Good busi­ness – In­crease pro­duc­tion, lower prof­its?

DEMM Engineering & Manufacturing - - EDITORIAL -

BY OREST PROTCH

In the chil­dren’s fa­ble of Chicken Lit­tle we find our pro­tag­o­nist run­ning around yelling that the sky is fall­ing. In the fa­ble of The Boy Who Cried Wolf we find our pro­tag­o­nist run­ning around yelling that the evil wolf is on a ram­page. In the fa­ble of The Em­peror Has No Clothes we fi­nally get a pro­tag­o­nist who ad­mits the ob­vi­ous truth and at the right time that no one else was will­ing to state.

Three dif­fer­ent para­bles but all three can be re­lated to the man­u­fac­tur­ing world and most likely to some peo­ple in your man­u­fac­tur­ing or­gan­i­sa­tion. Read that first para­graph again and see if you can find sim­i­lar­i­ties to any of your col­leagues and how they han­dle real life day to day man­u­fac­tur­ing sit­u­a­tions.

Our fo­cus here is go­ing to be on the story of Who is Will­ing to Chal­lenge the Em­peror.

The man­u­fac­tur­ing world has lit­tle re­sem­blance to what it was 30 years ago. Whereas it used to be com­mon for a coun­try to be fairly self- suf­fi­cient in terms of meet­ing its needs of sup­ply and de­mand in its own lit­tle mi­cro-world, that same coun­try can now be heav­ily re­liant on im­ports and ex­ports to meet these same needs of in­ter­nal sup­ply and de­mand in what is now the in­dus­trial com­plex of the macro-world.

In­ter­na­tional trade agree­ments at an un­prece­dented scale have al­tered how a com­pany has to look for raw ma­te­rial and even the labour pool to make the prod­ucts of its liveli­hood. What used to be un­of­fi­cial trade agree­ments be­tween per­haps two coun­tries in close prox­im­ity who shared a com­mon bor­der now en­com­passes po­lit­i­cally dis­sim­i­lar coun­tries around the globe.

Our three fa­bles at the be­gin­ning of this ar­ti­cle can be cor­re­lated to any man­u­fac­tur­ing com­pany. They give us three sce­nar­ios.

Com­pany ex­ec­u­tives state that un­less the com­pany in­creases pro­duc­tion then it will be crushed by the evil com­pe­ti­tion who is do­ing just that (the sky is fall­ing).

Com­pany ex­ec­u­tives state that its very sur­vival is al­ready be­ing crushed by the evil com­pe­ti­tion (the wolf eat­ing the sheep).

A lone com­pany ex­ec­u­tive states that all the above is com­pletely false and based on in­cor­rect anal­y­sis of the ac­tual ef­fects of the evil crusha­bil­ity fac­tor (the em­peror has no clothes).

Many com­pa­nies are very sim­i­lar to teenagers. Chang­ing pheromones and hor­mones keep teenagers in a con­stant state of anx­ious­ness and ag­i­ta­tion and chang­ing mar­ket con­di­tions tend to do the same to man­u­fac­tur­ers.

One com­mon de­nom­i­na­tor of man­u­fac­tur­ers since the dawn of the in­dus­trial age is to state that the solution to the per­ils of en­croach­ing com­pe­ti­tion to its mar­ket base is to in­crease pro­duc­tion. It is very easy to say that in­creased pro­duc­tion will equate to in­creased prof­its and that is very dif­fi­cult for any­one to dis­pute. Or is it? That is ex­actly what we are go­ing to look at.

The de­ci­sion to buy al­ready ex­ist­ing fa­cil­i­ties, adding ex­pan­sion cap­i­tal to cur­rently owned ones, or sim­ply mov­ing and build­ing in a new ge­o­graphic lo­ca­tion, is now of­ten made by board­rooms that are re­spond­ing to the stake­hold­ers de­mands of bet­ter in­vest­ment re­turns.

Too of­ten the knowl­edge­able peo­ple that could, or would, chal­lenge these sort of de­ci­sions are now ab­sent from the de­ci­sion-mak­ing meet­ings. Many com­pa­nies have grown be­yond ba­sic em­ployee in­put and it can be lo­gis­ti­cally dif­fi­cult to col­lect the right in­for­ma­tion from the right peo­ple. De­ci­sions to ex­pand and/or move are of­ten made with­out a de­tailed sta­tis­ti­cal anal­y­sis of what will hap­pen to real over­head costs if you do in­crease pro­duc­tion ei­ther lo­cally or in another part of the coun­try al­to­gether.

In­creas­ing pro­duc­tion by cap­i­tal ex­pen­di­tures can ac­tu­ally de­crease pos­i­tive cash flow when all the orig­i­nal profit pro­jec­tions in­di­cate it would go up. How can this be? It is called tun­nel vi­sion.

It may be an in­ter­est­ing con­cept, that of check­ing fu­ture pro­duc­tion goals against new over­head cre­ation, but an­tic­i­pated in­creased over­head may be sim­ply ig­nored (back to the em­peror fa­ble) if it makes the in­vestor charts and graphs look bad. And that is where many com­pa­nies fall short.

With in­creased pro­duc­tion ca­pa­bil­ity there will be more in­come com­ing in. And this is a good thing. But there are two ques­tions that need to be asked be­fore you make cap­i­tal ex­pen­di­tures and those are sim­ply will there be enough new in­come to cover all the new ex­pen­di­tures that come with in­creas­ing pro­duc­tion and does the com­pany have the cash or credit re­serves to cover the lag time of prof­its fi­nally sur­pass­ing over­head costs. Lag time? We will come to that shortly.

The most im­por­tant thing about ask­ing these par­tic­u­lar ques­tions is that it forces you to look in the proper way at all the fac­tors that go along with an in­crease in sales in­come. And if you miss a few, your net prof­its can and will ac­tu­ally fall with in­creas­ing pro­duc­tion ca­pac­ity. At head of­fice meet­ings, af­ter list­ing all of the rea­sons for in­creas­ing pro­duc­tion, es­pe­cially in vis­ually ap­peal­ing chart form, ev­ery­one will prob­a­bly feel pumped, re- en­er­gized and ready to roll up their sleeves to have at it. No one, af­ter all, wants to be a dis­sent­ing voice (again, with the fa­ble).

So the de­ci­sion will be made to ex­pand pro­duc­tion, move the fa­cil­ity or maybe both will hap­pen. But hope­fully there will be some­one who re­mem­bers the ba­sics of eco­nom­ics.

And the fol­low­ing points will be made, al­beit maybe qui­etly by some­one fear­ing the fu­ture un­em­ploy­ment line (the em­per­ors’ axe):

AN­NUAL FIXED COSTS WILL IN­CREASE, WHICH MEANS HIGHER OVERHEADS. THESE ARE CAUSED BY BUT NOT LIM­ITED TO:

• A big­ger man­u­fac­tur­ing build­ing may be needed with as­so­ci­ated in­creases in main­te­nance, mu­nic­i­pal tax, in­sur­ance and util­ity costs.

• Higher costs will be gen­er­ated in labour-hours due to the ad­di­tion of high-tech main­te­nance needs of state- of-the-art equip­ment. More of­ten than not highly paid spe­cial­ists will need to be from other coun­tries and will re­place or­di­nary mechanics and elec­tri­cians.

• Loss of fore­gone in­vest­ment which is the loss of in­come if the cap­i­tal had been in­vested else­where to col­lect in­ter­est or div­i­dends.

AN­NUAL VARI­ABLE COSTS WILL IN­CREASE. THESE ARE CAUSED BY BUT NOT LIM­ITED TO:

• Cap­i­tal may need to be spent to in­crease the truck­ing fleet to carry prod­ucts, both raw and fin­ished. This will in­crease fleet main­te­nance costs.

• Ex­port­ing or im­port­ing du­ties may rise.

• In­creased ware­house space for raw and fin­ished prod­ucts. More cap­i­tal will be tied up with raw ma­te­rial and fin­ished prod­ucts.

• Trans­porta­tion costs (fuel) will in­crease both for re­ceiv­ing raw ma­te­rial and for ship­ping the fin­ished prod­ucts (truck vs boat vs train).

• Ware­house space may be needed in other ge­o­graphic lo­ca­tions if prod­uct stor­age is re­quired be­fore it gets to the cus­tomer if just-in-time de­liv­ery is not part of the sup­ply con­tract.

We are go­ing to look at an ac­tual case study of a com­pany from 35 years ago. But the past is not much dif­fer­ent from the present. It was an au­to­mo­tive parts sup­ply sub­con­trac­tor whose man­u­fac­tur­ing fac­tory sup­plied com­po­nents to one of the big three North Amer­i­can car giants but wanted to ex­pand to get con­tracts with one or both of the other big car com­pa­nies.

There is one fi­nal truth to any busi­ness de­ci­sion. Hind­sight is al­ways 20/20. This com­pany al­most de­clared bankruptcy but it fi­nally was able to ne­go­ti­ate more bank loans to get it over the fi­nan­cial dif­fi­cul­ties it ran into.

You can add as many ze­ros as you want to each col­umn but to make the as­so­ci­ated graphs easy to read I have kept the num­bers quite ba­sic. True graphs would be of the log­a­rith­mic type where the su­per­im­posed ver­ti­cal scales are dif­fer­ent for each col­umn rep­re­sented but these can be quite daunt­ing to in­ter­pret for those un­fa­mil­iar with them.

Keep in mind one thing as you go through what you may ini­tially think is only a hy­po­thet­i­cal sit­u­a­tion that makes good copy. It ac­tu­ally hap­pens most of the time when com­pa­nies ex­pand. How re­al­is­tic are these num­bers to to­day’s re­al­ity? Move the dec­i­mals around in the col­umns and what you are see­ing can be in cur­rent time with a com­pany try­ing to fig­ure out what hap­pened to the black ink in the ledger books.

So, we are go­ing to start by as­sum­ing we are go­ing to spend cap­i­tal to in­crease yearly pro­duc­tion on a con­sis­tent in­cre­men­tal ba­sis be­cause of var­i­ous tax shel­ters and ex­ist­ing cash flow re­quire­ments and equip­ment de­pre­ci­a­tion rates. And it takes time to or­der new equip­ment and train new em­ploy­ees to op­er­ate it. Of course, this means that the an­nual to­tal pro­duc­tion cost will also go up with an­nual over­head. We also see an in­crease in the an­nual dis­tri­bu­tion cost of our prod­ucts as the more we make the more it costs to ship what we pro­duce.

The main prob­lem with charts and spread­sheets is that it so easy to leave off crit­i­cal in­for­ma­tion or to even look at the wrong parts of the data. In the nu­mer­i­cal chart we see costs as­so­ci­ated with in­creas­ing pro­duc­tion. Pre­sented in this form it is hard to see any­thing that could cause us grief in the fu­ture as pro­duc­tion in­creases an­nu­ally. The very peo­ple that may have seen the ob­vi­ous may have been down­sized, out­sourced or sim­ply no longer care what hap­pens to the com­pany.

Once in­for­ma­tion is in graph form we all find in­for­ma­tion eas­ier to see, es­pe­cially trends. One thing I would like to point out is that the com­bi­na­tion of var­i­ous rows in the chart to make each graph are not hap­haz­ardly cho­sen. So, let’s see what we have.

In the first graph we see that it will ac­tu­ally take a num­ber of in­cre­men­tal pro­duc­tion in­creases be­fore gross in­come from sales is greater than the cost to pro­duce the items and to ship them out to the cus­tomers. So even though the sales­peo­ple and the man­u­fac­tur­ing peo­ple are do­ing their jobs, this can be a men­tally taxing event for you if the bank state­ments keep com­ing back to you in the red. How would you re­act? Would you fire some­one?

No­tice what hap­pens at the end of the pro­jected time frame? Sales in­come starts to fall be­low pro­duc­tion and dis­tri­bu­tion costs. Re­gard­less of what you may think, ba­sic eco­nom­ics states that this will hap­pen with many com­pany ex­pan­sions.

In the se­cond graph we see that there is a point in pro­duc­tion where our prof­its will seem to surge, and that means cel­e­bra­tions will be in or­der. But then prof­its can flat-line lead­ing you to as­sume some­one or some group is slack­ing off. And yet the fixed costs are even de­clin­ing with in­creased in­cre­men­tal pro­duc­tion so if you re­act and cut staff at this point you have chased the wrong rab­bit.

What would be your re­ac­tion at the end of the time pe­riod where prof­its drop like a stone if you do not ap­pre­ci­ate the fact that the as­so­ci­ated in­creased pro­duc­tion costs are de­stroy­ing your profit mar­gins? Re­gard­less of what you may think, ba­sic eco­nom­ics states that this will hap­pen with many com­pany ex­pan­sions. ➔

In the third graph we see that gross in­come from sales can lag be­hind in­cre­men­tal pro­duc­tion in­creases un­til you over­come not only pro­duc­tion costs but ship­ping costs as well. There may even come a time when the gross in­come from sales falls be­hind pro­duc­tion and dis­tri­bu­tion costs. And yet your fa­cil­ity may be run­ning flat out. Re­gard­less of what you may think, ba­sic eco­nom­ics states that this will hap­pen with many com­pany ex­pan­sions.

In the fourth graph we have one that shows why it is so im­por­tant to track a va­ri­ety of busi­ness oc­cur­rences. Here we see that the in­crease of in­come from year to year does not come close to match­ing the in­crease in an­nual pro­duc­tion cost in­creases re­sult­ing from in­creased ca­pac­ity. Even though our cost to pro­duce each unit comes down ev­ery year, it’s the yearly vari­able costs that can lead to busi­ness prob­lems. Re­gard­less of what you may think, ba­sic eco­nom­ics states that this will hap­pen with many com­pany ex­pan­sions.

As you sip your morn­ing tea or cof­fee while read­ing this ar­ti­cle, what you have read does not hap­pen in the mi­nor­ity of cases when busi­nesses in­crease pro­duc­tion. It hap­pens with the ma­jor­ity. Those vari­able costs that climb when you pur­chase new equip­ment or build a larger man­u­fac­tur­ing plant can re­ally take a bite out of your prof­its.

If a com­pany does not un­der­stand why prof­its can de­crease when mak­ing cap­i­tal ex­pen­di­tures on new fa­cil­i­ties then they can end up in a world or trou­ble.

That new and im­proved man­u­fac­tur­ing cen­tre of yours cost you cap­i­tal to buy and set up, cap­i­tal that could have been in­vested else­where. This is the fore­gone in­vest­ment of the pur­chase. If you had put the money into stocks or bonds, then ev­ery se­cond of the day you would have made in­come from the money. This is a cost that has to be added to over­head.

When I talk to peo­ple who are ex­pand­ing their busi­ness about even this sim­ple con­cept they have no idea what I am talk­ing about. If I men­tion the need for cal­cu­lat­ing the in­creased in­ter­me­di­ate ware­house space for raw ma­te­rial or fin­ished prod­ucts, their eyes glaze over

If you are com­mit­ted to in­creas­ing your pro­duc­tion ca­pa­bil­ity by cap­i­tal ex­pen­di­tures, go for it. Just do it with ac­cu­rate fore­casts, rea­son­able sales ex­pec­ta­tions and a very tight vice-like hold on your wal­let when it comes to pay­ing all those “hid­den” ex­pen­di­tures that will pop up and take a bite. Af­ter all, you owe it to the peo­ple that may be dis­placed by bad de­ci­sions.

BIO - The au­thor’s back­ground ex­tends from met­al­lurgy, NDT, fore­man in­clud­ing in a foundry, steel mill and saw mill, work­ing in re­search and process labs, sta­tis­ti­cal process & qual­ity con­trol, wa­ter treat­ment and waste­water treat­ment, power en­gi­neer, pulp mill, in­struct­ing and train­ing, writ­ing man­u­als, oil & gas, writ­ing ar­ti­cles and weld­ing.

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