equation 25 is a condition for the cost curve to be flat over labor cost category i. With a
given labor cost, the fixed cost determined by Equation 25 is that fixed cost which brings the
average cost down to its minimum value over the production volume in the labor cost category in
question.

At a higher fixed cost, the derivative is negative and the new higher minimum is at the upper
volume limit of the labor cost category. With a smaller fixed cost, the derivative is positive over
the range and the minimum is at the lower limit of that range. Thus the minimum values appear
only at the volumes at which the marginal labor cost changes.

The derivative of the cost function is smaller for each cost category at smaller volumes than the
overall minimum cost volume, and larger at larger volumes. The difference between the marginal
labor cost and the average labor cost in Equation 25 increases as xi increases since labor cost
categories are ordered in ascending order. Since xi increases, the product (wi - wi ) xi also
increases.
 41

A useful application of the described cost behavior is the calculation of the annual fixed costs that
require the use of different working shifts in order to keep the unit costs at the minimum level.
Table 1 shows annual fixed cost values using the average labor cost and shift compensations
according to the 1996 agreement between the labor market parties in the Finnish metal industry.
Typical compositions of the fixed costs - up to which each working shift should be used - have
also been calculated as illustrative examples.

Table 1. Minimum fixed cost levels per worker required for justifying different process manning levels in
the long run. The figures for double manning are given per worker during the holiday period. The average
labor costs in the Finnish metal industry in 1996 are used. The numbers of hours per category and shift
compensations are according to the 1996 agreement between the labor market parties in the Finnish metal
industry. The variable costs including all tool and fixture costs are assumed to be constant. A monthly rent
of 40 FIM/m2 for floor area, 10 years obsolescence age for machinery, and 7 % interest rate are assumed.

ti Average wi Marginal wi Ce Area Rent etc. Machinery value

2
[hours] [FIM/h] [FIM/h] [kFIM] [m ] [kFIM/year] [kFIM]
Evening shift 1681 98 103 9 40 19 0
Night shift 3361 100 111 35 60 29 45
Saturday 5020 104 111 35 60 29 45
Saturday evening 5560 104 116 64 70 34 216
Saturday night 6100 105 120 91 80 38 372
Sunday 6633 107 181 496 100 48 3136
Sunday evening 7070 111 187 533 100 48 3396
Sunday night 7510 116 191 567 100 48 3630
Double manning 7946 120 606 3866 300 144 26057

The shape of the average cost curve can be further studied using the second order derivative of the
function:

d 2 LRAC / dx 2 = 2 wi xi / x 3 − 2 wi xi / x 3 + 2Ce / x 3 (26)

The second derivative is positive if

(wi - wi ) xi < Ce. (27)

As discussed above, this holds at volumes below the minimum production cost production rate. At
volumes above the minimum cost rate, the derivative is negative. Thus the average cost function is
concave from below at each labor cost segment above the minimum cost, and convex from below
at segments below the minimum cost rate. This form of the function is hard to distinguish from the
curve in Figure 8 using indivisible labor. However, the form is clearly shown in the case of Figure
9, where the average cost is shown, assuming divisible labor.

In the analysis above it was assumed that the length of time for the equipment to wear out is equal
to obsolescence age. This made the differentiation of the cost function and subsequent conclusions
easier without essentially affecting the results. The function rises more steeply after the minimum
value, if the wear-out starts to affect the costs at the minimum cost production rate. From this it
can be concluded that the results concerning the minimum of the cost function are valid. For the
same reason, the shape of the cost curve is still convex from below after the minimum cost
production rate, if the simplifying assumption is not made. This behavior is also evident from the
graphical representations of the cost curve.
42

240
230
Cost per hour, [FIM/h]

220
210
200
190
180
170
160
150
0 20 40 60 80 100
Units produced per year

Figure 9. The form of the average production cost curve with divisible labor.

3.4.2 Long-run cost function of a single technology and single unit of equipment with
unmanned night shift

The general form of the cost function in Equation 22 also applies to unmanned night shift
operation. However, because of the different labor cost function, the shape of the cost curve is
different from that of constantly manned technology. Figure 10 shows an example of an average
cost curve with realistic parameter values.

500 Total
450 Machinery
Labor
400
Cost per hour, [FIM/h]

Variable
350 Rent
Fixture
300
250
200
150
100
50
0
0 10 20 30 40 50 60 70 80 90 100
Units produced per year

Figure 10. Average manufacturing costs for a single technology with unmanned night shift. The labor cost
function is similar to the one shown in Figure 6. The other parameter values are the same as in the case of
Figure 9 for a constantly manned technology.

The function can have minima only at the marginal labor cost increase points similar to the one for
manned technologies. There are no minima at the beginning of the night shifts, since the marginal
labor cost decreases to zero and the derivative of the cost function is negative; see Equation 24.
Whether the other labor cost category change points are minima depends on the wages and fixed
 43

costs, as in the case of constantly manned operation. However, since the marginal and
subsequently the average labor cost is not ascending, there can be several minima. Which one is
global depends on the parameter values and has to be found by comparing them with each other.
The fixed cost that causes the global minimum to move can be calculated in principle in the same
way as the one for constantly manned operation. Here the marginal wage rate, i.e. the smallest, has
to be selected from all the marginal wage rates between the earlier global minimum and the other
labor cost change points.

Table 2 shows the critical fixed costs that cause global minima to appear at the different labor cost
category change points. The values are calculated for the same labor cost rates as those used in
Table 1 for constant manning. With these parameter values global minima exist only at those
production rates where the night shift is fully utilized.

Table 2. Minimum fixed cost levels per worker required for justifying different process manning levels in
the long run with unmanned night time operation. A cost-minimizing operation requires the shift
arrangement in the left column to be used if the value of equipment exceeds the value given in the rightmost
column. The machinery investment values shown have been calculated using the same assumptions as in
the case of Table 1.

ti Aver. wi Marg. wi Ce Area Rent etc. Machinery value

2
[hours] [FIM/h] [FIM/h] [kFIM] [m ] [kFIM/year] [kFIM]
Saturday 5020 67 76 44 60 29 107
Sunday 6633 69 123 416 100 48 2573
Double manning 7946 80 388 2450 300 144 16141

Table 2 should be interpreted in such a way, that if value of machinery is less than 107 000 FIM it
is worth while to run the machinery in three shifts with one unmanned, from Monday to Friday. If
the investment cost is higher than that amount, but below 2 573 kFIM, it should be run for 24
hours also on Saturdays. It is very unlikely that the first case is possible in practice, since
automated machinery in mechanical engineering workshops is usually more expensive. The last
two cases are certainly relevant. In practice other factors, especially work load fluctuation, have to
be taken into account when optimal capacity is planned.

3.4.3 Long-run cost function of machining using a given machine tool

Machining is a manufacturing process that allows for some adjustment within the limitations of
the physical equipment. E.g. the machining speed can be increased to some degree at the expense
of tool wear and subsequently increased tool and tool change cost. This kind of cost effects are
studied in the following.

For cutting tools the relationship between tool life and cutting speed is usually described by the
Taylor tool-life equation53:

(T / TR)n = (VR / V) ⇒ VT n = C (28)

where

53
Wu, S. M., Ermer, D. S. 1966. Page 436.
44

T = tool lifetime,
TR = reference tool lifetime,
V = cutting speed,
VR = reference cutting speed corresponding to TR,
n = constant related to the progress of tool wear,
C = constant.

The latter form of Equation 28 is not necessarily dimensionally correct, but it is commonly used.

The cost of machining consists of the costs of cutting time, tools, time to change worn-out tool
and other time factors such as that of changing a workpiece. The variable54 unit cost of machining
a workpiece is the sum of these four costs:

Cu = c0 tm + c0 tc tm / T + ct tm / T + c0 th (29)

where

Cu = total variable unit cost,

c0 = variable cost of operating time,
tm = machining time,
tc = tool changing time,
ct = cost of tool,
th = handling time per unit.

In addition, the fixed cost per workpiece has to be added in order to obtain the total cost. The total
time needed to machine a workpiece is:

Tu = t m + t c t m / T + t h (30)

The term tm / T gives the number of tools needed to cut one workpiece. The cutting time here
must be taken as the time corresponding to the type of cutting where the Taylor equation is valid.
There may be restrictions on the free choice of cutting speed due to tolerance or surface quality
requirements or workpiece or machine tool rigidity. All the other cutting time must be included in
th, the handling time. The cutting time is:

tm = s / V (31)

where

s = length of cut per workpiece with given feed and depth of cut.

The cutting speed for achieving the minimum cost of machining a workpiece can be derived from
Equation 29 by substituting T from Equation 28 and tm from Equation 31. Thus we have the

54
Boucher, T.O. 1987. Page 222.
 45

minimum unit cost as a function of V. Differentiating and setting the derivative equal to zero gives
the cutting speed for the minimum cost55:

[
Vmin = C / (1 / n − 1)(tc + ct / c0 ) ]
n
(32)

Substituting Vmin to Equation 28 gives the tool life for the minimum cost:

Tmin = (1 / n − 1)(tc + ct / c0 ) (33)

If the tool cost is set to zero, the cutting speed for the maximum production rate becomes

Vmax = C / [(1 / n − 1) tc ]
n
(34)

and the tool life for the maximum production rate:

Tmax = (1 / n − 1) tc (35)

It is easily seen that Vmin is always smaller than Vmax, since ct / c0 is positive and the denominator
of Vmin therefore larger than that of Vmax. So there is a possibility for increasing output (up to Vmax)
by increasing the cutting speed at the expense of increased costs.

The above equations assume that the hourly cost of operating the machine, c0, is constant and
given. Actually, as has been seen, the cost of a machine operating hour depends on the total hours
the machine is operated. On the other hand, the running hours needed for a given output depend on
the cutting speed. The minimization of unit costs by search for an optimal cutting speed is
formulated by substitution of T from Equation 28 and tm from Equation 31 to Equation 29, as
follows:

Minimize Cu (V ) = c0 s / V + sV 1/ n −1 / C 1/ n (c0 t c + ct ) + c0 t h , (36)

subject to conditions

Tu = s / V + sV 1/ n −1 / C1/ ntc + th , (37)

c0 = LRALCI + AFEC / Tu , (38)
t = x Tu ≤ tmax , (39)
x ≤ tmax / Tu (Vmax ) (40)

where

LRALCI = long-run average labor cost as in Equation 16,

AFEC = average annual equipment capital cost per unit of time; see Equation 19,
t = total processing time, which must be no more than the possible maximum,
tmax = maximum total processing time, typically a little less than one year,

55
Gilbert, W., 1950.
46

x = number of units produced annually.

The optimization has to be solved separately for each annual production rate of interest. If a
continuous curve is desired, then the cost and cutting speed have to be solved for all values of x.
Because of the awkward form of the LRALCI function, the optimization problem cannot be solved
analytically. Therefore, in order to demonstrate the characteristics of the solution, numerically
solved examples are shown in Figures 11 and 13. The curves in the figures show the total unit cost
at different cutting speeds and other parameter values. In addition to the unit cost minimizing
cutting speed, Vopt, solved according to Equation 36, cost curves with cutting speeds, Vmin,
calculated using Equation 32, are shown. This latter cutting speed minimizes the unit cost at all
utilization hours assuming the associated variable cost per hour to be constant. The difference
between the two approaches is that the latter does not optimize the cost at a given production rate.
Vopt allows the total labor cost to be decreased at the expense of higher tool and tool changing
costs. Also shown are cost curves with different constant cutting speeds. The associated cutting
speeds are shown in Figures 12 and 14.

500

450
Cost per unit, [Fmk]

400

350

300

250 Cu-maxn Cu-vmin-15% Cu-vminfixed

Cu-min Cu-opt
200
20 30 40 50 60 70 80 90 100
Units produced per year

Figure 11. Average manufacturing costs for a machining process at different cutting speeds. Cu-maxn
corresponds to the maximum production rate cutting speed. Cu-min is the cost at cost-minimizing cutting
speed determined at each hourly cost. Cu-vminfixed is the cost at the constant cutting speed giving the
lowest cost in the previous case. Cu-vmin-15% is same as Cu-vminfixed, but with a 15 % reduced cutting
speed. Cu-opt is the minimum cost at each production rate. The parameter values are: n = 0.25, C = 200
m/min (15 min)0.25 = 394, s = 7670 m, tc = 3 min, ct = 50 FIM, th = 15 min, capital investment in
machinery is 4.2 MFIM, interest rate 7 % and obsolescence age 10 years. There are no other fixed costs.
Minimum labor cost is 100 FIM / hour, indivisibility parameter a is 3, the constant variable cost is set to
zero. The maximum total annual process hours are assumed to be 8500. Values on the horizontal axis are
relative, representing percentages of the total annual production volume.
 47

240
220
Cutting speed, [m/min
Vmax
200 Vopt
180 Vminfixed
Vmin
160 Vmin-15%
140
120
100
20 30 40 50 60 70 80 90 100
Units produced per year

Figure 12. Cutting speeds for the different cases in Figure 11. Vmax is the maximum production rate
cutting speed. Vmin is the cost-minimizing cutting speed determined at each hourly cost. Vminfixed is the
constant cutting speed giving the lowest cost in the previous case. Vopt is the minimum cost cutting speed
determined at each production rate. Vmin-15% is 15 % lower than Vminfixed.

500
Cu-maxn
450
Cu-min
400
Cost per unit

Cu-vminfixed
350 Cu-opt
300
250
200
150
20 30 40 50 60 70 80 90 100
Units produced per year

Figure 13. Average manufacturing costs for a machining process at different cutting speeds. The different
curves are named as in Figure 11. The parameter values are the same as in Figure 11, except that s = 4300
m, tc = 6 min, and th = 30 min.
48

195
Cutting speed, [m/min

Vmax
175
Vmin
Vminfixed
155 Vopt
135

115

95
20 30 40 50 60 70 80 90 100
Units produced per year

Figure 14. Cutting speeds for the different cases in Figure 13.

At low production rates, the unit cost is not very sensitive to the cutting speed using the parameter
values in the examples. When cutting speed is adjusted, the change in tool cost and tool changing
cost is compensated by the change in labor cost caused by the change in processing time. This can
be concluded from the small differences between the different cost curves at low production
volumes. The heavy fluctuation of the optimized cutting speed is caused by the saw-toothed shape
of the labor cost function.

At higher production rates the cost-minimizing cutting speed, Vopt, is higher than the cutting
speed minimizing the unit cost at a given hourly cost, Vmin. This is explained by the high
marginal labor cost, the effect of which is reduced by a shortened processing time. The cutting
speed has to be increased even more in order to reach the very highest production rates. The sharp
increase in cutting speed at very high production rates is caused by the right-hand side constraint
in Equation 39 becoming effective.

The difference between the maximum production rate of 100 % and the production rate achieved
by the constant hourly cost curve Vmin is affected by the tool changing time tc and tool cost. Thus
the difference is significant in the case of Figure 11, but smaller in the case of Figure 13, where tc
is doubled.

The parameter values in the two cases also differ in the workpiece handling time th. The cutting
times in relation to total processing time were calculated in both cases. They are much higher in
the case of Figure 11 than that of Figure 13. In the latter case, the benefits of cutting speed
optimization to the unit cost are almost insignificant. In this case, the cutting time in is the range of
40 % - 50 % of total process time, which is in accordance with Lakso56 on machining processes
using numerically controlled machine tools. Thus the parameter values in this case seem more
realistic.

The effect of tool changing time makes the cutting speed optimization problem generally
complicated. In modern machine tools, tool changing is automated so that tools can be replaced by
new ones at the end of their expected useful life-time without the process being disturbed. Thus

56
Lakso, T. 1988. Page 23.
 49

there is no such maximum production rate cutting speed as defined by Equation 34. However, if
the life-time of the tool becomes, with an increase of cutting speed, so short that the tool does not
last a full cut, the tool changing time becomes significant. This sets a practical limit to the cutting
speed increase. The whole discussion on the search for an optimal cutting speed could be repeated
assuming such a cutting speed limit, but the resulting cost behavior would be very much like the
one obtained above; thus it is omitted.

The probability of unpredicted tool breakage usually increases if the cutting speed is increased57.
Recovery from such a breakage may require human interference in a perhaps otherwise automated
process, and may take a long time. This phenomenon also sets an upper limit to the cutting speed.

It can be stated by way of a conclusion that the presented method of cutting speed optimization
may often have cost saving potential. This is especially the case if the cutting tools are expensive,
the cutting time is long in relation to the total processing time, and the tool changing time is short.
Also other issues such as tool material, machine tool restrictions and labor costs influence the
issue. In usual workshop practice the cutting speeds have not been optimized in the way that has
been proposed here.

The results suggest that the cutting speeds at sub-optimum production rates should be a little lower
than they are at the unit cost minimizing production rate. It appears that the sensitivity of unit costs
to cutting speed is low at low production rates. If the low cutting speeds make the process more
reliable, it is beneficial to favor them whenever maximum production is not required. Japanese
manufacturers are generally known to pursue such practices58.

The proposed cutting speed optimization is especially beneficial at high production rates. There
high-cost working time can be avoided by the use of higher cutting speeds at the expense of higher
tool and tool changing costs.

Cutting speeds are considered constant for the remainder of the long-run analysis in this study.

3.4.4 Long-run cost function of a single technology with multiple units of equipment

The capacity of a process can be increased by installing additional stand-alone units of similar
process equipment. Since the equipment and technology do not change, major economies of scale
are not usually attained. It may e.g. be possible to increase the efficiency of the process by
dedicating some machines to certain product variations, in order to decrease set-ups and to reach a
faster learning speed. However, such arrangements do not conform to the assumptions of make-to-
order production discussed in this study. It appears that the existing sources of economies of scale
which relate to multiplicity of machines and are relevant to make-to-order production are rather
modest. After a discussion of these sources, the resulting average cost function is presented.

The capital cost of long-lived tools and fixtures that are product specific and are needed only by no
more than one machine at a time is spread over the whole volume of production. This scale
economy may be significant if the tools are expensive and have a long life-time.

57
Andersson, P. 1990. Page 108.
58
Lakso, T. 1997. Page 35.
50

Some economies of scale may exist due to specialization of resources serving similar units of
equipment. Example of such resources are maintenance and programming personnel for
numerically controlled machines. Normally these cost effects are likely to be small.

The possibility of sharing machine operators between several similar production machines may
offer another minor advantage. This is because the value of the worker indivisibility coefficient ai
in the long-run labor cost Equation 16 is directly related to the number of similar machines. It is
possible to adjust manning in smaller steps at sub-optimal production rates using more machines
than using fewer machines if the number of workers per unit produced does not change.
Consequently the average cost curve becomes smoother. This effect is demonstrated in Figure 15.

350
xmax = 20, a = 3
Cost per unit, [FIM/h]

xmax = 40, a = 3
300 xmax = 40, a = 6

250

200
0 5 10 15 20 25 30 35 40
Units produced per year

Figure 15. The effect of the worker indivisibility coefficient in the case of two similar machines or one
more efficient machine. The two curves with maximum production rate xmax = 40 represent cases of two
operators running one machine, and two slower machines with one operator running each machine. It is
assumed that one worker can run two other machines (a = 3) in different locations at sub-optimal loads. All
the unit costs are equal, but the indivisibility parameter a is doubled in the case of two machines and two
operators. The curve for one machine and one operator is shown for comparison.

There is a special kind of scale economy involved in maintenance costs. It relates to the spare parts
that are stocked and can be shared by similar equipment. At a constant service level, the cost of
stocking grows approximately proportionally to the square root of the consumption of parts
stocked. With dissimilar equipment the cost of spare parts would in principle be directly related to
the spare part consumption. With small numbers of equipment the advantage is even larger. This
scale effect is explained in detail in Hillier and Lieberman59 and, for a deterministic demand of
parts, in Section 4.1 of the present study, in connection with the materials holding cost. However,
the importance of this economy is not very large, since all maintenance costs typically form only a
small percentage of the total value added by a mechanical workshop. The square root relationship
is adopted here.

The long-run minimum cost function of a single technology using multiple units of equipment
becomes the set of the smallest values of the cost functions per unit produced obtained for the
different degrees of multiplicity:

59
Hillier and Lieberman, 1995. Pages 790 - 794.
 51

LRAC j ( x ) = min{LRALCI j (Tu x / j ) + j AFECm ( x ) + AFECt ( x )

(41)
+ j AFEC f ( x ) + M j x + LRAVC}, j = 1,2,..

where in addition to previous notation

LRACj = long-run average cost function of a single technology using multiple units of
equipment,
Tu = processing time of one unit using one machine,
x = number of units produced,
j = number of similar units of equipment,
LRALCIj = LRALCI in Equation 16 for j similar pieces of equipment with parameter ai = ja1 ;
a1 is the value of parameter ai in LRALCI for single equipment,
M = cost of spare parts per one machine included in AFECf in Equation 22, but not in
Equation 41.

The cost functions for the different numbers of machines are derived from the cost function for
one machine in Equation 22. The terms for labor cost, process equipment and rent are modified to
conform to the larger number of machines. The terms for tool and fixture cost and constant
variable cost stay unchanged and a term for spare parts is added.

The cost curves for different numbers of equipment up to six are shown in Figure 16. The costs per
hour are the same as those used earlier in the example in Figure 8. It is clearly demonstrated that
the minimum cost volume for each number of equipment has to be exceeded considerably before it
is beneficial to increase the number of machines. The increase in production cost above any such
volume which produces its minimum is due to the indivisibility of fixed costs. This increase
becomes smaller each time the number of machines is increased by one unit. The optimal number
of machines needed for a certain volume can be read directly from the curves. It is also obvious
that the effect of the decreasing cost of fixtures and spare part stock is small in this case.
52

500
Cost per unit, [FIM/h]

400

300

200

100
0 20 40 60 80 100 120
Units produced per year

Figure 16. Long-run average cost curves of 1 - 6 units of similar equipment. The hourly costs are the same
as in the example in Figure 8, except that a diminishing cost of 7000 FIM per year for one machine’s spare
part stock is taken into account. The labor indivisibility parameter (ai) also increases with the number of
machines, and the tool and fixture capital cost is distributed over the whole volume.

The long-run average cost for multiple units of similar equipment is shown in Figure 17 as the set
of sections of the cost curves for the different numbers of equipment. The values of the parameters
are the same as in the previous examples. The breakdown of costs into labor, variable and fixed
costs is also shown.

500
450 Total
Labor
400
Cost per unit, [FIM/h]

Fixed
350 Variable
300
250
200
150
100
50
0
0 20 40 60 80 100 120
Units produced per year

Figure 17. Long-run average cost curve of 1 - 6 units of similar equipment as the set of the smallest values
of the cost curves for different numbers of machines.

The risk of a total standstill of the process in the case of a machine breakage can be efficiently
reduced by the use of several parallel units. This is an important practical factor with indirect cost
effects. However, such cases and their effects on through-puts of the parallel units are not included
in the calculations of this study.
 53

3.4.5 Long-run cost function of a process with economies of scale due to more efficient
technologies

In order to fully reach the better cost efficiency made possible by larger production volumes,
economies of scale between different manufacturing technologies have to be utilized. The long-run
cost function of a manufacturing process consisting of alternative technologies is examined in this
section. This cost function is the set of the smallest values of cost curves of the different
technologies:

LRAC(x) = min{LRACi(x)}, i = 1,2,.. , (42)

where

LRAC = long-run average cost function of different technologies,

LRACi = long-run average cost function of a single technology with multiple units of
equipment,
i = number of different technologies.

It has been shown previously that the long-run average cost function of a manufacturing process
with several similar pieces of equipment is a continuous curve consisting of segments with local
minima. The slope of the curve between these minima varies and may alternate between positive
and negative values. Consequently a definition of economy of scale based on elasticity of cost to
output is not unambiguous and may be confusing. The condition for the existence of an economy
of scale is redefined for the purposes of this section:

“Economies of scale from one technology to another exist if the minimum cost of the latter
technology per unit produced is lower than that of the former one and appears at a higher
production rate.”

In addition, a necessary condition for a technology to be relevant is that at least some range of
production rates exists, the unit cost of which is lower than that of any other technology effecting
the same manufacturing function. Otherwise its cost curve would not appear as a part of the long-
run minimum cost function of the process.

In order to be in a better position to analyze the magnitude and causes of economies of scale in
different manufacturing processes, their generation by more efficient technologies is discussed in
terms of changes in major fixed and variable costs. The capital cost of long-lived equipment is
considered the major fixed cost and the labor cost the major variable cost. The different cases
examined are summarized in Table 3. As earlier, the terms fixed and variable refer to the time
period during which the main manufacturing equipment is fixed and other factors of production
can be adjusted according to the production rate. The change in fixed costs could alternatively be
given as change in cost per unit produced, but the change in absolute value was chosen because
this is the usual custom of expressing fixed costs.
54

Table 3. Summary of economies of scale between two technologies in the four cases of different labor costs
and/or capital costs of major manufacturing equipment. The change in the factor of production is indicated
by the + or - signs.

Change in labor cost per unit

+ -
1) Increased unit cost at all 2) Economies of scale possible
+ volumes - no economies at any due to more efficient equipment
scale and possibly automatization
Change in
fixed cost 3) Economies of scale possible 4) Decreased unit cost at all
due to more efficient labor and volumes - not relevant;
-
less mechanized or automatized economies at any scale
technology

Case 1 in Table 3 does not produce lower costs at any production rate, and is left unremarked for
now. It is reviewed at the end of the chapter, where the case of a combination of different
technologies is discussed. In Case 4 the average cost decreases at all production rates. Thus the
technology with the minimum cost appearing at a higher rate could and should be used for all
production rates. Assuming that this is the case, economies of scale do not exist. The two most
important cases in Table 3 are discussed in the following.

Case 2 - decreased variable cost and increased fixed cost

This is the normal case of more mechanized technologies. Faster machinery is usually more
expensive than slower machinery. Process manning typically increases with the speed, stays
constant or decreases due to automation.

If process manning stays unchanged the labor cost per unit decreases in an inverse ratio to the
increase in machine speed. This labor cost has to be readjusted with a possible increase if a new
minimum labor cost category is entered due to the increased fixed cost. The relationship between
labor cost and minimum unit cost was examined in the Section entitled “Long-run cost function of
a single technology and single unit of equipment” earlier in this chapter.

If manning is increased up to the same ratio as the speed of machinery increases, the labor cost per
unit will either decrease or remain unchanged, but will still be higher than that at constant
manning. It is also a relevant variation of this case since faster equipment may be more
complicated and require more operating personnel. Again, the possible effect of a change in the
hours of operation on labor cost must be taken into account.

If the manning is reduced by e.g. automation, the labor cost can decrease, toward the final limit of
zero.

Since the cost function for an individual technology has been defined, the relationship between the
different cost elements from one technology to another can be determined. The range of variation
of tool, labor and other variable costs is usually determined to a large degree by the nature of the
manufacturing process and the prevailing labor cost level. The cost of equipment is a much more
complicated issue, not to mention the variation of the equipment itself. Therefore limits are placed
on the fixed cost in terms of other costs.
 55

In order that economies of scale would exist, the minimum cost achieved with the faster
technology must be lower than that with the slower technology. This sets the following condition
on the capital cost of the machinery:

AFECm2(x2min ) < LRAC1(x1min) - LRALCI2(x2min) - AFECt2(x2min) - AFECf2(x2min)

- LRAVC2(x2min) (43)

where all costs are per unit produced, and

AFECm2 = capital cost of machinery of the faster technology,

LRAC1 = long-run average cost function of the slower technology,
LRALCI2 = long-run labor cost function of the faster technology,
AFECt2 = capital cost of process tools, fixtures etc.,
AFECf2 = capital cost for rent, heating etc.,
LRAVC2 = linear variable cost of the faster technology,
x1min, x2min = minimum cost production rates of the slower and the faster technologies.
The cost curve of the faster technology must also have higher values than that of the slower one.
The limiting condition appears at the smallest production rates, since the difference between the
two curves is decreasing until the curves cross. The following condition is obtained:

AFECm2(1) > LRAC1(1) - LRALCI2(1) - AFECt2(1) - AFECf2(1) - LRAVC2(1) (44)

where in addition to previous notation

x = 1 = the production rate of producing one unit annually.

If more than two technologies are available, conditions on cost curves appearing below the other
cost curves become more restrictive. Let us assume that LRAC1,2,3 represent the cost functions of
three technologies, so that the larger index indicates faster technology. The curves are cost curves
of the type presented in Equation 41 for multiple units of the same equipment. In this case, the cost
curve of the fastest technology, LRAC3, must cross the cost curve LRAC2 of the previous, slower
technology, at a higher production rate than the highest rate at which LRAC2 crosses the cost curve
of the slowest technology, LRAC1. This condition is realized by modifying Equation 44 with the
values at the production rate xa, at which the curves LRAC1 and LRAC2 cross each other. Figure 18
shows a situation typical of this case.

AFECm3(xa) > LRAC2(xa) - LRALCI3(xa) - AFECt3(xa) - AFECf3(xa) - LRAVC3(xa), (45)

and LRAC1(xa) = LRAC2(xa),

where in addition to previous notation

1, 2, 3 = index numbers of the different technologies (1 the slowest, 3 the fastest technology).
56

500
450 LRAC-1
400 LRAC-2
Cost per unit

350 LRAC-3
300
250
200
150
xa
100
0 20 40 60 80 100
Units produced per year

Figure 18. Average cost curves of three different technologies in a situation where economies of scale exist
and all technologies are relevant. The fixed cost of a technology is larger and labor cost per unit lower than
that of the slower technologies. LRAC3 crosses LRAC2 at a higher production rate than xa, at which LRAC2
crosses LRAC1.

Case 3 - increased variable cost and decreased fixed cost

Since the fixed cost per unit decreases as the production rate increases, it is possible to increase the
variable cost per unit somewhat and still preserve economies of scale. Assuming that parameters
of functions LRAC1, AFECt2, AFECf2, and LRAVC2 are known, the largest possible labor cost
increase can be solved from conditions set in Equations 43 and 44. However, because of the
difficult form of the LRALCI function the solution is simplified by replacing the LRALCI2 function
with

LRALCI2(x2min) = ki LRALCI2(1), i = 1,..,n, (46)

where

i = index of labor cost category,

ki = coefficient giving the ratio between the labor costs at the cost-minimizing production rate
and at the minimum production rate.

The maximum increased labor cost is solved from Equations 43, 44 and 46. After algebraic
manipulation, which is shown in Appendix B, the result is:

LRALCI2(x2min) = ki {[LRAVC2(x2min) + AFECt2(x2min) + AFECf2(x2min) - LRAC1(x1min)] x2min

- LRAVC2(1) - AFECt2(1) - AFECf2(1) + LRAC1(1)} / (1- ki x2min). (47)

Since the minimum cost production rates appear only at those production rates corresponding to
changes of labor cost category, the possible x2min and ki are easy to calculate. If the maximum
production rate, i.e. the speed of the technology, is known, the choice of the minimum cost
production rate can be estimated. This estimation is particularly easy, since the fixed cost and
labor cost are almost the same as they are for LRAC1 in this situation. The condition LRAC1(1) <
LRAC2(1) set in Equation 44 must be met. The difference, caused by the difference in the values of
AFECt, AFECf, and LRAVC between the two functions, is known and small. Thus the difference in
 57

the capital cost of process equipment is also small and it is likely that the minimum cost lies in the
same labor cost category change point as for LRAC1.

Figure 19 shows an example of the non-typical limiting case where the minimum costs of the two
technologies and the costs of producing just one unit annually are the same. Which technology
would be chosen in such a case in practice depends also on factors other than simply costs, as was
discussed in the previous section concerning multiple units of similar equipment. Purely from the
point of view of the cost planned production rate would determine the choice of technology.

500
450
400 LRAC-1
Cost per unit

350 LRAC-2
300
250
200
150
100
0 20 40 60 80 100
Units produced per year

Figure 19. A limiting situation where the minimum costs of two technologies and the costs of producing a
minimum annual output are the same: LRAC1(x1min) = LRAC2(x2min) and LRAC1(1) = LRAC2(1), which is not
shown in the picture.

If the variable cost of the faster technology is increased above the limit set in Equation 47, its
equipment capital cost must necessarily be lowered in order to keep the minimum cost below that
of the slower technology. The same general condition as before, Equation 43, stays valid. On the
other hand, the cost curve must stay above the minimum cost value of the slower technology at
x1min which yields:

AFECm2(x1min) > LRAC1(x1min) - LRALCI2(x1min) - AFECt2(x1min) - AFECf2(x1min)

- LRAVC2(x1min) (48)

The situation of Case 3 is anomalous: the faster technology produces lower unit costs at low
volumes, then it becomes less economical when the production rate is increased and finally
economies of scale will exist at its minimum cost production rate. Figure 20 shows an example of
this phenomenon. Note that with the slower technology the cost-minimizing production rate
relative to the maximum production rate appears at a higher relative production rate than in the
case of the faster technology. This is a natural consequence of the lower capital to labor ratio.
58

500
450 LRAC-1
400 LRAC-2
Cost per unit

350
300
250
200
x1m in x2m in
150
100
0 10 20 30 40 50 60 70 80 90 100
Units produced per year

Figure 20. A situation where LRAC1(x1min) > LRAC2(x2min) but LRAC1(x1min) < LRAC2(x1min) and LRAC1(1) >
LRAC2(1), which is not shown. Here the labor cost of the slower technology LRALCI1(x1min) = 70 % of the
labor cost of the faster technology LRALCI2(x2min) and equipment capital cost AFECm1(1) = 138 % of
AFECm2(1). The minimum cost production rate x1min = 45.5 and x2min = 76. The corresponding maximum
production rates using one machine are 50 and 100. The ratio 45.5/50 is higher than 76/100, which is due to
the higher fixed cost of the slower technology.

Theoretically, the capital cost of the equipment of the faster technology could closely approach
zero and such technology would be almost entirely manual work, and economies of scale would
still exist.

Whether the phenomenon described above has any practical relevance, and whether it can exist in
reality, is evaluated later in Section 3.5, after discussion of the different manufacturing processes.

Case 1 revisited - increased variable cost and decreased fixed cost as a combination of
technologies

A central assumption in this chapter and in the whole study has been that of a limited number of
technologies being available for the accomplishment of a manufacturing process. Although many
manufacturers and slight variations of the same type of equipment often exist, the differences
between their capabilities are usually small. In an investment situation the practical least cost
calculations are usually performed for different technologies. After the best technology for the
planned volume has been chosen, the best equipment is purchased or constructed. The existence of
a limited number of technologies is demonstrated by several examples in the following chapter.

Despite the limited number of available technologies, their combination creates a new technology
from the economic point of view. This means, for example, that the capacity of one machine can
be increased in steps which are smaller than its own capacity, if a slower technology exists. The
resulting combination of technologies has a capacity that is the sum of the capacities of the two
technologies. The cost values of the combination technology are capacity-weighted averages of the
costs of the individual technologies. Consequently the minimum cost of the combined technology
is always higher than the minimum cost of the faster technology. The cost curve of the combined
technology can have values which are lower than those of the individual technologies, if the
capacities of the individual technologies are not close to each other and the difference in minimum
costs is small. It is also necessary that there are no other technologies having lower cost values.
The combination, LRAC1/2, of two technologies, LRAC1 and LRAC2, having relevant cost values
 59

is demonstrated in Figure 21. A faster technology, LRAC3, exists but does not prevent the
combined technology from being relevant.

In principle any combination of different numbers of different technologies can be used

simultaneously. However, the larger the numbers, the more unlikely it is that the combinations
have least cost values. The curves become flatter at larger production rates and the probability of
combination curves below the curves of the individual technologies decreases.

The above discussion and Figure 21 demonstrate that a combination of different technologies can
have practical relevance. However, this requires that certain conditions are fulfilled, and even then
the significance of the phenomenon is not high. In addition the computational complexity of the
cost curves increases when the number of combined technologies increases, and general
conclusions are difficult to make. Thus the possibility of combined technologies is not taken into
account in the analysis of economies of scale presented in this study.

In reality different technologies often exist in the same factories simultaneously - usually for
historical reasons. The adaptation of technology to minimize long-run costs seems not to have
taken place.

500 LRAC-1
450 LRAC-2
400 LRAC-1/2
Cost per unit

350 LRAC-3
300
250
200
150
100
0 20 40 60 80 100
Units produced per year

Figure 21. An example of a relevant combination, LRAC1/2, of two technologies, LRAC1 and LRAC2. A
faster technology, LRAC3, also exists and is relevant.

3.5 Common mechanical engineering manufacturing processes

In this chapter, cost function parameters and economies of scale of typical mechanical engineering
manufacturing processes are discussed. These processes are categorized according to their
characteristics from the point of view of economies of scale. Because of the vast number of
different processes, only examples belonging to each category are presented. However, the
categorization should cover the whole range of possible mechanical engineering manufacturing
processes. The categories are the following:
− manual work,
− mechanized parts manufacturing with a constant machine operator presence,
60

− mechanized parts manufacturing with multiple units of similar equipment, expensive tooling
and constant machine operator presence,
− mechanized parts manufacturing with a partial operator presence, i.e. automation,
− mechanized parts manufacturing with different levels of operator presence at different hours of
day, i.e. automation without operator presence,
− continuous processes.
Finally, a discussion of the possibility of economies of scale with increased labor cost and
decreased fixed cost is included.

3.5.1 Manual work

Manufacturing processes, in which only a minimal amount of long-lived equipment is involved,

are a major source of added value in make-to-order manufacturing. Examples of such processes
are assembly, inspection and finishing of parts. The cost curve for manual work is the same as that
for one technology and one unit of equipment, with low fixed cost values. Since manual work is
mostly performed by several workers in parallel, the cost function for multiple units of similar
equipment, Equation 41, is usually more useful. Economies of scale are small and the cost curve
is essentially flat after the initial decrease. The major parameters determining the curve are the
labor cost and the processing time. The level of labor cost was discussed in Section 3.1 and in
Appendix A. Figure 22 shows a typical long-run average cost curve for manual work as the set of
the smallest values of the cost curves for different numbers of individual workers.

Figure 23 shows a cost curve for an average manual labor process. The curve is the average of 20
cost curves obtained by using random maximum production rates of between 5 and 100 units per
year. The random numbers used in this and other similar examples are equal. The day and evening
shift minima are around 19 % and 38 % of the total annual hours and the average of the production
speeds in this case is 51 units per year. The curve flattens between the 10- and 20-unit production
rates, as could be expected.
 61

200

Cost per hour, [FIM/h]

100

0
0 10 20 30 40 50 60 70 80 90 100
Units produced per year

Figure 22. Long-run average cost curves for manual work. The cost curve for the total process is the set of
the smallest values of the cost curves of the different numbers of individual workers. Parameter values are
identical to those Figure 23.

300

250 Total
Cost per unit, [FIM]

Labor
200
Fixed
150

100

50

0
0 10 20 30 40 50 60 70 80 90 100
Units produced per year

Figure 23. Cost curves indicating the average cost functions of a random set of manual work processes. The
parameter values are as follows: minimum labor cost 100 FIM/hour, indivisibility parameter a1 = 3,
constant variable cost zero, and average rent and equivalent fixed cost are 18 000 FIM/year.

3.5.2 Mechanized parts manufacturing with constant machine operator presence

The cost function of manned manufacturing processes involving long-lived equipment is that of
Equation 22, for a single piece of production machinery. The functions for multiple pieces of
similar equipment and different equipment are those of Equations 41 and 42. Constantly manned
manufacturing processes are common in make-to-order production because of the difficulty of
automation due to product variation and small batch size. Examples of mechanized processes
which often appear constantly manned are machining, forming, casting, welding and testing. The
major parameters determining the curve are labor cost, processing time and capital cost of the
62

process machinery. The most typical case is one where one worker operates one machine
independently of the speed of the machine. The examples below are for such a case.

In the case of multiple pieces of similar equipment the economies of scale are not usually
significant after the initial decrease in costs. This was discussed in detail in the earlier section on
the subject.

If different technologies are available, the fixed cost of a faster technology is limited by the
constraints set by Equations 43 and 44. If the fixed cost is at its maximum for each different
technology, i.e. at the limit set in Equation 43, economies of scale no longer exist after the initial
decrease of costs. An example of such an extreme case is shown in Figure 24, for four different
technologies.

1000
LRAC-1
900
800 LRAC-2
LRAC-3
Cost per unit

700
600 LRAC-4
500
400
300
200
100
0 10 20 30 40 50 60 70 80 90 100
Units produced per year

Figure 24. Average manufacturing costs of one process using four different technologies and constant
manning. The different technologies exhibit minimal economies of scale.

The other extreme case is obtained by keeping the fixed cost at a minimum for each technology so
that each technology is relevant from the point of view of economies of scale; i.e., at the limit set
by Equation 44. The resulting cost function is that of the individual technology; see the example in
Figure 25.
 63

1000
LRAC-1
900
800 LRAC-2
LRAC-3
Cost per unit
700
600 LRAC-4
500
400
300
200
100
0 20 40 60 80 100
Units produced per year

Figure 25. Average manufacturing costs for one process using four different technologies and constant
manning. A slower technology exhibits lower costs than faster ones only at the smallest production rates.

In order to comprehend the magnitude of economies of scale obtained by constantly manned

processes in mechanical engineering production, some typical maximum values are shown in
Table 4. These values correspond to the latter case above, which is demonstrated in Figure 25. The
increase in cost at 50 % and at 75 % of the minimum cost volume are shown compared to the
minimum cost with different fixed costs. One-man operation and zero linear variable cost are
assumed.

The range of equipment costs shown here can be considered realistic for machine tools. According
to the data in the Machine Tool Selector database60 the values listed in Table 4 cover the relevant
range of types and sizes of machines. - The database lists specifications for about 8000 machine
tools supplied by about 650 manufacturers and prices for about 825 machine tools in 40
categories. Installation arrangements, tools and special accessories are assumed to be included in
the investment.

The maximum theoretical cost increase at 50 % of the optimal rate would be 100 % and at 75 % it
would be 33 %. These would be reached with zero labor cost or infinite fixed cost. When
considering the example values obtained in Table 4, it should be remembered that the cost
increases are the largest possible with a constant operator presence and the given fixed costs. In
practice all existing technologies used for the same process are normally more relevant than in this
extreme case. Consequently the economies of scale are smaller than those indicated in Table 4. In
addition the linear variable cost of a particular technology reduces the relative cost increase, and
likewise the material cost, which may form a considerable portion of the total cost.

60
Machine Tool Selector database. 1998.
64

Table 4. Maximum cost increases at suboptimal production rates with different fixed costs and constant one
person manning. The parameter values are as follows: minimum labor cost 100 FIM/h, shift compensations
approximately the average in the Finnish metal industry in 1996, indivisibility parameter a1 = 3, interest
rate 7 %, obsolescence age of equipment 10 years and linearly variable cost zero. The rent and
corresponding machinery value in each case is given to demonstrate the magnitude of the investment
involved.

Annual Rent etc. Machinery value Cost increase Cost increase

fixed cost at 50% of xmin at 75% of xmin
[kFIM/year] [kFIM/year] [kFIM] [%] [%]
50 30 140 12 % 13 %
100 40 420 7% 3%
200 40 1120 18 % 6%
500 50 3150 38 % 13 %
1000 80 6440 51 % 14 %
4000 140 27020 82 % 26 %
7000 200 47600 90 % 29 %

In order to be able to estimate the general form of the cost function in more normal cases than the
extreme ones described above, sets of random cost functions were generated. Each set of curves
was calculated for 20 random production rate combinations between 5 and 100 units per year. All
production rates were generated from uniform distributions. Random production rates were used in
order to avoid regularity in the results. Different numbers of technologies and different initial fixed
costs were used for different sets of functions. In each case the cost functions presented earlier
were applied. The processes were manned by one operator and the labor cost function parameters
were the same as in the previous examples. The investment cost for each technology except the
initial one was chosen as the average of the limiting values determined by Equations 43 and 45.
This value was supposed to represent an estimate of the average of uniformly distributed
machinery investment values yielding economies of scale.

Figure 26 shows the results for one set of realistic parameter values for three technologies and
Figure 27 the results for the same parameter values but with an initial investment cost four times
greater. The total unit cost curve is initially decreasing in both cases. The decrease is faster first,
obviously due to under utilization of the capacity of the first technology. The decrease slows down
when capacity utilization is no longer the decisive factor and faster technologies are used. The cost
increases slightly once the fastest technology is fully utilized. Finally the cost level stabilizes.
 65

300

250 Total
Cost per unit, [FIM] Fixed
200 Labor
150

100

50

0
0 20 40 60 80 100 120
Units produced per year

Figure 26. Cost function as an average of 20 random constantly manned mechanized manufacturing
processes. Three different technologies with economies of scale are available. The minimum labor cost is
100 FIM per unit for the first technology. Annual rent and equivalent fixed cost is 18 kFIM per year. The
comparable average investment cost is about 320 kFIM for the first technology. The average investment
cost at the local minimum of 76 units per year is about 2.4 MFIM.

350
Total
300 Fixed
Cost per unit, [FIM]

250 Labor

200
150
100
50
0
0 20 40 60 80 100 120
Units produced per year

Figure 27. Cost function as an average of 20 random constantly manned mechanized manufacturing
processes. All the other parameter values are the same as in Figure 26, but the average investment cost is
about 1280 kFIM for the first technology. This gives an average investment cost of 4.6 MFIM at the local
minimum at 78 units per year.

In principle the behavior of the unit cost curve can also be seen in Figure 28, where the elasticity
of total cost to scale for the entire process is shown. However, because the value of the elasticity
of cost to scale behaves irregularly it is very hard to obtain a useful picture of the economies of
scale from it. The cost increases at different production rates, compared to the minimum costs, are
a more useful measure.
66

1.4
Elasticity of total cost to scale

1.2

0.8

0.6
0 20 40 60 80 100 120
Units produced per year

Figure 28. Elasticity of total cost to scale in the case shown in Figure 26.

The labor cost function does not differ much between the two cases. This is natural, since the
process is manned by one operator at all times whenever it is running. The difference comes only
from those incidents where the more expensive equipment produces lower costs despite its use of
more expensive running hours. Although small, such a difference exists at almost all production
rates between the average curves.

Because the share of labor of the total cost is high at the small production rates, the fixed cost per
unit decreases initially to a low level before increasing somewhat and then starts to decrease
slowly until the economies of scale are exhausted. This behavior is clearly visible in Figure 26,
where the fixed cost is lower than in Figure 27. In the case of Figure 27, the initial decrease does
not lead to the lowest value of fixed cost per unit.

The total cost is naturally higher in the case of higher fixed costs in Figure 27. The economies of
scale achieved are also higher with the higher fixed cost. The cost increase, at 50 % production
rate of the minimum unit cost rate below 100 units annual production, is 22 % in the case of higher
fixed costs and 20 % in the case of the lower ones. The respective figures for 75 % of the
minimum cost production rate are 9 % and 7 %.

Similar random processes were generated in the case of two different technologies. The case
otherwise similar to the case in Figure 26 except for the production rates is shown in Figure 29.
The general form of the curves is similar to the previous cases. The minimum total cost achieved is
slightly higher and the economies of scale are lower. The cost increase at 50 % and 75 % of the
minimum unit cost production rate below 100 units annual production are 13 % and 5 %
respectively.
 67

350
300
Cost per unit, [FIM] 250
Total
Labor
200 Fixed

150
100
50
0
0 20 40 60 80 100 120
Units produced per year

Figure 29. Cost function as an average of 20 random constantly manned mechanized manufacturing
processes. Two different technologies with economies of scale are available. All the other parameter values
except the maximum production rates are the same as in Figure 28. The average investment cost at the local
minimum at 89 units per year is about 3.2 MFIM.

The cases above were tested with lower fixed costs and the results conformed well to the general
behavior already noticed for the higher fixed costs. Four technologies were also tested but again
no irregular behavior was encountered. Therefore these results are not discussed in detail.

Case - Shaft machining

This example case is concerned with the costs of technologies available for machining electric
motor rotor shafts. The shafts are approximately 2.5 - 3 m long, their maximum diameter is about
250 mm and material construction steel. The technologies consist of the following operations:

Technology 1) Turning and grinding of the sawn and centered bar in a manually operated lathe.
Milling of keyways and drilling and tapping of various attachment holes in a manually operated
milling machine.

Technology 2) Turning, milling, drilling and tapping of the sawn and centered bar in a numerically
controlled turning center that is equipped with rotating tools and bar support bearing. Grinding
with a numerically controlled grinding machine.

Technology 3) Machining of the bar ends in a special purpose machine tool. Turning, milling,
drilling and tapping of the sawn and centered bar in a numerically controlled turning center that is
equipped with rotating tools. Grinding with a numerically controlled grinding machine.

Technology 4) Same as Technology 3), but with two lathes instead of one.

Example parameters in the cost functions of the four technologies are listed in Table 5. The
resulting cost curves are shown in Figures 30 and 31.
68

Table 5. Cost parameters of the shaft machining technologies presented in the case analysis of mechanized
parts manufacturing with a constant machine operator presence. The common parameter values are as
follows: minimum labor cost 100 FIM/h, shift compensations approximately average in the Finnish metal
industry in 1996, indivisibility parameter a1 = 3, interest rate 7 % and obsolescence age of equipment 10
years.

Technology Maximum Investment Labor Rent Linear

prod. rate variable cost
# [units/year] [kFIM] [workers] [kFIM/year] [FIM/unit]
1 2125 1350 2 100 320
2 2830 7500 1 100 350
3 3900 9000 1 150 300
4 7000 12500 2 200 300

3000 Manual machines

2500 Flexible NC-lathe
Cost per unit, [FIM]

NC-cell w. one lathe

2000
NC-cell w. two lathes
1500

1000

500

0
0 1000 2000 3000 4000 5000 6000 7000
Units produced per year

Figure 30. Cost curves of the shaft machining technologies presented in the case analysis of mechanized
parts manufacturing with a constant machine operator presence.
 69

3000

2500
Cost per unit, [FIM] Total
2000 Fixed
Labor
1500

1000

500

0
0 1000 2000 3000 4000 5000 6000 7000
Units produced per year

Figure 31. Total average cost curve of the shaft machining process example as a set of the smallest values
of the total average cost curves of the different technologies shown in Figure 30. The labor and fixed cost
curves show the corresponding values.

The cost increase at a production rate of 3181 units per year, i.e. 50 % of the cost-minimizing rate,
is 15 % of the cost minimum. This cost level is achieved with Technology 3). The cost increase at
75 % of the cost-minimizing rate is 10 % and is achieved with the same technology (4) as the
minimum cost.

The shape of the total unit cost curve and its components in this case conform well to the average
shapes of the randomly generated cost curves above. The curves are of course more irregular since
they represent only one process. Nevertheless, they clearly demonstrate how the average curves
have been formed.

3.5.3 Mechanized parts manufacturing using multiple units of similar equipment, expensive
tooling and constant machine operator presence

The cost function for this case was presented in the Section entitled “Long-run cost function of a
single technology with multiple units of equipment”; see Equation 41. Although similarity of
production machinery does not favor economies of scale, expensive and long-lived tooling can be
of significance in this respect. It is common in make-to-order production that a tool or fixture is
not constantly installed in a production machine, but is needed only occasionally. In such cases the
tool cost is spread over the whole volume, and economies of scale exist, even when the capacity is
increased by adding more of similar machines. Actually the parallel machines do not have to be
exactly similar, but this usually is the case for reasons related to the sharing of costs specific to a
special machine type. A necessary requirement for the economies of scale to be present is that the
volume increase is not entirely attained by adding new variations of parts or products. It is
assumed that only a limited set of tools is needed and that all the tools are purchased at the onset
of production.

This type of scale effect is typical in manufacturing technologies that utilize expensive tools.
Examples of these are forging, rolling, drawing, pressing, punching, and casting operations. In
addition to the cost parameters of a single machine, the parameters important to the magnitude of
economies of scale in such a case are the value of the tools and fixtures, their lifetime in relation to
70

the total volume and the age to obsolescence. This phenomenon is examined in the light of the
following example.

Case - Punching

This example deals with the costs of technologies available for blanking electric motor ferro-
magnetic core plates. These are thin steel plate rondels approximately 0.5 - 1 m in diameter. The
plate shapes and sizes are standardized and the technologies consist of punching, or blanking, of
the rondel in a one step operation:

Technology 1) Blanking the rondel in a manually served eccentric press. The tools are unique for
each rondel type.

Technology 2) Blanking the rondel in an automatic eccentric press. The tools are unique for each
rondel type and more complicated than in Technology 1) because of the requirements of the
automatic workpiece handling.

The parameters of the cost functions of the two technologies are listed in Table 6.

Table 6. Cost parameters of the punching technology case involving expensive tooling. The common
parameter values are as follows: minimum labor cost 100 FIM/h, shift compensations approximately the
average for the Finnish metal industry in 1996, indivisibility parameter a1 = 3, interest rate 7 % and
obsolescence age 10 years for both machinery and tools.

Technology Maximum Investm. Labor Rent Linear Investm. Tools'

prod. rate var. cost in tools durability
# [units/year] [kFIM] [workers] [kFIM/year] [FIM/unit] [kFIM] [units]
1 944 1500 1 50 360 2000 37500
2 6540 5500 0.5 100 105 2500 37500

The cost curves for the different cost components of Technology 1) are shown in Figure 32. It is
clear, that economies of scale after the initial cost decrease are mainly due to the fixed tool cost
and depend on the share of the tools in the total cost. The tool cost is hyperbolic up to the rate of
37 500 units/10 years = 3750 units per year. In this case the minimum unit cost is increased by
about 5 % at 50 % of the rate of 3750 units per year.

The more mechanized Technology 2) is much faster and becomes more economical than
Technology 1) even at low production rates. This can be seen in Figure 33, where the cost
functions for both technologies are shown. In Technology 2) the shape of the tool cost function
differs from those of the other fixed costs only with a volume greater than 3 750 units per year.
The minimum cost is at 5 940 units per year. The cost increase at 50 % of the minimum cost rate is
41 %.
 71

3500 Total
Labor
3000 Fixed
Cost per unit, [FIM] 2500 Variable
Tool and fixture
2000
1500
1000

500
0
0 500 1000 1500 2000 2500 3000 3500 4000 4500
Units produced per year

Figure 32. Cost components of punching technology 1) as functions of the production rate. The cost curves
consist of their share of the cost curves of 1 - 6 units of equipment

3000
Manually served presses
2500
Cost per unit, [FIM]

Mechanized press
2000

1500

1000

500

0
0 1000 2000 3000 4000 5000 6000
Units produced per year

Figure 33. Cost curves of the punching technologies presented in the case analysis of mechanized parts
manufacturing using multiple units of similar equipment, expensive tooling and a constant machine
operator presence.

3.5.4 Mechanized parts manufacturing with partial operator presence, i.e. automation

Increased mechanization of manufacturing processes may allow the machine operator to leave the
machine running without the operator being in attendance. This mechanization, or automation,
increases equipment complexity and cost. On the other hand, the operator is freed to run other
machines or do other productive work, and as a result the labor cost per unit is reduced. If the
unattended running time is not very long, the operator’s presence is still required at the workplace.
In such circumstances the cost function is similar to that already discussed in the Section entitled
“Mechanized parts manufacturing with constant machine operator presence”. The practical
difference is that the fixed cost to labor cost ratio is usually higher. As before, the maximum
theoretical cost increase at 50 % of the optimal rate would be 100 %. If the labor required for set-
72

up and other variable costs is low, the economies of scale of individual technologies can be high
compared to those reached with constantly manned processes. Correspondingly, the minimum cost
production rate is close to the maximum production rate, if not equal to it. Consequently the total
process minimum unit cost function usually experiences sharp increases after reaching the
maximum production rates of the different technologies. The dependence of economies of scale in
the total process on the cost and speed of equipment is emphasized. Contrary to the individual
technologies, economies of scale are not necessarily large for the total process.

In order to further study the effect of reduced manning on the cost curves, random processes were
generated in a similar fashion to those generated for the manned processes. This time the manning
level of each technology was assumed to be half of the manning level of the previous, slower
technology. This is supposed to represent the estimate of the average manning level for an
automated process, assuming uniform distribution of manning levels between zero and the
manning level of the previous, slower technology. The first and slowest technology is fully
manned. This policy produces the lower manning and labor cost per unit, the more technologies
exist. The curves for three technologies are shown in Figure 34. All the parameter values in this
case are equal to the ones in Figure 26.

350
Total
300
Labor
Cost per unit, [FIM]

250 Fixed
200
150
100
50
0
0 20 40 60 80 100 120
Units produced per year

Figure 34. Cost function as an average of 20 random automated manufacturing processes. Three different
technologies with economies of scale are considered. The manning of each technology is half of the
manning of the least slower technology. The first technology is fully manned. The parameter values are the
same as in the example shown in Figure 26 for the constantly manned process. The average investment cost
at the local minimum of 80 units per year is about 3.1 MFIM.

The minimum cost in the automated case shown in Figure 34 is 109 FIM at 80 units per year. The
corresponding figures for the constantly manned case of Figure 26 are 110 FIM at 76 units per
year. The cost increase in the automated case is 28 % at 50 % and 9 % at 75 % of the minimum
cost production rate. The curve is less flat, but otherwise the overall shape of the function is
similar to that of the manned case. However, the fixed cost to labor cost ratio is higher in the
automated case, especially at higher production rates.

With more technologies the minimum cost achieved becomes smaller both in absolute terms and in
comparison with the values obtained with constant manning. Higher initial fixed costs also
increase the differences.
 73

Although make-to-order production does not favor automation, different levels of it are commonly
applied to various manufacturing processes. Parts manufacturing, especially machining,
presswork, sheet metal cutting, forming and casting are typical such operations. The characteristics
of the cost functions of the automated processes discussed above are demonstrated by the
following example.

Case - Notching

Notching is a special punching operation in which slots for electrical winding is cut to the ferro-
magnetic core plates of electric motors. Both the stator and rotor plates are notched. The rotor
plate is cut from the center part of the stator plate. The notching is performed with specialized
presses that use tools of a relatively short lifetime. The available technologies are described as
follows:

Technology 1) Manually loaded and unloaded notching press. Both the stator and rotor plates are
processed separately using the same machine.

Technology 2) Robot served notching press. This technology is essentially similar to Technology
1), except that the worker is replaced by an industrial robot equipped with appropriate handling
devices.

Technology 3) Automatic single press. The notching press is equipped with a special purpose
workpiece loading and unloading mechanization.

Technology 4) Automatic tandem press. In this technology two presses are arranged around a
workpiece handling device, so that both stator and rotor plates are cut simultaneously. The first
press cuts the stator plate while the second press cuts the rotor plate cut off from the center of the
previous stator plate.

The parameters relevant to the cost functions of the four technologies are listed in Table 7.

Table 7. Cost parameters of the notching technologies presented in the case analysis of automated parts
manufacturing. The common parameter values are the same as in the previous cases, see for example Table
6.

Technology Maximum Investment Labor Rent Linear Investm. Tools'

prod. rate variable cost in tools durability
# [units/year] [kFIM] [workers] [kFIM/year] [FIM/unit] [kFIM] [units]
1 315 3500 1 25 720 1500 10000
2 500 5000 0.15 75 500 1500 10000
3 1000 6500 0.25 50 500 2000 10000
4 1600 11500 0.4 100 460 2000 10000

In this case, the investment in machinery rises significantly as the mechanization and speed of the
equipment increase. The amount of labor required for set-ups and supervision of machinery does
not differ much in automated technologies. It is about 2.5 hours per unit produced in Technology 2
and about 2 hours in Technologies 3 and 4. The cost functions are shown in Figures 35 and 36.
74

10000
9000 Manually served press
Cost per unit, [FIM]

8000 Robot served press

7000 Automatic single press
6000 Automatic tandem press
5000
4000
3000
2000
1000
0
0 500 1000 1500 2000 2500 3000
Units produced per year

Figure 35. Cost functions of the various technologies available for notching of electric motor stator and
rotor core sheets.

8000
7000
Cost per unit, [FIM]

Total
6000
Fixed
5000 Labor
4000
3000
2000
1000
0
0 500 1000 1500 2000 2500 3000
Units produced per year

Figure 36. Total average cost curve of the notching process example as a set of the smallest values of the
total average cost curves of the different technologies shown in Figure 35. The labor and fixed cost curves
show their corresponding extents.

In this case, the unit costs obtained with the mechanized technologies are much lower than those
obtained with the manual technology. The cost function of the total process exhibits a saw-tooth
shape as expected. The cost varies significantly depending on how well the capacity of the
particular technology is utilized at each production rate. The cost at 800 units per year is about 8
% higher than that at 1600 units per year, where the first minimum cost of Technology 4 appears.

3.5.5 Mechanized parts manufacturing with different levels of operator presence at different
hours of the day, i.e. automation without operator presence

Sometimes the manufacturing process can be automated to such a level that operator supervision is
not needed and the process can be left running unattended for several hours. In such cases the
 75

labor cost is reduced and uncomfortable working hours can be avoided. Consequently the
economies of scale are larger than those with constant manning. The largest possible cost
decreases for individual automated technologies are calculated for different fixed costs and
unmanned night shifts in Table 8. The parameter values are the same as those in Table 4 in the
case of constant manning. Comparison with the values of Table 4 clearly shows that higher
economies of scale can be reached with unmanned operation during night shifts.

Table 8. Maximum cost increases at suboptimal production rates with different fixed costs and unmanned
night shifts. The parameter values are: minimum labor cost 100 FIM/h, shift compensations approximately
average for the Finnish metal industry, indivisibility parameter a1 = 3, interest rate 7 %, obsolescence age of
equipment 10 years and linear variable cost zero.

Annual Rent etc. Machinery value Cost increase Cost increase

fixed cost at 50% of xmin at 75% of xmin
[kFIM/year] [kFIM/year] [kFIM] [%] [%]
200 40 1120 63 % 9%
500 50 3150 75 % 16 %
1000 80 6440 70 % 21 %
4000 140 27020 91 % 29 %
7000 200 47600 95 % 31 %

A similar random process examination as for the constantly manned and automated processes was
performed for processes with an unmanned night shift. The results of the calculations of such a
case, which is otherwise identical to that in Figure 27, are given in Figure 37.

350
300 Total
Cost per unit, [FIM]

250 Fixed
Labor
200
150
100
50
0
0 20 40 60 80 100 120
Units produced per year

Figure 37. Cost function as an average of 20 random manufacturing processes with an unmanned third shift.
Three different technologies with economies of scale are available. The first technology is fully manned
and the two faster technologies are manned during the day and evening shifts. The parameter values are the
same as in the example shown in Figure 27 for the constantly manned process. The average investment cost
at the local minimum at 79 units per year is about 5.0 MFIM.

The minimum cost in this case is lower than that for the constantly manned process, 152 FIM per
unit at 79 units per year production rate, compared to the 158 FIM at 78 units per year. The cost
76

increase at 50 % of the 79 unit production rate is 26 % and 12 % at 75 %. The corresponding

figures for the constantly manned process were 22 % and 9 %.

The result of the random process analysis indicates that the shape of the cost function is similar to
those of the constantly manned and automated processes. Clearly the economies of scale and the
fixed cost to labor cost ratio are higher than those for the constantly manned process.

Case - Machining FMS

This case deals with costs of technologies available for machining electric motor frame housings.
The housings are approximately 1.5 - 2 m long, made of cast iron. They require extensive
machining of the stator bore and the various attachment surfaces. The technologies consist of the
following operations:

Technology 1) Turning of the stator bore in a manually operated vertical lathe. Milling of the
various attachment surfaces in a manually operated boring machine.

Technology 2) Machining of the frame in a large horizontal machining center (HMC).

Technology 3) Machining of the frame in a flexible manufacturing unit (FMU), which consists of
a large horizontal machining center and a workpiece pallet storage for automatic work piece
change.

Technology 4) Machining of the frame in a flexible manufacturing system (FMS), that consists of
two horizontal machining centers and a workpiece pallet storage for automatic work piece change.

The parameters of the cost functions of the four technologies are listed in Table 9.

Table 9. Cost parameters of the machining technologies presented in the case analysis of automated parts
manufacturing with partly unmanned operation. The other parameter values are the same as those in the
previous examples, see e.g. Table 6.

Technology Maximum Investment Labor Rent Linear

prod. rate variable cost
# [units/year] [kFIM] [workers] [kFIM/year] [FIM/unit]
1 1700 3500 2 200 450
2 3400 9500 1 75 400
3 3540 12000 1 150 400
4 7200 21000 2 200 350

The cost functions of the technologies are shown in Figures 38 and 39. The costs curves of partly
unmanned technologies 3) and 4) are almost monotonously decreasing even at the highest
production rates. The cost increase from the minimum cost at 50 % of the minimum cost
production rate is 10 % in this case. The shape of the cost curve and cost structure at different
production volumes in Figure 39 conform well with the results of the random calculations; see
Figure 37.
 77

5000
4500 Manual machine tools
4000 HMC
Cost per unit, [FIM] FMU
3500
3000 FMS
2500
2000
1500
1000
500
0
0 1000 2000 3000 4000 5000 6000 7000
Units produced per year

Figure 38. Cost functions of the various technologies for machining of electric motor stator frames. HMC =
horizontal machining center, FMU = flexible manufacturing unit and FMS = flexible manufacturing
system.

5000
4500
4000 Total
Cost per unit, [FIM]

3500 Fixed
3000 Labor
2500
2000
1500
1000
500
0
0 1000 2000 3000 4000 5000 6000 7000
Units produced per year

Figure 39. Total average cost curve of the example of a partly unmanned machining process, as the set of
the smallest values of the total average cost curves of the different technologies shown in Figure 38. The
labor and fixed cost curves show their corresponding extents.

3.5.6 Continuous processes

A continuous process here means a manufacturing process in which one or more physical
properties, except the dimensions, of the object are made to change continuously. Typically the
capacity of the process equipment can be determined almost steplessly at the construction stage.
Usually the minimum investment required for the process is high. This is typical to manufacturing
processes that are based on physical or chemical reactions. In mechanical engineering industries
the most common examples of continuous processes are different kinds of heat treatment of metal
parts. Other typical characteristics of continuous processes are a high ratio of equipment capital to
labor and ease of automation. The economies of scale are often large and can be increased by the
78

low cost of added capacity due to the large physical size of the components. The steplessly
adjustable equipment size and capacity lead to a very smooth cost function. All these
characteristics are present in the following example.

Case - Impregnation

The windings of electric motors are impregnated with plastic resin in order to provide them with
the proper insulation and mechanical strength. The process consists of impregnation in a large
pressure vessel and curing in an oven. The size of the impregnation tank can be easily increased
with only a modest increase in price of the pumps, pipes, heat exchangers, and other such process
equipment. The number and size of ovens can be chosen freely. The equipment representing the
various “technologies” - in which the process is the same - are listed as follows.

Technology 1) One impregnation vessel and four ovens.

Technology 2) One impregnation vessel and six ovens.
Technology 3) One impregnation vessel and eight ovens.
Technology 4) Two impregnation vessels and 12 ovens.

The impregnation vessel and the ovens are loaded and unloaded manually. The curing time is
several hours and the usual practice is to leave the ovens unattended overnight. Thus the labor cost
function for unmanned night time operation is used. The cost parameters of the equipment are
given in Table 10. The relatively high linear variable cost is due to the included cost of the
impregnation resin.

Table 10. Cost parameters of impregnation technologies presented in the case analysis of continuous
processes. The other parameter values are the same as in the previous examples, see e.g. Table 6.

Technology Maximum Investment Labor Rent Linear

prod. rate variable cost
# [units/year] [kFIM] [workers] [kFIM/year] [FIM/unit]
1 2800 6000 2 168 1000
2 4250 7000 3 175 1000
3 5680 8000 4 200 1000
4 8500 11000 6 300 1000

The cost functions related to this case are shown in Figure 40. The cost increase at 50 % of the
minimum cost production rate is 4.9 %. This would be 13 % in the case of a zero linearly variable
cost. More variations of the equipment could be given, but the total process cost curve would not
change significantly.
 79

5000
4500 1 tank and 4 ovens
Cost per unit, [FIM]
4000 1 tank and 6 ovens
3500 1 tank and 8 ovens
3000
2 tanks and 12 ovens
2500
2000
1500
1000
500
0
0 1000 2000 3000 4000 5000 6000 7000
Units produced per year

Figure 40. Cost functions of the different equipment combinations for impregnation of electric motor
windings.

3.5.7 Economies of scale with increased unit labor cost and decreased fixed cost

It was shown in Section 3.4.5 that it is theoretically possible to maintain economies of scale from
one technology to another with increased unit labor cost and decreased fixed cost. The limiting
conditions concerning the relationships between the different cost components of the two
technologies in such a situation were discussed in that section.

All the examples presented above exhibited an increasing fixed cost and decreasing or constant
labor cost per unit in the transition from slower to faster technologies. This is logical in the
mechanization of relatively simple processes, where machine movements are faster than those of
humans and the forces required are often large. Numerical control of machines and development
of sensor technology have made it possible to increase the accuracy and controllability of machine
operations beyond the skills of humans. For these reasons it is unlikely that mechanized
manufacturing operations would be slower than manual ones. The mechanization is expensive but
frees humans for other tasks, at least by reducing the time spent in the manufacturing of one unit.
However, assuming that such slow, mechanized technologies exist, likely candidates would
probably consist of assembly or other such operations, where great flexibility is required and the
set-up time of the mechanized technology is long. Humans can generally be considered flexible
and their set-up times short compared with machines.

In order to be able to evaluate the effect of increased unit labor cost and decreased fixed cost on
the total process cost function, one should define criteria for such an effect. This is done here by
comparing the values of the cost function of the slower technology LRAC1 with those of the faster
technology LRAC2 at their minimum cost and minimum production rates; see the situation in
Figure 20.

By studying the conditions in Section 3.4.5 for economies of scale with increased unit labor cost
and decreased fixed cost, it can be concluded that such a condition is most significant when both
the fixed cost and the difference between the maximum production rates are large.

This significance is studied in the light of an example assembly process. It is assumed that the
faster technology is run by one person and the slower technology is automated, so that the labor
80

cost per unit is about 75 % of the labor cost of the faster technology. The faster technology is
twice as fast as the slower one, which means that the operator’s working time per unit in the case
of the slower technology is 37.5 % of that of the faster one. The minimum labor cost is 100 FIM /
hour in both cases. The equipment investment values are 1.4 MFIM for the slower technology and
1.0 MFIM for the faster technology, the economic life-time is 10 years and the interest rate 7 %. If
other costs are zero, LRAC1(x1min) is 3.8 % larger than LRAC2(x2min) and LRAC2(x1min) is 3.8 %
larger than LRAC1(x1min). LRAC1(1) is 30 % larger than LRAC2(1). This particular example is
shown in Figure 20. Test calculations using the above higher fixed cost but other parameter ratios
have not produced significantly larger differences between the cost function values.

Larger differences can be obtained with higher fixed costs, but such technologies do not appear
realistic. The above percentage values have been obtained assuming other costs are zero. Practical
linear variable cost values would reduce the relative deviation figures considerably. It appears that
a situation where economies of scale with increased unit labor cost and decreased fixed cost
appear at the transition from a slower technology to a faster one is not likely to exist in practice.
Even if it did exist, its effect would be insignificant. For these reasons such a situation is not
considered in the rest of this study.

3.5.8 Conclusions on the cost functions of mechanical engineering manufacturing processes

Based on the analysis in Section 3.4 of an individual process and also based on the examples of
mechanical engineering manufacturing processes in particular it can be concluded that:

1. Long-run average costs are decreasing functions of production volume.

2. The costs decrease rapidly at first until the capacity of the first unit of the slowest technology is
fully utilized or some other technology becomes more efficient. After the initial decrease the
costs decrease at a slowing rate or approach a constant value.
3. The more labor intensive the technologies, the smoother the cost curve.
4. When more than one technology exists an increasing fixed cost is a necessary but not sufficient
condition of economies of scale.

3.6 Cost of capital employed in the work-in-process

The cost of capital employed in the work-in-process concerns the total process. This issue is
examined in the following, before a discussion on construction of the cost function of the total
process in the next chapter.

For simplicity, it is assumed that the costs of inputs are paid as they are allocated to the products
during the production process. Similarly, cash is assumed to be received as the products are
completed. The production is assumed to be distributed evenly throughout the year. - The capital
costs of long-lived equipment accumulated before the equipment is used for production was
discussed in Section 3.2.

In the long run, the average work-in-process is always directly related to the average through-put
time. Interest cost accumulates in calendar time and through-put time should be measured in
similar terms. Consequently the running hours of the process directly affect the through-put time.
As has been seen, more capital intensive technologies may justify more annual running hours and
thus a shorter through-put time.
 81

Manufacturing process through-put time

With a given number of annual running hours, the factors which determine through-put time can
be examined from the point of view of queuing theory. According to this theory, the total through-
put time of a production process depends on the utilization rate of the resources, the batch
processing times, and the number of processing units. It is also assumed that arrival times and
processing times conform to known types of random distributions. These factors are discussed in
the following paragraphs.

It is assumed that in the long run the utilization rate is not affected by the scale of output. Whether
the factory is small or large, it is assumed that it is underloaded and overloaded by the same
amount in relative terms.

A large scale justifies efficient production methods with shorter processing times. In addition the
number of serial processing steps and corresponding queues is often reduced by more integrated
technology. Both of these effects appear in the typical manufacturing processes discussed in this
study. A large volume may justify larger batch sizes and fewer set-ups, and thus improve
efficiency, but it may also increase through-put time because of large batch sizes.

The randomly distributed arrival and processing times can be best avoided by efficient production
control and improved process stability. According to experience, production control is best
supported by a layout for flow production. This is usually only justified by a sufficient volume in
each process step, for it to be sufficiently far on its cost curve. Otherwise individual subprocesses
would have to be shared between parts of different processing levels or would have to belong to
different products and total processes. This would confuse the flow of production and is therefore
excluded from the present study by means of the assumptions made in the study.

A large volume speeds up learning, and helps to reduce disturbances and stabilize the process
faster, but large scale production also has some drawbacks from the point of view of through-put
time. A large number of orders may simply be more difficult for humans to understand and
control, even if the proper production control tools and procedures are available.

The technical diseconomies were mentioned in Section 2.5.2 as another potential drawback. The
large physical size of high capacity departments in industrial plants may prevent visual production
flow control and may imply long transportation distances.

Cost of work-in-process

The capital employed in the work-in-process depends on the structure of the total production
process. This determines the rate at which the manufacturing costs accumulate. Figure 41 shows a
typical S-shaped curve that demonstrates the accumulation of costs as a function of through-put
time.
82

2000000
1750000
Production cost, [FIM]

Total
1500000 Material
1250000 Labor
1000000
750000
500000
250000
0
38

42

46

50

10

14

18

22

26
2

6
Time, [weeks]

Figure 41. The accumulation of costs during the manufacturing of a large electric motor.

The annual cost of the work-in-process per unit can be calculated as follows:
T

Cwip = i ∫ (T − t ) C(t ) dt (49)

0

where

i = annual interest rate,

t = through-put time variable in fractions of a year,
T = total through-put time,
C(t) = rate of accumulation of production cost of one unit as a function of through-put time
variable.

The production through-put times of products in the make-to-order mechanical engineering

industry typically vary in the range of 3 to 20 weeks. If it is assumed that the work-in-process
accumulates linearly from zero during this time and that the annual opportunity cost of capital is 7
%, the cost of the work-in-process varies between 0.2 % and 1.3 % of total production costs.

There are other costs associated with the work-in-process in addition to capital costs, such as
material handling and storage costs. In the literature these are often covered by a higher interest
rate than otherwise used61.

Although it appears that the through-put time should be somewhat shorter with a larger output, the
overall effect of this is small. Consequently, the scale of production is assumed to have no effect
on the amount of work-in-process per unit produced. It is also assumed in the calculations used in
the rest of this study that production cost accumulates linearly over the through-put time t up to T.

61
Chase R. B., Aquilano, N. J. 1992. Page 649.
 83

The final outcome, however, is that the value of the work-in-process is smaller with a higher
output. This is because the economies of scale reduce the average cost and thus capital employed
in production per unit.

3.7 Total manufacturing process

3.7.1 Long-run cost function

The cost function of the total manufacturing process is formulated as the sum of the cost functions
of the individual processes and the costs of work in process:

TLRAC = ∑ LRACi + Cwip , (50)

where

TLARC = Long-run average manufacturing cost of the product as a function of annual

production volume,
LRACi = Long-run average cost function of process i as in Equation 42,
Cwip = annual cost of work-in-process per unit produced.

It is assumed that the costs of manufacturing support functions that are not specific to the
individual processes are nevertheless allocated to the processes and are included in the linear
variable cost of each process. Examples of such functions are quality assurance and data
processing support. Production management and other support functions less directly related to
manufacturing are discussed separately later.

3.7.2 Random simulation of the long-run manufacturing cost function

The cost function of the total manufacturing process is a sum of different functions, each of which
is a set of the lowest parts of other sum functions. Because of its complexity, this form does not
serve the practical applications of the cost function very well. In this section, the shape of the cost
curve as a function of production volume is analysed. In the next section a computationally easier
functional form is searched for by means of statistical fitting. The analysis is based on process cost
functions that are randomly generated within the relevant constraints and ranges of parameter
values. One real life example is also presented.

The number of parameters in the manufacturing cost functions of a factory is so large that an
exhaustive enumeration of all combinations of values is not possible. On the other hand, the
practical value ranges of parameters can be estimated, while correlations between most parameter
values are not evident. Therefore random simulation was used in order to obtain a representative
presentation of the form of the cost function. The parameter values were assumed to be uniformly
distributed within their ranges.

The individual subprocesses that form the total process are mechanical engineering processes of
the types described in Section 3.5. Each subprocess consists of 1 - 4 different technologies with
economies of scale. The costs of the subprocesses are summed in variable proportions in order to
achieve realistic combinations of process types and cost structures. The procedure used to generate
cost functions of the individual subprocesses is summarized in the form of a flowchart in Figure
42, and described in detail in the following:
84

Start random process cost

function generation

1. Generate maximum production

rate for fastest technology.

2. Generate max. production rates for

other technologies. Sort ascending.

3. Determine minimum labor rate for

slowest technology.

4. Generate investment cost for

slowest technology.

5. Calculate cost function of

slowest technology.

6. Generate minimum labor rate for

next, faster technology.
.
7. Generate investment cost for
same technology.

8. Calculate cost function of

same technology.

Yes 9. Any more

technologies
left?

No
10. Select smallest values of cost
functions of the different
technologies to obtain cost function
of the subprocess.

End

Figure 42. Procedure used to generate the cost functions of the individual subprocesses of a total
manufacturing process.

1. The maximum production rate of the fastest technology available for the subprocess in question
is chosen. The value is generated as a uniformly distributed random number between the
predetermined fastest production rate of one piece of the fastest equipment and the smallest
possible value of the slowest technology. The fastest possible rate was set at 100 and the
smallest at 5 in all the experiments. For the same production volume this would require 20
parallel units of the slowest possible technology per single unit of the fastest possible
technology. In practice the fast technology would most likely be capital intensive and the slow
technology would be manual work. Thus it would follow that the slow technology would
operate less shifts and more parallel units would be required. Based on experience, the value of
5 seems sufficiently small in relation to 100.
 85

2. The maximum production rates of the other technologies available are generated as uniformly
distributed random numbers between 5 and the maximum number obtained in the previous step.
The minimum value 5 is used for the same reasons as above. - The number of technologies is
varied between 1 and 4 for each subprocess in all the experiments. The production rates are
sorted in an ascending order.

3. The minimum labor rate per unit produced is determined for the slowest technology. The value
of 100 FIM was chosen for constantly manned processes.

4. The investment cost for the equipment needed by the slowest technology is determined. For
manual work it is set at zero and for continuous processes it is set at a predetermined value. For
all other - mechanized - processes the investment cost is generated as a uniformly distributed
random number between the minimum and maximum values. The maximum value is
determined as the product of the maximum production rate of the technology and a constant
parameter. The parameter value is predetermined according to the type of process. - The largest
parameter value used was such that the maximum investment cost of one unit of the slowest
mechanized technology was 4 MFIM. Three levels of parameter values were used in different
experiments. The minimum investment cost was always 5 % of the maximum value. The
obsolescence age used was 10 years and the interest rate was 7 % in all of the experiments.

5. The numerical cost function for the slowest technology is calculated as explained in the
previous chapters for the different process types.

6. If more technologies exist, the minimum labor cost value for the next technology is determined.
This is inversely related to the ratio of the speed of this and the slowest technology for
constantly manned technologies. For automated technologies the minimum labor cost is
generated as a randomly distributed number between 20 % and 100 % of the minimum labor
cost of the previous slower technology. 20 % instead of zero has been chosen as the lower limit
because at least some set-up work is always needed. The amount of this kind of work is
typically high in make-to-order production because of the small batch sizes and the high
variability of products.

7. The investment cost of the equipment used by the technology is generated as a randomly
distributed number between its possible minimum and maximum values. These values are
determined using constraints defined in Equations 43 and 45 in order to guarantee economies of
scale.

8. The numerical cost function for the technology is calculated as explained in the previous
chapters for the different process types.

9. Steps 6 to 8 are repeated as long as more technologies exist.

10. The smallest values of the cost functions of the different technologies are selected to form the
cost function of the individual subprocess; see Equation 42.

The cost functions obtained using the procedure described above were then summed up and the
interest on work-in-process was added to obtain the cost function of the total manufacturing
process; see Equation 50.

A series of simulations was performed in order to generate cost functions for different total
processes. The number of subprocesses was 20 in each total process simulation. Two sets of
different subprocess types were used. Each set of subprocesses was weighted with 10 different
86

weights so that more of different process combinations and cost structures were obtained. The
weights were chosen with the aim of creating total processes of different natures.

Table 11 shows one combination of process types, initial investment values and the weight matrix,
which always remained the same. In those weight combinations where some of the weights are
zero, the total number of processes is less than 20.

Table 11. One set of parameters and the process weights used in the random simulation experiments of the
total manufacturing process. Labor cost per unit
at first technology
Inv. cost at first
technologies

technology
Number of

Number of
processes

Process Total process number / weight-%

[kFIM]
[FIM] 1 2 3 4 5 6 7 8 9 10
Manual work 1 0 100 2 10 30 40
Constant manning 1 200-4000 100 2 10 5 5
2 200-4000 100 2 10 10 5 10 20
3 200-4000 100 2 10 10 5 10 10 20
4 200-4000 100 2 10 5 5 10 10 20
Long lived tools 1 400-8000 100 1 5 10 5 10 20 30 20
Automation 1 200-4000 20-100 1 5 5 10 20 10 20
2 200-4000 100 2 10 10 5 10 10 20
3 200-4000 100 2 10 10 5 10 20 10 10 20 20
4 200-4000 100 1 5 5 10 20 10 20
Continuous process 4 8000 100 1 5 5 10 20 30 20
Unmanned operation 3 200-4000 100 1 5 10 5 10 20 30 20 20
4 200-4000 100 1 5 5 10 20 30 20
Number of processes in use in each total process 20 16 20 14 6 5 5 13 7 9

Table 12 shows a summary of the results obtained in a random simulation made with the
parameter values shown in Table 11. The minimum cost and the corresponding production rate are
shown to compare the effects of the different weightings. The cost increases at sub-optimal
production rates are shown to evaluate economies of scale. Investment values can be related to the
realism of the cost of the machinery.

Table 12. Summary of results recorded in the total manufacturing process random simulation experiments.
The results in this table are from a simulation made using the parameter values shown in Table 11.

Total process number 1 2 3 4 5 6 7 8 9 10

Minimum cost production rate [units/year] 77 108 120 77 77 77 77 108 80 108
Minimum cost [FIM/unit] 147 138 134 138 112 115 138 147 135 149
Cost increase at 75 % of min. cost rate [%] 5 1 2 7 10 14 12 2 6 2
Cost increase at 50 % of min. cost rate [%] 9 2 3 11 22 28 16 4 3 3
Cost increase at 25 % of min. cost rate [%] 30 10 10 34 56 64 48 14 23 13
Ave. inv. per process at smallest rates [MFIM] 0.7 0.4 0.5 0.7 0.7 0.9 1.0 0.7 0.5 0.7
Ave. inv. per process at min. cost rate [MFIM] 3.3 3.3 3.6 3.7 3.6 3.8 3.9 4.3 3.3 4.1
 87

3.7.3 Approximation of the long-run manufacturing cost function

The cost functions obtained in the simulation experiments were used to find analytical
approximations for the total cost curve. The values of the cost function were calculated at 240
equally spaced points between zero and 120 % of the maximum production rate, which was 100.
Different functional forms were fitted to the cost values by trial and error. The objective was to try
to find a simple form that would fit the data as closely as possible, with a minimum number of
parameters.

The production rate range taken into account in the curve fitting was 3 - 120. Rates smaller than 3
% of the maximum production rate of any one technology were considered irrelevant. On the other
hand, the cost values of the smallest production rates are highest and thus their influence on the
curve fitting is relatively strong. The range was extended to 120 units because the levelling of the
curve seemed to continue beyond the highest production rate.

The goodness of fit of the model was evaluated using a regression quantity R2. The statistical
computer program used was the Curve Fitting section of NCSS 97. Since there is no direct R2 for
non-linear regression, the program uses a pseudo R2 which approximates the regular R2 value used
in linear multiple regression62. According to the program documentation, it serves well for
comparative purposes:

∑ (Yi − Y$i )
2

R = 1−
2
2 , (51)
∑ (Yi − Y )

where

Yi = value of variable,
Y$i = predicted value of Yi,

Yi = average of Yi.

The program estimates the parameters of the model using the Levenberg-Marquardt nonlinear
least-squares algorithm with numerical derivatives63.

Fractional power sum functions seemed to work well with two terms and two to four parameters.
Table 13 shows the parameter values and goodness of fit for four functions, which were the
models fitted.

62
Hinze, J. L. 1997. Page 1329.
63
Nash, J. C., Walker-Smith, M., 1987. Pages 203 - 215.
88

Table 13. Parameter values and goodness of fit of four functions approximating the total manufacturing
process cost functions. The parameters of the approximated processes are shown in Table 11.

Total process: 1 2 3 4 5 6 7 8 9 10
Model Parameter/Fit
Ax b + Cx d A 1556 1107 1167 1464 1400 1699 1937 1544 1191 1699
b -0.99 -1.08 -0.97 -0.91 -0.78 -0.79 -0.87 -1.07 -0.93 -1.08
C 72 104 72 50 11 6 22 96 69 92
d 0.14 0.05 0.11 0.19 0.45 0.56 0.35 0.08 0.12 0.09
R2 0.999 0.998 0.998 0.998 0.994 0.990 0.996 0.997 0.996 0.999
Ax -1 + C A 1353 880 1034 1382 1571 1897 1927 1238 1118 1343
C 130 127 121 123 102 103 120 132 124 132
2
R 0.988 0.986 0.988 0.990 0.989 0.983 0.987 0.984 0.990 0.984
Ax b + C A 1789 1218 1338 1699 1655 2038 2307 1723 1344 1910
b -1.19 -1.22 -1.18 -1.14 -1.04 -1.05 -1.13 -1.23 -1.12 -1.24
C 140 134 129 131 105 108 130 143 129 144
2
R 0.997 0.998 0.996 0.995 0.989 0.984 0.991 0.996 0.994 0.997
-1 d
Ax + Cx A 1575 1036 1195 1572 1683 2063 2179 1457 1256 1590
C 76 87 80 75 73 62 59 78 88 72
d 0.12 0.09 0.10 0.11 0.08 0.12 0.16 0.12 0.08 0.14
R2 0.999 0.998 0.998 0.997 0.991 0.986 0.994 0.997 0.996 0.998

Parameter values and results of all experiments are shown in Appendix C.

In order to give an idea of the meaning of the magnitude of R2, two typical cost curves with fitted
models are shown in Figures 43 and 44. These are the least and best fitting model and process
combinations from Tables 11, 12 and 13.

500
450
Total
Cost per unit, [FIM]

400
350 Model
300 Fixed
Labor
250
200
150
100
50
0
0 20 40 60 80 100 120
Units produced per year

Figure 43. The cost functions of process number 6 from Table 11. This is a highly automated and
mechanized process with 4 different types of subprocesses. The total number of subprocesses is 5. The
sharp corners in the cost curve are due to the small number of subprocesses and their capital intensity. The
parameter values of the fitted total average cost model of the form A/x + C are from Table 13. The smooth
form of the model curve can only follow the average form of the actual cost curve. The R2 goodness of fit is
0.983.
 89

500
450

Cost per unit, [FIM]

400 Total
350 Model
300 Fixed
250 Labor
200
150
100
50
0
0 20 40 60 80 100 120
Units produced per year

Figure 44. The cost functions of process number 1 from Table 11. This is a combination of 13 different
types of subprocesses. The total number of subprocesses is 20. The parameter values of the fitted total
average cost model of the form Axb + Cxd are from Table 13. The R2 goodness of fit is 0.999. The model
curve is very closely on top of the actual cost curve and is thus hard to distinguish.

Clearly all four models approximate the values of the original function rather well. The more
parameters are used, the better the fit. It seems that the value of coefficient b, the power index of
the first term, is rather close to negative unity. Thus the function resembles the simple fixed cost
and linear variable cost model. However, this is a coincidence, since here neither the capital cost
nor the labor cost are constant or linear.

The form Axb + C is perhaps the preferred form. Since its fit is good, it has only three parameters
and it does not have a minimum, which is a characteristic expected of a long-run average cost
function. It also has the constant C, in which linear variable costs can be included, without
complicating the form further. Linear variable costs were not taken into account in the simulations.

The approximation functions seem to fit best when the number of processes is high and they are
labor intensive. This is natural, since the curves are then smoother and all the models used are
smooth by nature.

3.8 Example of long-run manufacturing costs

In order to demonstrate the results obtained above, a practical example of the manufacturing costs
of a total manufacturing process is presented. The case concerns the manufacturing of large
electric motors. Six of the processes involved were presented as examples in Section 3.5. The
other processes, technologies and products are not explained in detail. The input cost data are
given as required by the parameters of the cost functions. Material costs are not included in the
cost functions.

The example manufacturing process is a make-to-order production process typical of the

mechanical engineering industry. It consists of 14 subprocesses involving parts manufacturing,
subassembly, assembly, testing and shipping. Eight of the processes can be considered parts
manufacturing, including impregnation and balancing. The number of assembly processes is 4. 41
technologies in total are distinguished, although the differences between them may be small in
some cases. From the point of view of economies of scale, 14 technologies can be considered
90

manual, 15 manned mechanized, 4 automated, 4 partly unmanned, and 4 continuous. Six of the
mechanized or automated technologies involve expensive tooling. The parameters of the cost-scale
curves for the different processes are summarized in Appendix D.

The average through-put time of the products is 4 weeks. The interest rate used in the calculations
for the capital costs of the work-in-process is 7 %.

The average cost curve for the total process along with fixed, labor, and variable components and
an approximation model are shown in Figure 45.

80000

Total
Cost per unit, [FIM]

60000 Model
Fixed
Labor
40000 Variable

20000

0
0 1000 2000 3000 4000 5000 6000
Units produced per year

Figure 45. The average cost curves of the electric motor manufacturing process in the example. The simple
approximation model (8 549 850 / x + 24 645) FIM of the total average cost function is shown. The model
curve is hard to distinguish from the actual cost curve, because the fit is very good; R2 = 0.9981.

The cost curve has a minimum value at a production rate of 6300 units. The unit cost increases
about 1 % at 75 % of that rate. The cost increase is about 4 % at 50 % of the minimum cost
production rate and 15 % at 25 %. - Based on visual assessment, the cost functions of all the
individual processes are at least as smooth as the ones graphically presented in Section 3.5.

The forms of the approximation functions, which were the same as those fitted to the randomly
generated processes, were fitted to the average cost function of the total process. The results are
shown in Table 14.

Table 14. Parameter values and goodness of fit for models approximating the average manufacturing cost
functions of the example process.

A b C d R2
Ax b + Cx d 7397499 -0.96 19928 0.024 0.9985
Ax -1 + C 8549850 24645 0.9981
Ax b + C 10448600 -1.04 24863 0.9984
Ax -1 + Cx d 8855713 22236 0.012 0.9985
 91

The original cost curve is smooth and it is clear that all four models approximate it very well. This
is also visible in Figure 45, where the least-fitting model curve is shown.

In none of the processes in this example did the fixed cost decrease or constant labor cost per unit
increase when slower technologies were replaced by faster ones.

3.8.1 Elasticity of capital-labor substitution

Since the example manufacturing process described above is considered well representative, factor
substitution will be discussed next in the light of it. The analysis concerns the total process and
thus in a way represents the average of its subprocesses.

The costs of the example process are now calculated using two capital-labor price ratios other than
the one used above, in order to study the elasticity of capital-labor substitution; see Section 2.1.
Capital cost is taken to represent capital input. It includes here the cost of machinery, fixtures,
tools and rent. Value-adding working hours are taken to represent labor input. The other price
ratios are obtained by doubling and halving the labor price while the cost of capital is kept
unchanged. The capital-labor input ratios at different output rates and the factor price ratios are
shown in Figure 46.

100
Capital-labor input ratio

capital-labor price ratio = 1/2

80 capital-labor price ratio = 1/1
capital-labor price ratio = 2/1
60

40

20
0 1000 2000 3000 4000 5000 6000 7000
Units produced per year

Figure 46. Capital-labor input ratios at different output rates and different capital-labor price ratios used for
the example process. The vertical scale is given in relative numbers. However, one unit equals FIM per
value-adding labor hour.

The capital-labor input ratio falls as the production volume increases. This is expected, and is due
to the increased utilization and to more efficient technologies at higher outputs. The homotheticity
of the manufacturing process, often assumed in cost and production studies, implies that factor
ratios only depend on factor prices and stay constant at different scales of output. This would mean
that the choice of technology does not depend on scale. This is contrary to experience and the
assumptions for the random simulations made previously. The production process in this example
is clearly non-homothetic.

The capital-labor input ratio is higher with lower capital-labor price ratios, which indicates that
there is some elasticity of substitution between these factors. The proportionate change in the
92

factor price ratio between capital and labor was 100 % in those two cases in which the labor cost
was doubled. The elasticity of substitution between these factors can therefore be calculated as the
proportionate change in the factor ratios. The average of the elasticities thus calculated for the two
doublings of the labor price is shown in Figure 47 for different scales of output.

0,25
Capital-labor elasticity of

0,20
substitution

0,15

0,10

0,05

0,00
0 1000 2000 3000 4000 5000 6000 7000
Units produced per year

Figure 47. Average elasticity of substitution between capital and labor inputs at different scales of output.

The elasticity is higher at lower production rates, except at the very lowest ones. This can be
explained by the greater availability of alternative technologies. However, the values of elasticity
are low in general. A consequence of this is clearly seen in Figure 48, where capital costs are
shown in the cases of the different factor price ratios at different scales of output. The capital cost
is higher despite the higher labor cost, since some of the labor intensive technologies are
substituted by more capital intensive technologies. The differences in capital costs are small. In
practice other factors than costs may also effect substitution. Quality aspects in particular are
likely to reduce the variability of technology even further.

40000
Capital cost per unit, [FIM]

Capital-labor price ratio = 1/2

30000 Capital-labor price ratio = 1/1
Capital-labor price ratio = 2/1

20000

10000

0
0 1000 2000 3000 4000 5000 6000 7000
Units produced per year

Figure 48. Capital costs for the different factor price ratios at different scales of output.
 93

3.8.2 Process utilization

Since the manufacturing equipment was assumed to be indivisible, its utilization rate at different
scales is of interest. The utilization rate was calculated for each subprocess and for the cost-
minimizing technology in use at each annual production rate. The calculation was carried out in
relation to the maximum production rate and the cost-minimizing rate of the cost-minimizing
technology in use at each annual production rate. The average utilization of the 14 subprocesses at
different production rates is shown in Figure 49.

100 %

80 %
Utilization

60 %

40 % U/opt. capac., capital-labor price ratio = 2/1

U/opt. capac., capital-labor price ratio = 1/1
U/opt. capac., capital-labor price ratio = 1/2
20 % U/max. capac., capital-labor price ratio = 2/1
U/max. capac., capital-labor price ratio = 1/1
0% U/max. capac., capital-labor price ratio = 1/2
0 1000 2000 3000 4000 5000 6000 7000
Units produced per year

Figure 49. Average utilization rate of the process at different factor price ratios and output scales. The rates
are given with respect to the maximum production rate (lower curves) and optimal cost-minimizing
production rate (upper curves) of the technology in use at each output rate.

The utilization rate increases as far as the highest output rates shown. There are only a few
technologies used, the maximum production rates of which are higher than the end of the scale
drawn. Accordingly utilization cannot be expected to significantly rise further.

The utilization rates in relation to maximum production rates are the highest with the highest
capital-labor price ratio. This is as expected, since the optimum utilization rate is generally higher
in the case of capital intensive technologies than in the case of labor intensive technologies.

The situation in relation to the optimum utilization rate is more complicated. The highest capital-
labor price ratio produces utilization rates that are furthest below the optimal rate at high
production rates. The reason is that, on average, a very high optimum utilization rate is impossible
to reach in practice, because the desired production rates of units of equipment usually fall below
their maximum values. Another reason is that, in the case of more mechanized technologies, the
maximum production rates are higher, and the cost curves level out at relatively higher production
rates than in the case of less mechanized technologies.

It may be concluded that the overall cost effect of the relationship between technology, factor
prices and the resulting utilization rate has to be considered separately in each case as it arises.
94

4 COSTS OF MATERIAL SUPPLY, ORDER HANDLING AND PRODUCTION

MANAGEMENT

4.1 Material supply

The unit costs of materials are usually considered constant in cost function studies. In make-to-
order production the vertical integration of the manufacturing process is often rather short.
Consequently the share of material costs in the cost structure of the products is high. Thus it is
well-founded to take a brief look at these costs.

The total cost of material supply can be formulated as a sum of the purchase cost, ordering cost,
and holding cost:64

TC = DC + (D/Q)S + (Q/2)H (52)

where

TC = Total cost,
D = Material demand,
C = Material unit cost,
Q = Order quantity,
S = Cost of placing an order,
H = Holding cost per unit of inventory.

The classic formula for economical order quantity, EOQ, has been derived from Equation 52:

EOQ = 2 DS H (53)

The effect of volume on each main item in the total cost Equation 52 is examined in the following
for make-to-order manufacturing of mechanical engineering products. Ordering-related costs are
discussed first, then the holding costs, and finally the scale effects for some common groups of
materials.

4.1.1 Ordering costs

Ordering costs are assumed to consist of the costs of procurement and inbound transportation of
the purchased material.

Procurement

Indivisibilities are a major source of scale effects in procurement. One-time costs related to the
opening of a supply channel can be distributed over the whole volume purchased during the

64
Chase R. B., Aquilano, N. J. 1992. Page 649.
 95

duration of the supply relationship. Contract negotiation, quality assurance, establishment of a

purchasing routine, and first time trial costs belong to this cost group.

Ordering is a regularly repeated activity whose one time costs can be spread over the volume
purchased in a single order. Specialization materializes in the form of a continuous development of
the purchasing routine and improved knowledge of the particular field of technology.

The extent of the scale effect depends largely on the standardization level of the parts and
materials purchased. Standard large volume materials and parts can be purchased to stock in large
quantities. Economies of scale in the distribution of initial and reordering costs over a large
purchased volume can be utilized. If standard parts are purchased separately for each project, only
the initial costs can be shared. If the parts are non-standard, no economies of scale can exist. In
such a case the purchasing effort and cost increase are directly related to the volume.

The magnitude of procurement cost is typically 0.5 % - 2 % of the cost of the purchased material
in for type of industry in question.

Transportation

The transportation costs were already discussed in connection with the distribution of end products
in Section 2.5.2. This issue will be re-examined in the application concerning optimal plant
locations in Chapter 6.

Unlike in the case of end products, large volume of parts and materials often lowers transportation
costs, because the quantities handled are smaller. The one-time dispatching costs can be shared by
a larger volume. This is valid up to a shipment weight of about 20 metric tons, which is the typical
maximum weight of a truck load.

Table 15 shows a random extract from the inbound domestic freight data for a Finnish mechanical
engineering factory in 1993.

Table 15. Inbound domestic freight data for a Finnish mechanical engineering factory in 1993. Collected by
the author from original data.

Shipment size Shipments Total weight Total cost Unit cost

[kg] # [kg] [FIM] [FIM/kg]
<50 201 4607 11827 2.57
50 - 199 259 27024 23253 0.86
200 - 499 204 63543 33755 0.53
500 - 1499 299 267921 102289 0.38
1500 - 2999 205 437472 100883 0.23
3000 - 4999 113 436096 67119 0.15
5000 - 9999 103 693044 87682 0.13
10 000 - 20 000 39 530970 51878 0.1
> 20 000 17 454929 29483 0.06
Total / Average 1440 2915506 508169 0.17

The same cost data are plotted graphically against shipment weight in Figure 50. A power function
has been fitted to the data.
96

2.5
Unit cost, [FIM/kg]

2
-0.5018
y = 11.108x
1.5 2
R = 0.9887
1

0.5

0
0 2000 4000 6000 8000 10000 12000 14000 16000
Shipped unit weight, [kg]

Figure 50. Shipment unit cost as a function of shipment weight in the example case.

The fitted function shows that, if the weight of the shipments were e.g. doubled, the average cost
of transportation per unit would be reduced by 30 %. It is realistic to assume that with proper
organization of logistics as production increases, this can be of some benefit.

4.1.2 Holding cost

Stock keeping costs include depreciation and rent for storage facilities, handling, insurance,
breakage, obsolescence costs, and the opportunity cost of capital. All of these are usually
approximately directly related to the amount and value of the material in stock. Typical total
values presented in the literature are 30 % - 35 % annually.65

The economical order quantity in Equation 53 increases in relation to the square root of demand.
Therefore, the stock level should decrease per unit of output when the production volume
increases. However, the benefit is small, since the proportion of stocked materials to all materials
is usually small in this type of production.

4.1.3 Purchase cost

Pecuniary economies

Large buyers may be able to utilize their bargaining power and obtain lower prices from their
suppliers at the expense of smaller buyers. These are called pecuniary economies66. Although there
may be real economies of scale involved in the production of larger volumes, it may be difficult to
distinguish the two effects from one another. The following discussion on the different types of
commodity tries to find a real justification for the scale effects found or not found in practice.

65
Chase R. B., Aquilano, N. J. 1992. Page 642.
66
Pratten, C. F. 1971. Page 17.
 97

One practical problem with a low vertical integration of production is that pecuniary economies
can not be easily utilized when many different subcontractors are buying the same material
separately. This is especially a problem with steel parts.

Economies of scale at the supplier

In the following, the economies of scale in the supply of some material types common in the
mechanical engineering industry are discussed. A major source of data concerning the economies
of scale of different materials has been the previously mentioned study by Pratten.

Steel

Cold rolled construction steel with thicknesses of 1 - 3 mm is commonly used for cover parts,
boxes, and the like in mechanical engineering industry. Hot rolled steel is used for heavy
constructions such as shafts, frames etc. Forged steel is normally used only for parts that require
high strength, such as shafts and other force transmitting machine components.

According to Pratten67 the minimum efficient scale of a steel mill producing a range of rolled
materials is about 4 million metric tons per year. The production cost increase at 50 % of
minimum efficient scale is about 8 % according to the same source. The steel consumption of a
make-to-order mechanical engineering factory is typically some tens of thousands of tons at most.
These volumes alone are too small to have any influence on the production costs of steel works.
Consequently the real economies of scale attainable are negligible.

Welded steel fabrications

The main process steps in turning a steel sheet into frames, cover parts, etc. are cutting, bending,
welding, and surface treatment. Hot rolled sheets are normally flame- or plasma cut by the
contractor or at a steel wholesaler’s service center. The service center concept guarantees the high
utilization of efficient machinery. Bending and welding are machine-assisted manual operations
where reasonable efficiency can be reached at quite low volumes. Large batch sizes can produce
substantial savings in the set-up cost. The overall cost saving is limited by the share of the cost of
materials out of the total cost of parts, which typically varies between 30 % and 50 %.

Surface treatment normally consists of blasting and primer painting for thick sheets and washing,
primer treatment, and painting of thin sheets. For environmental reasons, the thin sheet treatment
process requires expensive equipment, but it can normally be subcontracted and thus the costs can
be kept low even at small production volumes.

Iron castings

Typical cast iron components in the mechanical engineering industry are complex machine casings
and frame blocks, bearing assembly parts, etc. The minimum efficient scale for this type of casting
is about 10 000 tons and the cost increase at 50 % of that scale is about 10 %68. The consumption
of a mechanical engineering factory can form a substantial share of the minimum efficient scale.
From this it can be concluded that significant economies of scale can be obtainable.

67
Pratten, C. F. 1971. Page 122.
68
Ibidem. Page 131.
98

Machined metal parts

The hot rolled steel plate parts and iron castings mentioned above are also the main metal parts
processed by machining. Efficient machining involves high levels of investment, specialization,
high levels of utilization, and if possible, a large batch size. Subcontractors can normally offer
high efficiency in all other respects except specialization. They tend to use flexible standard
machinery in order to minimize volume sensitivity. The most efficient machine tools are always
dimensioned according to the products they are used for. Stable and long term supplier
partnerships are required to convince the subcontractors to invest in specialized machinery.
Nevertheless, high efficiency may sometimes be reached by subcontractors using existing
machinery for some simple workpieces.

Substantial economies of scale can be achieved in machining. The cost reduction for value-added
can be 30 % - 40 % from 50 % of the minimum efficient scale to 100 % of it. The share of material
cost in large castings and welded constructions is typically 60 % - 70 % of the total cost. For small
simple components such as bearing assembly parts it is typically 30 % - 40 % of the total cost.

Standard components

The possible benefits from economies of scale in the case of standard mechanical engineering
components such as bolts, nuts, and bearings are often minor in make-to-order production. The
volumes used are so small in relation to manufacturing volumes that significant additional
economies of scale can not be realized.

Such standard parts that are manufactured according to the specification of the end product
producer can be a major source of economies of scale. Since they are usually mechanical
engineering components themselves, the relative advantages are large at small manufacturing
rates.

4.1.4 Example of total material costs

The total economies of scale are demonstrated here with an example concerning electric motor
manufacturing. The data presented here is later used in an example of total production costs.

The most important stocked materials in make-to-order electric machine production are the stator
core steel sheet, copper wire, insulation materials and various small standard parts such as
bearings, bearing parts, fans, fan covers, and terminal boxes. The stocked materials form about 45
% of the value of a motor’s materials in this example. The rest of the materials are purchased
separately for each project. The level of standardization of these parts varies from a standard item
to a one-of-a-kind part.

The economies of scale for each commodity were estimated, weighted according to their cost
share and summed. The result of the total economies of scale in materials supply is presented in
Figure 51. The ordering cost, holding cost and material cost are shown separately together with the
total cost.
 99

80000
70000
Cost per unit, [FIM] 60000
50000
40000 Total material supply cost
30000 Purchase cost
Ordering cost
20000
Holding cost
10000
0
0 1000 2000 3000 4000 5000 6000
Annual production volume, [units]

Figure 51. Material supply costs for the case example as a function of production volume.

The learning function of Equation 11 was fitted to the total material cost data. Here the
improvement relates to the scale, not to the cumulative output. The cost improvement ratio
calculated from the fitted model for the total material supply cost is 95.5 %. This means that the
cost would decrease by 4.5 % each time the volume is doubled. The improvement ratio for the
ordering cost is about 65 %.

4.2 Order handling

Order handling in make-to-order production is a process where the scale effects from
specialization can be substantial. Order validation, order acknowledgement, pre-cost calculation,
project scheduling, quality planning, project start-up, order design engineering, order cancellation
and changes, and the follow-up are stages of this process. The organizational functions concerned
are usually project management, engineering, work planning, production planning, and cost
calculation. In order to be efficient the process requires standardized products, procedures and
software tools. Justifying their development requires a sufficient volume.

Project management involves a lot of non-standard communication with customers, the amount of
which increases with the increase in output. Project follow-up tools and standard forms, check
lists, quality plans, meeting agenda etc. have to be created to make the work more efficient.

Order design engineering heavily relies on the use of calculation and drawing tools. Opportunities
for developing these tools and automating the process are virtually endless. In addition, experience
accumulates with cumulative output. This experience is documented in drawings and data files and
thus is not forgotten. Of course - again - effective tools must exist for locating and reaching this
information when needed.

Work planning can also be automated in a standardized process. Human interference could
probably be eliminated completely from the function. Production planning and cost calculation
usually only require minor effort and can be made very efficient with the proper tools.

The potential efficiency improvement in the order handling process is difficult to estimate and is
not modelled here.
100

4.3 Production management

Although management efficiency is largely outside the scope of the study, a cost effect must be
defined in order to keep the total production cost within the right magnitude for the application in
Chapter 6. In addition, the management issue has already been discussed in Sections 2.5.2 and
2.5.3. It was concluded that, theoretically, the cost of management is almost directly related to the
number of workers in a hierarchical organization and this cost behavior is assumed in this study.
Work supervision, numerical control programming and testing engineering costs are included in
the appropriate process costs in the examples.
 101

5 EXAMPLE OF A TOTAL PRODUCTION PROCESS

The total long run average production costs for the case product, the electric motor, are shown in
Figure 52. The different cost groups have already been presented in detail in the various examples
in the previous sections. The costs of these groups were summed up in order to obtain the average
cost of the total production process.

The project and production management consists of the various processes as described in Sections
4.2 and 4.3. The manufacturing cost includes the costs of the manufacturing processes as described
in Section 3.8. The total material supply cost includes the actual material cost, the purchasing cost,
inbound transportation cost, and the holding cost; see Section 4.1 for details.

250000

Total production cost

200000 Model
Cost per unit, [FIM]

Total material supply cost

150000 Manufacturing cost
Project and production management

100000

50000

0
0 1000 2000 3000 4000 5000 6000
Units produced per year

Figure 52. Summary of the long-run average production costs of the example product. The approximation
model (6 678 137 x-0.853 + 84 787) FIM of the average cost function is shown. The model curve is plotted
on top of the actual cost curve, the goodness of fit R2 = 0.999.

The same approximation functions as before were fitted to the average cost curve of the total
process. The curve is smooth and a good approximation was achieved using all the functional
forms. The form Axb + C is shown in Figure 52. This function was chosen for the plant location
application in the next chapter.
102

6 APPLICATION OF LONG-RUN COST FUNCTIONS TO THE PLANT LOCATION

PROBLEM

6.1 Introduction

The profitability of a firm’s operations depends on the location of its production facilities in
relation to the markets. By optimizing the location the expected revenues from customers and the
total costs can be affected. In order to reduce costs of transporting products to customers and to
shorten service times, it makes sense to build factories close to customers. However, practical
production usually involves economies of scale, and consequently production has to be always
more or less concentrated.

The optimal production location depends on the demand served, production level, production
technology, and costs of factors of production. These parameters and variables should be
considered and solved simultaneously. Although the optimal solution may not be achieved in
practice, it is important to analyse the effects of such factors in order to obtain an insight into the
problem.

The allocation of a firm’s production is an important part of its strategy. Practical decisions on
location of production are affected by expectations of macroeconomical development in the
various market areas, the firm’s operating policies and earlier decisions. However, it is important
for the decision maker to be able to quantify the effect of the basic decision variables on the final
outcome. These effects are analysed in the present application study in the light of representative
examples.

Scope of the plant location study

The central problems that the study deals with are:

− What is the allocation of production minimizing costs when all markets are served in a given
market share?
− What is the allocation of production maximizing profits, assuming constant prices if all markets
can be served up to a given market share?
− What are the answers to the above questions when the maximum transportation time is limited?

The objectives of the study are to determine the cost-minimizing or profit-maximizing production
locations, output levels and demands served for given market shares in different market areas, and
given production and transportation cost functions.

The optimization criteria in this study are costs or profits depending on the problem formulation.
The decision variables are the locations and number of production units, their served market areas
and their production levels. The given parameters are a set of possible production locations,
market areas, market sizes, customs tariffs and the opportunity cost of invested capital. It is
assumed that the transportation costs per unit of distance are decreasing functions of distance and
that the average production costs per unit are decreasing functions of production volume. The
parameters of these functions are given as well as the transportation times between the production
locations and markets.
 103

The problem formulations assume a static situation. Effects of changes of demand in the long run
are not analyzed. Effects of short-run variability of demand are also outside the scope of this
study. It is assumed that these kinds of uncertainties have already been taken into account in the
parameter values describing the static situation studied.

It is also assumed that the product mix is constant and independent of location, and consists of one
average product or standard product mix. The production cost function and factor prices are also
assumed to be similar and independent of location.

The research approach used is operations analysis. Facility location problems have traditionally
been treated in the literature on operations research using mathematical methods. The method used
in this study is an application of mathematical programming models to the problems formulated,
followed by their solution using available software.

6.2 Production location problems

This section introduces production location problems in general and the basic prototype problem,
i.e. the simple plant location problem. Two important features of production location problems are
also introduced, namely the end point optimality property and the single assignment property.

Production location problems involve the location of one or several facilities serving a spatially
distributed set of customers. The spatial topology of these markets may be a continuous line or
plane, or a network with discrete nodes. The objective of the problem is to optimize a spatially
dependent criterion. Typical such criteria can be average travel distance, maximum travel distance
or total cost.

Hundreds of papers have discussed facility location problems since the beginning of this century.
Comprehensive reviews of literature and problems are available, for example in Brandeau and
Chiu69 and Francis, McGinnis and White70. They show that location problems can be classified
according to many different criteria. Brandeau and Chiu present several choices of objectives,
decision variables and system parameters. Francis, McGinnis and White classify location models
as planar, warehouse, network and discrete. Discrete models are the only ones in their
classification that involve fixed costs and a predefined set of possible locations.

Production location problems represent the kind of facility problem, where the choice of
production input mix determined by the chosen technology is considered simultaneously with the
decision on location71. In production location formulations the inbound unit cost of transportation
and unit costs of inputs are usually assumed to be independent of location.

6.2.1 The simple plant location problem

In the simple plant location problem production locations are chosen from a given set of
possibilities in order to meet the given demand from a set of customers. A fixed cost and linear

69
Brandeau, M. L., Chiu, S. S. 1989.
70
Francis, R. L., McGinnis, L. F., White, J. A. 1982.
71
Hurter, A. P., Martinich, J. S. 1989. Pages 2 - 4.
104

variable costs including transportation are assumed for the whole period considered. The objective
is to minimize total costs z. The problem can be formulated as follows72:
m n m
minimize z = ∑ ∑ Vij xij + ∑ FY
i i (54)
i =1 j =1 i =1

subject to

∑x
i ∈I
ij = 1, j = 1,..., n, (55)

0 ≤ xij ≤ Yi, i = 1,..., m, j = 1,... n, (56)

Yi ∈ { 0,1}, i = 1,..., m, (57)

where

n = the number of markets,

m = the number of potential plant locations,
Fi = the fixed cost at plant i,
Vij = the total variable production and transportation cost of supplying all of market j’s
demand from plant i,
xij = proportional part of market j’s demand supplied by plant i,
Yi = 1 if plant i is operative, 0 otherwise.

Constraint 55 guarantees that each market’s demand is fully satisfied. In order to maximize profits,
it will be demonstrated later, that it is easy to relax this requirement and modify the objective
function to include prices.

The simple plant location problem was introduced in the 1960s in several papers and has been
studied extensively ever since. Krarup and Pruzan73 thoroughly review the issue. The problem is
NP-hard, which means that the time taken to find the optimal solution increases exponentially as
the number of decision variables increases. A wide array of solution methodologies has been
developed. The formulation has been extended to include capacity constraints, multiple periods,
multiple products and uncertainty.

The combined fixed cost and linear variable cost model can be used to approximate continuous
economies of scale due to change in technology. However, it is difficult, since the real total cost
curve is non-linear. Piecewise linear cost models have been used by Feldman, Lehrer and Ray74
and others to approximate continuous scale effects. This method is laborious and complicated and
no practical applications have been reported. In fact, very few practical applications have appeared
in the literature to any variation of the simple plant location problem. The main reason for this
may be that the formulation requires the individual cost parameters to be determined separately
prior to solving. On the other hand, the technology and cost parameters are dependent on the

72
Krarup, J., Pruzan, P.M. Page 40.
73
Ibidem.
74
Feldman, E. F., Lehrer, F. A., Ray, T. L. 1966.
 105

production volume, which was one of the variables to be optimized. Consequently the problem
formulation separates the choice of technology from the choice of location and volume.

6.2.2 End point optimality

It has been shown that, if total transportation costs are concave functions of distance, the total
costs can only be minimized by locating plants at the ends of arcs connecting the possible
production locations75. In practice the transportation costs are concave functions of both
transportation weight and distance. Consequently, restricting the possible production locations to a
set of nodes in a network does not reduce the usefulness of such location models. Of course, if
transportation times or other non-cost criteria are used as constraints, this characteristic may not be
valid.

6.2.3 Single assignment property

If unit production costs of the plants are continuously decreasing functions of production volume
and their capacities are unlimited, the optimal solution involves that each market is served by only
one plant76. This characteristic is called the single assignment property. It can be used to simplify
computational methods of solving plant location problems.

6.2.4 Solution techniques for the simple plant location problem

The simple plant location problem is a mixed 0-1 integer programming problem with 2mn possible
solutions. Here m and n denote the numbers of possible plant locations and markets. There is no
simple way of telling whether or not a given solution is optimal. Thus the most efficient
techniques for solving these problems are based on enumeration.

A complete enumeration, by evaluating all possible solutions quickly becomes impossible because
of their large number. Thus it is necessary to try to exclude as many solutions as possible from the
explicit evaluation. Such methods are normally based on the “branch and bound” technique. The
concept in this method is to try to divide the problem into groups of subproblems, i.e. branches,
and then try to eliminate whole groups. The elimination is based on finding bounds for goodness
of the branch’s best solution. If it can be shown that the bound excludes the optimal solution, the
branch does not need to be considered any further. Step by step descriptions of the method can be
found in any of the operations research books. The credit for the most efficient solution algorithm
to the simple plant location problem is generally given to the DUALOC algorithm by
Erlenkotter77.

Although many efficient algorithms have been developed for solving the simple plant location
problem, it is likely that many practical problems can be reduced to a size in which they are easily
solvable without sophisticated mathematical methods. Plant locations may often be excluded due
to their distance, small local market size, political aspects or other such reasons.

75
Hurter, A. P., Martinich, J. S. 1989. Pages 45 - 59.
76
Krarup, J., Pruzan, P.M. 1983. Page 52.
77
Erlenkotter, D. 1978.
106

6.3 Plant location problems with economies of scale due to technological specialization

The simple plant location problem only considers economies of scale due to the distribution of the
fixed cost over a number of products. In the following, the location models utilize a power cost
function obtained in the previous chapter. This expresses the economies of scale also due to
technological specialization and other reasons.

6.3.1 Cost-minimizing plant location model with fixed demand

First, the basic problem of the simple plant location model is modified to include the power cost
function.

Problem formulation

The plant’s average unit cost function model used in the study is of the form

LRAC = Ax b + C, (58)

where

x = the number of units produced annually,

A,b,C = cost coefficients.

The transportation cost function takes the same power function form as the learning curve function
in Equation 11. In this case the variable x represents distance.

It is assumed that due to the make-to-order nature of the business in question, the average
transportation cost per unit of weight is known and can be used for all shipment sizes.
Consequently the cost of transportation per unit can be predetermined for each plant-to-market
distance.

The total cost is obtained by combining the production cost from Equation 58 and the
transportation cost for each supplier-market combination. Taking into account the single
assignment property, and assuming the model in Equation 58 is valid, minimization of the total
cost is expressed by the following equation:

m⎡ ⎛ n ⎞ (1+ b ) n n ⎤
minimize z ∑ A⎜ ∑ xij ⎟
= ⎢ + ∑ Cxij ∑ tij xij ⎥ ,
+ (59)
i =1 ⎢ ⎝ j =1 ⎠ ⎥⎦
⎣ j =1 j =1

subject to
m

∑x
i =1
ij = Dj , j = 1, .., n, (60)

x ij ≥ 0, i = 1, ..., m, j = 1, ..., n, (61)

where in addition to the notation used at the simple plant location problem and Equation 58,

xij = the number of units produced at plant i and shipped to market j,

tij = cost of shipping one unit from plant i to market j,
 107

Dj = demand at market j.

The formulation is a one of a non-linear optimization problem. This formulation is possible, since
the cost function does not involve a fixed cost. In the optimal solution xij is zero or equal to Dj
because of the single assignment property. Solution methods for non-linear optimization problems
are not reviewed here; a wealth of literature exists on the subject.

All the solutions presented in the following have been obtained using Microsoft Excel Solver
software78. It does not guarantee the optimality of the results. They were checked by
experimentation using a number of other initial variable values.

Example

The production in this example deals with electric motors. It is assumed that each plant produces a
similar average machine or a similar mix of machines. The cost function, given in Chapter 5, is
assumed to be similar for all locations.

The market areas, demands and the approximate customs tariffs for imports into the market areas
are shown in Table 16. The market areas are grouped into sets of countries within the same
geographical area and with similar economical characteristics. The most important characteristic
in this sense is a common customs agreement. The estimation of the relative sizes of markets was
based on published values of general economic indicators.

Table 16. Market areas, market sizes, and average customs tariffs for imports into the market areas. The
tariff is given as a percentage of the sales price.

Market area Market share, [units] Share of total market Tariff

Western Europe 1265 25 % 4%
Eastern Europe, incl. e.g. former USSR 434 9% 11 %
North America 1332 27 % 5%
South America 213 4% 21 %
South Asia, incl. e.g. India 114 2% 28 %
Japan 548 11 % 0%
SE Asian NICs 422 8% 14 %
East/SE Asia, incl. e.g. China 540 11 % 18 %
Australasia 52 1% 6%
Middle East and North Africa 29 1% 10 %
Sub-Saharan Africa 50 1% 20 %
Total/Average 5000 100 % 8%

Table 17 shows the possible production locations and the average transportation time between
them and the markets. Australasia, and Middle East and North Africa are excluded as possible
production locations due to their distant location and small demand. West Europe is represented by
France and Finland.

78
Microsoft Excel Version 5.0c Solver. 1994.
108

Table 17. Average transportation times between production locations and market areas in the examples.
Production locations are listed in the first row.

Sub-Sah. Africa
SE Asian NICs
N. America

S. America

E/SE Asia
E. Europe
Finland

S. Asia
France

Japan
Transportation time, [days]
To/from:
Western Europe 5 1 1 16 20 23 36 30 35 24
Eastern Europe 4 2 1 19 23 26 39 33 37 27
North America 19 15 18 3 20 30 20 27 23 28
South America 24 20 24 21 3 32 33 36 33 23
South Asia 27 23 26 30 28 1 24 11 17 16
Japan 39 36 39 20 36 24 1 11 6 26
SE Asian NICs 32 28 31 28 37 9 13 4 11 18
East/SE Asia 36 29 31 24 32 16 11 8 1 23
Australasia 39 36 38 26 26 22 19 18 20 21
Middle East and North Africa 18 14 18 22 28 14 28 22 27 19
Sub-Saharan Africa 25 22 25 27 15 16 26 19 24 1

The transportation cost functions used to calculate the costs of transportation are shown in Figure
53. The cost functions and transportation times have been compiled from data provided by
companies active in these service markets. The compilation process is not explained here in detail.
The average transportation distances between plant locations and market areas were obtained from
various distance tables and from maps. The calculated average transportation costs are given in
Appendix E. They typically vary from one to four percent of the sales price of the product. The
customs tariffs and the opportunity cost of the capital invested in the products during
transportation are included in the transportation costs in the model. The interest rate used as the
opportunity cost is 7 %.

600

500 Road transportation

Transportation cost,
[FIM/1000 tonkm]

400 Sea freight

-0.2011
y = 1886.8x
300

200 -0.7821
y = 154786x
100

0
0 5000 10000 15000 20000 25000
Transportation distance, [km]

Figure 53. Average road and sea freight transportation cost functions used for the products in the examples
of plant location optimization.
 109

The solution of the minimization problem in Equation 59 yields the results shown in Table 18.
With a total market share of 5 000 units the minimum cost is achieved using one factory located in
East/Southeast Asia.

Table 18. Calculated solution of the cost-minimizing plant location problem. 1 in the Market area/Supplier
matrix denotes that the plant supplies the demand of all of the market areas. 0 denotes that there is no
factory in the supplier area.

Market size, [units] /

Sub-Sah. Africa
SE Asian NICs
N. America

S. America

E/SE Asia
E. Europe
Finland

S. Asia
France

Japan

totals
Market area/Supplier
Western Europe 0 0 0 0 0 0 0 0 1 0 1265
Eastern Europe 0 0 0 0 0 0 0 0 1 0 434
North America 0 0 0 0 0 0 0 0 1 0 1332
South America 0 0 0 0 0 0 0 0 1 0 213
South Asia 0 0 0 0 0 0 0 0 1 0 114
Japan 0 0 0 0 0 0 0 0 1 0 548
SE Asian NICs 0 0 0 0 0 0 0 0 1 0 422
East/SE Asia 0 0 0 0 0 0 0 0 1 0 540
Australasia 0 0 0 0 0 0 0 0 1 0 52
Middle East and North Africa 0 0 0 0 0 0 0 0 1 0 29
Sub-Saharan Africa 0 0 0 0 0 0 0 0 1 0 50
Total supply, [units] 0 0 0 0 0 0 0 0 4999 0 4999
Total production cost, [MFIM] 0 0 0 0 0 0 0 0 447 0 447
Transportation cost, [MFIM] 0 0 0 0 0 0 0 0 20 0 20
Tariff, [MFIM] 0 0 0 0 0 0 0 0 49 0 49
Interest on WIP, [MFIM] 0 0 0 0 0 0 0 0 3 0 3
Total cost, [MFIM] 0 0 0 0 0 0 0 0 519 0 519

In order to get a rough idea of how much the total cost would increase if the number of plants in
the major market areas were changed, the costs for a set of non-optimal arrangements were
calculated. Additional constraints were added so that plants were assumed to exist in just Europe,
just North America, in both Europe and North America, in both East/Southeast Asia and North
America, in both Europe and East/Southeast Asia and in Europe, East/Southeast Asia and North
America. The corresponding total cost increases were 1.3 %, 2.0 %, 2.3 %, 0.7 %, 0.9 %, and 1.9
%. Were the total market share halved to 2 500, a similar three factory configuration as above
would increase the total cost by 5.7 % as compared to the cost-minimizing one-factory
configuration.

If the total market increased in size while the relative shares remained the same, the optimum
number of factories would be increased to two by a factory in Europe, once the total market
reaches approximately 7 000 units. One factory in North America would be added to the cost-
minimizing configuration at a volume of approximately 7 300 units. A factory in the Southeast
Asian Newly Industrialized Countries would be added when the total market reaches 8 300 units.
110

It appears that the cost effects become significant only if the production rates are in the steeply
downward sloping part of the cost curve. Such a situation, of course, is in practice possible if
either the total market is small or too many factories exist.

6.3.2 Profit-maximizing plant location model

The competition may push the price level below the average costs achievable in some markets.
This may happen due to the competitors’ lower costs, better quality or for some other reason.
However, it may become more profitable to leave these markets unserved.

Problem formulation

Assuming same price level at all markets, the profit-maximizing problem formulation is as
follows:
(1+ b )
⎡n ⎛ n
m ⎞ n n ⎤
Maximize π = ∑ ⎢∑ Px ij − A⎜ ∑ x ij ⎟ − ∑ Cx ij − ∑ t ij x ij ⎥ (62)
i =1 ⎢ j =1
⎣ ⎝ j =1 ⎠ j =1 j =1 ⎥⎦

subject to
n

∑x
j =1
ij ≤ Dj , j = 1, ..., n, (63)

x ij ≥ 0, i = 1, ..., m, j = 1, ..., n, (64)

where in addition to the previous notation

P = unit price of products.

Constraint 63 has been modified from the corresponding constraint of the cost-minimizing
formulation so that is does not require the markets to be fully served.

Example

The previous example is extended to maximizing profit. Assuming the initial situation shown in
Table 18, the price level is gradually lowered. Since the price level is assumed to be constant in all
market areas, the only difference compared to the cost-minimizing problem formulation is that the
unprofitable markets are not served.

The first markets not to be served would be South Asia, South America, and Sub-Saharan Africa,
in that order. The situation then changes completely and it would be more profitable then to have a
factory in West Europe, while the markets served would be West and East Europe, North America,
Japan and Australasia. All of these are low tariff markets.

However, the situation concerning the profitability of the different markets may change, if the
existence of several factories is re-considered in order to achieve a high market share in all
markets. This is demonstrated in the next section, where maximum limits are set for the
transportation times. This is done in order to enforce a more uniform geographical distribution of
factories.
 111

6.3.3 Cost-minimizing and profit-maximizing plant location models with fixed constraints on
transportation time

In the previous examples, the production and transportation cost minima are achieved by a high
centralization of production. However, since the market in similar situations in reality is usually
served by several plants in different countries, it is also evident that other factors have to be taken
or have been taken into account. Figure 54 shows the distribution of delivery times for the
products in the examples from customer order to readiness at the factory to ship to the local
markets. It is assumed that this distribution represents the distribution of requested delivery times,
i.e. the demand from customers. Also assuming that the distribution is similar in all markets and
comparing the delivery times in Figure 54 with the transportation times in Table 17, it appears that
all markets cannot be served equally well from a single location. This problem is tackled in the
following by adding a transportation time limit as an additional restriction.

100 100 %

80 %
Relative frequency

75
60 %
50 Frequency
Cumulative % 40 %
25
20 %

0 0%
13
17
21
25
29
33
37

41
45
49
53
57
61
65
5
9

Delivery time, [weeks]

Figure 54. Distribution of delivery times from customer order to delivery from the factory to the local
markets. This is taken to represent the delivery time demand from customers.

Problem formulations

The problem formulations are similar to those with the cost-minimizing model in Equations 59 -
61 and the profit-maximizing model in Equations 62 - 64, except that an additional constraint must
be satisfied:

Tij ≤ R i = 1, ..., m, j = 1, ..., n, (65)

where

Tij = transportation time from plant i to market j,

R = transportation time constraint.

The transportation times between plants and markets are considered to be known; see for example
Table 17.
112

The end point optimality property is not applicable under this constraint. However, since no cost is
associated with the time constraint, the existing location set of Section 6.3.1 is maintained.

Example

The solution to the minimum cost problem, assuming a transportation limit of 21 days, is shown in
Table 19. The optimum result is a three-factory configuration. The total production cost is 2.1 %
higher than the one-factory minimum cost configuration without transportation time constraints.

Table 19. Solution to the cost-minimizing plant location problem with maximum transportation time of 21
days. The shaded rectangles represent the plants and markets between which the transportation time
exceeds the limit.

Market size, [units] /

Sub-Sah. Africa
SE Asian NICs
N. America

S. America

E/SE Asia
E. Europe
Finland

S. Asia
France

Japan

totals
Market area/Supplier
Western Europe 0 1 0 0 0 0 0 0 0 0 1265
Eastern Europe 0 1 0 0 0 0 0 0 0 0 434
North America 0 1 0 0 0 0 0 0 0 0 1332
South America 0 1 0 0 0 0 0 0 0 0 213
South Asia 0 0 0 0 0 0 0 0 1 0 114
Japan 0 0 0 0 0 0 0 0 1 0 548
SE Asian NICs 0 0 0 0 0 0 0 1 0 0 422
East/SE Asia 0 0 0 0 0 0 0 0 1 0 540
Australasia 0 0 0 0 0 0 0 0 1 0 52
Middle East and North Africa 0 1 0 0 0 0 0 0 0 0 29
Sub-Saharan Africa 0 0 0 0 0 0 0 1 0 0 50
Total supply, [units] 0 3274 0 0 0 0 0 471 1254 0 4999
Total production cost, [MFIM] 0 300 0 0 0 0 0 56 125 0 481
Transportation cost, [MFIM] 0 11 0 0 0 0 0 1 3 0 15
Tariff, [MFIM] 0 25 0 0 0 0 0 2 5 0 32
Interest on WIP, [MFIM] 0 1 0 0 0 0 0 0 0 0 1
Total cost, [MFIM] 0 336 0 0 0 0 0 59 134 0 530

According to the profit maximization objective, markets served and production locations are
rejected if they are unprofitable. For the example case in Table 19 the following development then
arises. - By adjusting the price level it is found that the Sub-Saharan African market is first to
become unprofitable, followed by the South Asian market, then the South American market and
next the Southeast Asian Newly Industrialized Countries’ market. Further price reduction reduces
the production volume at the East/Southeast Asian plant so much, that it becomes unprofitable for
any market and is removed.

6.3.4 Cost-minimizing plant location problem with market share constraints depending on
transportation time

A fixed transportation time limit may be a practical criterion for market allocation planning, but it
is not very elegant and certainly not optimal.
 113

Not all orders are delivered within the shortest possible time. Therefore only some of the orders
must be delivered from a factory close to the market. Normally the contracted delivery time
distribution, for example that of Figure 54, and the minimum through-put time in production for
the products in question are known. The transportation times from the plant locations to the
markets are also known. This makes it possible to constrain the allocated market for each plant
according to the share of orders that the plant is capable of delivering on time. In other words this
means a strategy, based on which the delivery capability of a large, cost-efficient factory or
factories is complemented by small local factories.

Problem formulations

The optimized cost functions are similar to those of the cost-minimizing model, Equation 59, and
the profit-maximizing model, Equation 62, but the additional Constraint 66 has also to be satisfied
while Constraint 65 is no longer valid:
m

∑x ij ≥ F ( T ) Dj , ∀T ∈[TFT , ∞ ) so that TFT + Tij ≤ T , j = 1, ..., n, (66)

i =1

where in addition to the previous notation

F = cumulative delivery time distribution function,

TFT = standard flow time in the factory, i.e. minimum delivery time for the products at the
factory.

Constraint 66 guarantees that each market j is served with at least the share of the demand
requested at each delivery time T only by those plant locations i from which the delivery time is
short enough.

Example

The formulation of Constraint 66 is demonstrated in the light of the example data used in this
chapter. The standard factory flow time is taken to be 9 weeks. The cumulative distribution
function of Figure 54 is used, but modified so that the curve is lowered by 5 % units. Thus the
cumulative function is at 0 % at 9 weeks delivery time. Transportation times shorter than one week
are considered negligible. The share of each market that can be reached within the requested
delivery time is shown in Table 20.

A share which is out of reach of a production location has to be served from other locations. For
example, in order to fully satisfy the demand of the Southeast Asian Newly Industrialized
Countries within the requested time, at least 5 % of the market would have to be delivered from
the area itself. At least 10 % of the market would have to be served by factories in the same area,
South Asia, Japan and East/Southeast Asia together. The allocation between these four locations
would depend on the solution to the problem.

The matrix is interesting as such: The bottom line of the table shows the share of total market that
can be reached from each location within the one week. It appears that North America is the
optimum location for a factory from this point of view. However, the differences between the
locations are rather small.
114

Table 20. Maximum market shares that can be served within the requested delivery time from the different
production locations. One week’s transportation time or less is considered negligible. All units are in
percentages.

% of total market
Sub-Sah. Africa
SE Asian NICs
N. America

S. America

E/SE Asia
E. Europe
Finland

S. Asia
France

Japan
Market area/Supplier
Western Europe 100 100 100 90 90 85 76 81 81 85 25
Eastern Europe 100 100 100 90 85 85 76 81 76 85 9
North America 90 90 90 100 90 81 90 85 85 81 27
South America 85 90 85 85 100 81 81 76 81 85 4
South Asia 85 85 85 81 85 100 85 95 90 90 2
Japan 76 76 76 90 76 85 100 95 100 85 11
SE Asian NICs 81 81 81 85 76 95 95 100 95 90 8
East/SE Asia 76 81 81 85 81 90 95 95 100 85 11
Australasia 76 76 76 85 85 85 90 90 90 85 1
Middle East and North Africa 90 90 90 85 85 95 81 85 85 90 1
Sub-Saharan Africa 85 85 85 85 90 90 85 90 85 100 1
% of total 89 90 90 91 86 86 87 87 87 85

The cost-optimized production and market area allocation is shown in Table 21 for the previously
used case; see e.g. Table 18. According to this result, if all markets are to be served, it pays to
centralize most of the production in three large factories. The distant markets would be served
from smaller local factories whenever the main factory can not deliver on time due to the
transportation time. Consequently, the delivery time distribution for the local factories would be
totally different from the one shown in Figure 54. The cost penalty of this arrangement is 7.3 % of
total production and logistics costs compared to the minimum cost configuration in Table 18.
 115

Table 21. Cost-minimizing plant location and market allocation configuration with transportation time
dependent market share constraints. All markets are to be served allowing one week for transportation time.
A longer time is allowed for those markets in which there is no possible factory location. The figures in the
market area / supplier matrix are percentages.

Market size, [units] /

Sub-Sah. Africa
SE Asian NICs
N. America

S. America

E/SE Asia
E. Europe
Finland

S. Asia
France

Japan

totals
Market area/Supplier
Western Europe 0 100 0 0 0 0 0 0 0 0 1265
Eastern Europe 0 100 0 0 0 0 0 0 0 0 434
North America 0 0 0 100 0 0 0 0 0 0 1332
South America 0 0 0 0 100 0 0 0 0 0 213
South Asia 0 0 0 0 0 100 0 0 0 0 114
Japan 0 0 0 0 0 0 0 0 100 0 548
SE Asian NICs 0 0 0 0 0 0 0 100 0 0 422
East/SE Asia 0 0 0 0 0 0 0 0 100 0 540
Australasia 0 0 0 0 0 0 0 0 100 0 52
Middle East and North Africa 0 90 0 0 0 10 0 0 0 0 29
Sub-Saharan Africa 0 85 0 0 0 0 0 4 0 10 50
Total supply, [units] 0 1767 0 1332 213 117 0 424 1141 5 4999
Total production cost, [MFIM] 0 170 0 132 33 23 0 52 115 9 535
Transportation cost, [MFIM] 0 3 0 5 1 0 0 1 3 0 12
Tariff, [MFIM] 0 9 0 0 0 0 0 0 0 0 10
Interest on WIP, [MFIM] 0 0 0 0 0 0 0 0 0 0 0
Total cost, [MFIM] 0 182 0 137 33 24 0 53 118 9 557

If the markets need to be reached allowing for two weeks’ transportation time instead of one, the
only major change would be that the factory in the South Asia would no longer be needed. The
cost penalty would then decrease negligibly. If the transportation time limit is further relaxed to
three weeks, the situation changes considerably. This result is shown in Table 22.
116

Table 22. Cost-minimizing plant location and market allocation configuration when all markets are served,
allowing three weeks of transportation time.

Market size, [units] /

Sub-Sah. Africa
SE Asian NICs
N. America

S. America

E/SE Asia
E. Europe
Finland

S. Asia
France

Japan

totals
Market area/Supplier
Western Europe 0 100 0 0 0 0 0 0 0 0 1265
Eastern Europe 0 100 0 0 0 0 0 0 0 0 434
North America 0 100 0 0 0 0 0 0 0 0 1332
South America 0 0 0 0 100 0 0 0 0 0 213
South Asia 0 85 0 0 0 0 0 0 15 0 114
Japan 0 0 0 0 0 0 0 0 100 0 548
SE Asian NICs 0 0 0 0 0 0 0 0 100 0 422
East/SE Asia 0 0 0 0 0 0 0 0 100 0 540
Australasia 0 0 0 0 0 0 0 0 100 0 52
Middle East and North Africa 0 100 0 0 0 0 0 0 0 0 29
Sub-Saharan Africa 0 85 0 0 15 0 0 0 0 0 50
Total supply, [units] 0 3199 0 0 221 0 0 0 1579 0 4999
Total production cost, [MFIM] 0 293 0 0 33 0 0 0 154 0 480
Transportation cost, [MFIM] 0 11 0 0 1 0 0 0 4 0 15
Tariff, [MFIM] 0 24 0 0 0 0 0 0 11 0 35
Interest on WIP, [MFIM] 0 0 0 0 0 0 0 0 0 0 0
Total cost, [MFIM] 0 327 0 0 34 0 0 0 168 0 530

Plants are now only needed in Europe, East/Southeast Asia and South America; the South
American plant is very small. The saving in cost compared to a situation in which all markets
would be fully served, is about 6.2 %. With the three weeks time limit, about 96.5 % of the
demand is delivered allowing one week for transportation time. With the cost-minimizing
configuration, i.e. when only one factory exists, 87.3 % of the demand is served, allowing one
week for transportation.

The profit-maximizing model is not relevant here in the sense that the transportation constraints
prevent unprofitable markets from being rejected even when they become unprofitable.
Unprofitable markets are normally those that have to be served by the local factories. As a
consequence, the profit-maximizing solution is the same as the cost-minimizing one.

6.4 Validity of the results

In the following, some of the assumptions made in the problem formulations, and the feasibility of
the parameter values used are evaluated from the viewpoint of the practical applicability of the
results.

Constant cost function parameters

The production cost functions were assumed to be equal, independently of plant location. The
functional form used does not take into account differences in prices of factors of production.
 117

The cost of investment goods and materials for mechanical engineering production is partly
independent of location. The manufacturing equipment is specialized to a large extent and the
related business is international. The prices of many main raw materials are also determined
internationally. However, the prices of steel, tools, and many other items vary according to
exchange rates and the local price level.

The cost of labor and many services varies a great deal depending on the location of the plant. On
the other hand, the quality and efficiency of the work force should be considered at the same time
as the hourly cost.

It is obvious that practical decision making must not neglect the effect of the factor price
differences. However, the number of variables has been limited in the examples in order not to
lose generality and make the system too complicated to form conclusions.

Multiple products

It was assumed that only one type of average product or a standard product mix was produced at
each factory. In reality, while different products are produced, their allocation usually varies
between factories.

Demand uncertainty

Uncorrelated demand changes between different market areas tend to favor centralization of
production. Their effect on the optimal location allocation of production requires further research.

Customs tariff variability

The estimated customs tariffs were assumed in the study to concern trade between production
locations and markets. In reality, tariff barriers exist between states within some of the market
areas stated in the examples. However, they are usually rather low and appear mainly in the
smaller market areas.

Firm-wide scale effects

There may be firm-wide scale effects in research and development, marketing, cost of capital and
procurement. These effects favor larger overall production and should be taken into account, but
data for their estimation is not easily available.

6.5 Conclusions

The assumptions made in this application study, especially that of the constant factor prices for all
locations, are more restrictive than those of the practical decision making. However, the results
give an important insight into the effects of those factors taken into account. For example, the
advantage of local manufacturing in a market can be hard to quantify. On the other hand, the local
prices of factors of production are usually known. Thus the total direct cost effect of a local
presence can be calculated by summing up the manufacturing cost with the results obtained in this
study. The question of a local presence can then be formulated: are the total benefits larger or
smaller than the total costs? In many cases the answer to this question may be an obvious yes or
no.

The main findings of the plant location study are summarized in the following:
118

1. The cost-minimizing number of factories depends largely on the size of the total market share
of the company in relation to its position on the cost curve of the type of production in question.
The penalty resulting from a nonoptimal number of factories may be large if the factory
capacities lie on the steeply sloping part of the curve. Therefore it is important for a strategy
planner to know the parameters of the cost function.

2. The delivery capability of one large factory or a few large factories may have to be
complemented by small factories at markets distant from the main factories. Such an
arrangement may be needed in order to reduce transportation times or add a local presence. The
small factories would only deliver those orders that the main factory cannot deliver on time due
to a long transportation time. In practice this kind of strategy may be difficult to realize.
 119

7 VALIDITY OF THE RESULTS

The assumptions made and some features of the research method should be kept in mind when the
results are analyzed. Their consequences for the applicability of the results to practical problem
solving are summarized in the following.

1. The study deals with the production of a single product or product group. In practice some
processing units are often shared by other products. This is in order to increase utilization and
reduce costs at otherwise sub-optimal production rates.

2. It has been assumed that the lot size is not a decision variable. If it is allowed to vary, additional
economies of scale may be achievable. It is likely that in practical make-to-order production a
reduced number of set-ups and larger production batches are possible at larger volumes.

3. The results have been obtained assuming that invariable product constructions are maintained at
all outputs. If the volume is enlarged, modifications that reduce manufacturing costs at high
outputs may be made in these constructions.

4. The way labor indivisibility has been handled would require that there is always a suitable
number of processing units for workers to share their time between, in order for the model to be
completely accurate. This may not be true in most cases, but the resulting inaccuracy is likely to
be small. In any case, the model is considered an essential improvement with regard to the
closest earlier models which rely on the conventional assumptions of either full divisibility or
full indivisibility.

5. Other variable costs than labor are considered constant per unit in the random simulations
carried out. Other kinds of cost behavior may affect the form of the cost curve. Assumptions
about such behavior are considered artificial and not to extend the generality of this study.

6. The accuracy of the approximation functions tested improves the higher the number of
processes and non-dissimilar alternative technologies. If one or some technologies dominate the
cost behavior of the process, it has to be taken into account when the applicability of the model
is considered.
120

8 CONCLUSIONS

Make-to-order mechanical engineering production is studied in this report. Within the framework
of the assumptions made, and as stated in the Introduction, the research approach seeks generality
of the results, while the previous engineering cost function studies in the literature have dealt with
the manufacturing of specific products. This study considers the cost functions of those kinds of
manufacturing processes that have characteristics which are relevant from the point of view of
economies of scale. These cost functions have been combined in random simulation experiments
to generate models of different types of mechanical engineering production processes. In addition
one representative case analysis of an engineering estimate of a real manufacturing process is
analyzed.

Several important conclusions can be drawn from the results of the study. These are presented in
order of their appearance as follows:

1. The average cost function of an individual technology can reach its minimum value only at one
of the production rates where the labor cost category changes, i.e. where the working shift
arrangement changes to another one with a higher marginal labor cost. The cost curve consists
of segments that are convex from below at production rates lower than the cost-minimizing rate
and concave at higher rates.

The average cost function in the case of unmanned night shifts can have several minima at
different annual production rates that correspond to changes in the marginal labor cost. Which
one is global depends on the cost parameter values and has to be found by comparing them with
each other.

2. Cost functions of machining were analyzed as an application of the cost function of an

individual technology. It was concluded that it is often beneficial to optimize cutting speed in
such a way that high marginal cost production rates are avoided at the expense of increased tool
costs.

3. The economies of scale in a manufacturing process with alternative technologies are strong at
small production rates due to the indivisibility of manufacturing resources. After an initial
decrease the average costs may decrease further at higher production rates, if efficient
technologies are available, but at a slower rate. Continuous economies of scale can also be due
to long-lived tools or to other resources shared by multiple units of manufacturing resources.

Economies of scale are generally higher in more capital intensive processes. Consequently
automation, especially unmanned operation, tends to increase them.

4. It was shown that it is theoretically possible to maintain economies of scale in the transition
from a slower technology to a faster one with increased unit labor cost and decreased fixed cost.
However, after experimentation with technically and economically realistic manufacturing cost
parameters, it was concluded that such cases are unlikely to exist. Thus it was concluded that
increasing equipment capital cost is a necessary but insufficient condition for economies of
scale. Practical experience also supports this conclusion.

5. The long-run average cost function of a make-to-order mechanical engineering manufacturing

process can be approximated using a model of the form Axb + C, where x denotes annual
production volume and A, C and b (b < 0) are constant parameters. The simulations were made
 121

using cost function parameter values typical of the mechanical engineering industry in Finland
in 1996.

The cost model parameter values can be estimated using experience-based cost data on the
production of the product type in question. If such experience is not available, a thorough
bottom-up analysis of the process costs can be made utilizing the cost functions formed in the
study. These cost functions use parameters that directly relate to the characteristics of the
process and to the costs of the inputs. Once the cost data is available, an estimation of the
approximation model parameters is computationally easy.

The more subprocesses the total process consists of, and the more regularly the different
technologies within the subprocesses behave, the closer the approximate cost model above
approaches the actual cost function. “Regular behavior” means here that the capital-labor cost
ratio does not change radically from one technology to another in the same subprocess.

6. If the shares of the individual inputs to the production process were constant at all output rates,
the shares of these inputs would only depend on input cost ratios. In such a case the production
would be homothetic, which is a common assumption in production and cost function studies.
In mechanical engineering manufacturing processes the capital-labor input ratio is not constant.
Thus the production is non-homothetic.

7. In the light of the case analysis, it appears that the elasticity of capital-labor substitution is low
on average, in this case below 0.25, for a total mechanical engineering production process. The
elasticity is higher at lower rather than higher production rates, except the very lowest ones,
where only one technology is relevant.

8. Inclusion of economies of scale into a solution to plant location problems was found essential in
this main application of cost functions derived in the study. The use of the proposed
formulation of a long-run cost function in the examples of plant location problems demonstrates
that the optimal solutions are sensitive to the parameter values of the cost curve in relation to
the market size.

9. The delivery capability of one large cost efficient factory or a few large factories may have to
be complemented by small factories at markets distant from the main factories. Such an
arrangement may be needed in order to shorten transportation times.

The results obtained in the study provide new insight into the short and long term planning of
mechanical engineering production. Due to the practical approach of the study, many of the results
can be directly applied, as was shown by the application examples. However, immediate cost
minimization criterion used in many of the issues studied also has certain limitations. In reality
many other, often less tangible factors, have to be taken into account in decision making.

If the restricting assumptions made in the study are relaxed, opportunities for further research can
be foreseen.

Proposals for further research

The research carried out has resulted in long-run cost functions assuming a constant load. In
reality the make-to-order factories’ operating costs never exactly follow a function this average,
because their load fluctuates. Depending on the form of the short-run cost function and the
distribution of load fluctuation it may be advantageous to operate a smaller or larger factory than
122

the average load and long-run cost function alone would indicate. Derivation of the short-run cost
function and knowledge about the load distribution of a factory enables one to optimize its
capacity. Such optimization can be used to adjust the long-run cost function to correspond to the
fluctuating characteristics of the load. - The practical usefulness of the capacity optimization
described justifies further research on the subject.

The results obtained in the application study on plant location provide a deeper insight into the
production strategy of a make-to-order firm. The approach presented for optimizing production
allocation within the frames of a given delivery time distribution and transportation time
constraints is new and would also deserve further study.
 123

9 SUMMARY

It is generally assumed that large factories tend to be more efficient than smaller ones. In addition
to their larger output, they also manufacture products at a lower unit cost. This phenomenon is
called “economies of scale”. The study examines the dependence of production cost on production
volume in make-to-order mechanical engineering production. Knowledge of the best way of
establishing any production volume allows one to calculate the minimum production cost as a
function of output volume and input prices, i.e. the cost function. Firms can use cost functions for
judging economies of scale in production. Knowledge of the dependencies of costs on production
volume is essential for almost all basic strategic decisions made by a firm operating in a market.

The make-to-order mechanical engineering industry is characterized by standard product types that
are usually customized according to customer requirements. These products are made in small lots
and often under severe pressure for short delivery times. Consequently the production is generally
labor intensive and consists of a number of specialized resources. These characteristics result in
the high practical usefulness of cost function analysis. Make-to-order production is typical in the
mechanical engineering industry e.g. in Finland.

The objective of the study was to determine the form of the long-run cost function in make-to-
order mechanical engineering production.

The research method applied was the engineering approach. The engineering approach to
production and its economy is based on an analysis of the technology which is being applied at the
plant floor level. It can be compared with the statistical or econometric approach which deals with
overall economic data at various levels of business and industry, but does not involve their
technological background.

A method based on technological analysis implies a construction of the cost relationships of the
product and process in detail and their combination in appropriate ways. The result is a
mathematical cost model that is based directly on the technological and economical dependencies
of the production process.

Numerous cost models of individual processes were formulated during the construction of the cost
model for the total production process. Their characteristics were examined analytically and
numerically.

It was found that economies of scale in a manufacturing process using alternative technologies are
strong at small production rates due to the indivisibility of manufacturing resources. After an
initial decrease the average costs may decrease further at higher production rates, if efficient
technologies are available, but at a slower rate. Continuous economies of scale may also be due to
long-lived tools or other resources shared by multiple units of manufacturing resources.
Economies of scale are generally higher in more capital intensive processes. Consequently
automation, especially unmanned operation, tends to increase them.

Cost functions of machining were analyzed as an application of the cost function of an individual
technology. It was concluded that it is often beneficial to optimize cutting speed in such a way that
high marginal cost production rates are avoided at the expense of increased tool costs.

In order to increase the practical usefulness of the complicated model of the total production
process obtained in this study, other, simpler cost models containing only a few parameters, were
124

tested. Numerical random simulation was used to generate pseudo cost data with the original cost
models, and the simpler models were fitted to this data. The generality of the models was verified
by using differing but realistic parameter values in the simulations. The parameter values were
chosen so that a wide range of mechanical engineering production processes of different natures
was covered.

One real-life application of the total production process was presented. In this example
engineering estimates of the process parameters were used and the characteristics of the cost
function obtained were analyzed.

The main application of the cost functions presented, the plant location problem, was analyzed
using operations research methods. Different variations of the problem were formulated as
mathematical programming problems. These problems were solved using example input data and
existing standard software. Inclusion of economies of scale into solution of the plant location
problem was found essential in this application of the cost functions derived in the study. It turned
out that the optimal solutions to this problem are sensitive to the parameter values of the cost
curve in relation to the market size.

It was also concluded that the delivery capability of one large cost efficient factory or a few large
factories may have to be complemented by small factories at markets distant from the main
factories. Such an arrangement may be needed in order to shorten transportation times.
 125

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128

APPENDICES

A. Typical composition of the labor fringe benefits in Finnish mechanical engineering industry
in 1996.
B. Derivation of Equation 47 from Equations 43, 44 and 46.
C. Parameters used and results obtained in the random simulation experiments is Section 3.7.
D. Basic parameters of the cost-scale curves for the electric motor manufacturing processes in
the cost function examples.

E. Transportation costs between production locations and market areas for the products in the
plant location optimization examples in Chapter 6.
 129

APPENDIX A Typical composition of the labor fringe benefits in Finnish mechanical

engineering industry in 1996

The wage used in the calculations is the average basic wage for each type of job plus extra costs.
The average basic blue collar wage in the metal industry in Finland was about 59.1 FIM/hour at
the end of 1996. The most important extra costs are those paid for the evening shift 4.25 FIM/h,
and night shift 7.85 FIM/h, for overtime 50 % - 100 %, Sunday work 100 %, Saturday shift 7.85
FIM/h, and compensation for missed weekly rest 100 %.

The fringe benefits used in the calculations are typical for the metal industry in Finland. They
consist of compulsory social security 5.6 %, pension 12.4 %, accident insurance 5.3 %, sickness
insurance 2.4 %, first sickness day compensation 0.45 %, long working time bonus 2.3 %, and
payments and coverage for regularly paid wages during non-working times. The latter covers
annual holiday absence 20.28 % - 23.86 %, paid weekday holidays 5.72 %/blue collars, and the so
called working time shortening leave of 7.15 %. The compensation for reduced working hours is
12.95 % for interrupted three shift work, and 17.63 % for non-interrupted three shift work. The
total benefits are 43.3 % for white collar workers and 65.5 % - 75.7 % for blue collar workers.
Thus the average basic hourly labor cost of workers is 97.6 FIM.
130

APPENDIX B Derivation of Equation 47 from Equations 43, 44 and 46.

In order to find the limiting situation the inequalities in Equations 43 and 44 are replaced
with equalities. Combination of Equation 43 and AFECm2(x2min) = AFECm2(1) / x2min:

AFECm2(x2min) < LRAC1(x1min) - LRALCI2(x2min) - AFECt2(x2min)

- AFECf2(x2min) - LRAVC2(x2min)
⇒
LRALCI2(x2min) = LRAC1(x1min) - AFECm2(1) / x2min - AFECt2(x2min)
- AFECf2(x2min) - LRAVC2(x2min)

and Equation 44
AFECm2(1) > LRAC1(1) - LRALCI2(1) - AFECt2(1) - AFECf2(1) - LRAVC2(1)
⇒
LRALCI2(1) = LRAC1(1) - AFECm2(1) - AFECt2(1) - AFECf2(1) - LRAVC2(1)

with Equation 46
LRALCI2(x2min) = ki LRALCI2(1), i = 1,..,n

gives:
ki [LRAC1(1) - AFECm2(1) - AFECt2(1) - AFECf2(1) - LRAVC2(1)] = LRAC1(x1min)
- AFECm2(1) / x2min - AFECt2(x2min) - AFECf2(x2min) - LRAVC2(x2min)
⇔
AFECm2(1) = {ki [AFECt2(1) + AFECf2(1) + LRAVC2(1) - LRAC1(1)] + LRAC1(x1min)
- AFECt2(x2min) - AFECf2(x2min) - LRAVC2(x2min)}/ (1 / x2min - ki ).

Substitution of AFECm2(1) from above to Equation 43 gives Equation 47:

LRALCI2(x2min) = LRAC1(x1min) - {ki [AFECt2(1) + AFECf2(1) + LRAVC2(1)
- LRAC1(1)] + LRAC1(x1min) - AFECt2(x2min) - AFECf2(x2min) - LRAVC2(x2min)} /
[(1 / x2min - ki ) x2min] - AFECt2(x2min) - AFECf2(x2min) - LRAVC2(x2min) =

ki [(LRAVC2(x2min) + AFECt2(x2min) + AFECf2(x2min) - LRAC1(x1min)) x2min

- LRAVC2(1) - AFECt2(1) - AFECf2(1) + LRAC1(1)] / (1- ki x2min).
 131

APPENDIX C Parameters used and results obtained in the random simulation experiments
is Section 3.7

Parameter values

Labor cost per unit at

Number of processes
first technology
Inv. cost at first
technologies

technology
Number of

Process Total process number / weight-%

[kFIM] [FIM] 1 2 3 4 5 6 7 8 9 10
Manual work 1 0 100 2 10 30 40
Constant manning 1 200-4000 100 2 10 5 5
2 200-4000 100 2 10 10 5 10 20
3 200-4000 100 2 10 10 5 10 10 20
4 200-4000 100 2 10 5 5 10 10 20
Long lived tools 1 400-8000 100 1 5 10 5 10 20 30 20
Automation 1 200-4000 20-100 1 5 5 10 20 10 20
2 200-4000 100 2 10 10 5 10 10 20
3 200-4000 100 2 10 10 5 10 20 10 10 20 20
4 200-4000 100 1 5 5 10 20 10 20
Continuous process 4 8000 100 1 5 5 10 20 30 20
Unmanned operation 3 200-4000 100 1 5 10 5 10 20 30 20 20
4 200-4000 100 1 5 5 10 20 30 20
Number of processes in use in each total process 20 16 20 14 6 5 5 13 7 9
Results
Function values
Minimum cost production rate [units/year] 77 107.5 120 77 77 77 77 107.5 80 107.5
Minimum cost [FIM/unit] 147 138 134 138 112 115 138 147 135 149
Cost increase at 75 % of min. cost rate [%] 5 1 2 7 10 14 12 2 6 2
Cost increase at 50 % of min. cost rate [%] 9 2 3 11 22 28 16 4 3 3
Cost increase at 25 % of min. cost rate [%] 30 10 10 34 56 64 48 14 23 13
Ave. inv. per process at smallest rates [MFIM] 0.7 0.4 0.5 0.7 0.7 0.9 1.0 0.7 0.5 0.7
Ave. inv. per process at min. cost rate [MFIM] 3.3 3.3 3.6 3.7 3.6 3.8 3.9 4.3 3.3 4.1

Approximation functions Model Parameter/Fit

Ax b + Cx d A 1556 1107 1167 1464 1400 1699 1937 1544 1191 1699
b -0.99 -1.08 -0.97 -0.91 -0.78 -0.79 -0.87 -1.07 -0.93 -1.08
C 72 104 72 50 11 6 22 96 69 92
d 0.14 0.05 0.11 0.19 0.45 0.56 0.35 0.08 0.12 0.09
R 2 0.999 0.998 0.998 0.998 0.994 0.990 0.996 0.997 0.996 0.999
Ax -1 + C A 1353 880 1034 1382 1571 1897 1927 1238 1118 1343
C 130 127 121 123 102 103 120 132 124 132
R 2 0.988 0.986 0.988 0.990 0.989 0.983 0.987 0.984 0.990 0.984
Ax b + C A 1789 1218 1338 1699 1655 2038 2307 1723 1344 1910
b -1.19 -1.22 -1.18 -1.14 -1.04 -1.05 -1.13 -1.23 -1.12 -1.24
C 140 134 129 131 105 108 130 143 129 144
R 2 0.997 0.998 0.996 0.995 0.989 0.984 0.991 0.996 0.994 0.997
Ax -1 + Cx d A 1575 1036 1195 1572 1683 2063 2179 1457 1256 1590
C 76 87 80 75 73 62 59 78 88 72
d 0.12 0.09 0.10 0.11 0.08 0.12 0.16 0.12 0.08 0.14
R 2 0.999 0.998 0.998 0.997 0.991 0.986 0.994 0.997 0.996 0.998
132

Parameter values

Labor cost per unit at

Number of processes
first technology
Inv. cost at first
technologies

technology
Number of

Process Total process number / weight-%

[kFIM] [FIM] 1 2 3 4 5 6 7 8 9 10
Manual work 1 0 100 2 10 30 40
Constant manning 1 50-1000 100 2 10 5 5
2 50-1000 100 2 10 10 5 10 20
3 50-1000 100 2 10 10 5 10 10 20
4 50-1000 100 2 10 5 5 10 10 20
Long lived tools 1 100-2000 100 1 5 10 5 10 20 30 20
Automation 1 50-1000 20-100 1 5 5 10 20 10 20
2 50-1000 100 2 10 10 5 10 10 20
3 50-1000 100 2 10 10 5 10 20 10 10 20 20
4 50-1000 100 1 5 5 10 20 10 20
Continuous process 4 2000 100 1 5 5 10 20 30 20
Unmanned operation 3 200-4000 100 1 5 10 5 10 20 30 20 20
4 200-4000 100 1 5 5 10 20 30 20
Number of processes in use in each total process 20 16 20 14 6 5 5 13 7 9
Results
Function values
Minimum cost production rate [units/year] 95 118.5 95 95 95 64 120 94.5 95 103.5
Minimum cost [FIM/unit] 114 119 122 109 113 109 115 108 115 106
Cost increase at 75 % of min. cost rate [%] 4 4 3 6 7 14 8 5 3 5
Cost increase at 50 % of min. cost rate [%] 4 2 3 7 11 15 8 4 5 3
Cost increase at 25 % of min. cost rate [%] 16 11 12 23 33 46 29 15 15 14
Ave. inv. per process at smallest rates [MFIM] 0.2 0.1 0.2 0.3 0.4 0.6 0.4 0.1 0.1 0.1
Ave. inv. per process at min. cost rate [MFIM] 2.2 2.4 2.1 2.7 3.7 2.7 4.9 2.2 2.7 2.0

Approximation functions Model Parameter/Fit

Ax b + Cx d A 526 435 446 588 584 836 724 449 379 502
b -0.94 -0.94 -1.10 -0.98 -1.23 -1.34 -1.27 -0.95 -0.61 -0.92
C 99 104 128 114 199 237 181 96 55 82
d 0.02 0.02 0.01 0.02 -0.12 -0.16 -0.09 0.02 0.12 0.04
R 2 0.996 0.992 0.995 0.992 0.973 0.971 0.982 0.992 0.984 0.993
Ax -1 + C A 540 436 411 634 677 878 694 447 482 497
C 110 115 119 106 113 112 114 107 113 102
R 2 0.996 0.992 0.994 0.991 0.958 0.958 0.977 0.992 0.976 0.992
Ax b + C A 543 454 425 575 487 659 588 469 386 539
b -1.00 -1.03 -1.02 -0.93 -0.76 -0.79 -0.88 -1.03 -0.84 -1.06
C 110 116 119 104 102 100 109 107 108 103
R 2 0.996 0.992 0.995 0.992 0.972 0.969 0.980 0.992 0.983 0.993
Ax -1 + Cx d A 545 449 416 594 513 688 609 462 417 527
C 108 112 117 118 163 169 138 102 131 94
d 0.00 0.01 0.00 -0.02 -0.08 -0.09 -0.04 0.01 -0.03 0.02
R 2 0.996 0.992 0.994 0.992 0.973 0.970 0.981 0.992 0.981 0.993
 133

Parameter values

Labor cost per unit at

Number of processes
first technology
Inv. cost at first
technologies

technology
Process Number of Total process number / weight-%
[kFIM] [FIM] 1 2 3 4 5 6 7 8 9 10
Manual work 1 0 100 2 5 30 40
Constant manning 1 12.5-250 100 2 5 5 5
2 12.5-250 100 2 5 10 5 10 20
3 12.5-250 100 2 5 10 5 10 10 20
4 12.5-250 100 2 5 5 5 10 10 20
Long lived tools 1 25-500 100 1 5 10 5 10 20 30 20
Automation 1 12.5-250 20-100 1 10 5 10 20 10 20
2 12.5-250 100 2 10 10 5 10 10 20
3 12.5-250 100 2 10 10 5 10 20 10 10 20 20
4 12.5-250 100 1 10 5 10 20 10 20
Continuous process 4 500 100 1 10 5 10 20 30 20
Unmanned operation 3 200-4000 100 1 10 10 5 10 20 30 20 20
4 200-4000 100 1 10 5 10 20 30 20
Number of processes in use in each total process 20 16 20 14 6 5 5 13 7 9
Results
Function values
Minimum cost production rate [units/year] 120 120 112 112 112 112 112 101.5 101 83.5
Minimum cost [FIM/unit] 109 108 113 107 102 102 111 112 94 110
Cost increase at 75 % of min. cost rate [%] 2 2 2 3 7 8 5 2 6 1
Cost increase at 50 % of min. cost rate [%] 2 2 3 5 8 9 6 4 7 6
Cost increase at 25 % of min. cost rate [%] 7 6 7 9 13 10 7 13 18 16
Ave. inv. per process at smallest rates [MFIM] 0.1 0.0 0.1 0.1 0.1 0.2 0.2 0.1 0.0 0.1
Ave. inv. per process at min. cost rate [MFIM] 3.2 2.2 2.2 3.6 4.9 5.0 3.4 2.3 2.4 2.4

Approximation functions Model Parameter/Fit

Ax b + Cx d A 298 278 314 357 414 499 517 346 286 287
b -0.66 -0.59 -0.88 -0.67 -0.69 -0.71 -0.84 -0.75 -0.37 -0.59
C 70 55 98 64 63 56 77 78 6 62
d 0.07 0.11 0.02 0.08 0.07 0.09 0.06 0.06 0.43 0.09
R 2 0.992 0.991 0.992 0.987 0.979 0.963 0.979 0.995 0.990 0.989
Ax -1 + C A 372 337 332 440 533 625 554 395 380 369
C 107 105 111 105 102 100 107 109 93 109
R 2 0.985 0.984 0.991 0.982 0.970 0.957 0.978 0.993 0.963 0.978
Ax b + C A 304 283 329 367 420 513 550 366 267 285
b -0.85 -0.87 -0.99 -0.87 -0.83 -0.86 -0.99 -0.95 -0.74 -0.81
C 103 103 111 102 96 95 107 108 86 104
R 2 0.991 0.989 0.991 0.986 0.978 0.962 0.978 0.994 0.983 0.987
Ax -1 + Cx d A 329 307 334 395 453 552 561 384 293 311
C 119 114 110.0 118 125 122 105 112 119 125
d -0.02 -0.02 0.000 -0.02 -0.04 -0.04 0.00 -0.01 -0.05 -0.03
R 2 0.989 0.987 0.991 0.985 0.977 0.961 0.978 0.994 0.977 0.985
134

Parameter values

Labor cost per unit at

Number of processes
first technology
Inv. cost at first
technologies

technology
Number of

Process Total process number / weight-%

[kFIM] [FIM] 1 2 3 4 5 6 7 8 9 10
Manual work 1 0 100 1 5 30 40
Constant manning 1 200-4000 100 1 5 5 5
2 200-4000 100 1 5 10 5 10 20
3 200-4000 100 1 5 10 5 10 10 20
4 200-4000 100 1 5 5 5 10 10 20
Long lived tools 1 400-8000 100 1 5 10 5 10 20 30 20
Automation 1 200-4000 20-100 2 10 5 10 20 10 20
2 200-4000 100 2 10 10 5 10 10 20
3 200-4000 100 2 10 10 5 10 20 10 10 20 20
4 200-4000 100 2 10 5 10 20 10 20
Continuous process 4 8000 100 2 10 5 10 20 30 20
Unmanned operation 3 200-4000 100 2 10 10 5 10 20 30 20 20
4 200-4000 100 2 10 5 10 20 30 20
Number of processes in use in each total process 20 12 20 17 10 8 9 12 10 6
Results
Function values
Minimum cost production rate [units/year] 120 120 120 80 80 80 80 120 120 81
Minimum cost [FIM/unit] 133 130 127 130 117 121 142 149 144 150
Cost increase at 75 % of min. cost rate [%] 1 1 0 8 15 18 10 1 3 8
Cost increase at 50 % of min. cost rate [%] 6 6 5 7 14 11 7 4 6 2
Cost increase at 25 % of min. cost rate [%] 15 11 13 32 44 45 34 12 17 19
Ave. inv. per process at smallest rates [MFIM] 0.5 0.3 0.3 0.5 0.4 0.6 0.7 0.5 0.6 0.5
Ave. inv. per process at min. cost rate [MFIM] 4.6 3.3 3.3 3.6 3.8 4.1 3.7 5.0 5.4 3.7

Approximation functions Model Parameter/Fit

Ax b + Cx d A 1055 842 887 983 813 1094 1407 1019 1211 1038
b -0.90 -0.98 -0.98 -0.81 -0.68 -0.77 -0.92 -0.94 -0.84 -0.93
C 69 93 91 56 37 40 68 97 62 85
d 0.12 0.06 0.06 0.15 0.19 0.19 0.13 0.08 0.15 0.11
R 2 0.997 0.995 0.995 0.996 0.988 0.988 0.993 0.997 0.997 0.992
Ax -1 + C A 1025 763 813 1071 1029 1261 1365 953 1282 944
C 123 122 118 121 116 117 130 139 132 141
R 2 0.993 0.990 0.991 0.994 0.982 0.987 0.990 0.992 0.995 0.983
Ax b + C A 1183 927 964 1078 860 1191 1165 1128 1333 1199
b -1.10 -1.14 -1.12 -0.10 -0.87 -0.96 -1.20 -1.12 -1.03 -1.17
C 127 126 122 121 108 114 135 143 133 147
R 2 0.995 0.994 0.995 0.994 0.987 0.987 0.992 0.996 0.995 0.989
Ax -1 + Cx d A 1131 856 899 1098 919 1242 1496 1058 11339 1093
C 95 98 95 113 148 122 96 111 117 102
d 0.06 0.05 0.05 0.01 -0.06 -0.01 0.07 0.05 0.03 0.07
R 2 0.997 0.995 0.995 0.994 0.986 0.987 0.993 0.997 0.996 0.992
 135

Parameter values

Labor cost per unit at

Number of processes
first technology
Inv. cost at first
technologies

technology
Process Number of Total process number / weight-%
[kFIM] [FIM] 1 2 3 4 5 6 7 8 9 10
Manual work 1 0 100 1 5 30 40
Constant manning 1 50-1000 100 1 5 5 5
2 50-1000 100 1 5 10 5 10 20
3 50-1000 100 1 5 10 5 10 10 20
4 50-1000 100 1 5 5 5 10 10 20
Long lived tools 1 100-2000 100 1 5 10 5 10 20 30 20
Automation 1 50-1000 20-100 2 10 5 10 20 10 20
2 50-1000 100 2 10 10 5 10 10 20
3 50-1000 100 2 10 10 5 10 20 10 10 20 20
4 50-1000 100 2 10 5 10 20 10 20
Continuous process 4 2000 100 2 10 5 10 20 30 20
Unmanned operation 3 200-4000 100 2 10 10 5 10 20 30 20 20
4 200-4000 100 2 10 5 10 20 30 20
Number of processes in use in each total process 20 12 20 17 10 8 9 12 10 6
Results
Function values
Minimum cost production rate [units/year] 76.5 76.5 76.5 72 63.5 71 71 120 77.5 76.5
Minimum cost [FIM/unit] 105 115 116 105 112 119 112 106 108 105
Cost increase at 75 % of min. cost rate [%] 3 3 2 3 5 4 4 1 1 5
Cost increase at 50 % of min. cost rate [%] 8 8 5 10 12 10 9 4 9 9
Cost increase at 25 % of min. cost rate [%] 22 20 15 28 28 29 31 11 25 29
Ave. inv. per process at smallest rates [MFIM] 0.1 0.2 0.1 0.2 0.1 0.2 0.3 0.3 0.2 0.2
Ave. inv. per process at min. cost rate [MFIM] 1.9 1.7 1.6 2.5 3.0 3.0 2.3 2.8 2.7 1.9

Approximation functions Model Parameter/Fit

Ax b + Cx d A 443 500 381 515 336 392 692 794 554 597
b -0.67 -0.81 -0.84 -0.64 -0.39 -0.43 -0.78 -0.80 -0.68 -0.70
C 40 66 84 26 9 11 44 34 30 28
d 0.17 0.10 0.05 0.24 0.41 0.40 0.17 0.21 0.23 0.23
R 2 0.997 0.996 0.998 0.998 0.988 0.986 0.997 0.997 0.996 0.996
Ax -1 + C A 502 501 392 610 431 489 723 829 617 673
C 101 111 111 99 111 119 106 96 102 98
R 2 0.993 0.991 0.996 0.993 0.972 0.974 0.992 0.992 0.990 0.991
Ax b + C A 494 576 419 578 332 416 805 921 645 685
b -0.99 -1.10 -1.05 -0.96 -0.81 -0.88 -1.08 -1.07 -1.03 -1.01
C 100 113 112 98 106 116 108 99 103 98
R 2 0.993 0.993 0.996 0.993 0.982 0.978 0.993 0.994 0.990 0.991
Ax -1 + Cx d A 514 557 415 611 366 455 791 908 659 707
C 97 95 105 98 130 129 87 76 91 88
d 0.01 0.03 0.01 0.00 -0.04 -0.02 -0.04 -0.06 -0.03 0.02
R 2 0.993 0.995 0.997 0.993 0.979 0.976 0.995 0.996 0.991 0.991
136

Parameter values

Labor cost per unit at

Number of processes
first technology
Inv. cost at first
technologies

technology
Number of

Process Total process number / weight-%

[kFIM] [FIM] 1 2 3 4 5 6 7 8 9 10
Manual work 1 0 100 1 5 30 40
Constant manning 1 12.5-250 100 1 5 5 5
2 12.5-250 100 1 5 10 5 10 20
3 12.5-250 100 1 5 10 5 10 10 20
4 12.5-250 100 1 5 5 5 10 10 20
Long lived tools 1 25-500 100 1 5 10 5 10 20 30 20
Automation 1 12.5-250 20-100 2 10 5 10 20 10 20
2 12.5-250 100 2 10 10 5 10 10 20
3 12.5-250 100 2 10 10 5 10 20 10 10 20 20
4 12.5-250 100 2 10 5 10 20 10 20
Continuous process 4 500 100 2 10 5 10 20 30 20
Unmanned operation 3 200-4000 100 2 10 10 5 10 20 30 20 20
4 200-4000 100 2 10 5 10 20 30 20
Number of processes in use in each total process 20 12 20 17 10 8 9 12 10 6
Results
Function values
Minimum cost production rate [units/year] 120 65.5 110 120 102 49 100.5 109.5 120 119.5
Minimum cost [FIM/unit] 110 114 111 104 102 109 106 108 127 114
Cost increase at 75 % of min. cost rate [%] 3 2 1 3 3 10 1 3 3 3
Cost increase at 50 % of min. cost rate [%] 2 4 2 1 1 19 1 2 1 2
Cost increase at 25 % of min. cost rate [%] 10 13 9 12 20 55 15 8 9 9
Ave. inv. per process at smallest rates [MFIM] 0.1 0.0 0.1 0.1 0.2 0.3 0.2 0.1 0.1 0.0
Ave. inv. per process at min. cost rate [MFIM] 2.4 1.1 1.6 3.0 3.3 1.8 2.4 1.8 2.8 2.5

Approximation functions Model Parameter/Fit

Ax b + Cx d A 334 258 326 393 477 563 517 303 309 280
b -0.82 -0.88 -0.74 -0.65 -0.53 -0.56 -0.63 -0.87 -0.65 -1.06
C 84 99 71 43 10 10 21 90 78 115
d 0.05 0.03 0.08 0.15 0.40 0.43 0.29 0.00 0.08 0.00
R 2 0.994 0.982 0.991 0.995 0.996 0.996 0.997 0.984 0.987 0.979
Ax -1 + C A 356 258 338 452 614 708 597 313 360 262
C 108 113 108 100 97 103 100 106 124 112
R 2 0.993 0.980 0.988 0.991 0.985 0.986 0.988 0.983 0.984 0.978
Ax b + C A 361 279 348 429 528 644 599 323 325 277
b -1.01 -1.05 -1.02 -0.96 -0.89 -0.93 -1.00 -1.02 -0.93 -1.04
C 108 113 108 99 93 100 100 106 123 113
R 2 0.993 0.981 0.988 0.991 0.988 0.987 0.988 0.984 0.985 0.979
Ax -1 + Cx d A 365 275 356 453 579 701 630 324 345 270
C 105 108 103 100 107 104 91 103 128 110
d 0.01 0.01 0.01 0.00 -0.02 0.00 0.02 0.01 -0.01 0.00
R 2 0.993 0.982 0.989 0.991 0.986 0.986 0.989 0.984 0.984 0.979
 137

APPENDIX D Basic parameters of the cost-scale curves for the electric motor
manufacturing processes in the cost function examples

Process Characterization Max. prod rate Inv. w/o tools Rent etc. Labor Variable cost
[units/year] [kFIM] [kFIM/year] [workers] [FIM/unit]
1 Frame machining Manned 1700 3500 200 2 450
2 Frame machining Manned 3400 9500 75 1 400
3 Frame machining Unmanned 3540 12000 150 1 400
4 Frame machining Unmanned 7200 21000 200 2 350
5 End shield mach. Manned 2125 3500 200 2 450
6 End shield mach. Manned 5300 6000 75 1 400
7 End shield mach. Unmanned 5600 8500 150 1 400
8 End shield mach. Unmanned 11300 15000 200 3 350
9 Shaft machining Manned 2125 1350 100 2 320
10 Shaft machining Manned 2830 7500 100 1 350
11 Shaft machining Manned 3900 9000 150 1 300
12 Shaft machining Manned 7000 12500 200 2 300
13 Blanking Manned 944 1500 50 1 360
14 Blanking Automated 6540 5500 100 0.5 105
15 Notching Manned 315 3500 25 1 720
16 Notching Automated 500 5000 75 0.15 500
17 Notching Automated 1000 6500 50 0.25 500
18 Notching Automated 1600 11500 100 0.4 460
19 Stator stacking Manual 1415 1500 50 6 80
20 Coil manufacturing Manual 607 4900 150 3 756
21 Coil manufacturing Manual 1214 6750 180 6 756
22 Coil manufacturing Manual 1821 8600 240 9 756
23 Coil manufacturing Manual 2428 11400 300 12 756
24 Winding Manual 500 856 60 2 450
25 Winding Manual 1060 1212 100 4 450
26 Winding Manual 1590 1500 300 6 450
27 Winding Manual 2120 1900 400 8 450
28 Impregnation Unmanned 2800 6000 168 2 1000
29 Impregnation Unmanned 4250 7000 175 3 1000
30 Impregnation Unmanned 5680 8000 200 4 1000
31 Impregnation Unmanned 8500 11000 300 6 1000
32 Rotor assembly Manual 1700 1600 80 2 225
33 Rotor assembly Manned 8500 8000 32 3 225
34 Rotor balancing Manned 7700 1500 50 1 25
35 Final assembly Manual 1300 1300 26 2 260
36 Final assembly Manual 2600 1500 52 4 260
37 Final assembly Manual 3900 2000 78 8 260
38 Testing Manned 2125 11000 310 4 800
39 Testing Manned 4250 16800 470 8 800
40 Testing Manned 6390 21000 600 12 800
41 Shipping Manual 1700 1300 80 1 100
138

APPENDIX E Transportation costs between production locations and market areas for the
products in the plant location optimization examples in Chapter 6

Sub-Sah. Africa
SE Asian NICs
N. America

S. America

E/SE Asia
E. Europe
Finland

S. Asia
France

Japan
Freight/unit, [kFIM]:
Western Europe 1.9 1.6 1.7 4.6 2.7 3.1 3.0 2.9 3.0 3.2
Eastern Europe 2.8 2.0 1.2 6.2 4.4 4.7 4.8 4.6 4.7 4.9
North America 5.1 5.2 5.5 3.5 5.3 6.0 6.0 6.3 6.1 6.0
South America 4.5 4.6 4.9 6.5 2.8 5.2 4.8 4.9 4.8 4.9
South Asia 4.3 4.5 4.8 6.6 4.5 1.5 4.3 3.7 4.0 4.4
Japan 4.4 4.6 4.8 5.9 4.5 4.4 0.8 3.3 2.9 4.5
SE Asian NICs 4.2 4.4 4.6 6.2 4.5 3.5 3.5 2.7 3.3 4.1
East/SE Asia 4.8 5.0 5.3 6.6 5.0 4.4 3.6 3.4 1.3 4.9
Australasia 4.9 5.1 5.3 6.7 4.7 4.8 4.3 4.2 4.3 4.8
Middle East and North Africa 4.2 4.3 4.6 6.5 4.7 4.4 4.7 4.4 4.6 4.7
Sub-Saharan Africa 4.2 4.3 4.6 6.4 3.9 4.2 4.3 4.0 4.2 1.2

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