This is an excerpt from Ed Grinde’s new book Leveraging Lean with Lean Quoting, now available on amazon.com.
Have you implemented lean within the four walls of your facility and you are wondering, “We have made all of these improvements: faster flow, better quality, improved employee engagement, and increased on-time delivery. Why don’t the results show up on the Profit and Loss statement?” This is a common question within companies early (and sometimes later) in their lean journey.
You may have realized some minor cost improvements using attrition to assimilate the excess employees. But you are not seeing the large-scale profit improvements. There is a simple reason for that. A true lean transformation is not a cost cutting exercise, but rather it is a culture change first and foremost. It is respect for your employees so they are not worried about their jobs disappearing, and they are challenged to be the best they can be. After that, it is really a growth strategy. You need to use that freed up capacity to GROW the business systematically and strategically. The true benefit to the P&L of lean is to allow you to sell more with the same manpower and equipment.
What are your biggest expenses? Usually it is materials, depreciation, labor and fringe benefits, utilities, and supplies. The only real variable costs are material content and a few supplies. Your depreciation does not change just because you have improved flow time by 75%. You might see a reduction in overtime each month from efficiency gains; otherwise, your labor will only change if you reduce the employees you redeploy due to productivity gain. But doing that will stifle your lean deployment. If there is attrition, you can avoid hiring by utilizing the redeployed employees. But again, these are not huge savings. Most of your utility expense is for either heating or cooling the facility. Therefore, the only utility savings comes from running equipment less which is minimal from a financial impact.
Also, your lean activities pull capitalized labor and overhead from the balance sheet to the income statement as your customers realize that you are delivering product faster. While this is good, they will realize that they do not have to order so far in advance nor keep as much inventory on hand. You may see a short-term sales drop because your customers will start depleting their excess inventories without reordering because they know you can deliver faster.
In Exhibit 1-A you can see the impact to the value stream income statement. This explains why top management might not be able to understand all the excitement on the floor about the improvements from all the lean efforts.
If this were all you had to look at, you would not want to go any further with lean. Sales have stayed the same. Your profits actually decreased in dollars and as a % of sales. Even if you removed the impact of pulling into the quarter the capitalized labor and overhead from prior quarters that were sitting in your inventory, Exhibit 1-B shows that the impact is minimally favorable. Here you see that we only added $65,250, or 0.4%, to the bottom line for all our effort.
Let’s look at the income statement where instead of reducing the labor to sell the same amount of product, we use the freed-up capacity to strategically sell more product. That impact is shown in Exhibit 1-C.
This is the real power of lean as a strategy! We improved our profit margin by 1.6% points and $729,600. In our analysis you will note that we acknowledged we could selectively and strategically go after business in a more aggressive fashion. A slightly lower selling price will create a higher material content percentage (35% to 45%). Because we utilized our excess manpower capacity to sell more with the same number of employees, we were able to make a significant improvement in our profits. Using lean as a growth strategy, using your freed-up capacity, is the most effective way to take advantage of your lean improvements.
Thus far, the discussion has been around the strategic issues as they relate to the Profit and Loss statement. Another area in which lean impacts the financial statements is on the balance sheet and the statements of cash flow. For the balance sheet you will see a lowering of all three components of inventory – raw material (RM), work-in-process (WIP) and finished goods (FG). You will see a decrease in FGs because you will need less in stock since you can replenish your FG inventory much faster. You will also see a lowering of WIP inventory because your product is moving through the plant much faster and not sitting nearly as long. This is partly because it is flowing faster but also because you should have instituted Standard WIP (SWIP) which controls the amount of inventory allowed on the floor between successive operations. Finally, you will need less raw material in stock because you can schedule the receipt of the raw material in smaller quantities and more frequently due to the speed of product flow.
Because you will have less money invested in your inventory, the line of credit you utilize to manage your business will require less money, thereby reducing your interest expense. Finally, you will have an improved cash flow as you sell more product and tie up less money in inventory. This outcome is critical to a growth strategy since now you have more cash available for capital expenditures, if needed, or for other investment opportunities.
Even with all these balance sheet and cash flow benefits that are important, we find that too many managers/general managers/presidents fixate on the impact to the income statement. As noted earlier, until you properly utilize your excess capacity to build and sell more product, the benefit to the income statement is minimal at best. So why are customers not flocking to you with new business? You are delivering faster and with better quality. They get their product on time and can reduce their in-house inventory. You would think that you would be flooded with new opportunities and you would win many more quotes.
So far, your lean activities have attacked the plant floor but not the quoting process. How do you change the whole quoting process to be nimbler, thereby allowing the company to process and win more quotes at the margins desired? You simply cannot continue to use standard cost thinking, silo activities, and linear processes to accomplish the growth that lean promises. Just like leaning out the factory floor, you must lean out your quoting processes to utilize the capacity gains your other lean efforts have garnered. In a subsequent article I will discuss a unique quoting process that will allow you to quote faster and free up quoting manpower to spend the appropriate amount of effort on the few key quotes that can drive your profits higher.