Stories From the Field # 8 - May, 2004
Value Stream Costing & Decision-Making Lead To Significant Business Growth
by Nicholas S. Katko, CPA, Senior Consultant, BMA Inc.
A safety equipment manufacturer transformed itself from a traditional batch & queue manufacturer into a lean manufacturer with dramatic effect:
The company’s lean champion was its Vice President of Manufacturing, who was very consistent and insistent that lean manufacturing was a long-term growth strategy. He made it clear in senior management meetings that the Sales and Marketing arms of the organization had the responsibility to find new business opportunities to use the capacity that was being created.
Sales and Marketing agreed to this, but they worried that many business opportunities they explored were turned down because the standard cost of the product was greater than the price in the market. The senior management team turned to its Chief Financial Officer to come up with a solution.
The CFO had been involved with the implementation of lean manufacturing since its inception and clearly understood how traditional cost accounting actively worked against lean manufacturing. In fact, he was already in the process of simplifying the standard costing system with the goal of eliminating it in the near future. Now he had to focus on creating business decision models in a lean company. To do this, he turned to value stream costing methods.
The company decided new business opportunities will be evaluated in terms of their impact on value stream profitability by calculating the incremental cost of each opportunity. The approach required cooperation and communication between Sales, Marketing, Finance and Manufacturing. The CFO created the analysis template and assigned responsibilities for developing the model as follows:
Revenue – Sales and/or Marketing
Material costs – if the opportunity involved any new raw materials, Marketing would bring Purchasing into the decision to source materials. If existing raw materials were involved, the standard material cost would be used.
Conversion costs – Marketing would meet with Manufacturing to outline the customer’s demand requirements so Manufacturing could determine if there was available capacity, especially at the bottleneck work center.
Profitability & Return on Sales – the CFO would review the analysis for each opportunity to ensure that company targets were being met.
One of the first examples of the benefits of using value stream costing came in the safety helmet value stream. A government contract for 225,000 units to be supplied in equal quantities in a 12 month period was up for bid. The maximum bid price was $2.25 per unit. Marketing determined that an existing product met the bid specifications, and its material cost was $1.44 per unit. Manufacturing found it could meet the monthly production requirements with no additional conversion costs.
The following table summarizes the cost information:
In this case, Sales and Marketing knew they could bid $2.00, knowing the company could generate $176,000 of profit for the value stream. Without this analysis, they would have passed on making a bid. Using traditional standard costing would have meant losing the opportunity to make a profit.
As a result of their $2.00 bid, the company was awarded the contract.
This table shows the impact of this new contract on the value stream:
Another lesson learned by looking through this bid: the speed at which the analysis could occur and decisions reached. Sales and Marketing took hold of this new decision making tool and became quite aggressive on quoting new business. As a result, a long-term growth strategy emerged, as the annual growth rate of safety helmets grew to 20% as compared to an average rate of just 5% over the previous 10 years.
This is a good example of how value stream costing methods can be used to analyze new business opportunities rapidly, giving lean companies competitive advantages, and disclosing even more opportunities to grow the business.