High Costs ≠ High Costs Per Unit

Costs of production are top of mind for every manufacturer.

Raw material prices fluctuate with changes in economic conditions, regulations, tariffs, and trade policies. Shortages for skilled labor puts upward pressure on wage costs. Increasing energy costs from suicidal green energy and environmental regulations further increase the costs of production. The only way to stay competitive is by creating a Cost Advantage.

A Cost Advantage focuses on lowering costs per unit produced or sold.

The lower your costs per unit, the more options you will have to increase profits and cash flows. You will have room to be flexible on pricing, enabling lower bids to increase sales volumes. The cost savings from production improvements can free up capital to improve other areas in the business to further increase your bottom line.

High costs as measured in absolute dollars does not mean you will have high costs per unit produced or sold.

The Betrayal of Large Multi-National Manufacturers

Many view costs in terms of total dollars.

This means they look at costs per employee, costs per piece of machinery, costs per facility, etc. While this can be useful, it doesn't show us what actually matters. Do we really care if our costs per employee are 3x the industry average if our costs per unit produced is 10% lower than anyone else?

Manufacturing employment in the United States peaked in 1979 at ~19.6 million jobs. During this time, the U.S. had some of the highest manufacturing wages in the world.

Then the betrayal of large multi-national manufacturers began to snowball.

These businesses have zero allegiance to the people in the U.S. who were responsible for their success. They chose to maximize short term gains at the expense of the long term. Instead of making investments to create new technology, systems, and processes to improve productivity to lower costs, they chose to offshore their operations to foreign countries. This enabled them to take advantage of 3rd world labor costs, maintain access to the U.S. market which is the best in the world to sell their production into, while not having to take the risk from productivity investments.

Despite the offshoring, we still have ~12 million people employed by manufacturers in the U.S. today.

Manufacturers here in the U.S. are still able to be competitive. They're able to do this by focusing on increasing productivity to create Cost Advantages.

So how exactly can your manufacturing business create its own Cost Advantages to increase its price competitiveness and increase profits, while simultaneously providing high paying jobs to your employees?

Creating a Cost Advantage

Cost Advantages are the byproduct of improving productivity.

It comes down to getting more output for a given input. Instead of taking 5 machine hours and 10 direct labor hours to produce 10 units, we're able to produce 20 units with the same number of hours. Cheaper hourly wage costs, costs per ton of raw materials, or conversion cost does not always result in lower costs per unit. Increasing productivity is the key to outperforming the competition.

The 3 keys to create a Cost Advantage are:

• Systems & Processes
• Technology
• Human Capital

Let's dive deeper into each of these to uncover how they contribute to creating a Cost Advantage.

Key #1: Systems & Processes

Systems & processes focuses on improving how things are done within the business.

One of the best examples of a systems & processes improvement was Toyota's Lean Manufacturing System.

This enabled Toyota to dramatically reduce its costs per unit. Lean Manufacturing focuses on maximizing customer value while minimizing waste. One key component of this system was the Just-In-Time (JIT) inventory system. JIT focused on producing only what was needed for any given time. This helped reduce costs by decreasing inventory levels in raw materials, work-in-process, and finished goods, which frees up cash as there are less carrying costs required to store these inventories, reduced the likelihood of obsolescence, and minimized working capital requirements.

Lean Manufacturing also focused on eliminating product defects. This reduced the costs of reworking products as well as warranty and recall costs. It also had the benefit of increasing customer satisfaction as the quality of production was dramatically improved, which increased the value Toyota provided to customers.

The Lean Manufacturing process was transformed into a formal certification (Lean Six Sigma) and was adopted across various manufacturers and even applied to non-manufacturing industries such as healthcare and consulting. This is just one example of how transformative improvements in systems & processes can be for your manufacturing business by increasing productivity to drive down costs per unit.

Key #2: Technology

One of the best ways to increase productivity and reduce costs per unit is implementing technology.

Henry Ford's moving assembly line is a great example of this.

In 1908, the Model T was priced at $850 and it took over 12 hours to assemble each car. After the moving assembly line was implemented, the price of the Model T was reduced to $490 in 1914 and the time required to assemble each car was down to 93 minutes, an 87% reduction. Such improvements in the assembly process allowed Ford to lower the price by 42% over the same time period, enabling it to sell more volume which further helped reduce its costs per unit as fixed costs were spread over more units.

Internally developed machinery and software, or implementing new technology from suppliers help drive down costs per unit by allowing more work to be done in less time.

Key #3: Human Capital

The final key to creating a Cost Advantage is improving the quality of your workforce.

Human Capital is the largest area of the Cost Advantage to cover. There are 4 components to focus on:

• Hiring Process
• Training
• Compensation & Upward Mobility
• Employee Retention

Hiring Process

This key area begins by getting things right in the hiring process.

Doing so helps increase the success of all the other components of Human Capital. The cost of hiring new employees has elements of direct and indirect costs. Examples include job board advertising, pre-employment testing, background checks, the time spend by existing employees involved in the hiring process, administrative costs, etc. Other costs are not as obvious, such as new hires having far lower productivity levels until they ramp up and become more efficient. It could take several months, if not years for new employees to reach the same levels of productivity as existing ones.

Hiring costs can quickly add up and become a drag on the company if you get the hiring process wrong. You'll either end up with unproductive and potentially cancerous employees in your organization or you'll have excessively high employee turnover rates. Both will have disastrous effects on your financial performance.

To increase the success of this area, you'll need a filtering mechanism to ensure you are hiring the employees that best match your company's values, culture, and skillset requirements for the given position. Hiring the right people from day 1 will reduce your hiring related costs and employee turnover, which helps drive down costs per unit.

Training

Now that we hire the right people from the start, we can focus on increasing their productivity as quickly as possible.

Most manufacturers below the $15.0 million annual revenue level will rely on informal training for their employees. The most common way is usually sticking new hires with someone like Frank, the company's most productive employee on the production floor to shadow him for some period of time. While this is a great way to train new hires, the problem is all the production knowledge is stuck in Frank's head. There's no formal processes set up to ensure new hires are checking all the boxes to determine whether they have learned all that is required or if they are up to date on the latest strategies implemented by the business. Things can fall through the cracks as there are no processes in place to correct these errors.

Formalizing training can dramatically improve performance. Start by getting your best production employees together to go over the various processes that new hires must learn to be efficient and effective. Your training will not be a living document that can be adjusted as necessary when new systems & processes, technology, and other improvements are implemented.

Another overlooked area is cross training. Employees get sick, go on leave of absence, or flat out leave the company. When employees are trained in a variety of production areas, you can fill in gaps to address staffing shortages or cover large production orders that create a bottle neck in a specific area.

Ongoing training is the final aspect to consider. This helps upskill your workforce by ensuring they are trained in new processes, machinery, software, strategies, etc. Combine all these training aspects to ensure productivity is not only maintained, but dramatically increased.

Compensation & Upward Mobility

Attracting and retaining the best employees requires compensating them in a way that rewards their above average productivity and provides a career path if they choose to pursue it.

This helps address the "what's in it for me?" question. People want to know they will be rewarded for the hard work and results they deliver. Variable compensation is a tool that helps answer this question.

Variable compensation models require employees to clearly understand how their variable pay is calculated and the actions they must take to earn it. Metrics for determining whether performance is above or below target should be objective and easily quantifiable. They must balance speed and cost reductions with quality production and safety.

Let's use a production floor employee as an example.

We can provide a base hourly wage, plus a production & quality bonus as variable compensation. Variable compensation should balance output with efficiency and quality. For this example, the production floor employee has their variable compensation contingent on two separate metrics:

• Units produced above a daily/weekly standard (x number of units per hour) to incentivize speed and volume
• Achieving a <x% defect rate to ensure we balance speed with quality and prevent rushed work

To make this compensation effective, the base compensation should be within the range of market rates while the variable compensation should put them in the top end of the market range. This helps attract the type of employees who are most productive and the additional costs from the variable compensation will be more than paid for by achieving lower costs per unit.

Providing upward mobility for those who desire helps retain ambitious employees. If you do not give them an opportunity to advance into higher level roles, they will seek out opportunities elsewhere. A culture that promotes from within is crucial to retaining these high achieving employees.

Employee Retention

The final area of Human Capital is employee retention.

This is an area with large financial implications that aren't always obvious.

A high employee retention rate is an under appreciated productive asset for any organization. Employees with long tenures will be more productive than new hires. This is because they've built up industry and company specific knowledge over the course of their time with the company. They know the business inside and out and understand infrequent events and nuances that impact operations and performance. Costs per unit can be reduced by having retaining these highly productive employees by routinely meeting production targets due to limited open roles due to employee turnover at any given time.

By following the previously mentioned key sub areas of Human Capital, you will already will be in a position to increase employee retention.

Hiring the right people from the start reduces turnover caused by hiring people who aren't a good fit for your business. Training them during onboarding, cross training them, and providing ongoing training sets them up for success. Providing variable compensation and upward mobility rewards them for their efforts and provides them a path for progressing their career if they so desire. They are far less likely to voluntarily leave the company for opportunities elsewhere when you give them the ability to increase their pay towards the upper end of the market rate thanks to the variable compensation component of their pay.

All these help build trust with your employees as they know they will be set up for success and are rewarded for their hard work.

Creating a Cost Advantage is an iterative process. The key is to prioritize the areas that are currently constraining the business, implement changes to improve them, and then move on to the next constraint. A Cost Advantage is key to price competitiveness and frees up capital to make investments to improve other areas of the business to further increase performance.

You can watch videos and read newsletters all day, but nothing beats looking at your own numbers. If you're ready to stop guessing and start implementing a clear financial strategy that puts more profit in your pocket, then it's time for my 1:1 Financial Clarity Assessment. We'll deep-dive into your company's financials to pinpoint the exact levers you need to pull for immediate, actionable improvements.

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