The cost of "Production Delays"

Imagine for a moment that you owned a business and you were bring a new product to market. It could be running shoes or a new type of automobile or a new anticoagulant medication.

Furthermore, suppose the cost breakdown of manufacturing this product was 40% fixed costs, 40% purchased materials and 20% variable costs.

Fixed costs typically include tools, development costs, facility rental, pre-production advertising and management overhead.

Purchased goods come from suppliers, some of which may be counting on the widgets they will be supplying you to keep them in business.

Variable costs typically include the labor used in producing the goods, on-going advertising, and sometimes licensing agreements.

Suppose this new product is expected to be competitive for a four year time-horizon.

After crunching all of the numbers, you expect to make ten cents on every dollar of revenue.

What could go wrong?

Let's add some noise:

1. Your factory labor goes on strike and demands a 25% pay raise.
2. Your major suppliers goes out of business and the company that purchase the factory and the contracts demands higher prices...such that it increases your purchased parts costs by 10%
3. Start of salable production is delayed six months which would be 12.5% of the production run
   

Labor costs go up:

The cost of labor per dollar of product sold was (0.90 * 0.2) or eighteen cents per dollar sold. After the strike the cost of labor per dollar of product sold is (1.25 * 0.18) or twenty-two-point-five cents. Instead of making ten cents on every dollar of product sold, you are now only making five-point-five cents.

Cost of parts go up:

If cost of purchased parts goes up ten percent, then they went from (0.9 * 0.4) or thirty-six cents to thirty-nine-point-six cents per part. The ten cents per dollar of product sold drops from a dime per dollar to six-point-four cents per dollar sold.

Production delay:

Production delays impact more than just costs. They impact revenue and it isn't just the impact on the number of units sold.

Six month period on the horizontal axis. Relative revenue assuming 100% capacity along the vertical axis

Suppose for a moment that to keep the factory running at 100% capacity marketing has to cut the price 8% every six months as other competitors make newer offerings and yours becomes stale. In our example, the first six months' production sells for a 31% premium to the average for the four years of production and sales and for a 27% discount to the average for the last six months of production.

If you perform net-present-value calculations (7% interest)  and compare the two cash-flows then you find that a 6 month delay reduces your total project revenue by 18.2% which is much more painful than the 12.5% that you might calculate on the back of an envelop.

While that is happening, you are still accruing interest costs through that first six months when you thought you would be raking in money. 

In fact, your plan had you raking in the average (ten cents per dollar of sales) + the thirty-one cent premium which would be pumping forty-one cents for every unit. Instead, you are PAYING OUT forty cents in the fixed costs...i.e., credit costs.

You are going, hat-in-hand to lenders and promising your soul to keep the lights on long enough to work through whatever snarls are delaying your start-of-production. Many companies die at this stage, strangled by declining credit ratings and seemingly endless delays.