Variances Eroding Factory Profits? Learn How to Measure, Manage

What is a labor and overhead study?

A labor and overhead study is a pillar of plant profitability, helping leaders confirm their approach for measuring plant performance is accurate. Over time, the approach can become out of synch with operating reality, resulting in variances eroding profits. In reality, unfavorable variances or favorable variances are an issue: one impacts profit and one impacts credibility. Over absorbing expenses also misstates inventory on the balance sheet.

Why do a labor and overhead study?

Keeping a close watch on monthly variances is critical for measuring plant performance and avoiding write-offs. As profitability starts to slide, a study is a useful tool to help identify expense creep and cost reduction target areas.

How are costs organized?

Costs are allocated in three buckets for each job or unit of production: material, labor, and overhead. While material is relatively straightforward because there is a supporting bill of material, special math is required to assign labor and overhead to each job or unit.

Labor is organized in two categories: indirect and direct. Direct labor is work required for active production, indirect labor is work required for facility administration and included in the overhead allocation.

Labor absorption

Direct labor absorption measures the percentage of total direct factory labor costs (wages and benefits) allocated to each job or unit of production. Well-run factories typically like to see 85-90% of labor costs absorbed (start-up time, breaks, and clean-up time make up the balance).

Over time, however, turnover, machine inefficiency, a lack of training, and many other factors can result in extra labor required to produce each job or unit not baked into the initial assumptions of the underlying math. Local wage inflation may also cause labor rates to increase.

As a result, the percentage of total absorbed labor costs may erode from say 85% to 50%, and these unallocated labor costs are recorded as variances. Variances are related to underutilized labor and/or unplanned costs that erode profitability.

Overhead absorption

Overhead absorption math is similarly calculated. Overhead includes ongoing expenses required to run a manufacturing facility, including rent, utilities, production machinery, maintenance equipment, office supplies, insurance, and indirect labor (factory supervisors, maintenance staff, and management). These costs need to be accumulated by variable, semi-variable and fixed so the impact of activity can be accessed. A fixed overhead percentage is calculated and applied to each job or unit for costing purposes.

How often should a study be done?

Like any sound hygiene practice, the math needs to be validated periodically as business conditions change. While each plant operates differently, CLA recommends an annual study at a minimum. A significant variance in any given month should trigger a root-cause investigation. If a trend continues, a study refresh is a good idea to confirm mathematical calculations for absorption are accurate (and proper cost containment actions can be considered). Also, a study is recommended when significant changes to the business arise, such as purchasing new equipment, launching a new production line, etc. The goal is to curtail variances and write-offs.

What does the study cover?

The study helps confirm the accuracy of the math calculations used to allocate costs to each job or unit two ways:

• Direct and indirect labor as well as overhead costs, incurred or projected, associated with production. Costs are sorted as variable, semi-variable, and fixed. With a target of 85-90% utilization, we can project standard expenses and compare to incurred expenses which would yield a variance. That variance would show you where to address over-spending or underutilization.
• Production hours generated to manufacture items over the same period as the incurred expense. These are referenced as standard hours. For example, if each unit requires one hour to produce and a worker makes six units in one day, the worker would earn six standard hours. Six productive hours of eight total payroll hours yields 75% utilization.

What data is required?

A study typically requires a few days onsite and access to your enterprise resource planning (ERP and/or other) systems and production forecasts. Key data to analyze includes:

• Process times — Ideally, routing sheets or an ERP system is capturing the time each worker spends on each task related to each step of your production process. For example, in an injection molding process, this could include material handling, setup, operating a machine, finishing, assembly, packaging, etc. – for each job run. Discussions with operations leaders are recommended to confirm the routing sheet data’s reliability.
• Wages — Data from your payroll system, including wages, salaries, and benefits, will be pulled for direct and indirect labor rates calculations.
• General ledger — Data will be sorted for overhead calculations.

What will be required of my team?

• Access to reports — Chances are, you likely have the data – and we’ll work with you to mine it and organize it properly. If the data is difficult to access, CLA’s digital team can help. If the data is not available, we’ll recommend collection procedure(s) and sample sizes to reduce burden on staff.
• Confirmation — As our analysis comes together, we’ll collaborate with you and your staff to confirm the accuracy of assumptions.
• Training — If you’d like to continue with root cause analysis and studies on your own, we’ll help set you up for success with training and a smooth handoff.

What steps are involved in a study?

While each organization is different, here is a basic overview:

• Define scope (products, services, time frame, etc.)
• Analyze routing sheets and calculate direct labor costs.
• Calculate indirect labor costs.
• Calculate overhead costs and allocate based on an agreed upon method such as direct labor hours, machine run time, or other approach or measuring activity.
• Calculate a standard cost per unit including all the calculations above.

How do we get value from our study?

• Educate management on the method and importance of accurate costing.
• Add variance metrics to your KPIs.
• Compare your standard cost calculations to actual costs on a monthly basis.
• As issues are identified, conduct root cause analysis.
• Prioritize cost escalations and inefficiencies to investigate.
• If variances trend or business conditions change, refresh your study.
• Celebrate and communicate wins with your team.

How CLA can help with labor and overhead studies

Monitoring monthly variances is key to measuring plant performance and avoiding write-offs, and a labor and overhead study can help uncover those variances. CLA has conducted labor and overhead studies for a wide variety of manufacturers.