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Stories From The Field

Stories From the field # 6 - May, 2004

Making Money From Lean Improvement
by Brian H. Maskell, President, BMA Inc.

It is a common story among companies that embark on a lean journey. They want to reduce their costs and become more competitive using lean manufacturing. Lean manufacturing is certainly focused on cost reduction. As we eliminate waste from our processes it takes less work and less material to manufacture products, and our productivity increases. Higher productivity means making more products with the same amount of resources, and product costs go down.

#1: Using Target Costing to Increase Customer Value.
#2: Quoting Decision Without Standard Costs
#3: Value Streams for a Retail Products Manufacturer
#4: Value Streams for Plants With Many Product Families
#5: Make-Buy Decision Using Value Stream Costing
#6: Making Money from Lean Improvement
#7: Making Pricing Decisions based on Lean Accounting
#8: Value Stream Costing & Decision-Making Lead To Significant Business Growth
#9: One Company Learns About Quoting & Sourcing
#10 Making an Accounts Payable Service Center a Little More Lean


The problem faced by the company in this "Field Story" was that as they cut costs from their processes and the product costs came down, there was no short-term "bottom-line" improvement. In fact, instead of the company's profits improving, they got worse. The management team were relying on lean improvements to bring improved profitability and to bring it quickly. They were bitterly disappointed, and there was acrimony in high places.

This company - a manufacturer of electro-mechanical equipment - chose for their first value stream a product family that was approaching it's end of life. The intention was to pull the costs out of production using lean manufacturing methods and "milk the product line until it dies." The product family provides analog information and it is being replaced in the market place by smaller, cheaper digital devices. The writing is on the wall for this product family; they wanted to use lean manufacturing to keep it profitable for as long as possible.

Here's what the current state looks like -prior to any lean improvements:

The plan for this year is to make the value stream 40% profitable. That is the Hurdle Rate set for the Value Stream Manager and his team. The team had established five primary performance measurements value stream and there was a clear need to reduce inventory, improve on-time shipment, bring down the average product costs, and increase productivity - sales per person.
The Value Stream team began to work together on lean improvements. They created Value Stream Maps and, using the book "Learning to See", set about designing lean flow through a series of production cells. They created a Future State Value Stream Map and established a schedule to implement the changes required to achieve the future state in two, six-month improvement projects. They were excited about the changes they were planning to make and the improved results knew they could achieve.

Here's what they expected their future state performance measurements would look like:

During the first 6-months - project step one - they focused on flow so that their lead time would be substantially improved and the first-time-through quality of the process improved.
In the second project - step two - they focused on further inventory reduction, reduced cost, and waste elimination.

The Value Stream Manager asked the company's Cost Accountant to help develop the savings numbers so that they could see the financial effect of the planned changes.
The results were shocking. Profits got worse instead of better, as shown below:

The Cost Accountant explained that the lack of profitability had two causes:
- inventory reduction and
- increased manufacturing adjustments.

"Whenever there's a significant drop in inventory, profits are undermined," she said. "All the overheads that have been included in the inventory valuation on the Balance Sheet are shown as expenses on the Income Statement during the period they occur. This means that any month you do substantial inventory reduction, you will show your manufacturing expenses increasing. Even though you have not spent any more money, the Income Statement will look as though you have."

The Value Stream Manager was confused and dismayed.

"If it would be helpful, I can show you what it would look like if those extra inventory costs are excluded", suggested the Cost Accountant. Here's what the new numbers looked like:

These are better numbers but they are hardly the break-through improvement the Value Stream Manager was hoping for; and he knew that his senior managers were expecting something very much better.
"How come", he asked, "has our standard cost reduced by 22% and yet profits only show a 1.36% improvement?"

The Cost Accountant explained that despite the standard cost reducing owing to material cost reduction and less production labor, the people costs would not be coming down because they are not planning any headcount reductions. "You will have the same machines, the same facilities, and the same support costs you have now. The costs only go down theoretically. That's why we have a big manufacturing adjustments in the second phase."

This was devastating news for the Value Stream Manager.
"What's the point of doing all this hard work if we are not going to show any cost saving? In fact, over the next 12 months we are going to lower our profits because of the inventory reduction," he wanted to know.

The Cost Accountant explained to the Value Stream Manager that there is a better way to look at the cost and profitability information.

"The reason you are not showing much improvement is that most of your costs really are staying fixed. When you do the lean manufacturing improvements you will eliminate waste but not (in the short term) costs. The waste you remove will be converted into available capacity." The Cost Accountant went on to explain that the numbers she was about to show him did not have any standard costs; all the cost information was the true, direct costs of the value stream. The capacity information showed how the resources within the value stream were being used. This included the people and the machines.

Here is the Box Score information the cost accountant used to explain the true effect of lean improvement:

This Box Score shows a classic effect for an initial lean manufacturing improvement.
During the first six-month project the team made marked improvement in quality, lead time, and inventory reduction, but productivity and average product costs stayed the same. Productivity stayed the same because the value stream has the same level of sales and the same number of people. Product costs stayed the same because the team did not make any changes that effected costs much. The value stream has the same number of people, the same machines, the same facilities costs, etc.. The material costs within the value stream were reduced during the time they were reducing inventory, but in the "steady state" materials costs will be the same as before. The costs stayed much the same.

The way resource capacity is used changed a little. Productive capacity came down slightly owing to improved standardized work in the production cells and the non-productive capacity also came down owing to the elimination of some waste in the process. As a result there has been a 5% increase in available capacity. This is good improvement, but not enough to make a significant difference to the value stream operations.

During the second six-months the team worked on a number of improvement projects that did bring down costs. These included reducing scrap in the production process, reducing outside processes, eliminating overtime, and bringing down the cost of consumable tools. The average product cost fell considerably, although the value stream profit is still far below the 40% hurdle rate.

The biggest change shown on the Box Score is the significant reduction in the use of non-productive capacity and related increase in available capacity. The team's efforts during the second six-month period resulted in the elimination of considerable waste. As a result of line-side inventory, most materials are no longer kept in stock rooms. This eliminates the waste of stock-keeping, picking, kitting, and material handling. Improvements in standardized work, quality improvement, and other process improvements have removed a good deal of wait-time, downtime, rework, and scrap. The lead time reduction virtually eliminated expediting and the usual oriental fire drills the company had been indulging in for years. When all this is put together, non-productive capacity was reduced by from 40% to 12%. This increased the available capacity by 28% to 36% of the people's time.

The Big Question

The question that was plaguing the Value Stream manager was this: "How are we going to make more money from the lean improvements we have introduced?."
One approach would be to reduce the headcount within the value stream and bring down the conversion costs of the products. This was not possible because the company had given a commitment to their people and to the union that there would be no lay-offs as a result of lean improvements. It was also not desirable because, while it would result in a short-term cost improvement, it would jeopardize the other lean programs the company had on-the-go. No one was going to work hard on lean projects if it resulted in them (or their buddies) losing their jobs

Another approach was to let the headcount fall by the gradual attrition method. This means that as people leave the company they are not replaced and the value stream headcount gradually reduces. As far as he knew, there were not a lot of people ready to leave the company. In fact morale among the workforce was better that it had been for a long time. It seemed that the attrition approach would take too long to show any rewards. Besides, headcount was only a part of the conversion costs. Reducing headcount would not make the financial impact he needed.

A better approach is to grow the business. But this was an end-of-life product family and there would be no investment available for introducing new products. The marketing people were saying that there was no future for this product family. The value stream team met several times to discuss this issue and try to make progress. The breakthrough occurred when they realized that there was room for growth in this market; but not the usual kind of growth.

The product family comprised several hundred products, each of which was designed to meet a specific customer need. In discussion with some of their major customers, the engineers and marketing people recognized that - if they used some clever design approaches - they could develop new products that replaced the current products with newer & better units covering that covered a wider range of specification. This way they could reduce the number of products while providing their customers with a wider range of functionality.

Most of the customers maintained an inventory of these units to use as spare parts. The wider functionality of the new products would enable their customers to keep fewer items in stock. This increased the value of the products to the customer, simplified the production processes, reduced the number of component and raw materials required, increased sales and reduced costs. This was a win-win-win for everyone.

While the lean team was implementing the second phase of the lean improvements to realize the future state flow, the engineers and marketing people worked to create the new product designs. They spent a lot of time with the customers understanding how they could create more value for the customers and gaining a better understanding of the prices they could command in the market. Several of the shop-floor operators worked on the product designs to ensure they fitted well into the newly introduced lean flow through the value stream. Two of the shop-floor operators had experience with CAD tools and provided drawings, visual work instructions, and other documentation required. This was truly a team effort.

The Results

The results are summarized below:

The introduction of new products increased sales by a little less than 40% and increased profits to more than 46%. Productivity increase by 39%, stock turns improved, as did average cost. This became a lean success story.

Morals of the Story

Do not expect short-term cost savings to come automatically from lean improvement. Often the financial benefits come later rather than sooner.

Always develop a "long term future state" for the value stream. The "future state" value stream map shows you the operational improvements you an expect from the lean improvements. The "long term future state" shows the financial impact of these improvements.

Always have a "How are we going to make money from these lean improvements" strategy when you embark on your lean journey. If you just do the operational improvements without taking account of the newly freed-up available capacity, you will be missing the point of lean improvement.

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