Guest editorial: Applying “Lean” to the Financial Side of Manufacturing

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Manufacturing News, Source : The Manufacturer US
Zone : World class manufacturing
Published : 25 Jun 2007 17:57

By Rick Batty, Director of Product Marketing, Maxager Technology, Inc.

Fundamentally, “lean” manufacturing is about increasing profits. Lean addresses the flow of products through the manufacturing process and focuses on improving productivity, reducing waste, lowering cost and improving quality. It frequently incorporates tools such as kaizen (constant process analysis) and kanban / just-in-time. As described by Wikipedia, lean is about “getting the right things, to the right place, at the right time, in the right quantity while minimizing waste and being flexible and open to change.” So lean is really about optimizing the flow of products through manufacturing in order to maximize profits.

It is possible to apply this same concept to the flow of cash through the manufacturing process. Doing so provides answers to the four key questions shown below that any manufacturer must address on an ongoing basis. This enables making the “right” products in the “right” quantities for the “right” customers at the “right” place (production line / facility) and charging the “right” price.

1. What products should we make? – Product Mix

2. Who should we sell them to? – Customer Mix

3. Where should we produce them? – Asset Mix

4. How much should we charge? – Strategic Pricing

There exists a fundamental flaw in most manufacturers’ attempt to be “lean” from a financial perspective. Company shareholders are most interested in return on assets (ROA), the amount of profit generated by their investment in the company’s asset base over the course of a year or quarter. However, the key performance indicator (KPI) generally used to make the everyday decisions for the four key questions shown above is margin. Margin is a per-unit metric while ROA is time-based. So there exists a fundamental mismatch between the operational KPI and that which is of most importance to shareholders. The reason for this mismatch is that using margin-only as the KPI to maximize profits fails to include the run rate, or velocity, with which products flow through the manufacturing process. Consider the simple example shown below:

Margin-only approach:

Product: Price – Cost = Margin

A $5 - $2 = $3

B $4 - $2 = $2

Profit-per-minute Approach

Price – Cost = Margin;

margin X units/min = profit/min;

A $5 - $2 = $3 x 1unit/min = $3/min ($1.58m/year)

B $4 - $2 = $2 x 3 units/min = $6/min ($3.15m/year)

Based on a margin-only approach, product A appears more profitable than B. However, when production run-rate is factored into the equation, it becomes apparent that B is more profitable than A since it generates more profit over the course of a year. From this example, clearly it is essential to use a profit-per-minute approach rather than a profit-per-unit (margin only) one in order to achieve the “lean” goal of maximizing corporate profitability.

Many manufacturers have been aware of the importance of production run-rate in the profitability equation. However, there existed no easy way to incorporate it and they regrettably settled for a margin-only approach. However, the technology now exists to combine margin and production run times, thereby producing a profit-per-minute metric which, being time-based, is directly analogous to ROA. In effect, profit-per-minute is the operational equivalent of ROA. By being able to calculate profit-per-minute / ROA by product, customer, plant, production line, market or sales region at a granular level enables operational decision making, which will increase “leanness” and maximize overall corporate profitability and ROA.

The graphic above shows an example of the ability to analyze profitability from a profit-per-minute perspective. The bubbles could represent products, customers or any of the other dimensions mentioned previously. The vertical axis is margin per unit while the horizontal axis shows production velocity. The contour curves are lines of equal profit-per-minute or ROA and form a topographical map of profit which increases as one moves to the top right of the graph.

Such a topographical map presents a powerful means to make everyday decisions such as which products to prioritize for sales and marketing programs, which products or production lines to target for productivity initiatives, which products or customers to target for price increases or decreases and which products to potentially eliminate.

Moving from a margin-only approach to a profit-per-minute one enables ROA to be used as an operational metric, thereby applying the principles of “lean” to the financial side of manufacturing and achieving the goal of optimal corporate profitability. Such an approach can typically increase profits worth 3-5% of revenue.

“Lean” can, and should be, approached from a product view by carrying out productivity improvement efforts that will reduce costs and increase profits. But “lean” should also be addressed with a financial approach that looks at the flow of cash represented by those products through the production process. Only by combining the product view with the financial profit-per-minute view will corporate profitability and ROA be maximized.

Richard Batty is director of Product Marketing at Maxager. He is a 22-year veteran of the IT industry with experience in marketing, product management and operations. He background includes prior experience at Hewlett-Packard and an IPO startup.

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