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.

Capacity Has Value – Part 1

In manufacturing companies, the term “capacity” typically refers to the aggregate production capabilities of your factory.  It’s a bit like your factory’s bandwidth … it defines how much manufacturing can your operations support in a given period of time.  Understanding your production capabilities lets you project the capabilities of your resources (or “capacity”) into the future.

But, beyond knowing WHAT capacity you have, when you break this down into HOW you are using it, you should get the best information you need to measure the effectiveness of your resources,  know how you can make adjustments to best advantage, how to redeploy your capacity effectively, and how to make decisions that will critically affect how well you can achieve your company’s strategic goals.

In this in this and my next blog I will be showing you a different way to think about your capacity, and I’ll demonstrate a better way to understand how much money you can make with Lean. First, let’s establish the traditional context for thinking about capacity.

Capacity & Traditional Methods

Traditional manufacturing companies use software – MRP (Material Requirements Planning) in conjunction with CRP (Capacity Requirements Planning) – to calculate and plan their total capacity.

It works something like this: a production forecast is input into the software. Then the system uses data such as perpetual inventory levels, bills of material, routings and production run rates to calculate how much material you need and  how much machine and people resources you need to manufacture the scheduled products. The resulting schedule for materials goes off to purchasing; the capacity schedule goes to the shop floor (in the near term often in the form of a bunch of work orders.)

The forecast of capacity requirements is important information for you, the CFO. If you are using standard costing, you use the total hours required to determine the manufacturing production costs for financial forecasting purposes.

Moreover, companies using such traditional methods measure the effectiveness of their resources in three ways.  After month end figures are complete, they will look at:

  • The efficiency of labor,
  • The utilization of machines and
  • How much overhead production absorbs.

This information comes from comparing how operations actually performed with respect to standard costs.  Typically you want to measure whether operations is beating the “standard” production rates set up in the system.

Labor resources are considered “efficient” if they produce at a rate faster than the standard and producing more than planned. Machines achieve favorable “utilization” if actual run times are greater than planned. And all resources are considered to be doing well if absorption is greater than planned.

From a financial standpoint then, what you are looking for are “favorable” variances as described above.  The more favorable the efficiency, utilization and absorption the better the profits and vice versa. Of course,  as the CFO, you pay close attention to these numbers because they have a tremendous influence on your financial statements and often times are discussed more than actual operating numbers.

If you have ever been a CFO or controller of a manufacturing company using standard costing, you now what a headache these numbers are.

So far, I haven’t told you much that you don’t know already.

Now here is the good news! When you become a lean company you can throw these numbers away, because (IMHO) they are meaningless to lean operations.

Capacity & Lean Manufacturing

First, I want to make something very clear. Efficiency, utilization and absorption measures do not work in lean companies.

They work just fine for traditional manufacturing because they are designed to support traditional manufacturing assumptions.  But efficiency, utilization, and absorption  totally conflict with Lean operating principles. For a mind map that shows the 5 Principles of Lean have a look here on the BMA web site.  As a Lean CFO you have a tall order:

  • Job #1 for you is to banish these measures forever from your company;
  • Next  you have to ensure the integrity of the actual data used to calculate capacity; and
  • Lastly, you have to integrate Lean capacity information into business analysis and decision-making.

We’ve learned so far in my earlier Lean CFO blogs that the total resources that a lean company requires are based on a combination of actual demand and the productivity of the resources available to supply that demand.  Lean Flow, with other effective lean practices,  gives operations what they need to maintain productivity levels regardless of the level of demand. This is the reason why Lean companies are less concerned about the total amount of capacity and more concerned with constantly measuring the productivity of their capacity.

Lean companies measure the effectiveness of their capacity based on the effectiveness of lean practices being used. In a Lean company, resources can perform two types of activities – productive or nonproductive.  Lean companies look at capacity  from the customer’s viewpoint, not from an internal viewpoint. This is a major difference between traditional thinking and Lean thinking.  It’s pretty simple:

  • Productive activities are those activities required to deliver customer value. These are the activities customers are paying you to do.
  • Nonproductive activities are everything else.  These break down into:
    1. Pure waste (such as scrap, downtime, waiting, etc.) which  needs to be eliminated.
    2. Other necessary activities, i.e., activities that you must perform to support the productive activities (think purchase raw materials) or run the company (think accounting).  Customers won’t pay you more money if you have best-in-class purchasing and accounting.  But they sure will complain if an order is late because your were late getting raw materials in, or if their invoice is incorrect. It’s up to you to use Lean practices everywhere for all necessary activities  just as you do in your value streams.

Measuring capacity in lean companies is really about measuring the amount of time resources spend on productive and nonproductive activities, then showing this on the Lean Box Score.  The best part about measuring capacity this way? The information needed is already on the value stream map.

Here’s a picture that illustrates where you find this data on a value stream map of a typical non-Lean production process.

Next time, I’ll spend some time on the issues that can make or break a Lean understanding of capacity.