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Amortization

Let’s say that you and three friends rent a cabin for a week. During that week, you spend a hundred bucks a day on food, entertainment, and the other costs of being on vacation. Is that all you spent? Nope. You still have to account for the cost of the cabin, right? If the cabin cost $840 to rent, you’d take your share of that and add it to the cost of your vacation—an additional $210.

So, even though, on the first day when you checked in you spent $310 and the rest of the week you spent $100 per day, was the first day really more expensive? If it was, you could just show up a day later and save a lot of money, right? No—one seventh of the value of the cabin is used up each day. So in reality, the vacation cost you $130 per day.

On your vacation, you probably don’t give that much though—you likely account for the rental cost and then figure out how much of your budget is left over for the week.

You probably do think about it though when it comes to property taxes. In all likelihood, they are due twice a year, but, of course, you live in your home every month. Most people can’t come up with such a big chunk of money without planning, so they squirrel away a portion of it each month to be prepared. If you are like many people, your mortgage company might even handle this for you. They charge you for the monthly cost of your property tax, and then pay the semi-annual bills.

Businesses do the same thing. They allocate big expenses over a longer period of time. This process is amortization.

Amortization will likely affect your continuous improvement efforts in two ways. First, you some financial decisions will affect you. For example, you might want to buy a new system—perhaps an automated zip-tie machine—for a production process. The financial wizards will run the numbers and see if the purchase makes sense. They will want to see how the costs get applied, and whether the savings you expect to realize in the process are bigger. If the savings aren’t big enough, no machine.

The other more common way you will feel amortization is in relation to setups. When you spend ten minutes getting a machine ready to run parts, those ten minutes are not free. They have to get applied to the parts. The more parts that you run, the smaller each part’s share of the setup. That is the main principle that people use to support batch manufacturing. They believe that larger runs of parts bring down costs.

Unfortunately, that is only part of the story. Large batches case many other costs to rise. When parts move in small quantities approaching single-piece flow, the cost savings from the whole system more than offset the increase in per-part amortization of setup time.

 

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