Indirect manufacturing costs: An overlooked source for clear savings

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Production-related indirect functions—namely engineering, quality management, and production management—are core functions involved in bringing products to life. These, along with maintenance and supply-chain management, make up the five components of every manufacturing plant’s backbone. When these functions are standardized and seamlessly executed, companies have more flexibility to respond to the challenges of today’s market.

Indirect operation functions contribute a significant share of total operations resourcing—between 8 and 12 percent of total operations cost and between 30 and 35 percent of total operations full-time equivalent (FTE). Given an inflationary environment, in which the cost of materials, services, and labor are likely to increase, optimizing indirect operations offers a level of resilience that could make a big difference to a company’s success. It is not uncommon to identify and unlock a 15 to 25 percent optimization potential in indirect functions, which can translate to a sizeable impact on the bottom line.

McKinsey research conducted over the past five years has analyzed around 1,000 plants to establish benchmarking practices that can help identify and quantify potential for improved performance—and, in turn, increase resilience.

Why indirect operations are often overlooked

Indirect operations functions are often excluded from performance-improvement programs. Such programs tend to focus either on top-down approaches to managing sales, general, and administrative (SG&A) costs, or on direct, shopfloor operations.

Assessing processes in indirect functions is considered more complex than in direct areas, where standard metrics such as overall equipment effectiveness are pervasive. Instead, each company—sometimes even each plant within the same company—generally follows its own approach to structuring and evaluating indirect functions: some organizations integrate their support functions into the factory organization, for example, while others opt for a centralized support function above the plant level. This lack of standardization, combined with a limited understanding of the true workload drivers in indirect functions, makes it challenging to compare the performance of indirect operations across organizations (see sidebar, “Best practices in managing indirect functions”).

Yet indirect functions are essential in driving efficiency in day-to-day factory operations, raising the stakes for leaders looking to make changes. In the short term, new approaches can appear to be a drag on productivity—for instance, increasing rather than reducing resolution times for ad-hoc issues while indirect-function workers learn new problem-solving techniques. Moreover, the sheer range of tasks in indirect operations can make improvements more difficult to scale; improvements in the most meaningful, long-term activities can appear especially difficult to replicate. As a result, leaders can all too easily opt for the seemingly easier option of retaining a larger support team, with efficiency initiatives focused only on shopfloor processes.

The easier option is often a mistake. Indirect operations offer too much untapped potential to ignore.

Successful benchmarking: What it takes

The best way to assess the efficiency level of indirect operations is a detailed benchmarking against peers as well as an internal assessment between plants. A successful benchmarking has two requirements: comparability and calibration.

Comparability is essential for benchmarking. However, several steps have to be taken in order to compare two companies or plants, as there is typically very little standardization across indirect operations.

  • Benchmark capacity—not cost. Capacity is the primary object for benchmarking, as it avoids variables outside a company’s control, such as wage levels, living costs, and inflation across markets. Cost benchmarking can also be distorted by inadequate cost allocation models, which may not reflect the reality for individual plants.
  • Take an activity view. Focusing on the activities within a plant—as opposed to the organizational structure—controls for the differences in organization models across companies. It is even more effective to look at subfunction levels: for example, looking at maintenance as a function and breaking it down further to work-order execution, planning, and managing spare parts.
  • Use standardized definitions. The use of shared definitions ensures the comparison of apples to apples. Companies may struggle to carry out internal benchmarks when job titles and functional roles differ from plant to plant. External benchmarking is even more difficult when definitions are not standardized.
  • Reflect make-or-buy decisions. One company may outsource elements of its plant activities while another runs its warehouse in-house. To allow for comparability, the related costs for outsourced activities need to be transferred back into labor resources. This is done by separating non-labor-related costs, such as warehouse rentals, from labor-related cost items such as wages and salaries, which are then translated into the FTE calculation.
  • Using the right peer group. Every benchmark requires a good set of peers to act as comparators, and robust results require a sufficient number of data points from close peers.

Calibration takes into account the specific factors that have an effect on the scope and complexity of tasks to be performed in an indirect support function. This driver-based logic is common practice in benchmarking sales, general, and administrative (SG&A) costs and could be applied equally well to improve indirect operations.

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For each function, one or more workload drivers can be identified that could largely determine the overall workload for the team. For example, a maintenance technician’s team is driven by factors including the number and complexity of assets to be maintained, their criticality for production, and their loss profile.

But not all of these factors can be practically determined for a benchmarking exercise. Proxies such as asset replacement value (ARV) can help estimate the impact of changes on workloads—as at an automotive company, which sought to assess the effect on its maintenance teams of a proposed expansion with an ARV of $250 million. Benchmarking revealed that a top-quartile performer could plan to allocate 52 technicians to maintain an operation of equivalent size—a significantly lower figure than the 70 technicians the company would require (Exhibit 1). This difference of 18 FTEs represents a gap that can be further analyzed to understand which improvement levers would matter most.

Benchmarking using proxies can reveal major performance differences.

Finding major savings opportunities

The benefits of benchmarking can be substantial. A chemical company found efficiency improvement potential of around 25 percent in its indirect functions after leaders focused on optimizing processes and right-sizing functions within the organization—an exercise it had not undertaken before. A two-week top-down benchmarking exercise, backed by two weeks of shopfloor observations and maturity assessments, provided targeted insights into the most significant improvement opportunities.

When these optimization mechanisms were put into place, the company saw a 12 to 18 percent decrease in logistics costs, a 20 to 24 percent decrease in quality costs, and about a 30 percent decrease in maintenance costs—freeing up resources that the company could reinvest for increased plant performance.

An automotive company undertook both external and internal benchmarking, using top-quartile plants as a yardstick. The combination of these two approaches can reveal more detail about how a plant could perform better, and which actions would improve indirect operations. The results confirmed that the company’s own plants were sources of good practices that could be quickly redeployed in the rest of the network, including in areas such as quality control and production management (Exhibit 2). By emphasizing in-house solutions, this approach fostered manager and frontline buy-in and improved cross-plant development of new ideas.

Internal benchmarks can help confirm opportunities identified in external benchmarking.

From benchmarking to impact: Action steps for companies

Once a plant’s performance gaps are identified, they can be targeted by systematically examining and understanding the factors behind them. Typically, seven impact drivers matter most for indirect functions (Exhibit 3).

There are seven impact drivers for transforming indirect functions.
  • Reduce demand. Decreasing the number of work packages, reports, and meetings has a typical impact of five to 15 percent.
  • Consolidate and outsource. Adjusting the scope of responsibilities between local, central, and external roles has a typical impact of five to 10 percent.
  • Optimize process efficiency. Streamlining processes and tasks can see an impact of five to 15 percent.
  • Implementing stringent performance management. Ensuring optimal delivery of core activities while monitoring continuous-improvement efforts are both essential for [improvement over time].
  • Digitize. Introducing intelligent systems, such as robotic process automation to replace manual work, can achieve impact of 20 to 50 percent.
  • Optimizing organizational structure. Removing overlaps, decreasing the number of layers, and adjusting spans of control can see a five to 10 percent impact.
  • Developing capabilities. Improving team members’ skill sets, particularly versability and productivity, can see an impact of five to 20 percent.

Although benchmarking typically requires up-front effort to ensure comparability and calibration, the payoff—pinpointing needed changes so that the company can focus its transformation for impact— is worth the investment. Companies that realize the potential from improving indirect operations could develop a competitive edge and build up resilience to better face the instabilities of today’s market.

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