Recently a CEO of a mid-sized manufacturing company ($100 million) inquired about one of our
services, “Linking Lean to Profits.” He had received some information about the service and wanted to know how it would impact his bottom line and the expected return on his investment.
I thought about his question and decided that if he was like most executives he probably understood the concept of cost of goods sold and/or cost of sales so I thought I would pursue this line of thinking and explained to him that manufacturing products produces waste ranging from overproduction, waiting, and transportation costs to over-processing, excess inventory, unnecessary motion and defects. By eliminating these wastes, lead time and cost of goods sold (COGS) are reduced, with the added benefit of improved quality. Reduction in cost of goods sold is one of the fundamental drivers of a lean manufacturing initiative because it fundamentally captures material, labor, and overhead costs.
The cost of goods sold for most manufacturing firms is typically in the range of 70 to 95 percent of revenue. For many of these firms, net income is typically three to eight percent of revenue. I said, “looking at a representative company where COGS represents 80 percent of revenue and net income is five percent of revenue, a reduction of COGS by one percent (to 79.2 percent of revenue), generates a savings directly to the bottom line,” increasing net income to 5.8 percent of revenue; thus increasing net income by 16 percent. Based on this logic taking his revenues of $100 million I calculated his estimated return (ROI) on the consulting and training investment.
Sales of $100 Million: COGS of 80% = $80 million: 1% reduction =$80,000;
Consulting/training investment (includes staff’s time working on project) = $40,000
Estimated ROI = $80,000 /$40,000*100 = 200%.
Furthermore, by implementing Lean Manufacturing techniques, a manufacturing firm creates additional capacity by becoming more efficient. Top management can use this additional capacity to increase sales and earn even more revenue. Thus, Lean Manufacturing frees companies from old constraints, and opens up a world of new possibilities.
I also suggested to the CEO that he turn his traditional accounting system into a value stream performance tool and encourage his people to do the right things from a lean perspective. Traditional accounting systems encourage people to do the wrong things. Some of a traditional accounting system failings include:
- Inducing your company to build in large batches in order to keep machines running and people busy to absorb overhead
- Not providing daily performance information needed to support continuous improvement at the cell and value-stream levels
- Requiring huge amounts of computer resources and non-value-creating activities to gather and process work-order transactions
- Failing to capture the vast benefits that lean generates in the form of higher quality, shorter lead times, and especially the added capacity gained from people, equipment, and space.
The reason for the disconnect between lean and standard costing is that standard costing was developed as part of traditional accounting systems to support mass production. Such systems assume companies make money by keeping machines and people running in overdrive, creating mountains of widgets in order to lower unit costs. Financial control is exerted by checking the “mountain” frequently and recording the results as it is pushed at a glacial pace from process to process. This leads to a complex and time-consuming accounting system that chug-a-lugs thousands of transactions monthly and spits out reams of reports comparing the mountain’s actual results against a standard in such areas as labor and machine utilization. Unfortunately, the reports are useless for managers trying to run and improve the business.
On the other hand Value Stream performance measures are focused on process improvement including such indicators like quality, productivity, on time delivery, inventory, safety, setup times, etc.
Learn more about Linking Lean to Profits Process
Willie L. Carter is the president of Quantum Associates, Inc, a process improvement consultancy. He helps managers unlock the full promise, speed, and energy of their processes. Carter certifications include, Lean Sensei, ISO 9000 Lead Assessor, Manager of Quality/Organizational Excellence. He is an experienced facilitator, coach, and author. His company helps executives optimize their business processes to minimize their costs, accelerate their cycle time while simultaneously enabling them to do more with less. He can be reached at firstname.lastname@example.org