Tough choices improve bottom line numbers.

Smart managers know there's more than one way to lower a high charge-out rate. But what they may not know is that increasing the hours on the shop floor (in the "absorption pool") is never a good idea.

According to Robert Jeske, partner, Ingersoll Engineers, Rockford, IL, this little scenario between an operations manager (OM) and the general manager (GM), or even a company president, in discussing ways to improve bottom line results is more common than you might think.

GM: How does our charge-out rate compare with our competition's?

OM: Well, their rate is something like $50 an hour for machine time, while we're up to $75 or $80. We have to get more hours in the shop to get the rate down.

GM: Let's bring in some of the subcontract work. That will add hours and make us more competitive.

Mr Jeske says the conclusion - that more hours are needed in the shop - is typical and executed in a number of ways:

* Work that traditionally is cost effectively and efficiently subcontracted is brought in-house, regardless of the cost effectiveness and efficiency of internal operations.

* Managers worry about achieving the budgeted shop hours, instead of worrying about what is produced during those hours.

* Smaller companies are acquired and integrated into the organization to increase the number of people in the factory and the hours they work - regardless of their relative cost effectiveness and efficiency

Just about everyone does it, but there's a big problem, says Mr Jeske. "It's wrong. Getting more hours in the plant doesn't solve any problems, and it doesn't reduce the total cost of manufacturing one penny - it may increase it." He explains that accounting principles, as well as logic, show that manufacturing cost is made up of two factors:

* Variable cost is directly related to making a specific product. This category includes such items as machine operator salaries and fringe benefits, and the cost of raw material and parts that go into the product. The test of whether a cost is variable or not is to see what happens to it if no product is made. If it goes away, it's variable. If it stays, it's fixed.

* Fixed cost is not directly tied to a product or overhead. This category includes such items as building maintenance, debt service, insurance, taxes, administrative salaries and their ilk, depreciation (a non-cash item and a means of reducing tax, rather than a real cost), and even some energy costs. Again, the test: If the cost remains in the absence of product, it's a fixed cost. A convenient way to tie fixed costs to product is to put them all in an overhead pool, then allocate them to product by Wing them to an independent variable, such as factory hours:

Charge out rate = Overhead Pool / Absorption Pool.

Absorption Pool

Typically, the hypothesis that follows is a natural one, says Mr Jeske. If the charge-out rate is too high, the solution is thought to be increasing the divisor with more shop hours.

Right? he asks. Wrong, he categorically states.

"The true solution - the only solution - is to reduce the overhead pool so it matches the level of revenue, which is the real size of the business. Increasing the hours in the factory simply conceals the problem of too much overhead. Acquiring other firms just to add hours in the factory has exactly the same effect.

"Obviously, there is another option: increasing the level of business so it requires the size of overhead pool already in place, but that's another issue."

The real solution requires more thinking and, sometimes, "tougher decision making," says Mr Jeske.

If fixed costs are too high because the factory is too large for the level of business, the best solution may be to get rid of the factory.

If administrative costs are too high, the best solution is to reduce them by making administration smaller and more efficient.

If manufacturing costs are too high because of inefficiencies in the factory, the best solution may be to outsource more (perhaps all) rather than bringing more in - or to correct the inefficiencies in the factory.

"There may be good reasons for acquiring firms and products. There may be good reasons to integrate them into a factory. There may also be good reasons to bring in sub-contracted work. However, increasing the absorption pool is never one of them," Mr Jeske concludes.

Clean saws cut quake cleanup

That rumbling feeling in the pit of your stomach could be your reaction to the higher cost of replacing vapor degreasing using 1,1,1-trichloroethane with an environmentally acceptable parts cleaning system, or it could be an earthquake.

For MK Diamond, a Torrance, CA, manufacturer of masonry saws, in 1994 it was both. The California quake resulted in a surge in orders for the company's masonry saws, which, in sizes up to six feet in diameter, are used by demolition teams to cut through concrete walls, asphalt roadways, and floor slabs. Its smaller masonry saws are sold to contractors and consumers through home improvement centers around the country.

The sudden rise in demand came at a time when the company was planning a change in its parts cleaning operation. Figuratively and literally, the regulatory ground was shaking under impending federal deadlines and California's stringent environmental regulations, which require that the company be "hazardous waste-free" by the end of 1995.

Moreover, MK Diamond risked losing its installation permit if it couldn't satisfy local regulations. The number of operating permits issued in the area have been slashed in recent years to minimize the generation of hazardous wastes.

"The environmental agents can walk into your facility and basically start writing fines," says MK Diamond's operations manager, Brian Delahaut. "The moment that we are hazardous-waste free I no longer have to report to them about hazardous-waste movement or the waste streams I generate."

But becoming "hazardous waste-free" comes at a higher price, today. MK Diamond switched from a simple degreasing system to a $176,000 aqueous part washing system. Parts to be cleaned range in size from less than 1 lb to 50 lb. A basket holding up to 200 lb of parts was designed and the system scaled up to accommodate it. Aluminum parts require cleaning prior to powder coating. Contaminants range from foundry sand and metal fines to tapping oils and other tough-to-remove soils. The entire cleaning process, including an integrated heater and blower drying systems, takes only five minutes, using two mildly alkaline biodegradable cleaners that can be filtered, coalesced, and recycled.

Despite the initial high price of the system, MK Diamond finds itself saving about $7000 in hazardous-waste removal costs and breathing a bit easier when the environmental agents walk into its facility.

Getting your dollar's worth

Procurement Resource Services Corp, Troy, MI, provides third-party services in buying and leasing expensive equipment and production supplies.

"My experience and research indicates that most Americans do not possess good negotiating skills," says Brian S Mazar, Procurement's president. "Even purchasing professionals from the largest US corporations tend to be weak negotiators when compared to purchasing professionals from foreign countries."

Mr Mazar's service offers help with negotiations, lease analysis, procurement contracts, and cost reduction maneuvering. His reported procurement experience includes commodities such as machined parts, electronics, computers, software, general services and various types of capital equipment.

Client fees can be based upon a retainer, hourly rate, a fee, or percentage of savings. 'The percentage of savings option is risk free" insists Mr Mazar. "The client is billed only if savings are obtained by the efforts of our company."

RELATED ARTICLE: Charge-out rate too high?

Here's how to get it under control:

* Dive into the costs that make up the absorption pool and find out how (or if) they are related to revenues and operations.

* Analyze the overhead accounts in terms of the level of business and their importance to it. The true solution probably lies in reducing the size of the overhead pool, not in enlarging the absorption pool.

* Evaluate how fixed costs are allocated against an independent variable to see if each product or process is really carrying its own weight. The conventional approach, allocating against labor hours or dollars, often distorts costs.

* Determine the real strengths of the firm, they may not be at all related to manufacturing and internal resources. A strong distribution system may be a more important asset (and a lot cheaper) than manufacturing capability.