Month: February 2019

In the previous blog I explained cost reduction in lean organizations is different than traditional cost reduction practices because of method and measurement. In this blog, I want to dive deeper into labor cost to explain how lean organizations measure labor cost reduction and the methods used to achieve it.

Effective Measurement: Labor Cost as a % sales

Goal: reduce labor cost as a % of sales over time

Lean organizations consider their employees to be their most important asset, because they create the value, solve problems and improve the organization.

In lean organizations, the cost of labor is how much the company is paying for a level of capacity to perform work in value streams and other business processes. The amount of capacity needed in any process  function of the demand on the process and how much waste is in the process. The more waste in a process, the higher the labor costs.

Lean organizations look at their full-time employees as permanent capacity. Overtime, temporary employees and contract labor is considered temporary.  To better understand how lean reduces labor cost, think of labor cost the same way:

• Fixed costs – salaries and wages of full-time employees.
• Variable costs – overtime, temporary employees, contract labor.

Improvement activities result in creating available capacity. The “first choice” is to use the available capacity to meet demand. If excess available capacity still exists, it can be re-deployed in the organization or eliminated.

Eliminating excess available capacity is first done to the temporary capacity– overtime, temporary employees and contract labor.  This results in actual cost savings that is reflected on the income statement.

To deal with available capacity of full-time employees, lean organizations develop strategic methods to utilize the capacity. These methods have the financial impact of avoiding increased costs in the future.  Over time, these methods reduce labor cost as a percentage of sales.

Here are some examples:

• Attrition – not replacing employees who leave the organization
• Redeploy resources to other value-added activities
• Fill open positions internally
• Promote from within and backfill lower paying positions
• Insource previously outsourced operations
• Cross-training to create flexible capacity to move between operations or value streams
• Temporary strategic assignments: assign employees to continuous improvement activities or other strategic initiatives

In order to achieve a reduction in labor costs (as measured by labor as a percentage of sales), it is very important for an organization to be proactive in creating and executing  a comprehensive plan to address the capacity that will be created due to improvement activities across the entire organization, not just operations.

Here is a simple example of using some numbers. If lean organizational improvement activities achieve annual 20 % improvement in productivity, this means 20% capacity will be created annually. If revenue is not increasing 20% annually, then the organization will be faced with excess available capacity.

Labor happens to be an expense on the financial statements and conventional practices to reduce labor costs usually don’t work very well in lean organizations. As you begin your lean transformation journey, closely examine your current practices regarding managing labor costs and make the necessary modifications to align them with the lean strategy.

In the next blog we will look at both material and machine costs.

Does lean reduce costs? – Yes! Tiiachi Ohno stated this very clearly: “costs do not exist to be calculated, they exist to be reduced.”

In my career at BMA I’ve been fortunate to have worked in many different companies of different sizes and in different industries. Some have been further down the lean transformation journey than others. One common theme I have recognized in all companies I’ve worked with is a desire to better understand and control costs. What I’ve also learned is there sometimes is a disconnection between the financial analysis of cost reduction, which is usually based on conventional practices, and what a lean strategy achieves operationally.

This led me to write this blog series to explain how and why a lean strategy can achieve cost reduction and make some attempts to connect lean practices with cost reduction analyses.

Today’s blog will focus on lean cost reduction methods, measures and thinking. The following  blogs will focus on specific costs, such as labor and material costs, where we will look more deeply into exactly how lean practices achieve cost reduction.

A lean organization’s goal is to deliver value with the highest quality with the lowest costs possible. Lean organizations understand price is set by the market, and in some cases a company’s ability to  influence market demand may be difficult. This means in the “profit equation”: Price – Cost = Profit, the only part of that equation a lean organization can totally control is cost. Let’s now look at a general framework of how lean organizations approach cost reduction.

Method

The five principles of lean form the basis for lean organizations to become learningorganizations through lean problem solving, which is summarized in the chart below. The root causes of costs are pretty much the same as root causes of poor process performance. I explain this to finance people by suggesting if they want to better understand costs, go to the Gemba and observe.

The better a lean organization is at problem solving, the better it will be at reducing costs. But getting good at lean problem solving takes time because the organization as a whole must learn, which means cost reduction will also take time.

This long-term approach to cost reduction is counter to conventional cost reduction practices which usually focus on achieving a level of cost reduction over a short time period through top-down management decisions and actions.

Measurement

Lean organizations seek to reduce costs over time. Lean organizations understand that lean problem solving will reduce costs in two ways:

Actual Cost Savings– actions taken that lower current spending, investment or debt levels and the savings are tangibly reflected in the financial statements. Through continuous improvement activities specific, actual costs can be identified and can be eliminated once improvements are sustained with new standard work.  I’ve heard financial people call this type of cost reduction called “hard savings.”

Cost Avoidance– actions taken that avoidhaving to incur costs in the future. Potential cost increases are avoided through continuous improvement efforts and are never reflected in the financial statements. I’ve heard financial people this type of cost reduction called “soft savings.” How continuous improvement avoids costs requires a more detailed explanation.

A primary result of many improvement efforts is the creation of capacity (see chart below). Another way to think about this is the elimination of wasteful activities creates available time for the resources of a lean organization.

Lean organizations must decide what to do with this available capacity: enhance the deliver value to customers or re-deployed throughout the organization. In most cases, using the available capacity will avoid having to buy more capacity in the future.

Cost reduction in lean organizations is a combination of identifying specific, actual cost savings which are the result of improvement activities and measuring the potential future costs that will not occur in the future.

A cost reduction measurement which I think is very effective to use in lean organizations is cost as a percentage of sales. Cost can be one specific expense line item or a group of costs. I think this is a good measure because it captures actual cost savings, cost avoidance, and considers lean cost reduction takes time.

Financial A-3 Thinking

I believe the key to understanding and measuring cost reduction in lean organizations is matter of changing thinking habits. There are many established, conventional methods to analyze costs, some of which don’t work well in lean organizations because they either rely solely on identifying only actual cost savings or use other methods to “show” savings that never materialize. It’s often said “lean changes everything” and this also applies to measuring cost reduction.

I like to use the term Financial A-3 Thinking. If you are trying to understand the financial impact of a specific improvement activity, or a group of activities, think operationally first, then financially.

• Current State – does the operational problem being studied have any actual direct costs associated with it?
• Root Cause Analysis – would eliminating a root cause impact the actual direct cost?
• Future State – if the future state is achieved, will actual cost savings occur? Will achieving the future state avoid future cost increases? Will a combination of both occur?

It is very important to be clear and specific if any cost savings will appear on the external financial statements or not. If your company uses value stream income statements internally, the same holds true. Use real, actual numbers. Avoid using any estimate or rate.

In the next few blogs, I will look at specific costs and explain how lean achieves cost reduction.