In Part 1 of this series, I made the case for why standard costing is a poor, non-Lean way to make decisions in a Lean company. I went on in Part 2 to describe how Lean decision making methods using the Box Score can be applied in three common scenarios: setting product prices, assessing the profitability of new business, and measuring the profitability of customers or markets. In case you missed the first two parts, here are the links: Part 1, and Part 2.
In this blog I want to explain to you that Job #1 for you as a Lean CFO is to build new standard work for the financial analysis of all business decisions around the Box Score. I’ll use some illustrations. I commonly use these when I teach financial people how to use the Box Score as a tool for making the best decisions for their companies.
Outsourcing – Let’s Start With That
Traditional companies using standard costing usually base the outsource v. insource decision on what seems like a simple analysis: is the outsource price compared to the product’s standard cost favorable to you? They assume they’ll save money because production is decreased. This will not necessarily be true.
Lean thinkers understand that outsourcing creates available capacity but spending will not necessarily decrease unless you cut value stream capacity. Moreover, if you don’t use the available capacity to meet other demand (which means generating revenue) there will be no corresponding increase in profit. Material costs will often go up since the price the supplier is charging is usually higher than it costs you to purchase the raw materials.
The bottom-line questions for you are: What value are you receiving from the supplier? Is outsourcing improving operating performance?
In my opinion, if your company has the capability to produce a product to the market’s quality specifications, and if you have the capacity to produce the product, you should make the product in house. This is also the business case for in-sourcing production that may have been outsourced in the past. It is clearly a way to use the capacity created by Lean improvements. You actually will improve your ability to deliver value to your customers and reduce costs by in sourcing.
Below is an example of a Box Score that compares the alternatives; it clearly shows the impact of outsourcing on a hypothetical value stream. [i]
This company is considering making a new product in-house that requires a new production process. Making the product in-house will have a negative impact on productivity, but will increase value stream profits. Two suppliers are considered – one in China and one local. The Box Score shows the total impact on value stream performance. The change in material costs is easy to calculate. But, how do you calculate the value you receive from outsourcing? You will see this reflected in the performance measures. In the case of either external supplier, you won’t be receiving much improvement in on-time delivery or quality, and your inventory increases. Overall, taking everything into account, the company is better off operationally and financially by keeping the business in house.
Capital Purchases – How to Think “New”
Traditional companies analyze capital purchases based solely on analysis such as return on investment. In order to figure out whether a purchase in financially sound, financial people will calculate things like payback, internal rate of return or net present value of the investment. Is this is the right way to analyze capital purchases for a Lean company? The answer lies in how the profitability or savings (the “return”) of the investment is calculated.
In traditional manufacturing companies, the focus of the analysis is usually on efficiency, absorption or utilization improvements to determine a level of standard cost savings or profit increase. From a Lean perspective, this analysis is not always correct because cost savings don’t materialize when these types of standard cost measurements “improve.” The Lean Box Score provides an easier way; from it you understand the operational impact first, then we figure out the financial impact.
The operational decision to buy a machine means you are buying capacity. This means your projected Box Score (before you buy the equipment) would show there is not enough available capacity to meet expected demand. There may also be other operational reasons to purchase a machine, such as improving quality, delivery, lead-time or flow. The projected value stream performance measures on the Box Score will reflect these improvements.
Now comes the financial part. After your figure out the operational reasons for purchasing the machine, assessing the financial impact is straightforward. Value stream production costs will increase due to the purchase of the machine, primarily increasing depreciation and possibly maintenance. If you are purchasing the new equipment because of projected increase in demand, then your Box Score will show the expected increase in revenue and material cost. Finally, any improvements in operating performance will have a direct impact on value stream costs as well. A future state value stream Box Score should take into account the entire financial impact of the purchase. This, then, is what you should use to calculate the payback, internal rate of return or net present value.
Below is an example of a company looking at different alternatives when considering equipment purchases. The Box Score lays the alternatives side by side.
Hiring – Adding More People (or not)
Traditional companies look at hiring decisions based on payroll costs and head count. The standard cost justification for hiring people often is about improving efficiency and absorption. Also MRP may play a role in hiring people because it can calculate total people needed based on a sales forecast and your production capabilities as set up in the system.
Lean companies don’t view their people as an expense but as a resource that delivers customer value. The decision to hire people is based on the same operational issues as capital purchases: What’s is impact on your capacity?
In a Lean company, if you flow actual demand, then the reason to hire people comes about because of an increase in demand. In other words, there is a need for more capacity. You consider the question: Is the demand increase permanent or temporary? Full-time employees are considered permanent and they should be hired when a permanent increase in demand is expected. If demand is considered temporary, then using overtime, temporaries or outsourcing can be ways of adding temporary capacity.
The financial impact of hiring people will show up as increased actual labor costs coupled with increases in revenue and margin due to the increase in demand. If the future state value stream return on sales is greater than the current state return on sales and value stream productivity rates are maintained or improved, it is a sound financial decision. Below is a Box Score that demonstrates this.
Impact of Continuous Improvement
In traditional-thinking companies, improvements should yield cost savings. This drives a simple financial analysis: determine how much time is saved and multiply that by some labor rate to determine the financial impact of improvement. The weakness of this analysis shows up when cost savings don’t materialize, frustrating both executives and continuous improvement leaders.
Lean-thinking managers know that most continuous improvement activities create available capacity. They use this time to deliver more value to customers and/or improve productivity. Creating time has no direct financial impact on your costs because the level of resources has not changed. You are spending the same amount of money.
Assessing any financial benefits that derive from continuous improvement projects must be based on the change in actual spending in the value stream. Improvement events that focus on the product, such as improving quality, may have a direct impact on material spending. Events that focus on the process, such as reducing set-up time, are the events that create time (i.e., available capacity.) The actual financial impact of these events depends on what is done with the newly-created capacity.
Three things can happen. You can use the capacity to flow more demand through your value stream, in which case the financial impact is more revenue and margin. You can reassign the available capacity to another value stream, which would reduce the actual production costs in one value stream and increase these in the other. The final option is to reduce the actual level of resources by eliminating the available capacity, which would reduce actual costs.
Lean improvements can generate cost savings, only if the level of resources is actually reduced. But the real focus of Lean improvements is to generate capacity to get better at delivering demand and growing revenue.
Below is a Box Score that shows the impact on the future state based on planned kaizens.
You can also use the Box Score to track weekly progress. Below is an example.
Making the Box Score standard work to analyze business decisions will unlock the financial potential of Lean for your company. The Box Score will drive consistency in decision-making, improve collaboration between departments and make it easier for non-financial people to understand the economics of Lean.
[i] All the BMA illustrations here are copyright protected. All rights reserved.