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.

Keep it Simple

We have created an entire generation (or two) of managers who are very savvy with cost accounting models. They know exactly how “costs” and “profits” are calculated, and they know exactly what inputs to manipulate in order to make the numbers as good as possible.

They know, for example, how “inventory turns” are calculated, that “average inventory” is determined by end-of-quarter snapshots, and how to turn off production and pull in next quarter’s sales to starve the system for a week. Of course, anybody can also claim reduced oxygen consumption by holding his breath when it is being checked.

I put the terms “costs” and “profits” in quotes because one of the features characteristics problems(?) with modern cost accounting is that the models are complex. They are that way, not because costs are complex, they aren’t. They are that way because reporting is complex. They are that way because managers want to be secure in a fantasy that they can have a unit cost for every unit of production. “This product cost $4.72 to produce.” And once they have that number, they can calculate margins, forecast profits.

Here is the rub: That $4.72 cost figure is the result of a process that answers “What is 1+1?” with the statement: “It depends on your assumptions.” And by the time the PowerPoint Rangers are done with the summary, those assumptions are long buried and forgotten.

That unit cost figure is valid only for a certain level of production, because it includes allocation of costs that do not change as production levels change. Other costs that do change, change in non-linear ways.

There are lots of way to allocate fixed costs. Depending on which one you use (especially in multi-product operations), can completely alter the profit / loss numbers for a particular product.

So, while all of this cost accounting stuff is necessary to report taxes, and to report to the shareholders analysts, we forget that it is just a model. Aside from the top line (total sales) and the bottom line (the actual money we can keep), everything else is just someone’s representation of where the money actually went.

Here is my admittedly simplistic take.

A manufacturing company makes profit by adding value at a higher rate than they incur costs.
The value they add is the difference between what they pay for the parts and raw materials that are transformed into the final product, and the actual, real, cash-across-the-table revenue they get for the product when it is actually sold to a real customer who does not work for the same company. (This has nothing to do with internal transfer pricing, etc. because that is all just shuffling things from one column to another for the benefit of the cost accounting model. Until you actually cash the customer’s check, you have not sold the product.)

Since the idea of “unit cost” is really an artifact of whatever particular cost allocation you choose to use, then the idea of “unit margin” is equally dubious.

When I ask the finance folks to tell me how many units I need to sell to break even, they start by calculating a margin, then dividing the cost of operation by that margin, and presto!, break even.

Bzzzzt. The rub is that the margin per unit is only an estimate until the period is over, total costs are added up, and total margin is allocated across production. To use estimated margin to determine a break-even sales level is a circular reference.

But I can calculate how much value is added to each unit. [What can sell it for] – [What I pay for the pieces].

My break even is even simpler. Assuming that 100% of the value-add is allocated against the cost of running the factory (Total monthly payroll, total utilities, total everything except what I paid for what I will sell), until 100% of those costs are covered. With luck and good management, that happens before the end of the period. The total value add of the next unit is profit. And the total value add of every other unit after that is profit. This holds true whether you do it for a hour, a day, a week, a month, a year.

Now I can take projected sales, and determine, at any given rate of production (which drives a lot of the fixed costs), when I break even, and how much profit I can expect. Isn’t that what we are after anyway?

Why does everyone make it so complicated?

And yes, I know it is more complicated than this, but it isn’t THAT much more complicated.

Lean Dilemma: System Principles vs. Management Accounting Controls

Today I came across an article called Lean Dilemma:Choose System Principles or Management Accounting Controls, Not Both by H. Thomas Johnson.

It is, or it should be a thought-provoking read, especially for a CEO or other senior manager.

The author also wrote “Profit Beyond Measure” which I have not read, but based on this article, I will.

My personal challenge question is: What is the ROI on an environment where people work so well together that no detail is overlooked? It is, of course, impossible to calculate. Nevertheless, no one would argue that such a company would be a formidable competitor in any market.

Perhaps what you measure is what you get.
More likely, what you measure is all you get. What you don’t (or can’t) measure is lost.

Today the mantra of “Sarbanes-Oxley” is being used as justification to plant, fertilize and cultivate a garden of chokeweed that will embrace and strangle any attempt to streamline processes. I have run into the same “regulations won’t allow it” excuse in the aerospace industry (“the FAA won’t allow that”), in health care products (“the FDA requires this”), and, believe it or not, in ISO-9000 registrations. (“That violates ISO”) Of course, in every case, it was a smoke screen.

Once the assumptions are challenged, and the actual requirements are studied and understood, there is always a way to comply with the letter and spirit of the requirements with minimal (or no) waste. The problem comes in when people confuse the requirements themselves with the policies of the company to implement them. Those policies can be changed with the stroke of a pen, sometimes followed by convincing an auditor that the new way is better.

But I digress. Toyota operates in the USA and is subject to exactly the same regulations and financial securities laws as everyone else – yet, somehow, they manage to operate without these things as justifications for the status quo.

Read the article – tell me what you think.

Edit – 9 August – Someone pointed out to me that there are people who are turned off by Johnson’s environmental stewardship message toward the end of the article. My view is that intelligent people should be able to read the article and agree or disagree with that message, while still “getting” the core message: Traditional management accounting controls damage shareholder value.