Overhead Cost Defined

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14 8 Harvard Business Review S ep te mb er-O cto be t 1 9 5

Ove rhead costs definedI p f ln e lp le . manu1aC1U ( ln gov er head I S ea sy 0define. It I e ludes aA the d ir e ct a nd a ll oca ted cost sof mar l \ jlacture emer lI\atI direct labor an d purenasee materi a ls . Among l hes e cost s a re :oInd 'i rec labOr.including e wages of hourty worKerswn o do no t d ir e ct ly c on1Rbu t8 t o t he manuf aC lu r e o fa prOdUCIbut eonS lS l lng mostly of labor cJed lca edt o ma tenal s hand li ng . mam tenanoe , qual it y OOI1trOl.and Inspeetoon.oGeneral and admin iS ll 3 tl ve expenses wen aspersonnel adm,ntS lra IJ ( )l \. cos t aeooun In9 . secumy.salanes fo: p lan t managemen t. aI\C Clt8OliaborSUl)eMSiOn $we ll a s oo rpo ra te a l1oeat ion sfo r s na red s eN ices and co rpocal e s ta ff .oFacl .l le s and eqU Ipmen t cost S s uc h a s tnSUrance.oep rec la tl oo o f p la n t 8q \' lI pmen and tooling. Thesecosts 1$ 0 in clu de re Is a nd 0 h or fa dli e s-re la te de xp en se s s uc h a s e n erg y a nd ty CO St S. ( ot eIhatln ptooessbased II'IdUStfles. energy COStS mayo o rn pn se 1 1 1Si ng e IlI Ig e st c ompon en t o f o ve r-h ea d a nd to la l C OS ts .O ur d ata s ug ge st a t e ne rg yaoeounts for about 4% o f tlle 0IaI marou1actunngcosts for It yp ica l p i a t in th e e Clto nic s o r m a c hin er y industries.)oE ng ln ee nn g c os ts s ue a s the salanesof manufacturing. ondustr ial . al '\d Other engineers concernedW I h e d esIg n an d m aJ nle nano e o f t!'le produCllOnp ro ce ss l ISen.GMaUt1Ul1S ovethead OOS1.$. including t hos e r e la ted t oh e p r oc ut m en t. m o vem en t (WfII1Ihe excep ti on o ft hose s l' lOp f loor ma te r ia ls -Mnd !i ng eest s r e legal edto tM indirea labor category). an d eoorCitl8tlon ofr aw ma le ials, oo rn ponent s, s uba ss emb l 85 . a ndfinlslled prOdUCts.T ne se c os ts a ts o .n etu d th e s al-a n es o f pu rOhasm9 . product IOn p lann ing . receMng.s todCroom. t raff ic. an d manul ac tunog s ysl emspersonnel.Th IS f igu re ShOwsthe ave r age d is tr ib u ti on 01 t h escost ca tego ri es I II t he f ou r a fe c lr on ocs p la n ts weexamined. OM o f hese p lants ep t its ovemeadaoeounl$ exaClIy e tashoOr 'lw e ha ve descn J) ed,Although 1 1 1 8 1 1 basIC cal~nes were t he s ame . e ac l1had inven ted I SOtnewnal CI1"fferentnomencta lurevd taxonomy Of keepIng t r a ck of t rl esa COSts .Toam ve at a re 11V81yC01 lS I$ l ent - and eomparBbfe-set of n umber s. w e h


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Another factor which lead to PTTT's net operating losses was its rigid organizationaland decision making struc ures. As a result of this rigidity, PTTT was not able to meetchanges within the industry with the flexibility that would result in competitiveness. Forinstance, tin prices began to decline in 1985. Only efficient producers were able tocompete in the conditions that resulted. The lowest cost producers succeeded in the worldmarket. Even though the trend was clear, PTTI could not cut its cost to increase itscompetitiveness. For example, it was not able to reduce its unproductive labor force ordispose of its non-core businesses. As a state-owned company, such measures wouldneedto be fully supported by the govemment. However, "Gaining political support was notonly time consuming but costly" said an analyst who closely observed PTTT's restructuringprogram. Another example of PTTT's inflexibility can be seen in its slow response tomarket trends. The world demand for tin, especially for tin plate, had shifted to low leadtin ( ~ 100 ppm Pb). Countries which use tin had begun to realize that lead has toxiceffects on the human body. Yet PTTT did not promptly respond to this shift in demand.Prior to the restructuring program, no significant investment had been made in themachinery and equipment that would be needed to produce low lead tin.

The nature of PTTT's workforce also contributed to its operating losses. Prior to 1990,the company had a very large number of employees. Of the 24,000 people who workedfor PTTT, less than half were directly involved in the production process. The companyhad developed into a bureaucratic and seriously over-s affed enterprise.External factors also affected PTTT's performance. Since about 95% of the tinproduced by PTTT was headed for international markets, any disturbance in the marketwould significantly affect PTTI. Besides an excess supply of tin, other primary causes forthe deterioration of the world market were the shift of the demand schedule for tin, and thesubstitution effect of other metals. Additionally, even though tin prices were depressed,PTTT's competitors still flooded the international market with their product. This wasespecially true of Brazil and China, who were relatively new entrants into the world tinmarket.In response to the changing situation, PTTT conducted a restructuring program. Itbegan in April of 1990. The mission statement and strategy of the company werechanged. The primary purpose of the restructuring program was to guide the companythrough a series of cost reductions, which would ensure the company's competitivenessin the future. Prior to 1990, the company's corporate strategy had basically been toproduce enough tin to meet its annual tin quota, which had been determined by theAssociation of Tin Producing Countries (ATPC). This strategy had been implementedwithout thoroughly examining financial implications. Production and operation planninghad been carried out on a short-term (1-year) basis.

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relay stations and schools. As a result, their production costs declined from U.S.S7,OOOltonin 1990, to U.S.S4,900/ton in 1992.Employee productivity had also increased. In 1990. employees had produced anaverage of 0.9 tons of tin/year. while in 1992 they produced 2.4 tons/year. Reduction ofemployees from 24,000 in 1989 to 9,500 in 1992 substantially contributed to this increase.Besides the increased productivity of employees, machinery and equipment had also beenupgraded.In 1992, the company had successfully established a management information system(MIS). As of September of 1992, P:rTT's management was able to get consolidatedcorporate financial reports on a biweekly basis. This facilitated a quick decision-makingprocess. Dr. Mangkusubroto commented:

Since November of 1992, from Pangkalpinang, I have been able to monitorthings such as sales volumes of PITT tin in the New York, London andJakarta markets, through an on-line computer network.'

Indeed, observers could attest 0 the fact that in its initial steps, PTTT was successful inimplementing its restructuring program. However, any corporate restructuring program isa complex process involving readjustments of physical, organizational and financial affairs."

Facing the Future

DemandThe IMF (International Monetary Fund) predicts that the growth of the world economywill slow in 1993. A deep economic slump in Europe and Japan will result in a far moresluggish 1993 world market than had previously been predicted. The IMF released itsworld economic forecasts in December of 1992, which stated that growth in the industrialcountries would be two percent this year, well below the three percent predicted only threemonths ago. The economic slump in 1993 is predicted to harm American exports, andmake an upturn in the American economy more difficult. The United States economy isexpected to grow by three percent (1993), compared with one percent in Germany and 2.5percent in Japan. It is further predicted that growth in Western Europe will be a feeble one

percent. largely because of he recession in Germany.')From an Interview with Or. Mangku5ubroto on 2512193'See PT. Tambang Timah (el for detailed lnformation.~Wall StreelJoumal, December 22. 1992. p.t

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SupplyThe condition of the world tin market was indeed not very favorable for most tinproducers, including PTTI. Partly as a result of Brazil's large scale production and lowproduction costs, the international market price had been fallen steadily since 1980 (seeExhibit 2). In 1991, tin stock was still in abundance. even though the total amount of tinexported by the Association of Tin Producing Countries (ATPC) members had beenregulated for several years.The ATPC - the tin cartel, held its tenth session of its Conference of Ministers in

Jakarta, Indonesia. on September 28th and 29th. 1992. Presided over by Mr. GinandjarKartasasmita. the Minister of Mines and Energy of Indonesia, the conference revieweddevelopments which had occurred in the tin market since he association's previoussession in Canberra, Australia in October of 1991. In its assessment of the current andprospective tin market Situations, it was noted that:(a) the large overhanging stocks, which at the end of June 1992 were estimated to besome 33,700 tons, continued to adversely affect the world tin market. Thisproblem wascompounded by uncertainties. In particular there were prospects of increased U.S.Defense Logistic Agency sales.(b) the rate of depletion of overhanging stock could improve in 1992, if expectedimprovements in market fundamentals occur. It was possible that a total depletion of12,000 tons might be achieved in 1992. This would bring year-end stocks to around27,100 tons, still above the desired level of 20,000 tons.

At the conference, ATPC members also agreed to continue Supply RationalizationSchemes (SRS) over the 1993calendar year. According to the SRS. the Total PermissibleExport Tonnage (PET) for ATPC members would amount to 88,400 tons. It would beapportioned as follows:

ATPC Members Tons (1993) Tons (1992)

A stralia 6,500 6,600Bolivia 16,300 16,600Indonesia 30,500 28,500Malays'a 20,000 17,500Nigeria 500 800

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the supply period could vary depending upon the rate of depletion and explorationactivities. When discoveries are made, or when processes for extracting and convertingresources more economically are developed, reserves increase (see Exhibit 4).It was likely that additional reserves would be found if additional exploration wasundertaken. Indonesia was believed to have the second largest concentration of knownreserves in the world after Brazil. According to PTlT's senior geologist, this study did notinclude reserves which may exist outside of PTTT's traditional mining areas.PITT's production plan (see Exhibit 5) showed that PTTrs production could potentiallybe increased from the current production rate of approximately 21,000 tons to 25,000 peryear. This might lead PnT to an increase of its market share from approximately 10% to

12% to over 20%. This increase would require substantial exploitation of land-basedreserves on Bangka Island. In the lonq- term, the continued discovery and mining of newdeposits would be needed. The production plan also indicated that, upon restructuring,PTTT could reduce its cost of production from U.S.$4,900 per ton in 1992. to approximatelyU.S.$3,900 per ton in 1994. The cost curve shown in Exhibit 6 indicates that the reducedcost of production would move PTTT from a high cost producer in the lowest cost quartileof world producers, to a low cost producer in the same quartile.The implications of such an expansion would be Significant, and likely detrimental toPTTT. Expanded production would either come in place of PTTT's current production, orin disregard for the quota system. If PTTT were to disregard the quota system, it isexpected that a decline in the price of tin would result, along with market instability. Whilesome high-cost producers might be driven out, PTrTs profit margin would almost certainly

suffer. PTTT needed to decide whether that would be beneficial in the long-run.Projected Course of Action

Under the newly appointed President Director of PTTT, Dr. Mangkusubroto, arestructuring program had been undertaken. The program was now entering its fourth yearof development. The entire program was, in fact, scheduled to be completed in 1996.Some remarkable achievements had been made ahead of schedule: the reduction of thecompany's staff, the divestment of non-core businesses, and the installment of an MIS.This resulted in an increase in the company's produc ivity.On the other hand, the management of PTTT foresaw the future instability of the worldtin market, which would affect the future of PTTT. The oversupply that continuously

flooded the market, and the shift in the demand schedule from tin to its substitutes wouldsurely prove to be significant problems for the tin industry. "ln the long-run, the future ofthe world tin industry is a big question mark, and therefore so is the future of PTTr saidMr. Wimar Witoelar, a consultant involved in PTTT's restructuring program.As the management faced the fourth year of the restructuring program, it examined theopportunities and problems faced by PTTT. It was clear that they needed to make some

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PT, Tambang Timah (e)Exhibit 2, International Tin Prices

Price US$/MT Sn. Price US/MT Sn.(1990 USs. based)1970 3,572 15,8321971 3,462 14,0461972 3,638 13,5601973- 4,675 14.8391974 7.784 22,3591975 ~. . 6,637 16.7581976 7,299 17,5741'977 ::..- 10,606 23,5051978 I 12,502 24,079 -1979 14,818 25,9751980 16.405 26,3721981 . 14,024 22,6011982 12,943 20,9701983 13,009 20,7051984 12.458 20,0001985 11,885 18,8531986 6,130 8,2471987 6,681 7,9601988 7,056 7.8061989 8,534 . 9,4371990 6,086 6,0861991 5,593 5,4251992 (Jan- March) 5.571 5.348

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~.PT. Tambanq Tim~h (e)Ex~ib~t 3. Parameters for The ATPC's Supply ~ation l':ation Scheme

Supply/Sources3.).lanc 1991 SRS 1992 SRS 1993 1993Par ~ eers Parameters Mose LikelyCase(h'ithout SRS)

76,900 176,000 176,900 176,000

ToeAl SupolyOS OLAPro~uction-Othar~Unspecified Origin( )Sub-toca 1 (B)Balance for:"TPC/ Bra: il/C~\l.na.(C=A-8)

6,20023,3008,30037,800

8,000 9,,000 10,00020,000 21,000 21,0008,400 4,300 1,90036,400 34,300 32,900

39,600 1. 1,700 143,1007,700 15,000 20,000

121,900 126,700 _23,100

39, 00.ss: China's 15,700expo re (0)Sa ance for ATPC 123,400and Brazi (t;.C-O)

ATPC Production/ ?


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PT. Tambang Timah (e)Exhibi 5. The Estimated Production Capabili ies of PTn"

.un ltU W!!. l.W lW ill.!. l1U lU1 1222 ~IIl~!it~:"a !l!lll" 10,747 H 19,)1' l7,909 10,1" lO,n, H,O" n,'" n,no l2,lH~~~'2s:s;igD'SlW0 ,. 4" . . (&'!.s~ou) ll,4H 17,179 14,'1l U,7I7 20",27 20,~17 20,Q} 10,'7) 10,4H 20,'Htd,sc1.n.& C,,...,c.l

" ' " " P ' 7 ,&11 4,)U },Hl r. Jt) 2,HO 2,720 l,UO J,lH ),'lS ',H1S}C\;t"t CC4".1 ~. ,.(HI,h c ~.)P~nf\o:. 11) , 410 '10 '00 )00 I~O l o o }OO }OO )00.............

:-6C4 -:'."h 21.1" 22.1 n.H' u. t 0 2),299 2).9S l',on 2',ICO l',no 25.)".' 0- r . . , . . rr.~h.u;.tL~H\ 1,000 1,003 1,000 1,000 1,000 7,O~ 1.000 1.000 ' . 0 0 0 1,000

':'oca1 10, H9 a.t. l?, Sl 2',HO )O,2?4 l~.US ll, ~94>1.)00 n .'10 H.)1SSource: Arthur Anderson, 9921. PT. TOlmllang Timan (pc~sC!rol. RestruC:lu/,ing Study,Vol.2.o es:

" '.' , . Increasino drOdOOoutP t lo!lcets the p/ooreS$ of tho Icfurbl:;hmont program, Tho drop In 1994rotleet: tho f C, thilt thi:; J~ tno fi/~t yo!>r whon thO dry dock. a'o u~o


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Overhead Cost Defined