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Creating Value or Shifting Wealth?

Jim Womack
5/1/2008
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How do we judge the progress of the Lean Movement? One critical indicator is our success in extending lean thinking to new industries and activities. In recent years I have been greatly encouraged that lean thinking is moving far beyond its origins in manufacturing to distribution, retailing, maintenance and overhaul, consumer services, construction, and – perhaps most striking – healthcare. Indeed, the latter may be the most energetic area of lean practice today.

However, I have been concerned about our prospects for changing the thinking of investors, and specifically the giant private-equity investment firms that now control large parts of the economy. While we have gained a strong foothold in financial services, this has been at the operating level. Most efforts to date have focused on how value streams within financial firms can be made lean -- for example, those for processing loans or making credit checks. This is important work but it is on a different level from how financial firms think about investments and specifically how they might instigate lean transformations in the firms they control in many industries.

I was therefore delighted recently when I was contacted by one of the largest private-equity firms, an organization with dozens of firms in its investment portfolio garnering perhaps 100 billion dollars in total sales. This type of firm pools private investment funds to buy companies, in hopes of quick “turnarounds” with re-sale of these firms at much higher prices.

The partner contacting me noted that conditions in this industry have changed with the credit crisis and weak equities markets. Instead of selling firms after two or three years it may be necessary to hold onto them for a long time, even a decade, before they can be sold to advantage. His question was a simple one: “Given that we may now need to hold firms for many years, how can we take the long view. Indeed, how can we turn firms into the ‘Toyota’ of their industries in order to maximize their price when they are sold?”

I was delighted to engage in this conversation. But to avoid any misunderstanding I needed to start by comparing a traditional private equity “turnaround” with a “lean transformation”. In the former, the objective to this point has been to go quickly to produce a dramatic bottom-line result. This has often meant:

  • “Rolling up” two or more companies in the same industry to reduce competition and increase prices to consumers.
  • Negotiating lower wages and benefits.
  • Cutting spending on long-term development projects not critical to the firm’s strategic plan.
  • Reducing headcounts in activities judged non-essential.
  • Restructuring the balance sheet to add bank debt, often creating instant dividends for the private equity firm but high levels of long-term debt for the firm once it is sold.
  • Re-negotiating prices with suppliers, on threat of loss of business.

These actions quickly shift wealth from customers, employees, suppliers, and former owners to the new owners. This may do more good than harm, because otherwise the firm in question may completely fail. But it is often unclear that any additional value has been created in the sense of better satisfying customer needs with a given amount of human effort and capital investment. And, from society’s standpoint, the only way to increase living standards is to change the ratio of human effort and capital going into firms to the amount of value coming out. Otherwise the outcome is basically zero- sum, with some winners and some losers.

By contrast, the objective of a lean transformation is to analyze the core value creating processes of organizations in light of customer needs (which may have changed), then figure out how to create more value with the same resources so the organizations can grow and society can prosper. It’s the difference between shifting wealth from one party to another and creating more value, ideally value that can be shared with customers, employees, suppliers and owners. (Note that I never use the term “adding value” because this is an accounting convention for the difference between the input costs of a firm and its output prices. Often I find that only cost is added by the firm as inputs are converted to outputs, not value from the customer’s standpoint.)

I was relieved that after a frank discussion of the differences between traditional and “lean” private equity, the firm in question was still interested in pursuing lean. Indeed, this firm has now launched a wide range of experiments to “lean” the processes of its portfolio firms, and other private equity firms are now following its lead. It is far too soon to know how much progress will be made along this new path. But I’m heartened that an industry I feared I would never hear from is now actually listening.

As I always tell audiences, managers (and owners) will try anything that is quick and easy even if it doesn’t work (e.g. many of the traditional methods of private equity in the current environment) before they try anything long and hard that does work (e.g. intense process analysis linked to customer needs to create more value from the same resources.) So perhaps the massive private-equity industry, by virtue of the recent shifts in the global economy, is now ready to tackle long, hard things which do work.

Best regards,
Jim

James P. Womack
Founder and Chairman
Lean Enterprise Institute

P.S. As I travel to visit companies and make presentations on lean thinking, I am bemused by the perception that LEI is a private consulting firm. While our faculty members and authors make most of their living in independent consulting businesses, LEI itself is a non-profit organization with no owners and no consulting contracts. We are chartered to teach courses, hold management seminars, write and publish books and workbooks, and organize public and private conferences. We use the surplus revenues from these activities to conduct research projects and to support other lean initiatives such as the Lean Education Academic Network (www.teachinglean.org) and the Lean Global Network (www.leanglobal.org). Our activities are a continuation of the educational work I did for many years at MIT, directly across the street from our LEI office in Cambridge, MA.

As part of our research we do visit many companies during the course of the year – the private equity firm I have just mentioned is one of many recent examples -- and we often suggest experiments that they perform and that we can observe in detail in order to deepen our knowledge of lean thinking. However, we don’t perform the experiments directly, but instead pose the questions to answer. Then, based on the results, these experiments may become the raw materials for the next book project or management seminar or major conference in which we try to share all of our knowledge.

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