Costs and Kaizen

How does kaizen actually show up on the bottom line?
This is a question that gets asked a lot, and honestly, we owe the asker a better answer than “it just does, trust us.” (Even though this is true.)

Here’s my thinking – it shows up two ways.
One is intangible. By that I mean it is incredibly difficult to quantify, even afterwards. But it is there.

IF the organization manages to get the continuous improvement engine running – meaning they understand that “pursue perfection” is not a “step in implementation” but rather the thing that gets it going in the first place – then, over time, everything starts running more smoothly.

It is hard to put a hard-monetary return on things like:

  • Everybody is working together, as a team, toward the organization’s overall goals.
  • Everybody understands who the customer is, and keeps their focus there.
  • Every instance of a problem causes the organization to improve and learn.
  • Everybody comes to work knowing what they must do to succeed; knowing they can do it; knowing that, if there is a problem, they will find out right away; knowing that they will get support in resolving it.

In short, the organiztion performs, and that performance is getting better and better.
What is that worth? Is it better to have a superbly performing organization, or one which requires continuous micro-management of every detail? (Hint: It isn’t about hiring better people, it is about creating working conditions and processes where regular, competent people can create superb performance.)

But it is possible to understand some direct, tangible returns as well. In fact it is possible to set solid targets, understand what must be done to reach them, and track progress on activities and results.

Any organization that is self-funding (including a non-profit) must offer some kind of value to its paying customers. If “value” is what the customer is willing to pay, then it is easy to determine the, ah, value of the value.

“Value add” defines the economic result of a transformation process. We buy some stuff at some cost (value), transform it into something that is worth more to the customer, and sell it. The difference between what we paid for the stuff we bought, and what the customer paid for the product or service we sold is the “value add.”

Note that this has absolutely nothing to do with what it cost to make that transformation. Nothing at all. It is possible to add value and lose money at the same time. It happens every day.

It does cost something to run the operation that adds the value. When those costs are less than the total value added (over some period), then the organization gets to keep some of the money as profit.

When those costs are more than the amount of value added, then someone has to fund the gap – the owners / shareholders, debt, the money has to come from somewhere.

When it comes to costs, I like to keep things really simple and easy to understand.

Costs are incurred two ways, and in the details, they intermix.

  1. In order to operate, we spend money every day on things like payroll, rent, utilities. This is cash burn.
  2. We have stuff needed to operate. This is cash tied up in the business, capital, inventory, etc. Just having that stuff costs money, and a lot of this stuff depreciates. That depreciation can, in turn, be counted the same as cash burn, but real life is more abstract than that because, while payroll must be paid, “depreciation” is something we can hold our breath about.

I have not included the cost for materials that are transformed into finished product here. That cost is captured in “value add.” The above two things add up to the cost to add that value, and those costs are largely fixed (in the classic sense of the word), whether we make anything or not.

Aside from the actual materials that are bought, transformed, and sold, there are very few truly “variable costs.”

“Continuous improvement” means to continuously increase value add, and continuously decrease what it costs to add that value.

There are fundamentally four ways in increase value-add.

  1. Improve the product offering so that customers will pay more. Ideally this is done without increasing any costs. This is really the only leverage point of purely service businesses.
  2. Pay less for the raw materials and parts – push your suppliers for lower prices.
  3. Change the engineering design to one that is less expensive to source.
  4. Examine your make / buy. Look for high-leverage items that your currently purchase. These are items which:
    1. We could make if we wanted to.
    2. Have a very high differential between the cost of the pieces and what we pay for them. (i.e. the supplier has a very high value-add to us.)

    Now, here’s the rub (and where this ties in to kaizen). If you have been doing a good job at kaizen, you have made some people available. If you know how to make these high leverage parts, can you put those people to work making them? A lot of this depends on the capital required, etc. but, as a general rule, the further up the supply chain you reach, the higher your value add. It comes down to capability and cost. And if you are using labor made available through kaizen, it does not matter what this labor costs. If you are adding more value today than you were yesterday, and incurring exactly the same costs to do so, your profit is higher. And the last time I checked, that was the name of the game.

Aside from increasing value-add, the other objective is to do so at the lowest possible cost, and there is a bit of a circular reference here.

Good kaizen can free up a lot of time. I suppose, if you wanted to do scorched-earth kaizen, you could immediately lay those people off. (Don’t expect much help with further improvements after that.) Aside from the ethical issues, these kinds of actions are really disruptive to the organization, in ways that are difficult to quantify.

If you are trying to simply increase production volume (the right kind of problem to have), then dealing with this issue is fairly simple, you just avoid hiring more people. You increase output without increasing payroll.

But also take a look at the in-sourcing option mentioned above. A lot of organizations overlook these kinds of opportunities today.

Like I said, this model is very simple. It is essentially the “throughput accounting” model offered by the Theory of Constraints folks. (Believe me, I don’t just make this stuff up.) Traditional cost accounting models can be mapped directly into this model. I just find it a lot easier to understand, and more importantly, to explain to the people who actually have to make all of these things happen.

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