Dear Gemba Coach,
In our manufacturing business, we have several opportunities for improvement that involve reducing WIP and excess inventory (of both purchased and fabricated parts). Is there a way to put a dollar value (cost savings) on these types of improvements? We have trouble gaining CFO support for a process improvement that reduces WIP time for one specific option by one day, mainly because it doesn’t provide him any way to sell our product at a lower cost. Maybe it does, but we don’t know how to quantify it.
Interesting question, and one that many lean practitioners encounter at some time or other. Are you sure you’ve fully grasped the situation? I am surprised to hear that the CFO doesn’t see the point of reducing inventory in WIP or purchased parts. To explore this issue I believe we must keep in mind that every business situation has two dimensions: the deal and the relationship. Or, in lean terms: the improvement we’re making, and the teamwork we are building through cooperation across functions.
The first aspect of the issue is to try to clarify our understanding of the disagreement with the CFO. What are the implicit assumptions that both of you are making? Before we look into the cost issue, we need to bear in mind that the main impact of inventory on the books will be on cash flow – something that no CFO would not want to improve!
Reducing inventory in value will improve the cash flow of the situation. Less cash out means both less financial costs and an opportunity to pay back debt, invest, or even stockpile. This has to be a good thing. The only financial problem with reducing inventory would be reducing the overall amount of assets, but, as Orry Fiume (co-author of Real Numbers) is fond of saying: profit is an opinion, cash is a fact.
The dollar value on inventory reduction has two components: (1) the cash flow improvement and (2) the cost savings from requiring less space. Less inventory means less storage space and less handling. This leads to real budget-level cost savings if you’re in a situation to do one (or more) of three things: close external storage or sell or rent internal space; reduce the number of logistics operators; and reduce the number of forklifts and other handling equipment. In my experience, the cash component is by far the main gain.
Why would any CFO not be interested? Well, if I put myself in the CFO’s shoes (God forbid!), I can think of a number of reasons I would not buy the cash improvement argument. Here are the main ones on the top of my head.
My first worry is that a reduction of inventory, whether in WIP, or worse, in purchased parts, can result in lost sales if the On Time In-Full Delivery service rate is negatively affected by missing components or missing parts. This is a very real concern as many companies who attempt just-in-time without leveling correctly find themselves in exactly that situation: inventories go down, but so does customer service, which creates lost sales, damages the company’s reputation and generates all kinds of panics in production, not to mention exceptional costs in overtime, special freight, and more.
The first aspect of lean is complete customer satisfaction. In many cases, the first thing I’ve seen Toyota do with a new supplier is to increase the inventory in the system, to the point that they can now deliver 100%. Only then do they work on reducing the causes of this muda of inventory: the muri of inflexibility and the mura of poor planning decisions. So the first thing to check is that your lean activity is monitoring very carefully OTD and to explain how your leveling of customer demand will help you to both increase OTD and reduce Inventory. This absolutely needs clarification.
The second large concern I’d have from a finance point of view is that work-in-process reduction is essential from a lean perspective (as a key reflection of lead-time improvement) but hardly ever impacts the overall cash flow. In an assembly operation work in process typically represents a small share of the total inventory, the bulk of it being in purchased parts, and exactly where it’s more likely that reducing stocks will create parts shortages.
It’s not easy to explain that making the process level and flexible will first reduce WIP, and, as this generates a more level pull signal to suppliers, will enable us to carry less stock, mainly by increasing the mix in the deliveries (or the deliveries themselves), with milkruns, crossdocks, etc. To a financial mind, this sounds like overcomplicating things when straightforward solutions exist such as consignment stock (the supplier has to hold some inventory for you, which they carry on their books until you help yourself at will). Trying to explain to a CFO that by lowering the apparent cost of holding stock, in effect, you increase the economic order quantity and thus create an incentive for the firm to become less flexible, not more, is something of a challenge (one that this Gemba Coach has failed at so far). The issue here is to demonstrate that WIP reduction is the entry ticket to safe purchased parts inventory reduction – where the big bucks are. I know a company that has recently followed that path and reduced their parts inventory by a third whilst improving customer service, becoming cash positive for the first time in ten years. The CFO is looking at this “lean thing” in a very different light.
Thirdly, from a financial perspective, I’ll worry about the cost of all this proposed kaizen activity to reduce stocks. Furthermore, there’s a good chance that if I support the initiative, they’ll come up with investment demands which will affect my free cash flow and impact my costs event further. From a purely financial perspective, kaizen can be seen like cost (of putting people in a room away from their desk) to give license to ask for more spending!
You have to make very sure that the opportunities for improvement you mention are pure kaizen: zero investment! If you can’t guarantee that, then go back to the gemba and do more people kaizen before equipment kaizen. Even a dry towel can deliver a drop of water if it’s squeezed hard enough as the old lean hands used to say. In other words, zero-investment performance improvement is the only way to persuade a financier that, at some point, it might be worth it to put some money into it to get even further results. But the key is to demonstrate that without spending any money (barring small stuff costs, of course) you have a credible return on the kaizen actions. If your zero investment activities have not delivered visible performance improvements, why would finance believe you’ll do any better with capital expenditure?
So, yes, there is a way to put a dollar value on inventory reduction (beyond the cash flow improvement), but it’s a tricky, technical, and highly subjective debate about the cost of holding inventory. Clearly, inventory has a cost – both fixed (warehouses, handling, etc.) and variable in terms of depreciation of the inventory. I tend to attack inventory by suggesting that people go into the warehouse and tag every crate which has not been moved in the past six months. Then, once all these crates have been tagged, the idea is to lower a few every week and look at what’s inside. The amount of obsolete parts in the stock is always staggering. To the cost of the physical holding of the inventory we can then add the real costs of obsoletes.
And what do we most know from doing lean? That the real cost of holding inventory is much, much higher than just the total of the cost of goods of parts held in the stock. First, holding huge inventories doesn’t help with missed deliveries because we often have the wrong parts in stock (because forecasts are always wrong); second we know that inventory begets inventory because the time of production of part A is the time of non-production of part B, so the longer my batch of A, the larger the stock of B in order to deliver both As and Bs; and thirdly, inventory is the deadly muda that hides all the other wastes in the system. But whereas from a lean point of view inventory is one of the ultimate evils (that and defective products to customers) it’s going to be hard to convince a CFO. For one thing, inventories are counted as assets and, as such, increase the balance sheet. For another, inventories are measured as the cost of goods sold applied to the products in stocks, so clearly under-evaluated from a lean point of view.
Now to the relationship aspect. Reevaluating the cost of inventory is not a five minute discussion while waiting for the elevator. This is a long, technical discussion that can only happen within a positive working relationship. The deeper issue I see in your question is how to develop teamwork: how to learn to solve financial problems with the finance department – not by convincing them, but by solving problems together. What problems could we possibly solve which would introduce financiers to lean thinking?
If you go back to the cash flow calculation, there are two issues which can be interesting to tackle with finance: accounts payables and accounts receivables. Holding kaizen events with the finance folks on either the invoicing process or the paying process to suppliers could create platforms for teamwork where you could demonstrate the power of kaizen and have many discussions with your finance counterparts! The main thing is to accept that you can’t convince anyone of anything in their own fields. The only answer is to work with them on specific problems until you both forge a common way of seeing the issue.