Lean and Financials

Dear Gemba Coach,

During the webinar, you mentioned the importance of quantifying the financial impacts of lean efforts before introducing the system. This is a very common obstacle. Please go into more details about how to do this.

This is indeed a common problem, and a difficult one to solve because it reflects deep differences in management assumption. For the past century or so, there have been two fundamental ways to assess the value of investing in new tools, projects, products, and even improvement programs. The prevailing view has been the orthodoxy of Return On Investment (ROI). While there are multiple ways to assess the value of our capital, ROI dictates that the clear choice is to invest in that which promises the most profitable return based on current calculations. There is nothing inherently wrong with the idea – in theory. In practice, of course, returns are often hard to evaluate and invariably wildly wrong. Moreover, few people care how the returns are achieved as long as the numbers are met. This first approach is very powerful because it provides clear and simple criteria to follow. No need to examine core assumptions deeply.

The alternative position recognizes that some processes and activities have to be in place regardless of how they affect the ROI. The direct ROI of these activities (which can be legal, or safety, or deal with long-term planning, or other intangible matters) is hard to evaluate, but every one will agree that they create value for the company in the long-term, in everything from disaster avoidance to better operations. Many organizational development programs in the past fall on this side of the mountain. They often involve comical efforts to quantify results in terms of ROI to fit in with managerial biases. Unfortunately, many lean initiatives are treated this way because of lack of a better option. But seriously: try quantifying the ROI on a “5S” campaign. If someone here has succeeded, please let me know so we can share how it’s done.

Lean thinking takes a third approach. Performance and process are linked. They are the two sides of a same coin, the back and the front of the same hand. This approach does not come naturally to people, so we must train ourselves to mentally keep performance and process connected in every lean activity we do. In fact, many of Taichi Ohno’s writings center around the link between production methods and costs – he actually rants against the fact that accounting methods often hide the true cost of things.

What would be these essential connections? One can think of four explicit ones:

1. Quality and sales
2. Production method and costs
3. Lead-time and cash
4. Kaizen and capex

Quality and sales is an odd connection. While this link is proved every day that higher quality products sell more, it’s still very hard to get people to fully invest in quality. It’s a tough subject, as Toyota veteran Tatsuhiko Yoshimura points out, J.D. Power’s 2006 IQS difference between Cadillac and Lexus is 99.2% customers satisfied with Cadillac versus 99.4% for Lexus. An apparently minimal difference in perceived quality still makes a huge impact at the point of purchasing: customers will respond very differently to these two scores. His explanation for this gap is not so much in the big problems, because it’s easy to mobilize resources and people to solve them (again, ROI thinking) but all the small one-off issues which require another approach, that of standardized work with constant questioning and challenging. Clearly, if there’s one lesson to take away from Toyota’s success it is that product quality can bring competitors to their knees.

One of the reasons that lean outperforms other management approaches is that product quality is free – paid for by process excellence. In other words the extra value provided to customers in product quality comes out of a lean process whereas competitors have to add costs (quality firewalls, rework, control, etc.) to deliver the same quality. Since they have to follow suit to compete, their costs increase and they land in real trouble. In other words, competitors carry some common costs (materials, bought out parts, labor, equipment, overhead, etc.), but the production method accounts for an overlayer of cost – the plum around the nut, to take the lean image.

The single-piece-flow at takt time method of production affects costs in three main ways:

1. Quality build into the process, so no big batches of defectives parts to check and rework
2. Leveling of processes, so no over-resourcing processes to cope with the peak use of the process
3. Making waste visible, so taking out all unnecessary operations (i.e., unnecessary use of labor, equipment and materials) by “leaning” processes day after day.

Thirdly, after sales and costs, lean is strongly connected with cash. On the numbers side, the link between inventories and cash is more intuitive, but recently, I heard an investment fund manager remark that everybody knows that carrying 28 days of inventory is way too much for an automotive supplier in terms of cash weight (which affects the equity structure), and yet knowing this doesn’t help companies to reduce their inventories. This is a realistic but surprising statement considering how long lean inventory reduction methods have been around. Beyond the inventory numbers, the lean link is about reducing the lead-time between the moment of investment on one hand and collecting the money on the other: product planning, design, procurement of equipment and tools, production, distribution and then sales. There is far more to lead-time reduction than just cutting those inventories, but they’re still a good place to start with. In any case, lead-time and cash-in-hand are tightly linked.

Finally, ROI thinking is naturally oriented towards capex – I haven’t yet come across a production problem that couldn’t be solved: please just sign the check. The lean attitude here is “use your ideas, not your money”. Capex is reserved for new things: new products, new technologies, anything innovative that requires investment. Existing processes must perform at standard levels without re-injection of capital expenditure – which means a lot of kaizen. Furthermore, kaizen thinking will lead you to develop different kinds of equipment, far less costly, more flexible (not in terms of being able to do everything right this minute, but in terms for being re-usable for the next product and easy to change), with smarter, lighter technical solutions – a real big fight in mature lean programs. Also, by using the proper production method to maximize the OEE of existing equipment (and making this equipment easier to changeover) we limit the purchases of new equipment (the extra machine because we feel there is a capacity bottleneck and we really need to ship those parts), and over time, work with a much lover level of new capital expenditure.

Now, none of these four links are self-evident in accountancy method, so it’s up to us, lean guys to do our homework in order to convince the hard-nosed finance managers. The first step is usually tracking a list of operational indicators. In The Lean Manager, we use:

1. Sales:
   1. Customer parts per million (ppm)
   2. Quality complaints
   3. Missed-deliveries per million
2. Labor:
   1. Accident rate
   2. Internal ppm
   3. Parts per hour (pph)
   4. Suggestions
3. Materials
   1. Supplier ppm
   2. Supplier mpm
4. Equipment
   1. Overall equipment effectiveness
   2. Changeover time
   3. Number of changeovers
5. Inventories
   1. Total percent of sales
   2. Days of raw materials
   3. Days of work-in-process inventory (WIP)
   4. Days of finished goods

Every company finds its own ways of calculating these in details. The key thing is that they have to fit with the reality of operations.

Now for the hard work: reconciliation. Lean theory has spelled out the four basic relationships, but these need to be fleshed out in your specific case. The indicators typically reflect shop floor conditions: a certain level of implementation of visual management, pull system and kaizen. These indicators also reflect a level of financial performance. The trick now is getting teamwork from the finance functions, the lean office and line management to reconcile and flesh out these relationships – and the relationships are there.

Again, no magic wand. No easy answers, only hard work. However, to me, here’s the takeaway. Lean officers often complain that senior managers don’t “get it” (true) and that the company’s cost accounting is all wrong for lean (also true) and so on, so what can they do. Well, we’re the change agents, so the onus of convincing others is on us. In order to sell our ideas, we need to speak the other person’s language well enough to find common ground. I’m certain that this common ground exists, because I’ve seen some companies find it (rarely on the whole list but at least on some aspects). So it’s up to the lean community to take up the challenge of learning how to establish case-by-case relationships between shop floor “normal conditions” and P&L and balance sheet numbers. If any of you are doing this already, please comment on it, I’d love to hear about it.