Application of Production Efficiency

Feb 28 2017 - 1:44pm

Dada Adefolami

By Dada Adefolami

Efficiency signifies a level of performance that describes a process that uses the lowest amount of inputs to create the greatest amount of outputs. Efficiency relates to the use of all inputs in producing any given output, including personal time and energy.

The principles of economic efficiency are based on the concept that resources are scarce. Therefore, there are not enough resources to have all aspects of an economy functioning at their highest capacity at all times. Instead, the scarce resources must be distributed to meet the needs of the economy in an ideal way while also limiting the amount of waste produced. The ideal state is related to the welfare of the population as a whole with peak efficiency also resulting in the highest level of welfare possible based on the resources available.

However, Production efficiency is based on a business’ ability to produce the highest number of units of a good while using the least amount of resources possible. The aim is to find a balance between the use of resources, rate of production and quality of the goods being produced. When production efficiency has been reached, it is not possible to produce more goods without using excess resources or sacrificing product quality
A standard hour is the amount of work achievable, at the expected level of efficiency, in an hour.

Example
If XY Co manufactures three products (A, B and C) in one of its production cost canters. It is expected that 10 units of product A can be manufactured per direct labor hour, 25 units of product B and 20 units of product C.

The standard hour for product A is, therefore, 10 units, product B is 25 units and product C is 20 units.
The standard hour is especially useful as a common measure for combining heterogeneous dissimilar products so that manufacturing performance for a cost Centre or production unit as a whole can be assessed.

Analysis
Budgeted production of the three products (A, B and C) in period 1 is:
Product A 12,400 units
Product B 10,000 units
Product C 18,500 units

The total budgeted direct labor hours for period 1 in the cost Centre, based on the standard hour data above, is:
Product A 1,240 hours (12,400 units ÷ 10 units per hour)
Product B 400 hours (10,000 units ÷ 25 units per hour)
Product C 925 hours (18,500 units ÷ 20 units per hour)
2,565 hours

It can be seen that the budgeted production of the three different products can be combined into an overall labor activity measure and this also can be applied to the actual production volumes, using the same data about the standard hour of each product. This enables the effect of changes in the production mix to be measured.

Analysis
In period 1, the actual production output of the three products was:​
Product A 13,300 units
Product B 9,600 units
Product C 18,000 units

A total of 2,430 direct labor hours were worked in period 1.
Taking these actual results into account and the data concerning the standard hour of each product, the total expected direct labor hours for the actual production output in period 1 can be calculated as follows:

Product A 1,330 hours (13,300 units ÷ 10 units per hour)
Product B 384 hours (9,600 units ÷ 25 units per hour)
Product C 900 hours (18,000 units ÷ 20 units per hour)
2,614 hours

Using the above data about the budgeted direct labour hours, the actual direct labour hours and the expected direct labour hours to manufacture the actual output, a series of ratios can be calculated to measure the performance of the cost centre as a whole in period 1 and to understand the causes. The ratios are:

1. Production volume ratio
2. Capacity utilization ratio
3. Efficiency ratio

Production volume ratio
The production volume ratio measures how the actual production output for a period, measured in direct labor hours, compares with that budgeted for a production cost Centre. It is calculated as:

(Expected direct labor hours of actual output ÷ budgeted direct labor hours) × 100%.

A ratio of > 100% will indicate above budget production volume and vice versa.

The production volume ratio can be further analyzed by:
1. The number of hours worked compared with budget (measured by the capacity utilization ratio).

2. The efficiency with which the output is produced (measured by the efficiency ratio).
Capacity utilization ratio:
The capacity utilization ratio measures whether the total direct labor hours worked in a production cost Centre in a period was greater or less than what was budgeted. It is calculated as:

(Actual direct labor hours worked ÷ budgeted direct labor hours) × 100%.

A ratio of > 100% will indicate that more direct labor hours were worked than budget and vice versa.
Efficiency ratio.

The efficiency ratio measures whether the production output for a period in a production cost Centre took more or less direct labor time than expected. It is calculated as:

(Expected direct labor hours of actual output ÷ actual direct labor hours worked) × 100%.

A ratio of > 100% will indicate greater labor efficiency than budgeted and vice versa.

Example
Continuing to use the above data concerning the total budgeted, actual and expected direct labor hours in period 1 for the production cost Centre, the three ratios can be calculated as follows:

Production volume ratio:
2,614 expected direct labor hours of actual output
÷ 2,565 budgeted direct labor hours
× 100%
= 101.9%

Capacity utilization ratio:
2,430 actual direct labor hours worked
÷ 2,565 budgeted direct labor hours
× 100%
= 94.7%

Efficiency ratio:
2,614 expected direct labor hours of actual output
÷ 2,430 actual direct labor hours worked
× 100%
= 107.6%

Analysis
It can be seen, from the above ratios, that the actual output in the production cost Centre in the period, measured in expected direct labor hours, was 1.9% higher than budget it may be noted that the total number of product units manufactured was the same as budget, but the units of one product are not comparable, in terms of production effort, with another.

The over-budget production activity occurred despite the fact that utilization of capacity was only 94.7% of the budgeted utilization. This was because direct labor efficiency was 7.6% better than expected – i.e. fewer hours than expected were required to produce the actual output.

The relationship between the three ratios can be demonstrated as follows:

Production volume 101.9% = [(capacity utilization 94.7 × efficiency 107.6) ÷ 100] or, alternatively, [(capacity utilization 0.947 x efficiency 1.076) x 100]

Efficiency is a measurable concept that can be determined by determining the ratio of useful output to total input. It minimizes the waste of resources such as physical materials, energy and time, while successfully achieving the desired output

Efficient production is achieved when a product is created at its lowest average total cost; production efficiency measures whether the economy is producing as much as possible without wasting precious resources

Dada Suraju Adefolami, Professor of Finance, School of Business Administration, UNEM University Costa Rica, is a Finance / Management Consultant and Certified Forensic Accountant. You can reach him via: surajudada@yahoo.com; 08052043855

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