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.