Product cost can be interpreted in many ways and consists of many cost elements, such as people, materials, energy, equipment, buildings and land. You can add all these costs up, obtain a total and say that it costs so much to manufacture a certain product. But is this the true cost? If you consider it carefully, you realize that this total does not reflect the true cost at all.
Look at the people cost for example. A worker must work a required number of hours to process a certain amount of material needed for the day. This may be close to the true cost. But what if the worker processes much more than is required for today? This excess material will then need to be transported, stored, inventoried, monitored and managed.. Additional people will be required to perform these activities and everyone must be paid. This additional cost is part of the people cost and in the end their wages become part of the cost of the product.
The same can be said for the material cost. If you have just enough material for today’s work, your day’s work can run smoothly. A ten day supply of raw material may be sufficient. But in many companies, the raw material inventory is one or two months and in some it can be as high as six months. In addition to the material costs, there is also the interest charge. The excess material must be stored where it can rust, get broken or damaged, or somehow become unusable. This waste, the cost of unused materials, that are discarded also becomes part of the cost of that particular product.
Many companies buy equipment that is too large for the product they manufacture, because they think it gives them flexibility to manufacture many products on the same equipment. They don’t realize that the larger equipment usually means longer change-over times, higher energy usage, and a much larger floor space requirement. All these waste contribute to the cost of the product.
At Toyota, there is a saying: “The true cost is only the size of a plum seed.” The trouble with many companies is that they have a penchant for bloating the plum seed into a huge grapefruit. Then they shave off some unevenness from the rind and call it cost reduction.