Toolkit on how to Start and Improve your Business

Business Implementation

Toolkit for the creation and follow-up of your business

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Organisation and Management  I  Financial Plan

2. Instruction to Production
 

2.1   What is the Production Process?
In order to find out what costs (labour, raw material and overheads) are involved in production, it is useful to follow the whole production process and to identify how the raw material are received and gradually, step-by-step, transformed through various processes (e.g., cutting, mixing, assembling, finishing, packaging, etc.) into a finished product. Description of the process need not be a lengthy explanation, but should cover all the major operations. A process flow chart is a useful tool to depict the production process. This will also clarify how many workers are required at each stage and what skills are needed.

2.2   What Building and Machinery (fixed Assets)
are needed and what will be their Costs?
Identify these items carefully and estimate their costs accurately. If the requirements are over-estimated, the results can either be:

a) Too much production occurs and stocks are built up - this costs money and ties up capital uselessly and unnecessarily;

b) Excess capacity means that you are investing in certain assets or paying interest on building and equipment that are not providing you with any return. This will also increase costs in the long-run by having a higher depreciation than necessary;

c) There is also the possibility that the project may not be financed at all because it appears too expensive.

In general, it is better to start on a very modest scale with a small building, or even rented space, and with the minimum essential machinery. Remember, if the demand for your product exceeds the 8-hour capacity (one shift) of the equipment, an extra shift can be added at a later stage, or you can operate on overtime after the regular shift has ended.  Especially when starting a business, proceed with capital purchases with extreme caution and only when the market is secured.

Regarding machine capacity the supplier should give the correct information to the entrepreneur. In many cases, suppliers tend to over-rate the capacity and efficiency of their machinery; so do not count on the machines working at 100% rated capacity. By determining the realistic capacity of each machine, it is then possible to estimate accurately the proper balancing of the machines and men, i.e. how many of each tools or machines are required, and correspondingly the workers and skills required operating the machines to ensure a smooth and efficient production operation.

Determining the costs of building and machinery should be relatively easy, since every entrepreneur can find out this information from machinery suppliers. Again, you should be cautious not to build fancy buildings or obtain equipment which is too modern or too sophisticated to operate and maintain. Machinery salesmen usually try to sell the most expensive or most modern equipment first, so be aware of what you need and can afford, and do not be led into purchasing equipment which may not be essential or even suitable to your scale of production, especially in the initial stages of your operation.

Be aware that there may be a wide range of technology options ranging from labour-intensive (more labour is required relative to the number of machines or investment in machines) to capital-intensive (more machines are used or higher investment in machines relative to the labour required). 

If quality labour supply can be assured, it is often wise to use labour-intensive technology, since your factory will be less dependent on its machines, which can break down at any time, suffer from power failure, and be idle for lengthy periods. If, on the other hand, labour is troublesome and unreliable due to seasonal availability, a more capital-intensive approach on a modest scale may be more practical. However, if workers are properly motivated, they can be encouraged to become more reliable.

Finally, list all the land and improvements, building, furniture and fixture, machinery and factory equipment including installation costs, stating their size, capacities and costs, to eventually arrive at the total costs of fixed assets.

2.3   What is the useful Life of the Building and Machinery?
The answer will depend on the make of the building (i.e., whether made of wood, concrete structure, etc.) and machinery and on how much you use your fixed assets. To arrive at an annual depreciation charge, deduct the scrap value at the end of its expected life, and then divide the value of the asset by the number of years of its productive life.  If it has no scrap value, simply divide the value by the number of years.

In your country, the Tax Office publishes general rates of depreciation. In many countries, general practice is as follows, although certain variations may exist:

2.4   How will Maintenance be done and are Spare Parts available locally?
It makes little sense to import equipment which, although it may be more dependable, may result in long work stoppages while you wait for the arrival of spare parts from abroad.  Maintenance service and spare parts should be available locally to ensure continuous production. Do not forget

to estimate the costs of maintenance and spares, as this will form part of the production costs. Maintenance costs are part of factory overhead expenses.

2.5   When and where can the Machinery be obtained?
It is necessary to check with machinery suppliers. Estimate accurately the delivery time of the machinery, as this is vital in preparing your pre-operating schedule. Also, do not forget to include in the costs of the machinery, the transport costs to the factory, import duties (if imported), insurance up to the point of installation and installation charges, if any.

2.6   How much Capacity will be utilised?
100% capacity utilisation normally means that the equipment is working eight hours a day, six days a week. Most factories work on an 8-hour, one shift basis and many of them use their equipment for only a portion of this time. Seasonal fluctuations in capacity utilisation should be accounted for. A good example is a brick factory where operations may run continuously for 24 hours a day during the construction season and may be shut down for six months due to Monsoon rains.

2.7   What are the Plans for using Spare Capacity?
Machines and equipment should be used as much as possible. This keeps the workers in a steady rhythm and the equipment in good running order. During periods where low capacity utilisation is foreseen, attempts should be made to ensure that other works (e.g., product improvement and development) are undertaken, which may not at first be directly related to the main production, but which at a later stage may be developed into a new product.

2.8   When and how will the Machinery be paid for?
Certain machinery suppliers are prepared to sell their equipment on hire-purchase scheme.  This spreads the costs of the machinery over a longer period of time, resulting in higher total costs, but it enables the business to have greater cash liquidity or lower investment requirements during the start up period. Before purchasing the equipment, find out the terms of sale, i.e. whether cash, credit, or leasing, the length of payment and other conditions, such as guarantees, after-sales services, training of operators.

2.9   Where will the Factory be located and how will the Factory be arranged?
Almost always in small and medium industries the factories have the same location as their business addresses. 

Equally important is to determine the floor space required by the business (for production, office, store room, toilet, etc.) and more importantly how the factory space is going to be laid out in terms of the spatial arrangement of the machines and equipment. To answer this question, it is essential that you must know the production process and the machines/equipment needed for each process, so that you can arrange the machines according to the production flow as much as possible. 

You can also determine the size of the machines and the space they will occupy (including allowance for movement). A plant layout will be very useful for this purpose. You can arrange your machines in a straight line or a U-shape. 

2.10 How much Raw Material is required?
Now that you have a good idea of the production level you want to achieve, find out the type, quality and quantity of raw material needed.  Find out the input-output ratio or conversion ratio, e.g. how many kilos of oil would be required to produce 120 kg of soap per day. These should be specified according to square meter, kilo, ton, pieces, etc., which will be used per month.

2.11 How much will the Raw Material Cost?
After determining the quality and quantity of the needed raw material, find out their unit costs (i.e., LC2,000 per ton, LC15 per square meter, etc.), list these costs next to the material and prepare a list of average monthly raw material requirements and their costs. Include duties and relevant taxes, if raw material is imported.

2.12 What are the Sources of Raw Material?
Are they available throughout the Year?
In sourcing raw material, at least three factors are critical. Firstly, the price should be as low as possible.  Secondly, their source should be as close as possible to the production site to reduce transport costs. Thirdly, the source should be reliable. 

If raw material is not available throughout the year, at least two alternatives are possible - either the factory will have to reduce production or it must build up a stock of raw material when they are available and plentiful, so that production can be continuous. If the latter is chosen, additional working capital is required and should be included in the calculation of your cash needs and determination of your project's investment requirements, so that the business can cope with this situation. For example, think of the problem involved in obtaining fruit for a fruit processing plants during off-season!

2.13 How many direct and indirect Workers are needed
and what Skills should they have?
Labour in a factory is divided into direct and indirect labour. Direct labourers are those who are directly or intimately involved in the production process. Indirect labourers are all further workers who facilitate production such as utility men, foremen, maintenance workers, among others, who are not directly involved in production. 

To determine the number and type of direct labourers needed, break down their skills into three categories: skilled, semi-skilled and unskilled. Their salary scales should be calculated accordingly.

2.14 What will be the Costs of Labour?
Estimate how much each worker (for example, from the production supervisor/foreman down to the production worker, maintenance man, utility man) should receive on a monthly basis. Labour costs should include effective total labour costs to cover basic salaries, wages, fringe benefits, paid leaves, free meals, social and medical insurance, etc. In certain cases, direct labour will be paid according to piece work. If this is the case, estimate the production output of the worker and multiply this number by the respective piece rate.

2.15 Are Workers available throughout the Year?
If not, what Effect will this have on Production?
Many factory workers in small and medium businesses receive low wages and, therefore, supplement their income with agricultural or other extra external jobs. If this is the case, the business must be ready to cope with such a situation and, either pays its workers competitive or a higher wages/salaries/piece rates, or recruit new or temporary workers during this period, or even be prepared to reduce production.  Whatever course of action is decided upon, it must be accounted for in determining the production schedule.

2.16 How will the Workers be motivated?
Workers can be motivated in a number of various ways: humane treatment, good working environment, increased responsibility, other incentives (e.g., profit sharing, awards for deserving workers, bonuses and providing facilities, such as meal and snack allowances, transport allowances, medical allowances, lodging, etc.) If these are given, their costs should be calculated and included in computing actual labour costs or as overheads.

2.17 What Factory Overhead Expenses are incurred?
Factory overhead expenses include such costs as rent of factory space, maintenance and repair costs, depreciation of factory machines and equipment, costs of utilities (water, electricity, and salary of supervisors, cleaners and maintenance men. In the case of electricity, if it is used in a large quantity and the amount used depends directly on the level of production, it should be treated as a raw material rather than as an overhead expense. But if electricity is only used for lighting and general purposes, treat it as an overhead expense.

Only the costs, such as those listed-above that do not change or vary much according to the level of production are treated under overheads.

2.18 What are the Production Costs per Unit?
Production costs include the costs of direct raw material, direct labour and factory overheads. Two methods are mentioned here to calculate production costs per unit, as follows:

To arrive at the production costs per unit, add the monthly costs of direct raw materials (step 2.11), direct labour (step 2.14), and overhead expenses (step 2.17), then divide this amount by the number of units produced during the course of the month (step 2.6).

It is unfortunate that in real life costing is not quite as simple as illustrated above. The complication arises from the fact that few small and medium industries produce only one item for sale. Whereas it may be easy to identify the raw material costs in any one item, estimating the labour content or allocating a portion of the overheads to a particular item presents another problem.

Allocating Labour Costs:
To assign direct labour costs to any product, follow this simple rule:  Multiply the hourly direct labour charge by the number of hours of direct labour that goes into manufacturing the product. The hourly direct labour charge is derived by dividing the total direct labour costs by the number of hours of direct labour available. For example, if 8 direct labourers work 8 hours a day, 6 days a week for 4 weeks, then the total hours of direct labour available per month is:

8 workers x 8 hrs/day x 6 days/week x 4 weeks = 1,536 hrs

If the total costs of these direct labourers amount to LC4,000, then the hourly rate (LC) is:

Total direct labour costs of LC4,000/1,536 hours available = LC2.60 per direct labour hour (hourly rate).

Example:
If a chair requires 6 hours of direct labour to manufacture, then the direct labour costs of that chair lies at: 

Hourly rate of LC2.60 x 6 hours = LC15.60

Allocating Overhead Expenses:

There are two ways of allocating overheads. These are:

a)  by relating overheads to labour hours,

b)  by allocating them in relation to sales.

The first and preferred way is to relate overhead expenses to the hours of direct labour involved in manufacturing the product. This can be done by dividing the total overhead expenses by direct labour hours available and then multiplying this amount by the number of hours it takes to manufacture the product.

Example:
If total overhead expenses amount to LC3,000 and total direct labour hours are 1536 then the hourly overhead rate is:

Total overheads of LC3, 000/1536 total hours = LC1.95 per direct labour hour (Hourly overhead rate). Then, multiply the hourly overhead rate by the number of direct labour hours used to make the product: 

Hourly Overhead Rate of LC1.95 x 6 hours to manufacture one chair = LC11.70

This figure can then be added to the raw material and direct labour charge to arrive at the unit production costs of the product. The second method of allocating overheads is according to the % of sales of that particular product in relation to total sales. If, for example, a furniture maker produces the following products:

Total sales are LC20,000 of which 20% are chairs, 20% beds, and 60% tables. Therefore, 20% of overheads could be allocated to chairs. The overhead charge per chair can then be calculated as follows:

Total overheads for 20 chairs lies at:

Total overheads per month of LC3,000 x 20% = LC600

Therefore, the overhead charge for each chair is LC30:

LC600/20 chairs = LC30

Similarly, for beds, it is:

LC600/10 beds = LC60

And for tables:

LC600/12 tables = LC150

After having determined the raw material costs per unit, the direct labour costs per unit and the overhead rate per unit, the unit production costs can be calculated by adding all of these three cost components:

+ Unit Raw Material Costs
+ Unit Direct Labour Costs
+ Unit Factory Overhead Costs
= Unit Production Costs

Alternatively, unit production costs can be derived from the following calculation:

+ Total Raw Material Costs
+ Total Direct Labour Costs
+ Total Overhead Costs
= Total Production Costs divided by Total Production Volume  (e.g., kg or units)

= Unit Production Costs

back to Business plan 2  I  Executive Summary  I  Sales and Marketing
Organisation and Management  I  Financial Plan