How to Manage Through Worse-Before-Better

Several years ago, a Pennsylvania manufacturer of industrial sensors — we’ll call it Caspian Corp. — launched an ambitious effort to become a lean enterprise in hopes of achieving higher quality, lower costs and better customer service. Management’s goal was to eliminate all unnecessary expenses and surpass its leading competitors in terms of productivity and efficiency. During the first six months, Caspian, whose total annual revenues were about $225 million, achieved significant operating improvements. Product lead times to customers and on-time delivery performance were up sharply. Over the next six months, operational performance continued to show impressive gains, and the vice president of operations was pleased. Meanwhile, customer service was making significant strides as well, and with greater efficiencies the company was able to reduce the number of direct labor employees involved in production. Payroll savings in a single value stream alone amounted to more than $40,000 per month — around 20%.

However, the CFO saw a radically different picture. During the same initial months, she saw no financial improvement at all: Sales were flat, and costs didn’t decline. During the second half of the year, Caspian’s revenues actually fell by 17%, and profits declined by an even bigger percentage. The CFO was baffled: The sales forecasts had looked encouraging, and the operations people had talked about significant savings. What happened? Unfortunately, she was at a loss to explain the disparities to the company’s board or to outside investors.

Caspian’s management spent the next 12 months attempting to generate stronger results. Previously, the company had deliberately kept inventory levels high to ensure that customers would be well served. Now seemed like a good time to cut inventory — something the CFO hoped would lead to financial gains. With less inventory, she looked forward to having more cash on hand. In addition, she anticipated that quality improvements would pay a nice dividend in terms of lower materials costs. She certainly wasn’t prepared for more bad news: Despite higher productivity and efficiency, Caspian’s profits remained lower than they were before the company began its transition to lean. Return on sales fell from 7% to zero.

At this point, the CFO and CEO were ready to pull the plug on the lean program and go back to the “good old days” of mass production. They simply couldn’t afford more surprises, no matter the “success” of the overall effort.

The Allure of Lean

Many Western managers were introduced to lean production in 1990, with publication of The Machine That Changed the World.1 Based on a five-year study of Toyota by MIT’s International Motor Vehicle Program, the book showed how management, line workers and suppliers could join together to improve quality and productivity and to lower costs. Since then, thousands of managers have been drawn to the principles of lean management. Managers have applied them to consumer products (including automobiles and electronics), commercial products (including aircraft landing gear, electrical components and batteries) and a wide range of service environments (including hospitals,2 insurance companies,3 government offices,4 retail stores5 and call centers6).

In contrast to traditional methods based on mass production and economies of scale, lean management is built on responsiveness and economies of scope. It replaces Henry Ford’s “any color that you want, as long as it is black” with “any color you want.” Lean enterprises achieve this flexibility by adopting a “just-in-time” production philosophy: They produce what customers want when they want it, as opposed to manufacturing a limited menu of products ahead of demand and forcing customers to choose from what’s available in inventory. For many companies, the initial decision to go lean is a no-brainer. In a relatively short period of time, companies have found that they can achieve faster cycle times, reduced defect rates and sharp gains in on-time deliveries. In addition, for companies relying on inventory as a buffer against uncertain supply, there is a marked reduction in inventory levels required across the supply chain. Logically, these changes should result in better financial performance, especially because companies achieve simultaneous declines in manufacturing and service costs.

But the transition takes time, and it is full of obstacles. One of the biggest and most predictable hurdles is the crisis in confidence that occurs when management isn’t able to improve financial performance quickly enough. When the numbers fall short of internal and external expectations, managers often try to modify the lean initiatives — or abandon them altogether. Orest Fiume, former vice president of finance and administration at Wiremold Co., a manufacturer of industrial and domestic wiring systems in West Hartford, Connecticut, describes what happens when enthusiastic operating people square off with finance and accounting managers who are appalled by the deteriorating results in their financial statements: “Managers who still use standard costing say, ‘I don’t know what you’re doing, but whatever it is, STOP IT! You’re killing our profits.’”7

Management needs to anticipate these challenges and to understand that traditionally measured financial performance will decline before it can rise to new heights. That worse-before-better phenomenon must be explained — and clearly — or everyone from executives to floor employees to shareholders will get off the “lean” bus long before “better” can be reached. To help managers overcome the financial hurdles on the path to lean, we have developed new tools for anticipating the deterioration in financial performance that invariably occurs as a mass producer goes lean and for understanding the real performance improvements that take place during this period. Our approach involves replacing (or, at a minimum, augmenting) the traditional cost-accounting system with a new, transparent accounting system that tracks the company’s value streams, which incorporate all of the value-adding and non-value-adding activities required to bring a product or service from start to finish. This system is designed to help companies resist the pressure to show financial results that are consistent with historic levels in the old production environment.

The Source of the Financial Performance Crisis

What happens to a company’s financial performance as it transitions from mass production to lean? In a typical company, lean management techniques generate a mixture of “good” and “bad,” both externally and internally. Some of the most significant developments involve operational improvements that affect customers. (See “The External Effects of Going Lean”) The lead time for providing products or services to the customers shortens, and on-time delivery improves. These changes are good for customers, but from the seller’s perspective they affect customer behavior negatively in the short term: Customers buy less (because they can place their orders closer to the time they actually need the products and hence can reduce their safety stocks), resulting in revenue reductions. The result is a temporary decline in profits that continues until customer inventories are fully drawn down, at which time sales and profits return to normal levels.

Consider what happened at Caspian during the first three years of lean transformation. The company eliminated most of the queues in the production processes. This led to a reduction in lead time from 12 weeks to around one week. At the same time, because of improved reliability and quality, the on-time delivery percentage to customers went from the low 70s to the high 90s. These results are fairly typical for mature lean companies.

As customers come to rely on improved lead times and on-time performance, they begin to alter their buying habits, shrinking their on-site inventories. Since these safety inventories often represent as much as three months (or 25%) of a customer’s annual requirements, cutting back on inventory can have a significant impact on sales. Although suppliers might see only a modest drop in revenue (typically around 15% in months six to 12), their profits can drop by more (anywhere from 25% to 50%, reflecting the difference between revenues and costs).

Internally, there is dramatic improvement in operating performance as well. In particular, the cycle time for taking a product from raw material to finished goods shrinks. As the cycle time drops, so does the need for in-process inventory. Furthermore, as the cycle time shrinks, the company can shift from push production (producing ahead of customer orders) to pull production (producing to demand). (See “The Internal Effects of Going Lean.”) In response, the need for finished goods inventory drops from months of production to days of production. As both types of inventories drop, the “good news” is that operating cash flow improves dramatically as unneeded inventory is sold. The “bad news” is that most cost systems allocate fixed costs to products that are manufactured during the financial reporting period. When sales levels exceed production levels (that is, when inventory is declining), fixed costs that were previously capitalized on the balance sheet must be added back into the fixed costs for the products that were produced and sold in the period. Thus, when inventory levels are falling, the total fixed costs that are incorporated into the profit and loss statements include some from prior periods. Therefore, they exceed the annual fixed costs of manufacturing, further reducing profits. (See “As Inventory Is Sold, Profits Are Further Depressed.”)8

Consider what happened to Caspian during the same three-year period. Based on a reduction in cycle times from 12 weeks to one week, inventory levels fell from around 200 days to around 30 days. These improvements are typical of mass-to-lean conversions.

These inventory reductions and their effects are not one-time occurrences. As companies become more experienced with lean methods, continuous inventory reductions are the norm until mature lean inventory levels can be achieved. Typically, the reductions begin to have an impact about 12 months into the lean transformation. It is not unusual for companies transitioning from mass production to lean to reduce inventory levels by 60% to 80% over a four- to five-year period. These reductions can decrease a company’s profits by 25% to 50%; with both forms of inventory reduction occurring at the same time, the profit decreases can easily range from 50% to 100%.

Why Financial Performance Lags Operational Performance

Despite the adverse financial implications, a successful transition to lean always brings two positive changes: Productivity per employee increases significantly, and a facility’s output capacity improves as well. (See “How Going Lean Increases Capacity.”) For example, during Caspian’s lean transformation, the company increased labor productivity by 1.5% to 2% per month. This represented a productivity increase of 36% to 48% over a two-year period. These productivity gains apply to the entire work force, not just those considered “direct labor.” The productivity improvement, in turn, adds to the company’s productive capacity. Both of these changes should be good. However, taking advantage of these improvements in the short run is difficult, if not impossible, for two reasons: First, lean companies aren’t in a good position to reduce their number of workers; and second, companies can’t quickly find other ways to use the new capacity they create.

Laying off workers is not an option because the transition to lean requires considerable involvement on the part of the work force; for example, the traditional orientation toward the individual (with dedicated assignments) has to be replaced by a new spirit of cooperation (with each team member playing multiple roles). To spur these changes, senior management typically promises the work force conditional job security. Therefore, significant reductions cannot be initiated even if productivity improvements reduce the need for workers. Even without such a promise, there is a practical consideration: the likelihood that further productivity improvements would not materialize if employees believed these improvements would lead to more layoffs. Given this reality, Caspian’s vice president of operations reassigned workers to other lean tasks rather than let them go; as a result, there was no overall bottom-line improvement.

Similar capacity improvements have been seen in service processes as well. Methodist Hospital in Minneapolis held “rapid process improvement workshops” for the staff of its endoscopy clinic in 2004. A team of doctors, nurses and technicians applied lean methods to their processes and found they could increase capacity by 100%. Today, the clinic is able to see twice as many patients as it did before, patients spend less time in the clinic and doctors and nurses can devote more time to each patient.9

The additional output capacity companies create through productivity gains can’t be used for other purposes in the short run, in part because companies need to maintain a stable production environment. In many cases, moreover, it takes time to find opportunities for growth. Stability is important in lean transitions because the work flow has to be standardized — and this is difficult to achieve if order volume is increasing rapidly. Smart transition teams wait about 18 months before trying to increase sales volumes, even if they think they have spare capacity. This gives the sales force time to recognize that the additional capacity is not a glitch, and it gives customers confidence that the performance improvements will continue.

The Advantage of Value-Stream Accounting

Everyone knows that the stock market brutally punishes unexpected poor financial performance. When financial results are worse than expected, many executives will want strong evidence that going lean was the right decision and that improved financial performance is indeed coming. Without such evidence, some will lose confidence and demand that the lean initiative be dismantled.

To help companies head off a crisis in confidence that could evolve into a full-blown financial crisis, we have developed a methodology for reporting financial performance during the lean transition so that the potential value of the various performance improvements is visible throughout the process. The method, which we call “value-stream accounting,” allows senior management to maintain their confidence in lean while managing future opportunities and analyst expectations.10 The approach takes full advantage of the simplified production environment of the lean enterprise, in which there are typically only a few value streams (usually no more than five).

Although value-stream accounting has been applied most often in manufacturing companies, it also has been applied widely to service businesses, including hospitals, banks and financial service companies.11

It may seem strange that we created a totally new approach to costing to help managers understand the downturn in financial performance. However, conventional cost systems designed for mass production environments can’t provide insights into either (1) what causes the decreased profits; or (2) how much companies are apt to benefit from going lean. The core problem is that conventional cost systems do not map costs to value streams — instead, they link them to production or service delivery processes and then to products. In other words, traditional cost systems view the production or service delivery process as a series of independent steps performed in geographically isolated machining or service processing centers, not as an integrated flow along a value stream.

Because lean companies allow customers to select “any color they want,” their value streams tend to be organized around product families (for example, a consumer electronics company might have one value stream for CD players and another for DVD players), with each product family following a similar production path. Value streams typically comprise one or more dedicated production cells, which produce products or subassemblies one at a time, from raw materials all the way to the finished product.

To maintain the discipline of lean, both physical assets and people are assigned to a particular value stream. The physical assets are right-sized so that they have enough capacity to support a single value stream, and the work force is trained to perform many tasks, not just as narrow specialists. Because the physical assets and the work force are dedicated, there is no need to assign their costs indirectly. Consequently, nearly all resource costs (even electricity) are measured directly at the value-stream level. The only major exception is floor space, which can be assigned indirectly based on square footage.

Direct costing allows for the creation of much simpler income statements, which can be read and understood by almost anyone in the business. These “plain English” financial statements can facilitate a company’s transition to lean by showing how the improvements employees make flow to the bottom line.

At Caspian, the CFO eventually overcame her opposition to the lean transition and embraced value-stream accounting. The first step involved developing plain English financial statements for the whole company. The new statements were an immediate success. Without resorting to standards, variances or opaque accounting ideas, they showed how and when money was spent during the period. Rather than requiring management to spend time deciphering the numbers, the statements pointed management to actions they needed to take. For example, the lean statement isolated the profit impact from a large reduction in inventory from the profitability of the value stream. It reported that the company made a healthy profit of $3.23 million from revenues of $19.04 million, which had been eliminated by the accounting impact of the inventory reduction. (See “Comparing Caspian’s Traditional and ‘Plain English’ Income Statements.”) By contrast, in the standard cost statement, the only reported number was a loss of $9,000, which totally obscured the operating profit (see same diagram, left side).

Looking Beyond the Bad News

Plain English financial statements can reveal hidden improvements in financial performance that are often masked by lower sales, the vagaries of cost accounting and the time required to grow the business. Direct cost assignment coupled with disciplined lean production enables managers to develop accurate estimates of how different output levels might play out financially. In particular, it is possible to remove the negative financial impacts of inventory reduction and add in the impact of taking advantage of the increased productivity, either by right-sizing or by producing at higher capacity levels.

Adjusting for External Inventory Level Decreases

As customers begin to decrease their inventory levels, they necessarily postpone sales. There are several ways to measure postponed sales. The simplest is to estimate sales trends from earlier periods to gauge what would have occurred. However, it’s possible to create more accurate estimates by interviewing representative customers and determining how they are changing their buying behaviors. Either way, it’s important to have a reasonable estimate of what the revenue would have been if customers were not eating into their safety stocks.

Once management determines the revenue adjustment, it can estimate the corresponding costs. Value-stream accounting makes it relatively easy to estimate the bottom-line impact of lost sales. All of the products that are manufactured in the value stream belong to the same family and have similar economics. Therefore, it is possible to identify how the average product consumes resources. Dividing the selling price of the average product into the revenue adjustment determines the volume of the postponed sales in units. Factoring the variable costs of the average product by the number of units gives the anticipated incremental costs of the postponed sales. Typically, labor is considered fixed (especially since workers have been promised that they will continue to be employed), as are machine and facilities costs. Only materials, utilities and external processing costs are expected to vary. Because few costs are variable at the levels of change we’re discussing (with the exception of materials), almost all of the revenues go to the bottom line, which explains why the impact of lost sales on profits is so high.

Adjusting for Internal Inventory Level Decreases

The profitability of the value stream if there are no changes in inventory can be calculated using the same approach developed for postponed sales: Once you determine the revenue from selling off the inventory, identify the associated variable costs and add them to the costs in the value stream. On the surface, one might expect this to be relatively straightforward. However, the adjusted profit and loss statement is different from the inventory-adjusted statement because the inventory was created when the company was a mass producer; the inventory in the adjusted report was produced by a more efficient lean enterprise. The adjusted profit for the lean enterprise is therefore higher than the conventionally reported profits, even though the revenue stays the same. Comparing the prior period’s profit and loss statement (when no inventory changes occurred) and the adjusted profit and loss statement highlights the real improvement in value stream performance. (See “Caspian Income Statement Adjusted for Lean Transition.”)

Adjusting for Increased Productivity

The need to establish standard work and the challenges of finding new sales growth opportunities make it difficult for lean companies to take immediate advantage of new output capacity created by the transition to lean. To help senior management understand the economic potential of the increased capacity, it is useful to develop two alternate future-state profit and loss statements — one for the right-sized business and one for the full-capacity business. (See “Two Alternative Lean Futures.”) The right-sized statement assumes that sales stay the same but that the value stream changes by reducing the costs of both labor and dedicated production equipment. The full-capacity statement assumes that all of the newly available capacity will be utilized by selling more of the current mix of products. Unlike the inventory reductions that occur only for companies that have large inventories in their value and supply chains, these adjustments are applicable to all businesses that go lean.

Right-sized scenario.

Managers can develop the right-sized picture by adjusting the resources dedicated to the value stream so that they are properly aligned with current revenues. We suggest using a five-year horizon. The material and outside processing costs remain essentially unchanged, as they already reflect the changes in efficiency, but the other costs (particularly labor, machine and facilities costs) need to be modified. First, for labor costs, managers need to determine the number of individuals required to produce the output. This calculation is fairly straightforward (multiplying the number of units by the production cycle time for each product). Second, where appropriate, machine costs must be adjusted for right-sized machines. This adjustment is difficult for some machines because they are expensive to acquire and have low resale values; therefore, these machines need to be retained. Finally, managers need to reduce their facilities costs to reflect any reductions in floor space that will be dedicated to the value stream. The right-sized profit and loss statement will typically report profits approximately twice that of the value stream’s current performance.

Full-capacity scenario.

The full-capacity picture can be created by identifying the long-term bottlenecks in the value stream and fully loading them (in most settings, there will be only one long-term bottleneck). Typically, expensive machines operating at full capacity create bottlenecks; to relieve the bottleneck, the company needs to buy another machine. By contrast, if the restriction is labor, management can usually add people. To calculate the revenue associated with loading the bottleneck, managers need to divide the time per unit into the machine’s available capacity, and then multiply the full-capacity volume by the average selling price of products made in the value stream. Realistic levels of capacity utilization must be incorporated into the full-capacity future-state financials. Instead of assuming that 100% of available capacity will be utilized, it is safer to assume that 20% remains available to allow for fluctuating demand. The labor loading for each production step in the value stream is calculated using the standardized work estimates, and finally the associated outside processing costs are estimated. Over a five-year period, the full-capacity future state will report profits that are typically four to eight times higher than the value stream’s current performance.

Managing Into the Future

Because lean transitions take several years to accomplish, management needs to update the alternative-scenario profit and loss statements on a regular basis to reflect ongoing improvements in the performance of the value stream. By integrating statements that reflect external, internal and inventory changes with the full-capacity view, managers will find that even as they report the unavoidable profit trough, the company’s potential profitability increases.

Furthermore, these forward-looking statements should send important messages to the product development team and the sales department. The product development team should begin working on new products that take advantage of the enhanced lean capabilities of manufacturing. These products should be ready to roll out as capacity frees up and manufacturing is ready to ramp up production. Meanwhile, the sales department must actively seek out new markets for both existing and planned products to fill as much of the newly created capacity as possible. If successful, this should lead to the full-capacity scenario.

As management navigates through the profit crisis and the company gets back to “normal” financial performance, it can discontinue the adjusted statements. However, many lean companies continue to use right-sized and full-capacity statements because they show how well lean productivity improvements are being incorporated into future plans. Senior managers should accept that for the foreseeable future their efforts to keep the value stream at full capacity will generally lag behind the continuous growth in productivity. In other words, the full-capacity future state will always be more profitable than actual performance. The imbalance will not disappear for several years, until the value stream reaches lean maturity and capacity increases become more gradual.

LEAN TRANSFORMATIONS GENERALLY have short-term adverse impacts on a company’s bottom line. However, managers need to understand that the “bad” news isn’t really bad — it’s part of the necessary process of establishing a stronger, more productive organization. Traditional accounting systems are not designed to help senior managers understand the causes of these adverse impacts or to see the future benefits that will accrue from the much-improved operational processes. Our approach helps managers confront this problem by giving the CFO and divisional controllers tools to plan for the short-term financial impact, monitor the progress of these issues, understand the operational improvements and develop strategies to maximize the longer-term benefit.

When the financial impacts are effectively communicated throughout the organization and the executive team, expectations are set realistically. Eventually, organizations see superior results, which tend to benefit everyone — investors, customers and employees. By being clear about the challenges and expectations, and demonstrating the company’s strategy for achieving longer-term profitability and growth, managers don’t have to worry about Wall Street surprises and negative impacts on stock price or investor confidence.