ELSEVIER Int. J. Production Economics 46-47 (1996) 459 467

I

international journal of

product!on e c o n o m i c s

Life-cycle cost analysis of the labor factor

Per Dahl6n*, Gunnar S Bolmsj6

Lund Institute of Technology, Department of Production and Materials Engineering, Box 118 Lund, Sweden

Abstract

A central part of the design of a production system is to methodically weigh the production tactors, labor and capital and integrate them into a well-functioning unit. The life-cycle costing technique is primarily used when quantifying the costs related to a production system from the perspective of the life cycle of investments in production equipment or product development. The purpose of this paper is to widen the field of application for life-cycle costing and carry through an analysis of investments done when raising the production factor labor in a Swedish engineering company. The analysis covers the costs for an employee over the whole employment cycle - from the recruitment until retirement. The costs for labor are suggested to be graphed in a way similar to the costs over the life cycle for production equipment. The costs are divided into three basic categories:

(1) Employment costs: consisting of costs for recruiting, introduction and training of new employees - to compare with acquisition costs such as projecting (planning), installation and start-up of new equipment.

(2) Operation costs: consisting of wages, and labor related overhead -- to compare with depreciation, maintenance and repairs.

(3) Work environmental costs: consisting of additional costs for absenteeism, rehabilitation and pensions - to compare with costs for increased maintenance and repairs and finally to scrap the equipment.

Keywords: LCC analysis; Labor factor; Employee costs

1. Introduction

Life-cycle costing is a me thod of analysis used when quantifying the costs related to a p roduc t ion system or a p roduc t during its life cycle. See for example, [1, p. 214] for a historical background to life-cycle costing. Starting from the definition of cost categories, the life-cycle costs (LCC) are grad- ually divided into a more precise cost est imation in

* Corresponding author.

a cost b reakdown structure (CBS), Blanchard [-2]. The method can be enunciated in the following steps:

1. Identify the basic cost categories connected with the product ion method.

2. Divide the basic categories into subcost cat- egories.

3. Define and quantify elements of costs. 4. Estimate the economic lifetime of the whole

product ion system and its different parts. 5. Sum up the costs and relate these to the num-

ber of p roduced parts.

0925-5273/96/$15.00 Copyright ~') 1996 Elsevier Science B.V. All rights reserved Pll S 0 9 2 5 - 5 2 7 3 ( 9 6 ) 0 0 0 8 9 - 8

4 6 0 P. Dahl~n, G.S. Bolmsj6/Int. J. Production Economics 46-47 (1996) 459-467

The typical LCC-graph for a production system is usually associated with a bathtub. The bathtub hazard rate curve shows the variation of the risk for breakdowns in a production system over time [3]. The costs are high in the beginning of the life cycle because of purchase, installation, projecting, and start-up costs. When the equipment is installed and working as intended the costs are decreasing. In the final stage of the life cycle, the costs for repairs and disruptions increase, finally reaching a no longer profitable level. The life cycle can therefore be divided into three phases: the Acquisition phase, the Operation phase and the Disposal phase, Fig. 1. Some authors however, divide the life cycle into four phases where an initial phase is added to the previous three. An initial phase called Concept & Definition phase is, for example, added in Dhillon and Reiche [1] and the costs in a similar initial phase are called Research and Development costs in Fabrycky and Blanchard [4].

The methodology that life-cycle costing repres- ents has shown to be effective and is frequently used as a decision basis for a number of industrial deci- sions. Life-cycle costing can, for example, provide information about which machine or other produc- tion equipment brings the lowest production costs and how to organize the most cost effective main- tenance of the equipment. Life-cycle costing has also been used to show the total costs associated with the development, marketing and production of a product during its life cycle. Since the focus is directed at the life cycle of the investments in pro- duction equipment or product development, the costs for labor are generally treated summarily. The

Costs

• . . _ c I t l O p e r a t i o n -

p h a s e

Fig. 1. A characteristic LCC-graph for a production system.

production factor labor is usually regarded as a variable cost, rented by the hour.

In this paper, a company is instead suggested to look upon the employment of a new employee as an investment in training, education, instructor hours, reworks, scrapped materials, etc. The purpose of the paper is to use the life-cycle costing technique to carry through an analysis of the costs for an em- ployee over the whole employment cycle. A theor- etical framework will be presented where the basic labor cost categories are examined. The framework is thereafter applied in a case study of a low auto- mated assembly department in a Swedish engineer- ing company.

2. Theoretical framework

It is possible to pinpoint a number of parallels to the LCC-graph in Fig. 1 when estimating the costs for an employee during the employment cycle: • The costs at the beginning of the cycle are high

due to recruitment costs and introduction of the new employee.

• After a while these additional costs should de- crease and the personnel costs get closer to the average costs for wages and labor-related over- head.

• If the working environment is unhealthy, serious production disruptions might occur because of absenteeism or work injuries. The costs for wages, vacations and fringe benefits, depending on the wage system, also may increase over time.

It is therefore natural to divide the employment cycle in a similar way as the life cycle for a machine in a traditional LCC graph. The basic categories that the personnel costs can be divided into are: employment costs, operation costs and work environ- mental costs. After identifying the major cost cat- egories, the cost structure will be broken down step by step according to the CBS model. Here are examples of subcategories related to the three basic categories.

2.1. Employment costs (E)

Bekiroglu and Gonen [5], Kesner and Dalton [6] Jackofsky [7] and Dahl6n and Wernersson [8]

P. Dahl~n, G.S. Bolmsj6 /lnt. J. Production Economics 46-47 (1996) 459-467 461

have shown that the costs for hiring an employee for the production process can be quantified fairly well. The employment costs can, according to the literature, be divided into three major sub catego- ries: (el) Recruitment costs: are generated from the mo-

ment the company decides to hire until the selected employee is ready to start the employ- ment.

(e2) Additional (surplus) production costs: occur as a consequence of the introduction of the new employee in the production.

(e3) Education costs: represent costs for internal and external education of a new worker.

2.2. Operation costs (0)

When the employee is introduced and masters the work tasks, the costs decrease towards a level consisting of the operation costs: (ol) Wages: including the wage to the employee

and payroll taxes. (oz) Overhead: of which the consumption of labor

hours is a cost driver.

2.3. Work environmental costs (W) If the work is monotonous and connected with

static stress the personnel might, just as the ma- chines, be worn out after a while. One can assume that this will affect the attendance, the number of work injuries and the need for disability pensions and thus generate a number of additional costs for a company: (Wl) Costs for absence are primarily costs that an

unstable access to labor causes in the form of disruptions in the production. There are a number of techniques developed to quantify these costs. Mirvis and Lawler [9] created a schedule to systematically count the costs for each occasion of absence. Kuzmits [10] developed a six item program to standardize the quantification of the costs for absen- teeism. Kivenko [11] revealed the hidden costs for absenteeism from existing elements of costs in a traditional accounting system. Dahl6n and Wernersson [-8] used an activity

based costing-technique to quantify costs related to absenteeism. According to Miller and Vollmann [12] and Duimering and Safayeni [13] the effects of disruptions in production increase in a low inventory pro- duction system, such as a Just-In-Time (JIT) system.

(w2) Sickness benefits: that the company has to pay to the ill employee. A Swedish company has to pay sick from the second to the fourteenth day of illness each sick period. The company also pays payroll taxes (approximately 40% of the sick pay). Finally, Swedish companies are ob- liged to pay vacation benefits during the first 180 days of illness each year for each em- ployee.

(w3) Rehabilitation costs: According to Swedish law (Chapter 22, Section 3 in the law of public insurance) a company is obliged to carry through an investigation concerning the need of rehabilitation if: 1. the employee has been absent from work

during a period exceeding four weeks, 2. the employee has been absent on more

than six occasions during the last 12 months,

3. the employee demands an investigation. The rehabilitation brings not only costs related to the rehabilitation itself, but also productiv- ity losses if the rehabilitated workers remain incapable of working with full capacity after returning to work, Dahlan and Wernersson [14]. Especially, the rehabilitation of em- ployees absent from work more than four weeks seems to be connected with high costs.

(w4) Disability pension costs. The costs of pensions are covered by a social insurance that all com- panies in Sweden have to pay. Therefore, Swedish companies are not charged for the pensions as a direct cost but they do have to pay indirectly in the form of high payroll taxes.

The next step is to identify and quantify all the personnel costs in detail and try to find out how the costs vary over time. This is, of course, difficult to carry through in general and therefore a case study of a particular system is presented.

462 P. Dahlkn, G.S. Bolmsj6/Int. J. Production Economics 46-47 (1996) 459-467

3. Case study 3.1. E m p l o y m e n t costs

The example covers the personnel costs in a low automated assembly department in a Swedish en- gineering company. The department was chosen because the work tasks carried out were highly repetitive and monotonous and therefore suspected to cause high work environmental costs. On aver- age, 70 employees were working at the department during the period measured. The absence due to illness was approximately 24% of the total avail- able time and during the period eight persons ended their employment and three employees were included in a rehabilitation program.

The quantification was carried through in co- operation with the management at the assembly department and with personnel at central depart- ments that were suspected to be influenced by the personnel situation at the assembly department. The internal statement of accounts for the year of activity 1991 was the basis for the cost estimations. All costs, depending on the assembly personnel, were allocated from the total amount of costs at the company. Thereafter, the personnel costs were fur- ther analyzed and employment costs, operation costs and work environmental costs defined.

Table 1 shows the costs identified as costs related to the employment of a new employee. The total costs for new employment at the assembly depart- ment were estimated and thereafter divided by the number of new employees hired during the time of measure, in this case during one year.

There are a number of techniques to estimate the time it takes for a new employee to learn a new work task, see, for example, Canada and Sullivan [15, pp. 114-116] on the learning curve technique. In this case, an approximation made by the fore- man at the department who indicated that a new employee is regarded as fully trained after one year of employment, is sufficient. The recruitment costs occur before the new employee is hired.

3.2. Operat ion costs

The operation costs for the personnel consist of wages and overhead related to the consumption of direct labor hours. Manufacturing overhead, con- sisting of the direct and indirect wages percentage rate, cover common costs generated in the assembly

Table I Employment costs

Cost category Sub costs Element of costs Costs (SEK)

Employment costs (E) Recruitment costs (el) Interviews (eL 1) 3000 i~3 j=4 Information (el.2) 3000

E = ~ el = 118500 el = ~ el.j Advertisement (el,3) 1000 1 1 Administration (el.4) 3500

Subtotal 10 500

Add. Prod. costs (ez) Learning curve (ez.0 31000 = 3 Controls (e2.2) 9000

e2 = ~ e2.j Rework (e2,3) 10000 1

Subtotal 50 000

Education costs (e3) Instructors (e2, 1) 20000 j=3 Agreed gang wage a (e2,2) 21000

e3 = ~ ea.j External education (e2,3) 17000 1

Subtotal 58 000

a In Swedish industry, it is common that a production group receives a compensation when introducing a new member.

P. Dahldn, G.S. Bolmsji~/lnt. J, Production Economics" 46-47 (1996) 459-467 463

department. The costs allocated to employment costs and work environmental costs are excluded from the manufacturing overhead. For example, it turned out that approximately 75% of the overtime was caused by absenteeism. Therefore, 75% of the additional costs for overtime are regarded as a cost related to absenteeism and thus allocated to the work environmental costs. The factory overhead represents overhead generated at central depart- ments. In this case parts of the original factory overhead are also allocated to the employment costs and the work environmental costs. The costs in Table 2 are a summary of the operation costs at the department under study divided by the average number of employees during the period of measure.

The operation costs are here approximated as constant over time. However, this is not necessarily true. A more accurate estimation also takes general increases in real wages and general cost increases related to the number of years employed in the company into account. In this case the increases turned out to be negligible. The employees at the department did not receive any major increases in wages due to the time they had been employed. The differences between wages at the assembly depart- ment were therefore quite small and not related to the number of years in the company. The annual increases of wages in Sweden during the 1980s have, to a large extent, been covered by inflation. A fair approximation therefore indicates that the operation costs are constant over time in real terms.

3.3. Work environmental costs (W)

Absenteeism is believed to increase if the work tasks are monotonous and involve static stress. The reasons for this are considered to be both the risk for injuries and that the motivation to attend de- creases. Brooke [16, p. 351] examined the literature concerning the correlation between absenteeism and routinization, defined as the degree to which the cycle of tasks in a job is repetitive. Brooke found a strong correlation between routinization and absenteeism. Steers and Rhodes [17, pp. 393-394] carried through a review of literature concerning job scope and absenteeism. The authors found strong evidence that job enrichment reduced absenteeism.

At the department studied, neck pain and sore shoulders are common symptoms. In order to examine the impact that the monotonous work load had on the sick leave, the causes that the personnel claimed for sick leave were studied. It turned out that 24% of the total available time was lost due to sick leave. More than 50% of the total sick leave, or 13% of the total available time, was claimed to be caused by neck or shoulder pain. This indicates that at least 50% of the total time losl due to sick leave can be regarded as related to the place of work. The remaining 50% is assumed to be related to factors outside the company. This is in accordance with the other departments at the fac- tory where the work load is lower and the losses due to sick leave represented 12% of the available

Table 2 Operat ion costs

Cost category Sub costs Element of costs Costs (SEK)

Operation costs (O) Wages (ol) Salary (ol, 1) 112 500 j - z j=2 Payroll taxes" 1o1.2) 51 000

0 2 - ~ Oz,~ O1 = ~ Oi, j Subtotal 163500 1 1

Overhead (02) Manufact. overhead ( O 2 . 1 ) 72 000 Factory overhead (02,2) 27 500

Subtotal 99 500

"The payroll taxes that a Swedish company has to pay vary between different categories of employees. For a blue-collar worker these taxes are approximately 40% of the salary that the employee receives.

464 P. Dahl~n, G.S. Bolmsj6/Int. ,1. Production Economics 46-47 (1996) 459-467

time, which is more representative for Swedish in- dustry. See The Economis t [18] for an analysis of absence in Swedish industry from an international perspective.

One consequence of work related injuries is that the need for rehabili tation increases. Approxim- ately 50% of all rehabili tation done in Swedish industry fails in the sense that the employee does not receive a sufficient working capaci ty after the rehabili tation and thus is forced to cont inued sick leave or pension. That is showed in: Arbets l iv i

utveckl ing [19, p. 4]. This is the reason why the costs for the rehabili tation of injured personnel

are allocated to the final stage of the employment cycle, despite that the purpose of the rehabili- tat ion is actually to increase the employment cycle.

Table 3 is an estimation of the costs related to absence, sickness benefits and rehabili tation for the assembly personnel during the period measured. The costs were first calculated as a total cost for the whole depar tment and thereafter divided by the number of employees. Finally, the costs for non- work related sick leave, that is 50% of the total absence, are excluded and allocated back to the opera t ion costs.

Table 3 Work environmental costs

Cost category Sub costs Element of costs Costs (SEK)

Absence costs (w~) Quality related costs (wl. i) Rejects (wl. 1.1) 2200 ~=3 .,=2 Reworks (wl, 1,~) 1300

wa = ~ wl,j = 16000 w1,1 = ~ w1,1.,. Subtotal 3500 1 1

Productivity losses (w t,2) Overtime (wl, 2,1 ) 2200 m= 3 Over staffing (W1,2 ,2) 2800

W1,2 = ~ , W1,2,m Stand-ins (wl,2,3) 3100 1

Subtotal 8100

Administration (wl,3) Foreman (wt, 3, ~ ) 1200 m = 3 Planner ( W 1 , 3 , 2 ) 1100

Wl,3 = ~ Wl.3,,. Centr. admin. ( W I , 3 , 3 ) 2100 I

Subtotal 4400

Sickness benefits (w2) ,.=3

W 2 = ~'~ W 2 , 1 , m = 7 0 0 0 I

Sick pay (w2,1,1) 3000 Payroll taxes (w2,1,2) 2100 Vacation benefit (w2,1,3) 1900

Subtotal 7000

Rehabilitation costs (w3) j = 3

w3 = ~ w3,i = 6300 1

Rehab. equipment (w3,1)

W3, 1 ~ ~ W3, l,m 1

Equipment (w3.1,1) 1800

Subtotal 1800

Training (w3, 2) ra=2

W3, 2 ~ ~ W3,2,m 1

Learning curve (w3, 2,1 ) 2000 Instructors (w3, 2, 2) 1000

Subtotal 3000

Work environmental costs i = 3

W = ~ wi=29300 1

Investigations (ws, 3) r a = l

W3, 3 ~ ~,, W3,3,ra 1

Rehab. investi. (w 3,3,1) 1500

Subtotal 1500

P. Dahlbn, G.S. Bolmsj6/lnt. ~L Production Economics 46-47 (1996) 459-467 465

3.4. Summary of the personnel costs during the employment cycle

If all costs are put together, a general LCC curve for a person working at the assembly department can be graphed as in Fig. 2.

The total LCC for one employee was found to be 3041 500SEK (1991 value of money). The real in- crease of the costs measured is estimated to be negligible and thus the cost increases are the same as the inflation in the whole economy.

During the past five years the annual labor turn- over was on average 10% of the total work force at the department. We therefore assume that a new employee works 10 yr in the assembly department. The impact from the work environment, generating increased absence and the need for rehabilitation, are assumed to occur after half the employment time, reaching its maximum at the end of the em- ployment cycle, that is after 10 yr. The work envi- ronment costs are assumed to increase linearly over time from year five, Fig. 2.

It is shown in a variety of scientific studies that the introduction of new employees generate costs in an organization. The allocation of the employment costs to the early stage of the employment cycle is quite natural. It is however more difficult to analyse how the costs vary in the later part of the employ- ment cycle. The case study presented in this paper is based upon an estimation that the work environ- ment costs accelerate after half the average employ- ment cycle and that the allocation of all costs during the employment are based on the ac- counting, absenteeism and labor turnover from one year. These parameters form the base for the alloca-

Costs [SEK] 400000

300000 [~] Work environ.

[ ] Overhead

• Wages

-1 1 2 3 4 5 6 7 8 9 10

Tree Wearsl

Fig. 2. The LCC over the employment cycle for one employee at the assembly department.

tion of the labor related costs in the case study. This paper does not therefore present an exact LCC- curve valid for all employees in the organization as the true LCC-curve varies between individuals. The LCC over the employment cycle should in- stead be used as a tool when managing labor costs. The same goes however for the general bathtub hazard rate curve which also is a management tool rather than a scientific estimation of true break- downs.

4. Discussion and conclusions

"Most accounting and control systems have major problems; they distort product costs; they do not produce the key non-financial data re- quired for effective and efficient operations; and the data they do produce reflect external report- ing requirements far more than they do the reality of the new manufacturing environment" [20, p. 95]. This is claimed by Robert S. Kaplan, who is of

the opinion that too much attention is focused on measuring the consumption of direct wages. Educa- tion, skill levels, attitudes, absenteeism and labor turnover should also be measured and included in the evaluation of manufacturing performance ac- cording to Kaplan. The quantification of the LCC labor accentuates this problem. The allocation of labor-related costs in the case study would be smoother and more reliable if the accounting sys- tem providing the input data to our calculations was different. In the present system all labor-related costs are allocated through the consumption of labor hours. This means that costs occurring in the early and late phases of the employment cycle are also treated like operation costs driven by the con- sumption of labor hours. Goodman and Atkin found similar problems when they investigated the costs related to absenteeism. They state that:

"traditional company accounting records are not designed to deal with the general issue of deter- mining costs of absenteeism". Goodman and Atkin [21, p. 310].

When allocating overhead generated by absent personnel through direct labor hours, the production

466 P. DahlOn, G.S. Bolmsji~/Int. J. Production Economics 46-47 (1996) 459-467

department is charged for these costs when the personnel is present collecting wages. When the personnel, on the contrary, is absent the depart- ment avoids these costs. The connection between the cause of the costs, that is absenteeism, and the charging is therefore missing. In this case the charg- ing is opposite. A department that wants to minim- ize the costs for overhead caused by absenteeism must minimize the attendance. It is however pos- sible to widen the allocation basis and thus intro- duce additional cost drivers. To improve the control, all costs must be grouped according to the original cause of the cost and thereafter allocated to the cost unit regarding to a proper allocation basis and this is not always direct labor. Cost drivers for the labor-related costs could be labor hours but also the number of new employees, absenteeism or the number of work injuries, Dahl6n and Werner- sson [8]. This leads to an accounting method where the costs are related to activities with a wider allo- cation basis, including a number of cost drivers, that is Activity Based Costing (ABC), Berliner and Brimson [22] and Cooper and Kaplan 1-23].

The focusing on the labor-related costs in the LCC for a production system is widening the field of application for the life-cycle costing method to include industrial decisions like: - Who is to be employed? - How much can be invested in education and

training of a new employee? - What is the correlation between costs and the

shape of the work tasks and the working envi- ronment?

- What should the mix of the production factors capital and labor look like to achieve the most cost-effective production system? In traditional capital budgeting, the incentive for

automation is the reduction of direct labor, compa- rable with the operational costs in this case study. The employment costs and the work environmental costs should be additional incentives for the com- pany to improve the organization and layout of a low automated production system or to increase the automation level. See Dahl6n and Bolmsj6 [24] for an example of how the LCC for employees can be used in the justification of an advanced manufacturing system (AMS) in order to create less monotonous work tasks with larger content.

The LCC can also be used when justifying invest- ments in the organization of work, in education of new employees, in the maintenance of the labor force such as ergonomically designed workplaces, etc.

The justification is, however, only possible if the company can predict the correlation between dif- ferent actions and, for example, labor turnover or absenteeism. Traditional research models for ex- plaining and predicting absenteeism and labor turnover are generally based on the individual worker's ability and motivation to be present and remain in the organization. The original model by March and Simon [25] has been further developed in, for example, Steers and Rhodes [17, 26] and Brooke [16] concerning absenteeism and in Jackofsky [7] concerning labor turnover. These models have some shortcomings, however, that make them less suitable to use in the economic control of a company:

1. They are too complex which makes them diffi- cult to verify empirically and to use practically.

2. The models do not distinguish between fac- tors that the company can affect itself and factors outside the control of the company.

3. It is difficult to use a model based on the individual worker's situation in a large production system with hundreds of individuals.

A general problem when implementing the LCC- curve in capital budgeting is that different compo- nents in a production system have different life cycles. The employment cycle varies between indi- viduals and the life cycle of, for example, a robot is seldom the same as the life cycle of a NC-machine. The life cycles of each production factor must there- fore first be estimated and thereafter given a rest value if the factor has a cycle longer than the life cycle of the product produced in the system. Hence the human capital in the form of well trained and educated employees should be given a rest value in the capital budgeting if it is likely that the employee will remain in the organization longer than the actual product produced. If the employment cycle is estimated to be shorter than the life cycle of the product, additional employment costs should be budgeted as the labor turnover will force the com- pany to hire new personnel during the life cycle of the product.

P. Dahl~n, G.S. Bolmsj6/lnt. J. Production Economics 46 47 (1996) 459-467 467

5. Future research

In this case s tudy the p r o d u c t i o n f ac to r l a b o r is

r e g a r d e d as a cos t factor . O n e can in this case c l a im

tha t a c o m p a n y does n o t hi re m a n p o w e r for cos ts

bu t for skill, c o m p e t e n c e a n d revenue . The re fo re ,

the ana lys i s c o u l d be w i d e n e d to c o v e r the c o n c e p t

of l i fe-cycle p rof i t (LCP) . T h e L C C - a n a l y s i s s h o u l d

the re fo re be c o m p a r e d wi th a prof i le of the life-

cycle i n c o m e (LCI) . T h e poss ib i l i ty to inc rease in-

c o m e s s h o u l d be incen t ives for i n v e s t m e n t s in the

h u m a n capi ta l . A c c o r d i n g l y , an ex tens ive inves t -

m e n t in t r a i n i n g and e d u c a t i o n in the ear ly s tage

of the e m p l o y m e n t cycle will i nc rease the e m p l o y -

m e n t costs , b u t cou ld be jus t i f i ed wi th h ighe r L C I ,

as the e m p l o y e e is ab le to p r o d u c e wi th h i g h e r

qua l i ty .

An in t e r e s t i ng v iew for fu tu re r e sea rch is fu r the r

d e t e c t i o n of fac tors wh ich h a v e the g rea tes t i m p a c t

on a b s e n t e e i s m a n d l a b o r t u r n o v e r , a n d the deve l -

o p m e n t of a m o d e l based u p o n these, e x c l u d i n g

fac to rs wi th l ow o r m e d i u m i m p a c t on a b s e n t e e i s m

and l a b o r t u r n o v e r .

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