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:

Capacity 03 Box_Score_Example_1

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.

Capacity 03 Box_Score_Example_2

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.