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Make It or Buy It? Part 1: Manufacturing Overhead Costs

Source: http://www.wisegeek.com/what-are-indirect-manufacturing-costs.htm Source: http://www.wisegeek.com/what-are-indirect-manufacturing-costs.htm

Doug Sharpe President of Elasto Proxy

What types of products does your company make? No matter what your industry, manufactured goods have two types of costs: direct and indirect. Direct costs, such as labor and materials, are expenses that you can attribute to the production of specific items. Indirect costs, such as management salaries and property taxes, represent all of the other costs of doing business. These overhead costs can be fixed or variable, and include manufacturing overhead costs (MOH) that some companies underestimate.

Until you capture all of your MOH or factory costs, your company may price its products too low – and fail to turn a profit. Your technical buyers and production managers may also make the wrong decisions about outsourcing the production of parts such as rubber gaskets. Although some companies claim it’s cheaper to produce these components in-house, their true factory burden indicates that outsourcing is cheaper.

So how can you determine whether it’s better to outsource your gasket fabrication?

What Are Your Costs?

Every company is different, and manufacturing overhead costs vary by industry, location, plant size, and sales volume. By expressing overhead as a percentage or proportion – a rate – instead of a dollar amount, you can compare indirect costs to direct costs and calculate total expenses. According to Grant Thornton, one of the world’s largest accounting firms, overhead rates can vary from 20% to 130%. Often but not always, these rates are lower at larger companies because these firms can spread the cost of indirect expenses across higher volumes of manufactured units.

Years ago, the Harvard Business Review studied the challenge of reducing factory costs and concluded that “across the spectrum of U.S. industry, manufacturing overhead averages 35% of production costs.” The RAND Corporation, another well-respected institution, reported that general and administrative (G&A) costs in one industry alone (defense) could exceed direct labor costs “by a factor of two or more”. An EPA study of the automotive industry puts the ratio of direct costs to indirect costs at 1:1 or 1:1.5.

Only your cost accountants know your company’s MOH costs, so let’s apply a range of overhead rates to an example of in-house gasket fabrication. In this way, even if you can’t pinpoint a percentage, you can see for yourself whether outsourcing is more expensive.

Some Examples

In North America, the average hourly wage for a factory worker is about $25. According to the U.S. Department of Labor, workers earned $24.93 (USD) in August 2014. In Canada, the last available data is from May 2014, when workers earned an average of $22.80 (CSD). Canadian manufacturing soared in August, however, so it’s likely that number is now higher. Even considering the U.S.-Canada exchange rate, it’s reasonable to put manufacturing’s hourly rate at $25.

Let’s say you need gaskets to complete a project, and that a custom fabricator can supply them for $20 each. Your alternative is to buy standard rubber profiles at $5 each, and then cut and splice the parts in-house. If per-unit production takes 30 minutes, you’ll spend about $12.50 for labor and $5 for materials (not including waste). That $17.50 is less than what you’d pay for outsourced, fully-finished $20 gasket.

Remember, however, that $17.50 represents only your direct costs. Now let’s apply a range of overhead rates to see what your total per-gasket costs could be.

Direct Labor Direct Materials Total Direct Costs Overhead Rate Overhead Dollars Total Gasket Cost*
12.50 5.00 17.50 25% 4.375 21.88
12.50 5.00 17.50 50% 8.75 26.25
12.50 5.00 17.50 75% 13.125 30.63
12.50 5.00 17.50 100% 17.50 35.00
12.50 5.00 17.50 125% 21.875 39.38
12.50 5.00 17.50 150% 26.25 43.75
12.50 5.00 17.50 175% 30.625 48.13
12.50 5.00 17.50 200% 35.00 52.50

*Total gasket costs include rounding

Some Conclusions – and Questions

Across every scenario, it’s cheaper to outsource your gasket fabrication than it is to produce these parts in-house. Why can the custom fabricator produce these components more cost-effectively? Instead of using a cardboard cut-out and a utility knife, the gasket fabricator uses a state-of-the-art waterjet cutter. Instead of splicing profiles by-hand, the specialist uses a splicing machine. Ultimately, this means that outsourcing’s per-unit costs are lower, both in terms of labor and materials.

When you calculate the cost of in-house production, do you include the cost of re-work, too? Unless your production team cuts profiles all the time, they won’t have the experience of a custom fabricator. Also, are you still “saving money” since each worker requires training, and quality assurance personnel must check each fabricated part for defects? Your tooling costs may be as inexpensive as a utility knife and an adhesive, but how much longer does it take to use them?

There are material costs to consider, too. Do you track waste from in-house production? If so, how much rubber is wasted? Whenever a worker makes the wrong cut and throws away a profile, those costs are absorbed by your business. As the complexity of cutting and splicing increases, so does waste – or muda, as it’s known in lean manufacturing. Seals for five-sided doors, and profiles that require 30° or 35° cuts are challenging. So are rubber floor mats that must fit cabs precisely and account for bolts and pedals.

How Can We Help You?

Do you need finished gaskets for applications such as automotive, construction, defense, electronics, food equipment, green power, mass transit, medical equipment, or mobile specialty vehicles? For 25 years, Elasto Proxy has been helping partners to solve sealing and insulation problems. From compound selection to seal design and custom fabrication, we’re ready to listen. How can we help you?

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