9.4 Nature of Manufacturing Costs

Defense Manufacturing Management Guide for Program Managers
Chapter 9 - Manufacturing Cost Estimating

9.4 Nature of Manufacturing Costs
9.4.1 Fixed Cost
9.4.2 Variable Cost
9.4.3 Direct Cost
9.4.4 Indirect Cost
9.4.5 Nonrecurring Cost
9.4.6 Recurring Cost
9.4.7 Other Cost
9.4.7.1 Tooling Cost
9.4.7.2 Special Test Equipment Cost

The cost to manufacture a weapon system or equipment results from a combination of the design, the physical facility, and the five M's (manpower, materials, methods, measurements, and machines) used to build the design and the management efficiency of the operation. This is illustrated in Figure 9-1. As such, the manufacturing cost for a product should be viewed within the context of the factory in which the product will be built. Three other very significant cost factors will need to be identified to support the estimating activity, and these are rate, quantity and efficiency.

Figure 9-1 Manufacturing Cost

You will need to have a basic understanding of several accounting terms, especially as they relate to the manufacturing environment, if you are to understand manufacturing costs. These terms include:

• Fixed Cost,
• Variable Cost,
• Direct Cost,
• Indirect Cost,
• Nonrecurring Cost, and
• Recurring Cost.

A classic division of manufacturing cost is between direct and indirect costs. Costs can also be described as fixed or variable based on their behavior as production volume changes within broad limits. Finally, costs can be described as nonrecurring or recurring depending on when and how often costs are accumulated. Finally, costs can be described in multiple terms, thus materials could be both a direct and a variable cost.

Fixed costs are those costs that remain constant or fixed and do not vary with output or activity. Fixed costs are further subdivided into committed fixed cost and discretionary fixed costs. Committed fixed costs are costs that typically cannot be changed (up or down) over a short term and often include buildings and facilities, insurance on the buildings, taxes on buildings, salaries of permanent employees, and major pieces of equipment. Discretionary fixed costs are costs that can change over a short period, often due to management decisions about certain cost activities. Examples of discretionary fixed cost can include the budget for research and development, maintenance, advertising, and programs to develop managers, employees or interns.

Figure 9-2 Variable Cost

Variable costs, as the name implies, are costs that vary with production or the level of activity. So as you produce more units your costs go up as you use more material, energy, direct labor, etc. Variable costs include direct materials, direct labor, indirect materials, energy, and a portion of manufacturing overhead.

Fixed and Variable costs can be further broken down into two other cost types.

1. Direct, and
2. Indirect.

Direct and indirect costs classify the costs of production (fabrication and assembly) and are critical to calculating shop overhead rates.

A direct cost can be defined as "any cost that is specifically related to a particular final cost objective, but not necessarily limited to items that are incorporated in the end item as material or labor." The majority of the direct cost is involved in the direct material and direct labor used in designing and fabricating the system or equipment.

Direct material includes the cost of material used in producing a specific product and that cost is not shared among other products. For example, an aircraft manufacturer may buy aluminum sheets in bulk, but the material cost gets allocated to a specific aircraft family (F-14, A-6, C-2) which uses the material. One way to look at direct costs is to look at the bill of material (BOM). A BOM (Figure 9-3) lists the materials, components and quantities of materials that go into a specific job or end product. The typical BOM accounts for hardware only and does not take into consideration other manufacturing costs such as fabrication and assembly cost. A BOM supports the determination of the final cost for direct material.

Figure 9-3 Bill of Material

Direct labor includes the cost of the workmen or craftsman used in producing a specific product and that cost is not shared among other products. For example, labor used to fabricate parts for the Saratoga (a light weight, mobile, multipurpose vehicle produced by Navistar for the U.S. Army) or for assembly and test operations on the Saratoga, are kept separate from the fabrication, assembly and test costs for the Navistar MXT Cargo vehicle.

Direct costs are important elements of cost and often account for 30 to 60 percent of total cost. But equally important consideration is that direct costs form the basis for allocating most of the indirect (overhead) cost. Direct costs of material and labor (manufacturing and engineering), in particular, often serve as bases for the application of costs from overhead pools. If the price to the government (Figure 9-3) is the total of direct cost (material and labor), indirect cost, general and administrative cost, cost of facilities capital and profit, then a change in direct cost can produce a much larger change in price to the government. This is due to the wrap rates of G&A (25 percent) and Profit (15 percent) multiplies the effect of changes.

An indirect cost can be defined as "any cost not directly identified with a single, final cost objective, but identified with two or more final cost objectives or an intermediate cost objective." After direct costs have been determined and charged directly to the contract or other work, indirect costs are those remaining to be allocated to the cost objectives. Indirect costs cannot be directly attributed to the manufacturing of a specific product. Utilities are an example of indirect costs because it is extremely difficult to identify which products used the energy. Employee's who are not working on specific products are considered indirect. Another way to look at indirect cost is to look at costs or expenses that are shared by more than one product or function. So the company's legal organization is usually considered an indirect cost as they support all other organizations and functions and usually do not allocate cost to specific products.

Figure 9-4 Indirect Cost

At the beginning of a production program, the contractor expends funds to establish the specific capability to manufacture the weapon system or equipment. These nonrecurring costs are a one-time expenditure and generally include such things as special tooling, special test equipment, plant rearrangement and the preparation of manufacturing instructions. The objective of the contractor and program office should be the definition and achievement of a level of nonrecurring cost that will minimize total cost of manufacture. The investment in nonrecurring costs can be evaluated as a tradeoff decision in that improved tools, test equipment and planning can result in lower recurring cost.

Recurring cost are the costs which must be incurred each time a unit of equipment is produced, such as direct labor and direct materials. The relative levels of recurring and nonrecurring costs can be evaluated in investment terms since the nonrecurring costs should provide the capability to manufacture the equipment with a lower direct labor input per unit. The total cost to manufacture is the sum of the recurring cost plus an amortized share of the nonrecurring cost. As a result of the relationship, decisions on the level of nonrecurring cost should be based on a specific quantity to be produced and rate of production.

Two other cost types of manufacturing cost will be reviewed. They include:

1. Tooling Cost, and
2. Special Test Equipment.

Tooling is one of the major categories of preproduction and production cost. Tooling refers to special tooling consisting of jigs, dies, fixtures, and factory support equipment used in the production of end items, and does not include machines, perishable tool items, or small hand tools. Tooling cost can be a very significant budget item. The Joint Strike Fighter programs planned investment for production was estimated to go from $100 million a month in 2007 to $1 billion a month in 2013. And an additional $1.2 billion in tooling would be needed to ramp up the production rate to 143 aircraft a year.

The key issue in estimating and analyzing tooling costs is the planned rate and duration of production. The production rate and duration will establish whether there will be hard (durable) or soft (limited life) tooling; whether the tooling will be limited to the production rate required under the proposed contract, or whether it also anticipates production rates of future requirements or the need for surge or mobilization. If tooling is planned in anticipation of future orders, the justification for these plans should be verified. Follow-on purchases should always be analyzed in light of the type and extent of tooling authorized by the government in prior contracts. Any changes to the rate of production or quantity may have a significant impact on tooling costs. It is important that the contractor's tool planning be based on the needs of present and reasonably predictable future purchases.

There should be an inverse relationship between the amount of tooling and the number of direct labor hours expended per unit of product as tooling if often used to reduce touch labor. Analysis of tooling cost requires evaluation of material requirements recognizing that many contractors purchase all or a significant part of their basic tooling requirements. Analysis of the labor hours, labor rates, and overhead rates applied to the tool design, fabrication and maintenance efforts is still a significant cost item to be examined, even though passed on to a vendor.

The Federal Acquisition Regulation (FAR) Subpart 45.1 defines special test equipment, as "either single or multipurpose integrated test units engineered, designed, fabricated, or modified to accomplish special purpose testing in performing a contract. It consists of items or assemblies of equipment including standard or general purpose items or components that are interconnected and interdependent so as to become a new functional entity for special testing purposes. It does not include material, special tooling, facilities (except foundations and similar improvements necessary for installing special test equipment), and plant equipment items used for general plant testing purposes."