In an e-mail, blog reader Heather asked:
How else can you use lean to achieve bottom line results besides a growth strategy?
The growth strategy for delivering bottom line results through lean goes something this: lean improvements create production capacity without adding cost other than direct materials, and as a result the contribution margin from the added sales using the new labor and equipment capacity goes straight to the bottom line.
For a simple calculation, let’s say that before lean a factory has the capacity to produce products that sell for $1,000,000 with the breakdown as follows:
Labor cost of this capacity = $100,000
Overhead costs of this capacity = $100,000
Material cost = $700,000
Gross Profit = $100,000
As a result of implementing lean practices let’s say that capacity doubled, such that the same labor, equipment, facilities and support staff can now produce and sell $2,000,000 or product. Deducting the $100,000 for labor and $100,000 for overhead, plus $1,400,000 for materials the gross profit is now $400,000. Although direct consumables and energy costs would likely lower this gross margin number, this demonstrate the idea of “bottom line results through a growth strategy”. We should all be so fortunate in 2010.
But as we achieve improvements through lean, many of us are seeing flat or declining sales. How are we to show results of our improvements on the bottom line in such conditions? The obvious, least pleasant and ultimately self-defeating approach is to cut the largest of variable costs, namely direct and indirect labor costs. This is antithetical to lean and only the last resort for the survival of the business, not one of the ways that lean is used to achieve sustainable bottom line results. The first and most neglected places to look for bottom line lean savings are variable cost losses such as energy, quality losses, expedite costs, carrying cost of inventory, cost of breakdowns and repairs. After a discussion with the site financial controller these areas should be targeted for kaizen.
When faced with the question of how lean delivers return on investment, we often talk of “hard savings” and “soft savings”. Hard savings are the kind that the financial controller can see and which are directly tied to improvements in productivity or the reduction of losses. Some choose to include the avoidance of capital expenditures such as additional buildings and equipment as a hard savings, while others argue this is a soft savings. Soft savings may be indirect, understood to happen when other conditions such as an uptick in business take place to make use of the new capacity, or when a valuable business capability such as quality of speed has been created and waits to be utilized.
It is an obvious but often overlooked fact that while while costs can only go down to zero value can increase infinitely. There are only two parts to the Taiichi Ohno’s profit equation, and while he teaches that the customer sets the price and that we can only lower costs in order to affect profit, we can in fact affect the price by enhancing value.
The reduction of cost is often much easier than increasing value. One of the reasons is that while waste is easy to define and agree upon, value is defined by customers and is subject to change constantly. The improvement of business processes is an important part of lean that is often considered the foggy realm of innovation. This includes making marketing, sales or product development processes more effective contributors to bottom line results. Similar to the growth strategy, the reduction in time to market, the shortening of the cycle time to complete a sale or the improvement in customer service can all be value differentiators which allow one to command a price premium.
The Lexus is not all that different from the highest end Toyota vehicle, but the shopping experience for one certainly is worlds apart. The Ritz-Carlton hotel staff who excel at knowing their customers and ensuring a value-filled experience provides what is in the end a sleeping space not too dissimilar from a lesser chain’s high end hotel. Where Apple does not compete on price with Windows PCs, they do on style, image and accessorizing. No amount of lean and supply chain optimization can overcome these differences. Lean operations may be necessary but not sufficient; only when lean is taken as an overall customer-centric philosophy to deliver maximum value and minimize waste will it truly deliver long-term bottom line results. Simply put, lean must always be enterprise-wide, not just a factory initiative.
This question of how to show a return on investment for lean activities in the absence of a growth strategy also requires a discussion of the difference between a short term and long term perspectives on lean implementation. One of the questions to ask at the very start of a lean deployment is whether there is a leadership coalition with has a strong sense of urgency to change, a sufficient understanding of the challenges posed by lean for their culture, and whether they are prepared to defend the long-term vision of lean as investing in people, building internal capability, and creating mutual-win relationships with suppliers and customers. For most Western corporations that report profits quarterly and whose leaders are compensated by the upward movement of share price, the answer is a conditional “yes” at best.
Group Health Cooperative lean sensei Lee Fried tackled this question in his Daily Kaizen blog recently, stating:
When people ask how we calculate ROI at Group Health I let them know that we don’t. When they ask how I would recommend they approach calculating ROI I tell them they should not.
Lee argues that lean is about more than ROI, that overemphasis on ROI takes the focus away from front-line deployment, and that accurate ROI calculation is a complex thing, potentially a futile exercise. The string of comments and responses to his article is enlightening also.
Group Health Cooperative is a not for profit organization in the enviable position of having a community-focused long-term vision, a sense of urgency strengthened by the need to cure sick people at ever lower reimbursements, and a coalition of people who care deeply about the work they do. They are off to more than a good start. We should all be so fortunate in 2010.