Every business involves production. Even a service company follows some production process in order to deliver the service to the customer. Every investor should understand the process by which the product or service is produced for the customer. Most of this chapter deals with the manufacturing process. However, the investor should become familiar with all the stages of production in order to understand this area.
The production process also includes purchasing. Here you will identify the suppliers for the business. In addition, there is usually a shipping and a receiving area; both of them need to be examined. Customer services usually pertain to the production area. That is, after the product has been shipped to the customer, if the customer complains, the production department has to make good on what it has shipped to the customer. Finally, research and development (R&D) is critical in every growing business and must be understood by the investor if he or she is to determine whether the investment is suitable for the long term.
You should also examine the facility where the production takes place, even if the property is leased or owned. A number of basic questions need to be asked. First of all, what is the exact address of the production area? If it is on the property, what is the square footage of the land? If it is owned, what is the cost of the land? Also, if it is owned, what is the assessed value for tax purposes and the fair market value today? If you have an appraisal, what is the date of the last appraisal and what was its appraised value?
The building size is another important item, along with the age of the building and any expansion that has been done. The condition of the building and the possibility for expansion should also be investigated. To understand the value of the assets, you should determine the assessed value of the facility for tax purposes, the fair market value from an appraiser, and the date of the last appraisal.
Here you are trying to determine whether the plant is adequate for the company. If it is not, a move in the near future may be necessary. Your analysis should also determine whether the facility is a “good deal” or is an albatross around the company’s neck.
One nice little business was doing $5 million a year, but unless it could crank the operation up to more like $15 million in a year, the facility would remain too large. The company was investing a great deal of money into a huge facility in hopes that sales increases would soon fill up the plant. Sometimes entrepreneurs don’t understand real estate. They take on far too much real estate and let it drag the company down. Entrepreneurs should also realize that they are not in the business of investing in real estate. Ownership of real estate may be nice for a mature company that needs to invest its money. However, for a start-up company, owning its own real estate is not nearly as important as having enough working capital to produce the product.
This is a good time to ask questions about the insurance coverage on the building. Does the company have fire and hazard insurance? Does it have insurance against floods and hurricanes?
Also, you should ask questions about the amount of the mortgage on the property and the monthly payments. If the property is leased, of course, you should make notes on the amount of the monthly payments, when the lease is to expire, and whether there are any renewal options.
As part of your due diligence, you may determine that the company will have to move its plant. This is perhaps the single most traumatic event any company can experience. Moving a company will be extremely disruptive and will take up a great deal of management time in the planning process, the actual move, and the adjustment period. Many management groups can be hired to help with the move, so most entrepreneurs believe that a move is a fairly simple process and will not engage them. The truth is that moves usually cause considerable disruption in production, as well as in the overall management of the business. Many companies go through such difficulties when having to move, and you could witness your investment dwindle so rapidly in the process that you should avoid them whenever possible.
Once you have an understanding of the facility itself, it’s time to move on to the machinery and equipment. Ask some basic questions, such as the age of the equipment and current repair costs per annum. It is also important to know whether new replacement equipment and spare parts are available.
A firm that was started in 1920s found that the very specialized equipment that it used was no longer being manufactured. This meant that every time a part was broken, the company had to make the replacement item itself. This is the type of very time-consuming process that could interfere with production for some time if a major piece of the machinery breaks.
As an investor, you should know what kind of new equipment appearing in the marketplace might make this company’s equipment obsolete or put it at a competitive disadvantage. It’s been reported that the new steel mills in Europe and other parts of the world are much more efficient and better able to utilize the new technologies than the old steel mills in America. As a result, the American steel industry has suffered.
You should ask the production people what kind of production equipment is used by the competition and how efficiencies are gained, as compared with the company. Does the competition have more modern equipment or a better assembly-line process? Is its plant better laid out? What does the production process at the competition look like and how can it be emulated here? If the company has a poor process, perhaps a different method of production will have to be invented.
You should ask whether the company has a formal preventive maintenance program for repairing machinery on a regular basis. If so, investigate the program and determine whether staff are maintaining the equipment adequately or are just running it into the ground; also determine whether you can expect huge maintenance costs to show up as soon as you make your investment.
Be sure you meet the person who is in charge of preventive maintenance and talk to that person about what kind of reports are prepared on the maintenance of the equipment. Make sure to ask whether the company anticipates any major repairs or reconditioning work to the equipment in the next 12 months. Get an idea of what kind of repairs are going to be done in the future and see whether this amount corresponds to the figure being used by the financial side of the business in its projections.
Ask the person in charge of equipment whether new capital equipment or new production space is needed during the next 12 months. If the answer is yes, you should try to determine how much more space or equipment the company will need. You should review these items and amounts with senior management and compare them with the company’s capital expenditure budgets for this year and several years to come.
Always ask people in production the following questions: If you had no money constraints, what pieces of equipment would you replace? What new equipment items would you add to improve efficiency? This usually gives us a pretty good idea of what items are needed in the production process.
Also ask which piece of equipment is responsible for the current bottleneck in the production process. Looking to the future, ask which area of the production process will need to be increased as the number of units produced increases.
Another factor to consider is what pieces of equipment can cause a production stoppage for any significant period of time; for example, anything over four hours. How many times has the production process been shut down in the past because of equipment failures? What plan exists if a certain piece of equipment fails and shuts down the production process? What will management do if production is shut down by this one piece of equipment?
It is important to know how easily production can be shut down. If it seems a likely event because the company has only one piece of critical equipment, this means that the risk in investing in this company is fairly high because there is no backup.
One company was in the business of making jackets for records and CDs. As the company developed, it decided to purchase a special piece of equipment for making record and CD jackets from Germany. Although the company did spend a great deal of time making sure that the German equipment worked properly, it was not until the company had actually installed the equipment and began operation that it discovered a serious problem. To begin with, it took hundreds of hours to get the equipment to operate. Many Germans flew to the company’s plant to help the management team make the piece of equipment work.
After months of working on the equipment, it was found that the equipment was not much better than some of the existing machines already on the market. Even though the piece of equipment handled the entire operation from start to finish, it was no faster than two smaller, American-made machines operated by seven people. The savings in labor were not realized because when all was said and done, it took seven people to keep the new German machine in operation, three in actual operation and four as a support group handling software tapes and other aspects of the machine after some months of operation.
Here are some other important questions to ask about equipment: Do you have surplus equipment, and if so, is there a plan to sell off this equipment? Do you have any surplus or idle building area that could be subleased? These kinds of questions should tell you whether the company is overcapitalized from the standpoint of machinery, equipment, and building. If there is a substantial amount of excess equipment, perhaps it should be sold off.
In this world of ever-changing technology, it is critical to understand that a company’s equipment must be modern enough to prevent it from sinking to a competitive disadvantage. This may take some snooping among people (other than management) in the production area so that you can understand what they are thinking. If they constantly complain about not having the latest equipment, you can be sure that they are at a disadvantage.
You should establish whether a formal procedure exists for approving capital expenditures. You should also determine whether equipment can be purchased just because the production crew wants to have the latest gadget.
At a company involved in high-technology video production, the management was in love with new equipment. They bought every new “gizmo” that came on the marketplace, and they were constantly changing every part of the production process. This wreaked havoc on the process itself and drained the company of the capital needed to do the marketing, even though it had the most modern, beautiful equipment. After the company failed and went into bankruptcy, the beautiful equipment was auctioned off for a few cents on the dollar.
In purchasing equipment, management should look at this as a return on investment. When the company is about to buy a piece of equipment, it should calculate the return on investment on the basis of the expenditure of funds. If the company buys a $60,000 piece of equipment and the return on investment is 10 percent, the company probably should not buy it. As an investor in the company, you will want to know how the company calculates the return on the money it invests in equipment or any other part of the business.
All of the questions above were oriented toward determining the capacity of the facility. It is important to know how much it can produce. If you are investing in a company that is near its capacity and none of the investment capital is going to be used to increase that capacity, the company will obviously have to obtain financing for new equipment before it can expand capacity.
You should also compare the capacity with the backlog. If the plant cannot chew up the backlog for several months or even a year, perhaps management should consider increasing its capacity so that it can catch up with the backlog for delivery to the customer.
Even though you have already spent a lot of time investigating the employees of the firm, you still need to look at another aspect of the employees. What you are looking for now are the really tough jobs in the production process. You need to identify the key production positions and determine what personnel backups you have for each of these key positions. If there is an extremely high-skilled job and only one person is doing it, what happens to the firm when that person is out sick?
You must recognize that the people involved in the production process can be a limiting factor. If it is extremely hard to find a critical person, such as a qualified machine operator to operate certain types of equipment, the production process can obviously reach capacity quickly and will be difficult to expand.
Training is the key to the growth of any company. You should review the company’s training manuals and determine how it is training employees to help increase its capacity and its productivity. Find out how production management selects and trains individuals, as well as new supervisors. Determine who does the training and how it is carried out. Here you are looking for a logical approach that will show employees how to be highly productive and get the job done. A haphazard approach to production training will be a deterrent to growth.
Employees must be motivated, whatever the production process. You need to understand specifically how management measures employee productivity and efficiency. You also need to know whether employees understand the importance of this productivity and efficiency. Try to get a handle on the specific techniques that management uses to motivate the employees.
If you have the opportunity, review several employee evaluation forms and see whether management is making a conscientious effort to spur the employees on through regular evaluations. In addition, ask for the amount of turnover in the production process every year and the average number of years that a full-time employee works in production. The number of years people work in a plant is very telling. Some production plants hire temporary labor, due to seasonality. You may want to find out how many workers are hired and whether they see the same people returning or whether they constantly have to retrain new temporary labor.
Review the written wage rate schedule for employee positions and determine the last date of revision. Try to determine whether the wage rates are high, low, or average in relation to the industry, the competition, and the area. Is the company training people only to have them leave shortly thereafter for a higher-paying job down the street? These are all key things to know. If the turnover rate is high because the pay is not very high, you can be sure this company is going to have to increase its pay before it can grow. One question that we always ask is, Does the company have a formal procedure for reporting employee absences, reprimands, promotions, and transfers? There should be a file that follows employees, as well as the entire workforce.
Ask production management to classify the production employees into production staff, supervising of shipping, quality control (QC), receiving, R&D, and management. Then break down the payroll by these categories. Ask management where people need to be added and where they need to be cut. Ask the head of production to name five major personnel problems at the present time. The answers may be revealing.
If you have an opportunity, make sure you talk to the production people about the union and its activities. Ask for the union’s grievance log and talk to the labor lawyer for the company. It is important that the relationship between the union and the company be one of mutual respect and harmony. If there is bitterness and constant disagreements, it will affect the competitive strength of the company. If the company does not have a union, ask what activities have been going on to bring in a union.
You should talk to the production people about the retirement plan to determine whether they are satisfied with it. If they are not satisfied, find out what they would like to change. Also, make sure that the retirement plan is treating the people well or whether people are afraid to retire because the plan is so poor.
Do the production people meet regularly with all the supervisors to determine what problems are going on in the plant? What regularly scheduled meetings does the company have for each of the department heads? The company should be holding meetings that allow the production process to learn from its many activities.
Every production process seems to be regulated by a myriad of governmental regulations. The most prevalent of these emanate from the Equal Employment Opportunity Commission (EEOC). Ask management whether it has received any EEOC reports concerning discrimination based on age, race, or sex. What kind of grievances have been filed with federal regulatory or state regulatory agencies regarding equal opportunity employment?
The occupational safety and health laws are stringent in every state. The Environmental Protection branch of the state government usually handles the Occupational Safety and Health Administration (OSHA). Determine what kind of OSHA regulations are required of the company, whether OSHA has audited the company, and whether it is in compliance. Review the file from OSHA and make sure you understand what risks are involved with this company and OSHA.
Other federal, state, and local laws and regulatory agencies have an impact on companies. For example, for radio stations it is the Federal Communications Commission (FCC). In this regard, you should contact the agency directly and determine whether the company has any problems at that agency. With regard to the FCC, you can actually go to the agency and review the records on the company that are in the public reading rooms.
Determine whether part or most of the work is subcontracted out to other companies. If it is, get the names, addresses, and telephone numbers of the subcontractors so that you may contact them to determine what kind of subcontracting work is being carried out.
There are really two kinds of entrepreneurs when it comes to subcontracting work. Some entrepreneurs are marketing-oriented and subcontract out every piece of work possible. They have someone else make the product that they are selling. In doing so, they sometimes miss having the flexibility to control their own destinies. When they make big sales, they are unable to deliver the product because they don’t have the ability to command the production process to meet the demand. They also miss some tremendous profits they could gain by producing some parts of the process themselves. These entrepreneurs loathe the production area and don’t want to deal with the headaches. You need to make sure that subcontracting is the best strategy for the company.
The second type of entrepreneur is more manufacturing-oriented. This entrepreneur may be a scientist who loves dabbling in R&D and tinkering with the production equipment to make it work better. This type of entrepreneur wants to manufacture everything. He or she also wants to control the entire process, from the time it comes in the door until the finished product goes out. Some of these entrepreneurs are at a disadvantage because they often produce items that have no margins to speak of. For example, they might manufacture a product that could be purchased for 5 percent or 10 percent over its manufactured cost. These entrepreneurs are tying up their own time and working capital to make a very small profit.
In discussing the production process with management, you should determine why it has decided to make or buy each component in the production process. There is a very straightforward, simple analysis on making or buying that should be carried out by those in charge of production before they make a product and before they buy it. By performing such an analysis, it is easy to determine whether one should be using subcontractors. (See Chapter 7 for the questions for subcontractors.)
You need to ask the production people about the inventory levels. That is, is their current level of inventory at an optimum level? Is it too little or too much? Who establishes the optimum inventory level and who do they have to answer to if they increase inventory? Ask how they determine the optimum inventory level for finished goods and for raw materials, as well as work and process. You want to make sure that the production people are sensitive to the amount of inventory carried by the company. After all, a large amount of inventory means that capital is tied up in that inventory. Unfortunately, a company can’t operate without inventory. You need to know that the production people are conscientiously trying to reduce the inventory level at all times.
Determine whether any of the company’s inventory items require long delivery lead times. If anything has to be scheduled 60–90 days out, you need to find out who that supplier is. This will be discussed later, in the supplier section.
What inventory items, if any, have only one source of supply? You need the names, addresses, and telephone numbers of these suppliers because they are as critical to the company as any of the bottlenecks in the plant. If for some reason one of these suppliers were unable to deliver, the company could come to a standstill. You will want to investigate these sole sources to see whether they are stable businesses.
Find out whether any items in inventory are obsolete, outdated, out of style, subject to markdowns, or have become unsellable in any way. If so, make a list of them and determine their value. You will want to compare this with the value they carry on the balance sheet. Some companies try to carry obsolete inventory on their balance sheets. A good accounting firm will usually catch this, but sometimes it doesn’t.
Does the company have specific employees in charge of QC? You should determine who is in charge of QC and make sure you speak with them. What QC standards, if any, are followed by the QC department? Ask management to describe in detail the company’s QC program and to provide to you with any procedures manual used by the QC people. A specification sheet for each product that is produced should also be available. The manufacturing process is like putting together tinker toys or cooking a pie. There should be a recipe for each product that is produced. It should be written down in straightforward language so that anyone can produce it. The QC people will use this book to measure quality. If it is not produced by the book, the quality is probably not good.
It’s always intriguing to talk to the production people about cost. You will be surprised to learn how few production people know what money is involved in what they are producing. The production people should have a detailed worksheet for determining the direct labor costs, the indirect labor costs, and the labor content of each one of their products. If they don’t, management will never know how much labor cost goes into producing anything.
Usually the production process involves a standard cost system. If it does, this will be all the more confusing to those who don’t have an accounting background. It is essential to know that the standard cost program is frequently updated to ensure that it does not get completely out of sync with reality. You should know who is monitoring and controlling the various costs of production, especially the cost of labor. Frequently, reports are put together on the direct and indirect costs going into every product being produced. You should get a copy of these reports on costs.
Is there a daily, weekly, or monthly production schedule? The production people should have a schedule, and you should know how they determine what will be produced and the quantity. There should also be a log of the production process that summarizes each of the production runs. In addition, records of the production stoppages should be available. Whenever the company experiences a shutdown for more than four hours, the reason should be documented so that it doesn’t happen again. Always ask about production levels and why they are not higher.
Now you should be able to determine the production capacity of the firm. You have to determine how many shifts and days it is operating, and from that you should be able to walk through the production capacity, assuming that no new plant or equipment is being added. From that, you should calculate at what percentage of capacity the company is currently operating and how it can improve its capacity.
You should make a mental note of three major strengths and three weaknesses in the production area of the company. Ask management to list them, and then try to draw conclusions from what you have seen, heard, and read.
In small companies, purchasing is usually handled by one person. As the size of the company grows, the purchasing work increases, and a team may be used. You need to analyze the purchasing process. Here you want to ask the purchasing people some questions to check on what you have heard before. Do they have any inventory items where less than two suppliers are available? In other words, do they have any sole-source suppliers?
Are there any contracts between the company and any suppliers? If so, obtain copies so you can find out whether the company is locked into a high-cost supplier because of a stupid purchasing mistake. Determine the company’s objective in maintaining inventory levels. How many months of production is it supporting in its inventory?
Ask the purchasing person whether any inventory items have delivery lead times in excess of 60 days. If any do, you should make a list of these items. It may be critical to have certain products in stock in large quantities rather than having to order them frequently, especially if lead times are in excess of 60 days.
What are the normal credit terms that the company is getting from suppliers? Does the company take advantage of purchase discounts? If it doesn’t, the company may well be losing a substantial amount of money by not taking the discounts offered.
How often is a physical inventory taken? Who takes the inventory and what procedure is used to take it? When an inventory is taken, are the numbers often incorrect?
Who establishes the specifications for the items to be purchased? Before something is purchased, what purchasing requisition or approval procedure is followed? Is there a procedures manual for purchasing items? If so, you may want to take a look at it to see whether it is actually a current working book.
How much theft goes on in the business? How much “shrinkage” is involved in the inventory area? What system is in place to reduce the possibility of theft, both internally and externally? What has been the company’s experience in inventory shortages during the past few years?
When it comes to reordering, does the company have a formal reorder policy? That is, when a certain item that is to be used in the production process reaches a certain level, is it automatically reordered? Does the purchasing agent have to receive a formal command before he or she can reorder something?
You need to obtain the names, addresses, and telephone numbers of the major suppliers to the company. You need to know the number of units purchased from them during the last time period; for example, the last 12 months. You should know the dollar volume of the products being purchased.
Once you have this list, you will need to begin calling suppliers. Questions to be asked of suppliers are found in Chapter 7.
Once a product has been ordered, it will be received by the company and brought into inventory. Receiving goods should follow a regular procedure. Ask the people in receiving what procedure is followed for receiving products and what kind of procedures manual is available. They should be able to describe the procedure for receiving goods and services. There should also be a method for requisitioning and receiving tickets being reconciled so that those items that have been purchased are received. You should determine who is authorized to sign a receiving ticket. Is there a regular procedure for signing and completing a receiving ticket for every item that is received? You should understand how the company is handling its receiving because a great deal of money can be lost in the receiving process.
A common problem here is that the items received are improperly recorded from the company’s records. Some items received are never logged into inventory and, therefore, aren’t used until they are found. This could take a number of months. It is also important to determine what system is in place to reduce the possibility of internal theft at the receiving process area.
There should be a procedure for determining that the goods and services received meet the specifications and quality of those ordered. You should identify the company’s three major strengths and three major weaknesses in the receiving area. Usually, management can name these very quickly.
Once the product has been manufactured, it needs to be shipped. There should be some kind of shipping procedure and perhaps even a shipping manual. There should be someone to sign the shipping tickets to make sure the accounting department knows goods were shipped out the door. When the product is received by the customer at the other end, there should be some way of determining that the customer has signed the shipping ticket so that the company can prove that the merchandise was received.
One company, for instance, had a computer failure and did not know which items had been shipped. Fortunately, there were notices indicating that the customer had received the items and the company could use them to reconstitute the accounts receivable and rebill the clients accurately. However, another company that didn’t have a good shipping policy or didn’t keep good records went out of business because it couldn’t reconstitute its accounts receivable.
As an investor, you need to know what checks and balances are in place at the company to reduce the possibility of theft at the shipping level. It is also important to understand the method of shipping. Are items shipped by truck, by a delivery service such as UPS, or by common carrier? In emergencies, what kind of air freight service does the company use?
Frequently, customer service is placed in the marketing area, but for larger items, customer service becomes part of production. The customer service people are part of the production area and are responsible for making sure that customers get the product that they ordered. As part of your due diligence, determine how many employees are in the customer service department and who performs the customer service work. Sometimes, the employees of the firm prepare the product for reshipping to the customer. At other times, service reps in the field handle customer service. You need to delve into the customer service side to understand how the customer is kept happy.
You should ask staff to identify the most frequent customer service problems. List the top ten. This will give you a good idea of what the customer service people are up against. We remember one company that had to rework a complete order because of a production process, and this caused a great deal of overtime and an extremely frustrating working experience for the people in customer service. They did it, and the company saved face, even though it lost a great deal of money on the order.
The customer service people should be able to describe the product warranties and guarantees provided by the company, and the cost of these warranties and guarantees to the company. It is important to understand the customer service area because it will give you a sense of how the product is being accepted in the field.
Sometimes the company contracts out the customer service work. If it does, you need to know who is providing this customer service and what it is costing the company. You also need to have a copy of the customer service contract with this service agency. You should determine the names, addresses, and telephone numbers of any of these contractors.
Here are some questions to ask about customer service that is contracted out.
How long have you performed the customer service work for the company?
How many customer service calls do you have on a monthly basis?
What is the basic nature of the customer service calls that you get?
What specific items have you been asked to fix that pertain to customer satisfaction?
If you could fix one item in the company, what would you want to fix so that it would make customer service easier?
How much does the company pay you to perform customer service?
On the amount that you are being paid, can you make a profit?
Will you continue to do the new customer service in the future?
How would you change your customer service contract if you could change it today?
You should ask management to identify the three major strengths and three major weaknesses in its customer service area.
It is extremely important to know what R&D goes on in the company. First, you should identify the people responsible for R&D. Are they tied in with production or separate from it?
What has the R&D budget been for the last five years? What kind of money is the company going to spend on R&D in the next five years? Once you have these figures, you can ask the following questions about financings.
What specific projects are in progress? Why were those projects chosen? Who made the decision to proceed on these projects? Usually, the market where the products are to be sold has been carefully studied. Entrepreneurs in some of the smaller companies claim to have “intuitive” knowledge of what the market is looking for. Usually, these intuitions are incorrect. Every product that is being brought to the marketplace should have been market-tested. You should look at the past to see what kind of formal research projects were completed by the company before it instituted R&D programs for those products.
Often, an outside consultant will be used to help the company determine what products it should go after or to evaluate products that the company has determined are the best. One of the critical aspects of the R&D area is secrecy. You need to determine how these projects are protected from being stolen by the competition. You should describe the company’s procedure for capitalizing or expensing its R&D budget. If it is being placed on the balance sheet, this may artificially inflate the value of the company because the product has not proved itself.
Find out to whom the people in research and development report. If they report to the production area,R&D will most likely be enhancements in some minor way to the existing product line. If those in R&D report to the marketing people, you will probably see all kinds of items being added to the existing product to make it sell. Many of them may be little more than bells and whistles. If R&D individuals report directly to the president of the company, the company is probably charged with a long-term vision and is coming up with good products for R&D.
Review any reports that are coming from R&D staff. If there are no reports, you may ask top management how they know that the R&D people are doing their job.
When reviewing a product that is being researched and developed, you should ask the company’s management whether there are any patents or patents pending around the new product. Sometimes new products are produced under a patent license. If there is a license for the patented products, you should review it in detail. You may find that the patent license for a company is about to expire. Ask the company what it intends to do if the individual who owns the patent will not license it again. You may be stunned to hear that management hadn’t even thought about it.
Ask middle management to show you the reports they are generating and sending to top management. If they have no reports at all, ask them why not. What value does top management place on these reports? Determine who receives the production reports. Also determine whether reports are made at the change of each shift and whether a production log report is made out regularly to keep up with what is being produced.
Although a number of critical ratios need to be examined in a manufacturing company, we will mention only a few key ones. If you want to develop this further, obtain a good book on production processes and make sure you study the ratios used by manufacturing personnel.
You can determine hours needed to produce a unit by dividing direct labor hours by the number of units produced. This will measure the units of labor it is costing for each unit to be produced and indirectly will measure employee productivity.
Calculate labor cost as a percentage of total production cost by dividing labor cost by total production cost. This will give you a measure of the total labor cost to the total production cost and show the labor required to produce each item. If you see this labor content going up over the months and years, you need to determine why.
Material cost to total production cost can be determined by dividing cost of materials by total production cost. This, too, will show you the percentage of total cost going to materials. If you see the cost of materials going up, you should ask why.
Calculate manufacturing overhead to total production cost by dividing the total manufacturing overhead by total production costs. This will give you the percentage of total production costs that is consumed in overhead. If you see the overhead percentage going up over of periods of time, it will be a clear indication that something is wrong.
Determine idle time as a percentage of total time available by dividing the total idle time by the total available direct labor hours. This is often a hard number to get to, but if you can, it will measure the efficiency of the company in achieving and keeping all of its employees busy and productive.
An interesting but difficult calculation to make is the percentage of total factory hours taken up by direct labor hours. You can obtain this figure by dividing the direct labor hours of people on the production floor by total hours of all the factory personnel. This will measure the amount of support personnel needed to complete the production process and will also show you what percentage is direct labor. If you see direct labor going down and support labor going up, there may be a problem.
Calculating overtime as a percentage of total hours can also give you a measure of the company’s costs. To calculate, divide the total overtime hours worked by the total hours worked. You will see how often people have to be brought in on overtime. If this number is large, it may mean that the company is having to schedule overtime to catch up with work that was not completed during the regular shift. You will need to investigate this in detail. Overtime hours are paid at a higher rate than regular hours, so it is costing the company considerably more to produce the product in overtime hours.
Machine utilization is another interesting figure. You can compute this by dividing productive machine hours used by total available hours on the machines. This will measure the efficiency with which the equipment is utilized and perhaps give you an indication of a scheduling problem. If the machines are not being used efficiently, it may mean that the company is buying excess equipment instead of getting the efficiency out of its existing machine base.
Finally, calculate the scrap rate by dividing the number of units scrapped by the total units produced. This will be a good measure of efficiency of the production process and of the quality control of the company.
Once you have analyzed the production process in detail, you need to determine the efficiency of the overall plant. Does the company use its assets (such as land, building, machinery, equipment, employees, supervisors, etc.) efficiently? You need to come up with a general idea of whether the company is efficient, inefficient, or falls somewhere in between.
You also need to reach a basic conclusion about the management of production. Are these people able to manufacture the product efficiently? Are they able to meet the production schedule as set forth in the business plan? Can they maintain the production process like a well-oiled machine? Are you confident that they will be able to achieve the production goals that they have projected?
As part of the production analysis, you should evaluate R&D. Do you think the company is engaged in the proper R&D? Is it on the forefront of technology or merely following the leader in the industry? Does it seem to know what it is doing in R&D? Do you believe management is capable of handling R&D? By the end of the day, you should have an overall feel for production management, the production process, and the R&D area. If you come out feeling uneasy or negative about the production area, you should turn down the investment opportunity.
Appendix A contains a list of questions about the production process. You should ask yourself these questions. You will want to pay particular attention to the checklist provided under the documentation area and make sure that you receive many of the items listed.