Recently in the Lean.org Community Daily Forum, a question was posted that really hits squarely on a topic that many people struggle with. A member asked:
I work in an ETO environment where nearly every unit is a unique part. We plan for 7 days of production time prior to shipping to customers. Our demonstrated average production time (velocity) was as high as 22 days. I was able to get the average velocity down from 22 to 10 days. How would I calculate that cost savings? All the units follow roughly the same production path; complexity related to uniqueness usually results in longer cycle times in given operations. The major factor in reducing lead time was decreasing WIP between cells and turning over “offline” units faster, thereby reducing total units “offline”.
Here is my reply (expanded here):
Congratulations on your great performance in reducing lead time from 22 to 10 days. The workplace is freed when WIP is greatly reduced. I suspect pull was a key part of getting this reduction!
Let’s talk about your question on how to calculate cost savings. This is a common question in traditional corporate environments. A great way to begin deeply understanding this, and to orient outside of the traditional “box” is to ask: “What is the purpose of the question?” Often your question arises from a need to justify the improvement to someone who does not understand the high value of this important improvement.
I want to investigate this scenario by asking a series of questions based on what you have shared.
First, do customers perceive value from and are they willing to pay for this quicker, more reliable lead-time?
Second, what costs have been reduced? Based on your description, it does not sound like you have reduced the materials in the product. Nor did you alter the transformation of those materials. If so, there does not seem to be a direct variable cost reduction. However, you did not say, but you may have been able to (or might still be able to) reduce expedite costs of bringing materials in house and/or shipping the product to the customer.
Third, what capacity has been gained with this improvement? Have you freed up more available space in the factory due to less WIP? More capacity due to a reduction in people trying to shuffle between stations, looking for inventory, moving WIP, counting WIP or repairing damaged WIP? Any gained capacity in reducing these wasteful activities, is not a cost reduction unless you have been able to reduce the overtime of the people impacted or reallocate the people or other resources to other activities.
In addition, these resources are now available to be deployed in any future growth (from your improved competitiveness), so adding more products or services will not require as large of an investment. And, keep in mind there is a very strong multiplier effect on reducing future investment costs as a company does more and more lean improvement events because of freed up capacity.
Often, newly available capacity is the largest immediate benefit of waste elimination. In your company’s situation, where you described excess processing and inventory, you probably have reduced motion, transportation, defects, and mind-numbing work—all of which took time and effort that is now available to be applied to new work. Without the benefit of this capacity, you will continue to have the current overall cost structure. Utilizing this available capacity as you grow will improve your overall cost structure, often dramatically. More product passing through existing people, space and equipment greatly improves margins.
Fourth, what is your reduction in inventory? Is it significant enough to reduce your costs of insurance? Does it eliminate the need for some fork trucks, storage racks, and/or warehouse space? Has it freed up cash flow because of the speed at which raw materials now are turned into shipped product? It is important to be aware of Generally Accepted Accounting Principles (GAAP) that reward inventory creation in the short term and punish reductions in inventory, also in the short term, which can confuse the financial perception. In the book, Real Numbers, co-author Orry Fiume and I describe how to avoid this confusion.
Fifth, consider the overarching value of your company learning of how to make and sustain this type of waste elimination change. Consider the implications for future improvement opportunities that might have additional safety, competitive, cost, and capacity impacts. This is not an immediate and direct cost reduction, but it is a long-term strengthening of overall organization capability.
Too often people feel that cost reduction is the only goal/impact of lean thinking. Nothing could be further from the truth. The effect of these changes does affect financial outcomes and dramatically.
In the new book Designing the Future, authors Jim Morgan and Jeff Liker summarize the benefits of lean product and process development (LPPD) at Ford Motor Company. Ford is a company who most think of as a traditional, numbers-based company, and the numbers churned out from their LPPD work are very impressive. But nowhere is product cost, using the accounting meaning of a specific cost associated with a product, described as one of the benefits. Overall profit improvement, yes. Gross margin, yes. Sales per employee, yes. Stock price, yes. Credit rating, yes. But no product cost. Why? Because product cost is not a lean measure. It is irrelevant and gets in the way of so many meaningful measures in evaluating performance. It blends variable costs with managed costs and fixed costs and is based on disproven, 100-year-old, misleading accounting-based interpretation of cost assigned to units.
The levers of creation of financial value all benefit from application of lean thinking and practice. And only two of the five levers are affected by cost reduction. My book The Value Add Accountant describes these levers and how each are improved from lean practice.
So in terms of your original question….“How would I calculate that cost savings?” Some other questions to consider might be: “How much capacity is created in people, space and equipment from application of pull? How has the capital structure improved from reduction in WIP inventory? Have the overall value stream costs reduced compared to the flow of products through the value stream? How is the reduced lead time translating to customer value/demand? What costs have been avoided by removing inventory? What human development has occurred from changing the mindsets related to inventory and push processing? How is that human development being deployed to new problems? What is the longer-term impact to our company’s well being?
Lean affects financial outcomes. And, dramatically so in firms that incorporate corporate-wide lean thinking over the long term. But don’t fixate on cost reduction or product cost. Look at the real numbers.