Capacity Has Value – Part 3

In my last couple of blogs I proposed a new way the analyze capacity in a lean company, and gave you a lean way to think about this.

I made the case that what you really need to measure is whether or not your company is spending value stream resources on productive or nonproductive activities, using the value stream map as your analytical starting point.  I stressed that your value stream maps – beyond being mere Lean “wallpaper” – have to be the accurate and living representation of what your processes for delivering customer value are really doing.  If you keep an eye on the way capacity is being used and see how this contributes to higher revenue and lower costs, you are on the way to getting the most out of your Lean operations.

In case you missed them, here are links for the first 2 parts of this discussion:

Part 1  https://maskell.com/?p=637
Part 2  https://maskell.com/?p=799

This time around I want to spend some time telling you why it’s vitally important in a Lean company to understand your capacity and how to put it to use to make more money and beat your competition.

What’s the Value of Capacity to Operations?

Establishing flow and continuous improvement will get rid of waste. Eliminating waste means Operations stops spending time on wasteful activities and literally creates available time. You will see this on the value stream Box Score when nonproductive time is converted into available time.

If you are a Lean CFO, you need to establish the standard work for measuring continuous improvement in your company.  But this is not always easy to do; and misunderstanding how to do this has sometimes led to scaling down or abandoning good lean efforts, because nobody could demonstrate how they “paid off.”

One of the major frustrations of Lean Manufacturing people is the difficulty they have in explaining what the company has gained through continuous improvement.  How do you monetize “eliminating waste?”  Many companies will fall back on the “old reliable” – cost savings. – mistakenly thinking you have to be able to show where you saved money.

Some lean companies even have policies in place that require calculation of cost savings to justify continuous improvement activities. Typically this is done by calculating the amount of time freed up by eliminating waste and multiplying it by some labor or machine rate.

If you are the CFO in a Lean company where demonstrated cost savings in this manner is mandated  in order to evaluate continuous improvement, you should insist immediately that it has to stop.

Instead, people need to begin using the Box Score.  Every major improvement activity should “move the Box Score” in the direction of the future state (which is in line with the strategic direction of the company.)  Most major improvement activities should demonstrably improve one or more value stream performance measures and convert a portion of nonproductive capacity into available capacity.

Some improvement events will have an impact on value stream costs and this will be reflected in reduction of value stream costs on the financial portion of the box score.  Here’s a example of a box score that tracks continuous improvements over time:

 

Because the value stream income statement reflects actual value stream spending, it is much easier to see the direct impact of continuous improvement on spending decisions.  This represents a good Lean way to demonstrate the effectiveness of good Lean work.

Another area where capacity has operational value is in resource planning. Most lean companies have a 6-month continuous improvement cycle and target 10% productivity improvements every 6 months. Because you can calculate future state capacity from a future state value stream map, you can easily project operational resource requirements that will reflect the productivity improvements.

As a CFO, you can use these resource projections in your financial forecasting. The economics of lean now become part of your financial forecasts with revenue increasing at a greater rate than costs. This financial trend is supported by the future state capacity data.  They show exactly how your company is delivering more value to your customers without adding resources or piling up costs.

What’s the Financial Value of Capacity?

Perhaps where you can have the most impact on the long-term profitability of your company is by incorporating capacity data into the standard work for financial analysis of your business decisions.  Here is how.

The cost of capacity changes only when the level of capacity changes. If available capacity exists and it is used in productive activities, such as meeting customer demand, there is no change in production costs.  Got that?

Putting it another way:  If available capacity exists, and there is an increase in demand, the only increase in cost is material cost. The profit your company makes from the increase in demand is the contribution margin. There is no change in the cost of labor or other production costs because the available capacity exists.  Conversely, if demand increases and there is not enough available capacity, the cost of buying the capacity must be part of your financial analysis.

This is one area where using standard costing works especially badly in a lean company. If you use a standard product cost to calculate the profitability of anything you plan to do,  you are basically making the assumption that costs will be incurred based on each unit sold.  Even if you make the assumption that all or a portion of the overhead is “fixed” this still assumes labor cost will vary with each unit sold and this is simply not true.

If you need more capacity, you can easily see it because you notice see a low percentage of available capacity.  The value stream determines how many and what resources are needed and what spending will be required.  It’s quite a simple financial analysis to determine its cost, which typically will be cost of machines, of hiring new full-time or temporary people, or the number of overtime hours required. None of this is complicated to calculate.

In fact, your box score is a great tool for “what if” analysis.  Here’s an example of one that looks at a few different scenarios.   It considers whether to take new business and increase revenue by making the product in house, outsourcing it to Asia, or outsourcing it locally.   Laying the  options side by side in the box score makes it easy to see the effect on value stream performance, capacity, and profit.  This method will lead to optimal decisions for the value stream.

 

Wrap up

Value stream capacity data is the missing link between lean operational improvements and visible financial improvement. Most, but not all, lean practices focus on reallocating resource time away from nonproductive activities to productive activities.  This is reflected in improved performance measures but does not change the total cost of resources. Value stream capacity measures this change in time.

By incorporating value stream capacity into your standard financial analysis, the impact of flow and continuous improvement will become clear. You will be able to accurately project the true profitability of increasing demand without adding resources.

Stay tuned for my next series of blogs about decision making.  I plan to walk through some more scenarios, and I hope to convince you that this simple Lean method is really the way to go.

Capacity Has Value – Part 2

In my last blog (here’s the link in case you missed it: https://maskell.com/?p=637 )   I proposed a new way the analyze capacity in a lean company, and gave you a lean way to think about this.   I made the case that what you really need to measure is whether you are spending your resources in the value stream on productive or nonproductive activities.

The best part about measuring capacity this way? The information needed is already on the value stream map.

BUT (Usually when there’s a “but” someplace, it’s time to pay attention!) … your value stream maps have to be up-to-the-minute correct, and verified by actual observation.  Just a guesstimate won’t do.

Integrity of Value Stream Map Data

If you are going to use value stream map information to calculate the capacity each process in the value stream it must be created by direct observation.  This will yield the very best available data for calculating the capacity of a value stream. It forms the foundation for calculating the productive, nonproductive and available capacity for a value stream.

I’ll go further.  As a Lean CFO you should insist vehemently that direct observation be used to gather all operating information for a value stream.  Do not allow people to use data from the ERP system or let people simply use what their “experience” tells them.  Part of your goal, as a Lean CFO, is to make sure everyone in operations, accounting, and finance are on the same page when it comes to understanding the business.  The Value Stream map has to be everybody’s focal point.

Use the Values From the Map in Your Capacity Calculations

Sample Current State Value Stream Map With Process Data
Sample Current State Value Stream Map With Process Data

Total Productive Capacity of a value stream is its total cycle time multiplied by the average demand (usually normalized to a month.) Cycle time is the uninterrupted work time to complete each process step. It does not include any of the 7 wastes. Average demand is used because producing at a rate greater than demand is waste.

Total Nonproductive Capacity is the total time spent on wasteful activities as shown on the value stream map. The value stream map data for some types of waste is expressed in rates, such as scrap, rework and downtime. These rates need to be converted into the units of time used on the value stream map. Other types of waste such as waiting and transportation are usually already expressed in units of time on the map. Convert all observed waste into units of time and simply add them up to get total nonproductive capacity.

Total Capacity is the total time the value stream resources work in a month. This would be the total resources in the value stream multiplied by work hours per day by the number of days worked each month. Productive and Nonproductive capacity are expressed as a percentage of total capacity.

Available Capacity in the value stream is calculated by subtracting productive and nonproductive capacity from total capacity. There should always some available capacity in a value stream for 2 reasons:

  1. The tools and practices used in a pull system slow down your faster processes to the rate of the bottleneck, which is the process step with the longest cycle time.
  2. Lean companies always reserve a portion of capacity as a buffer for variability that cannot be predicted. This is typically between 10-20% of total capacity.

Capacity should be calculated for both people and machines. It’s best to calculate capacity based on the resource that is performing the value added work. The value stream maps indicate which resources are performing the value added work

No Benchmarks.  Finally, it’s important to remember at the outset that there are no “benchmarks” as to what your capacity numbers should look like – they are what they actually are.  In other words, you want the current state capacity to reflect the real current state of the value stream based on however much waste is observable.

What is important is the trend of capacity numbers over time, which should measure the maturity of lean practices, improving productivity and getting better at delivering customer value.

Next time we’ll look at some specific ways to use this analysis of capacity to improve your company’s ability to assess the true financial benefits that flow from Lean.

That’s where Lean Accounting comes in.

Untangling Complexity with Lean Accounting by Eldad Coppens

Logo
 First, a note from Brian Maskell:   
 Eldad Coppens is the CFO of Qfix.  Mr. Coppens  holds an MBA from the Wharton School of the University of Pennsylvania and a BA in Economics from Princeton University. Before becoming an investor in and officer of Qfix, He was Managing Director of Credit Suisse First Boston, a leading global investment bank.
 
Dan Coppens (CEO) and Eldad Coppens (CFO) with Qfix positioning device.
Dan Coppens (CEO) and Eldad Coppens (CFO) with Qfix positioning device.”Qfix is a world leader in the design, manufacture and marketing of patient positioning and immobilization products for radiation therapy, located in Avondale, PA, just west of Philadelphia.  Our business is characterized by a high degree of vertical integration, a broad portfolio of products manufactured both by us and by others which we distribute worldwide, and a significant level of organizational complexity involving managing everything from an intensive research and development program for new products, 24/7 manufacturing facilities, a full-fledged customer service operation, a direct sales force spanning the continental U.S., and a global distribution network everywhere else.”Qfix is a world leader in the design, manufacture and marketing of patient positioning and immobilization products for radiation therapy, located in Avondale, PA, just west of Philadelphia.  Our business is characterized by a high degree of vertical integration, a broad portfolio of products manufactured both by us and by others which we distribute worldwide, and a significant level of organizational complexity involving managing everything from an intensive research and development program for new products, 24/7 manufacturing facilities, a full-fledged customer service operation, a direct sales force spanning the continental U.S., and a global distribution network everywhere else.

“Qfix is a world leader in the design, manufacture and marketing of patient positioning and immobilization products for radiation therapy, located in Avondale, PA, just west of Philadelphia.  Our business is characterized by a high degree of vertical integration, a broad portfolio of products manufactured both by us and by others which we distribute worldwide, and a significant level of organizational complexity involving managing everything from an intensive research and development program for new products, 24/7 manufacturing facilities, a full-fledged customer service operation, a direct sales force spanning the continental U.S., and a global distribution network everywhere else.

If you look at our website at www.Qfix.com, or download a catalog there, you’ll understandQFix_Products the breadth of our product offering.

Before we discovered Lean Accounting and BMA, we were already deeply engaged in implementing Lean Manufacturing and the Lean mindset in our organization.  As a manufacturer, the initial appeal was to maximize the efficiency of our production lines, and so we were already busy creating value stream maps and introducing visual management tools such as kanbans and charts for various productivity-related metrics.  In all of our reading and learning about Lean, we occasionally came across the concept that accepting the Lean framework also implies abandoning traditional financial and accounting paradigms.

We were eager to learn more.  Frankly, we had never been satisfied with the quality and utility of financial information produced by using the traditional cost and financial accounting approaches.  Trying to understand the cost of a production unit by allocating/absorbing such fixed overheads as rent, back office, utilities, etc. or even direct labor, which is also essentially a fixed cost, never seemed satisfactory either as a foundation for tracking costs or for pricing products.  And traditional financial reporting might be a guide to overall profit and loss, but was useless for answering the question we were always asking ourselves, which was “why and where do we make (or in some instances, perhaps unaware, lose) money, and how can we use that information to make good decisions and improve our results?”

Anyone who has ever taken an introductory course in Microeconomics is indoctrinated with the concept that while the average cost of a product is a function of both fixed and variable costs, rational economic decisions are made at the margin.  Profitability is maximized with increasing output as long as the marginal (variable) cost is less than the price that the marketplace will offer for a product.  So why is it that traditional cost accounting focuses so much firepower on time-consuming and misleading calculations of average costs by endlessly determining the fixed cost “content” of a unit of production and deviations from “standards” determined in circular fashion by the same methodology?  Lean Manufacturing teaches us that running an efficient process is all about smooth flow and removing bottlenecks which produce unnecessary inventory, poor resource utilization and wasted effort.  In other words, you maximize efficiency/profitability when you optimize the exploitation of your fixed costs.  This is an approach entirely consistent with sound Microeconomics, but at odds with traditional accounting.   Lean Accounting not only addresses this conceptual flaw – it also eliminates a great deal of accounting drudgery that is costly, counterproductive and anything but lean.

Having experienced the epiphany of our initial encounter with the concept of Lean Accounting, we were thrilled to be able to work with BMA, the Lean Accounting Leaders (yes, they really are), to bring its advantages to Qfix.  In 2011, we happened to be in the process of implementing a new ERP system, so we decided to take the opportunity to create an entirely new Chart of Accounts mapped tightly onto our identified value streams.

The benefits of implementing Lean Accounting in our company have already been manifold.  To list a few, we now have:

  • Financial data that provides a quantitative “x-ray” of our operations along all of its major dimensions
  • Timely reporting in a straightforward, actionable format – rather than wait to close out a month, by which point one is increasingly staring in the proverbial rear-view mirror, we receive bi-weekly reports of real-time information that highlight variations in performance and spending in a palpable manner.
  • Financials that are consistent with GAAP without the distortions of traditional GAAP accounting – in fact, one of the benefits of Lean Accounting is that it provides increased insight into both the strengths and weakness of GAAP accounting.  Lean Accounting, because of its focus on tracking the flow of resources and spending in real time, is a superior tool for monitoring cash-flow generation (though it is decidedly not cash based accounting).  Lean Accounting also clarifies inventory measurement and valuation by dispensing with the notion that fixed costs are somehow absorbed in inventory and sitting on a shelf (with the perverse distortion that profits are actually magnified in the process of inventory accumulation!).  In theory, GAAP accounting’s approach of matching revenue accruals with associated costs is designed to provide a more faithful guide to actual performance, by adjusting out timing effects related to cash inflows and outflows.  However, adjusting out flows weakens GAAP as a tool for controlling – flows!
  • Greater diffusion of financial results within the company.  Lean Accounting creates data that is useful for managing the business and therefore valuable to place in the hands of managers.

QFix ProductsWbLgWe are only beginning to reap the potential benefits of this powerful management tool.  Already, it has helped us to have a much deeper understanding of the true economic characteristics of our various value streams and resulted in better management of our working capital.  One of the major goals of Lean is to free up capacity that can be redeployed to grow the business.  Because of Lean Accounting, and through the application going forward of capacity analysis tools and box scores for decision making at the margin, we will increasingly be in a position to see how operational decisions that improve flow in the value streams impact our financial results and to maximize our returns on capital invested.”

Visit Qfix on the web at www.qfix.com.  Qfix is located at 440 Church Road, Avondale, PA 19311 USA Phone: 610-268-0585610-268-0585 Fax: 610-268-0588