This is a recounting of a conversation I had with a plant manager about the financial impact of missing shipment of his product for that month (which since it was December, was also be a miss for the fiscal year). The lesson is an old one: be sure to do a marginal (incremental) analysis when assessing the impact of a change in revenue, cost, or profit, and be aware of how you handle allocated fixed costs.

Me: So you may miss shipment for 5 units this month? How will that impact the company financially?

Plant Manager: Well, cost accounting shows that the profit for this product is $50,000, so this may be a $250,000 hit to the company.

Me: I’m afraid the impact will be larger than that. $50,000 is the average profit per unit (writing on my tablet):

Profit = Revenue – Variable Costs – Allocated Fixed Costs

But, what’s the financial impact if you don’t ship a unit?

∆Profit = ∆Revenue - ∆VC - ∆FC

∆FC = 0 (these are fixed costs, and don’t vary with volume), so

∆Profit = ∆Revenue - ∆VC

So the impact to profit of not shipping a product is its incremental revenue less its incremental variable cost. You said that revenue per unit is $1,300,000 and its variable cost is $1,070,000, so the impact to profit of missing shipment will be $230,000 per unit.

PM: That’s over $1 million in lost profit for 5 units!

Me: Sorry to be the bearer of bad news, but remember that ∆Revenue - ∆VC is sometimes called “profit contribution” which is a significantly larger number than the “profit” that cost accounting attributes to a product.

And the impact to cash flow (what really gets some companies in a bind) may be even greater. For example, what if much of the raw materials for this product are already purchased and sitting in inventory?

The impact to Cash Flow (∆CF) would be:

∆CF = ∆Revenue - ∆VC + (inventory already purchased for that item)

PM: I get the idea, but I’m not even going to calculate that number. But I do have a heightened sense of the financial impact of not being able to ship a customer order.

Note: This is a continuation the Marginal Accounting post describing a dialog between a manufacturing executive and me.

M: So you want to simplify how you manage costs, while at the same time provide accurate cost information to support decision making. Like most manufacturing companies, you’re now using a cost accounting scheme that uses some sort of allocation process for assigning indirect costs to individual units or batches of product. There’s an underlying assumption with cost absorption that all expenses must be allocated to individual product – an assumption that I encourage you to challenge. Instead of spending resources to calculate individual product cost, focus on your total cost. Recognize that most of your expenses – including labor - are fixed costs, and then report them that way.

This means that you’re left with a simple cost accounting model that reports fixed costs as line items – and not allocated – while variable costs which are mostly material costs are reported as variable costs. This model is vastly simpler to maintain since there are no burden rates to maintain and no cost allocation. To adhere with GAAP, you’ll need a way to value inventory and we can help you put a simple process together to do that.

Since the distinction between fixed and variable costs remains clear, this model also supports decision analysis. The marginal revenue and marginal costs of decisions are easy to determine, and the impact to cash flow to a specific change is easier to determine.

E: What’s the reaction by CFOs with this type of model?

M: Well, a trait of most CFOs is they are open to decisions based on a rational argument. We’ve found that if we get them on board with this project early and take them through the thought process, they often become a strong advocate for a simplified cost accounting model. We can also put them in touch with other companies who have been through this.

For more information about this, don’t hesitate to contact us. You can also browse the Lean Accounting page of our web site.

E: Thanks Mark.

Note: Those of you who have already read Real Numbers: Management Accounting in a Lean Organization by Jean E. Cunningham, Orest Fiume and White Lisa Truit can skip this post.

Several times a year, I’ll have a conversation with a manufacturing executive or business owner that goes something like this:

Executive: We don’t even know what our product cost is!

Me: What do you mean by product cost?

E: Well, for example, we’re building 15 widgets today. Our cost accounting report says that our total unit cost is $120,000 which means we’re losing money on these since revenue per unit is only $100,000.

M: Has this product always shown a loss?

E: No. Direct labor for this product has gone up, which has increased the allocated overhead expenses for this product.

M: Why is direct labor higher for this product?

E: Because of our ongoing efforts with lean, we had some excess capacity earlier this year. So we decided to do sub-assembly in-house rather than outsourcing it like we were. Consequently hours went up.

M: So your cost accounting system is allocating more overhead to this product because you shifted some assembly work from a vendor to your plant. Has overhead costs for the company really increased because of this action?

E: Of course not. In fact, building more in-house has simplified our supply chain and manufacturing process, resulting in less work for purchasing and procurement engineering.

M: So you made a good business decision resulting in lower overall cost. Yet as a result your cost accounting system is now arbitrarily allocating more fixed costs to the product, making it look unprofitable.

E: Right. And you can imagine the time I’m spending with our CFO explaining why this was really a good decision. Not to mention the time spent by cost accounting, finance, and engineering trying to “fix” this problem by adjusting overhead burden rates and their variance reports.

M: Now you’re describing real waste that’s avoidable. Would you be interested in learning about how to greatly simplify the way you manage costs, while also providing you with the accurate cost information you need for decision making?

E: I’m all ears.

M: Great; let’s talk later this week about this.

[To be continued]

Your people are smart, and they soon learn that optimizing their metric of performance is what counts during their evaluation.

Here are examples we run across showing how measuring the wrong thing can lead to unintended results:

• Measuring “recordable injuries” sometimes results in more unrecorded injuries.
• Measuring machine or labor “utilization” sometimes results in overproduction.
• Measuring customer complaints may discourage documenting customer feedback.
• Measuring “available to promise” delivery performance sometimes results in quoting longer lead times, while not tracking what your customers really need.
• Measuring “throughput” sometimes creates overproduction and impacts quality.
• Measuring “overhead burden rates” may only institutionalize some costs as fixed, while distorting make versus buy decisions.

Is your performance management process encouraging the behavior you intend?

Is your management team focused on the vital few measures that will result in your company’s success?

Do all of your employees clearly understand what they must do today, this week, this month, and this year to achieve your business objectives?

These are the questions that Policy Deployment addresses. To learn more see www.leanaffiliates.com/policy_deploy.htm.

[Editor’s note: Affiliate Bill Waddell’s post “Manufacturing’s 5 Golden Metrics” generated several comments from our readers. What about customer satisfaction? What if Operations does a great job with the 5 key metrics, but the design or performance of the product does not meet customer requirements? Bill’s response: “That’s the fourth metric – quality - which must be quality in the eyes of the customer.” Measuring performance from the customer’s perspective is critical, so below is a short post describing some of the metrics used by our clients to do this.]

Most organizations measure “what’s in it for them” while using lagging key indicators such as profit, sales and accounts receivable when looking at their numbers. These indicators measure what has happened in the past rather than what will happen in the future. Managing your business by focusing on lagging indicators is analogous to driving a car by looking into the rear-view mirror: it’s confusing and creates unpredictable results.

Your challenge is to guide and adapt your company in a predictive manner so it creates value for the customer. That’s why it’s important to create and track a set of customer-focused leading indicators to help you determine the direction in which your company is headed.

Here are some examples of Customer-Focused Leading Indicators that our clients are using. Every company is a bit different, so we’re not suggesting that all of these are right for you, but they should give you some ideas for defining indicators relevant to your business.

· On-Time Delivery
On-time delivery is an excellent indication of how well your company is currently functioning. If all of your operations are running smoothly, there’s a good chance that your on-time delivery is within acceptable parameters. If you are promising your customers a certain delivery date and not delivering, you give the perception that your company is incompetent and doesn’t place a high value on its customers.

And be sure you measure on-time delivery using the customer’s original requested delivery date, not a promise date assigned by your order entry system or customer service representative. If the product is not in the hands of the customer when the customer needs it, the value of your product diminishes severely. Charts tracking on-time delivery (daily, weekly or monthly) should be posted where employees can readily see them.

· Lead Time
Lead time measures the length of time between when customers place an order until they receive their product or service. If the number of days or hours is less than your competitors’, that’s a competitive advantage. Demands from your customer’s world are causing them to demand shorter lead times from you and other suppliers. Tracking lead times and posting them so employees see their current performance can help improve the company’s performance in this key indicator.

· Time to Answer Inquiry
This measures how long it takes you to respond to a customer’s inquiry. This can be a request for information, a response to an ad, etc. Tracking inquiry response time and responding quicker than competitors can translate into a competitive advantage.

· Response Time
Hospitals are beginning to measure how much time elapses when a patient pushes the call button beside their pillow until a nurse or staff employee arrives. Most lawyers return phone calls within 24 hours. Customer service representatives for merchandize catalogs and 911 operators should answer the phone within three rings. Other businesses could benefit from a “response time” key indicator as well. Unmeasured and unchecked, customers may interpret your lack of attention as a lack of caring about their business.

· Fill Rate
This key indicator measures what percentage of time the right products are available for customers. Obviously, the higher the fill rate, the more sales you are going to make. Conversely, if the right product is not available or on the shelf at the right time — it’s hard to make the sale.

· Error Rate
The Error Rate measures how many mistakes were made in your organization while fulfilling a customer’s order. Mistakes often equate to wrong products being shipped or increased delivery time.

· Target Segments
All customers are not the same and not all customers are worth pursuing. It’s important to understand which customers you provide the most value to. These customers will most likely result in your highest margin and/or profit.
Measure sales and growth rate by segments to ensure you’re growing in the segments that bring you the most value and can lead to higher future profits.

· Volume by Customer
If you track customer sales by dollars or units per month and some of your key customers begin ordering less frequently, it might be an early indicator they are giving business to one of your competitors. It also is important to track the growth rate of your customers. If a customer’s business is growing significantly and the number of orders from them is not increasing, perhaps you’re missing an opportunity.

· Product Up-Time
This measures the percentage of time your company’s product is up and running in the customers’ environment. If your product constantly breaks down or is unreliable, it could severely diminish the value of your product or service in your customers’ eyes.

· Unused Product
Unused product can let you know which items are not effectively fulfilling a need or purpose. For example, a restaurant has a large white dry-erase board directly above a trash bin. The bus boys mark the name of any portion of a meal that a customer has eaten less than 50 percent. The restaurant tallies up the totals each month to determine which items are frequently not eaten.

· Returns/Rejects
This indicator focuses on how many products customers return or reject.

· Complaints
Complaints can be a vital source of information. The number of complaints is important, but so are the types of complaints. Complaints offer companies an opportunity to re-engineer parts of their businesses that are failing.

The reason for fixing this problem area is two-fold:
1. Your customers are unsatisfied.
2. Your employees are probably spending a significant amount of time fixing these problems.

And be careful that you don’t shoot the messenger: Knowing about a customer complaint is vital, so don’t admonish your staff if more complaints are logged. This is one of the few metrics that we don’t recommend having a target for “improvement”. The last thing you want to do is ding your organization because the volume of reported complaints goes up. An upward trend may mean that your organization is doing a better job of listening to the customer and informing you with what’s going on. Remember that complaints are an opportunity to learn what the customer doesn’t like about your product or service. What isn’t reported, you can’t fix.

· Surveys
Surveys are a valuable tool to measure current customer satisfaction on a wide variety of product and service attributes. Surveys also can measure the relative importance your customers place on each attribute. Companies should attempt to excel at those attributes customers rate most important while diminishing their investments in those areas that are least important from the customer’s perspective.

· Retention Rate
Customer turnover can be an effective indicator of the value customers are receiving from your product or service.

· Referral Rate
The referral rate will measure what percentage of your business comes from referrals. It also can sum up your overall success rate at creating value for your customers.

The Bottom Line

These are just examples of leading customer-focused indicators that we helped our clients put together…each of these may or may not be appropriate for your business. Once your organization determines which indicators it wants to quantify and measure, establish a baseline of current performance (again, except for “number of complaints” – see text above). Then, set goals to increase your performance in these critical areas. As customers feel more value from you in the marketplace, this will drive the company’s bottom line in a positive direction.

After a couple of decades of fumbling around with lean and getting marginal results, the realization that it takes a whole lot more than a bag of Toyota-like tricks on the shop floor is growing. The second annual Lean Accounting Summit starts next week in Orlando with almost twice the number of participants as last year.

Articles like the one that appeared today in the Bend Bulletin in tiny Bend, Oregon describing the lean efforts of Keith Manufacturing are becomong more commonplace. Keith gets it. “We are sending three members of our accounting department to a lean accounting seminar this month [the Lean Accounting Summit]. We plan to set the competitive bar so high that we will make our competitors irrelevant in every market in which we compete.” In that effort, the three folks from Keith will be joining with better than 500 other manufacturing folks at the Summit who also ‘get it’.

The companies that are wrapping their minds around the understanding that Toyota beats GM by out-managing them - not by deploying kanbans and U shaped cells - are distancing themselves from the American manufacturers who persist on managing by the same old methods. The lean accounting folks are at the forefront of that effort. They understand that lean is a different economic model of manufacturing.

Here’s a dirty little truth that software companies and system integration consultants don’t want to come out: Few companies have an effective performance measurement system. And the few companies that do have good performance measures throughout their business generally have a simple, straight-forward measurement process that doesn’t use an elaborate, expensive software solution.

But if you Google “Enterprise Performance Management”, the search results include all the major business software companies: Oracle, PeopleSoft, SAS, SAP, Microsoft, Business Objects, Infor, Lawson and more. These are nice looking sites, so I’m thinking they must have real products with a lot of real customers. But after working with hundreds of companies over the years, our Affiliate team just has not seen an “enterprise performance management system” from a software company that is used effectively by a manufacturing company. What we do see is:

- Most companies have a traditional financial reporting process in place, with Operations Management spinning their wheels trying to understand and explain their monthly financial “variances”.

- Many companies have a few selected operational measurements in place, which often train plant management to sub-optimize - indeed warp - their operations based on a particular metric (we often see direct labor or machine utilization used this way). See the article, “Goal Obsession“, for an example of this.

- A very few companies have a simple, straight-forward measurement process with metrics carefully selected to complement business objectives. The process is sometimes based on Hoshin Kanri or an A3 planning system adopted from Toyota’s model.

So if your company doesn’t have an operational performance measurement system you’re not alone. But you don’t need to be with the general crowd for long. Instead, there is a simple, straight forward performance management process your company can use to effectively align your people’s activities with your business objectives.

Want to get started? Read Bill Waddell’s post, Manufacturing’s 5 Golden Metrics , and then feel free to contact us.

Manufacturing performance is optimized when management recognizes that there are five golden metrics – five measures of value stream performance that really matter – and all other measurements are subordinate. Subordinate metrics may also have a great deal of importance within the factory, but optimizing performance to them is only valuable if it results in improvement to the five golden metrics.

[Editor’s note: Part 1 of Bill Waddell’s post may be viewed here.]

The big five are: Total Cost, Total Cycle Time, Delivery Performance, Quality and Safety. Activities and efforts in manufacturing that result in improving one or more of these performance measurements, without degrading performance to any of the others, are good performance. Activities and efforts that result in improvements to any other subordinate metric that do not result in improvements to any of these five, are meaningless.

The first and most significant is Total Cost, but not in any traditional sense. First, the only meaningful measurement of total cost is on a cash basis. All money spent on manufacturing must be summarized and the total compared to the previous period – not to a flexible budget or a plan. What matters is whether the total cash spent on manufacturing was more or less than it was in the previous period. It is important that this cost figure is exclusive of all allocations, and that it does not exclude S,G & A costs. The only exceptions are major capital investment spending and adjustments for Accounts Receivable and Payable. While these exceptions must be added back in to create a total lean accounting based income statement, manufacturing performance should be measured as if payment were made at the time materials and services were delivered, and payment was collected at the time finished goods were shipped to an outside customer.

The second metric is Total Cycle Time. This is calculated by studying the major purchased components and determining the total days on hand of each one. The total days on hand is the sum of all of the component in the plant regardless of its form – still in its original purchased state as raw materials, embedded in assemblies or sub-assemblies in a modified state as Work In Process Inventory, or embedded in a finished product. This total days on hand figure is divided by the planned shipments per day for all products that require that purchased component. For example, if there are 5,000 of a component in the plant in all of its various forms, and one each it goes into two final products that are each projected to ship 100 per day, the cycle time for that component in 5,000/200 = 25 days. The Total Cycle Time for the plant or for an individual value stream within the plant is the cycle time of the component with the greatest cycle time.

It is important to note that only “C” type bulk items can be excluded from this calculation, and that the Total Cycle Time is not an average cycle time, nor is it weighted in any way for the cost of the component. This is a measure of operational performance – not a financial metirc.

The third metric is Delivery Performance and it is simply the measure of the percentage of customer orders that shipped when the customer requested them to be shipped. It should not be modified in any way to accommodate company policies or shipping promises. It is purely a metric of manufacturing’s ability to meet customer requests and requirements.

Fourth is quality and this will vary by company, but it must be quality in the eyes of the customer. As a result, customer returns or warranty claims are typically the basis for this metric. It is not a summary of internal quality metrics, such as first pass yield. It is important to realize that internal quality metrics are only important to the extent that they provide information management can use to minimize cost, improve flow and meet customer quality. The only measurements of quality that truly measure operational performance are those from the customer’s perspective.

Fifth is Safety, and the standard metrics of accident/incident frequency and severity are usually sufficient.

These five measurements are manufacturing’s ‘bottom line’. All manufacturing efforts must be aimed at improving one or more of these performance indicators, without degrading performance to any of the others. All other performance metrics are subordinate to one of these, and are useful to management to the extent that they provide information necessary to improve performance to one of the Golden 5.

One of the most widely discussed aspects of lean manufacturing is performance measurement, which makes a lot of sense because it is probably the most important element of manufacturing management. You get what you measure. Since most companies measure their performance by metrics based in traditional accounting principles, they get traditional – that is to say, not very lean – results.

The accounting system is usually built around standard costs with labor or machine hours as the driver, so labor efficiency and machine utilization metrics are the norm. Since the accounting system rewards production volume with ‘earned hours’, which in turn earn labor, material and overhead dollars in flexible budgeting schemes, it should come as no surprise that this approach typically achieves good direct labor efficiency, high machine utilization and a lot of production … and a lot of inventory, high overhead expense and not necessarily very good quality.

The flaw with many performance measurement schemes, including those advocated by quite a few ‘experts’, is a failure to differentiate between measuring overall process (or value stream) outcomes, and measuring specific activities or attributes of a portion of the value stream.

For example, in traditional manufacturing measurement schemes, a great deal of weight is often put on labor efficiency. In fact, most companies track and measure labor efficiency or productivity in great detail and monitor the numbers closely at the highest levels of the company. However, labor efficiency is a meaningless number by itself. It is treated as the primary driver of overall cost, and is measured as a surrogate for cost, but it is not the total cost. There can be no substitute or surrogate for measuring total cost.

Management focus must be on total cost, and metrics such as labor efficiency and machine utilization should only be subordinate data points that shop floor managers can use or not as they see fit to attain lowest total cost. The same is true with many quality metrics: First pass yield, rework percentages, and scrap rates are all potentially useful pieces of information for shop floor managers. None of them, however, can stand as substitutes for the final quality performance of the value stream. Only quality metrics from the eyes of the customer can do that.

Even the most basic manufacturing operation is extraordinarily complicated. Most factories have thousands, perhaps millions, of variables moving around at the same time. Just about every event has multiple drivers. Actions people take to optimize one variable often come to the detriment of another. Most performance metrics at the activity level can be traded off against other measures of performance: Labor efficiency can be increased to the detriment of quality; machine utilization can be maximized in the short term to the detriment of the life of machines; delivery performance can be increased to the detriment of inventory levels and overhead expenses.

Management cannot possibly measure all of those thousands of variables with equal attention and diligence. When one or two of them are elevated to the top level – treated as overall process outcome metrics, rather than the event metrics they are – a strong motivation to optimize performance to those few variables is created, usually to the detriment of offsetting variables that have not been elevated to such high level monitoring status.

In My Next Post: Part 2 of the 5 Golden Metrics.
Manufacturing performance is optimized when management recognizes that there are five golden metrics – five measures of value stream performance that really matter – and all other measurements are subordinate.

To a recent post to Evolving Excellence concerning the misapplication of IT resources to lean transformation, Karen Wilhelm of SME made the astute comment that a fundamental problem with IT efforts is the general absence of IT folks on factory floors. This is the epitome of the cultural gap that must be closed for lean success.

It has long been known that the traditional, primary focus of information systems has been finance and accounting - the money people are IT’s number one customer. The difference between traditional management and lean is largely embodied in Henry Ford’s comment, “Profit is the inevitable conclusion of work well done.” Instead of devoting so many bits and bytes to analyzing the profits, the IT focus must be on the work - and having it “well done” - and the money will take care of itself.

When IT resources are applied to manufacturing at all, the tendency is to develop and implement massive, ERP-type systems, designed by experts far away from the plant, then implemented top down for the primary purpose of control. The benefit of such systems - the ROI - is usually difficult to find and typically takes years to realize.

Far better to deploy IT folks as Karen suggests - on the shop floor. The primary customers of IT should be the people adding value in the core processes. The ongoing questions driving IT priorities should be ‘what information do they need to do their jobs and to create greater value for customers’. Most of the answers will result in small projects with immediate, measurable returns.

The degree to which a manufacturer has empowered its employees and truly harnessed the value of their knowledge and experience can be measured by the access the average employee has to necessary information. If the management model still revolves around senior people prioritizing scarce IT resources, and usually allocating them to strategic, enterprise wide applications while production folks do without basic data, lean manufacturing performance is impossible.