Why can't I see productivity gains in my financial statements?

Sunday, October 1, 2017

Retired CFO and director of The Wiremold Company and co-author of "The Lean Strategy," published in June 2017.


CEO to CFO: “Last month our kaizen teams reported average productivity gains of 50 percent.  Why can’t I see them in this month’s financial statements?”

CFO to CEO: “I don’t know. I’m beginning to suspect that this lean stuff isn’t real."

If I had a dollar for every time that I have been told about conversations like that, I’d be rich. And it demonstrates that most CEO’s and CFO’s don’t really understand what productivity is. I believe this is because their accounting systems focus on “labor efficiency”…the relationship of actual labor hours vs. standard labor hours, with the erroneous presumption that the standards are correct. Their systems don’t even try to measure productivity.

A central message of a new book that I’ve produced with three colleagues is that lean, which is widely known yet unfortunately misunderstood, is not simply a way to cut costs, but represents a complete strategy. Strategy is what we do to create sustainable competitive advantage and the lean strategy is a fundamentally different way of thinking about how to do that. And as such, leads us to a different way of framing productivity…let me explain how.

At the risk of stating the obvious: 

- Everything we do is in the context of some process

- Processes are comprised of activities

- Activities fall into one of three categories:

                        - Activities that add value for customers

                        - Activities that don’t add value for customers

                        - Activities that don’t add value for customers but are required

                          (e.g. preparing and filing tax returns)

One of the underlying principles of the lean strategy is to eliminate all activities that don’t add value for our customers. In the Lean lexicon these activities are called either “muda” or “waste.” It’s fair to say that no one would intentionally create a process that contains waste. But we do. I believe that is because historically we have defined waste with an internal focus rather than a customer focus. We call scrap “waste.” We call people standing around the copy machine just talking “wasting time.” But as long as they are “working” we don’t see that as waste.

When Art Byrne came to The Wiremold Company as our new CEO in 1991, as the CFO, I gave him a plant tour. At the end of it he said “this company has twice as many people as it needs.” Needless to say, this statement surprised me because as we walked around what I saw was that everyone was “working.” What he saw was a lot of activity that didn’t add value for the customer. Art had developed “lean eyes”…the ability to see value being added and to see waste. One of the stretch goals that Art set at the beginning of our Lean transformation was to achieve a 20 percent annual labor productivity gain. None of us thought that was even remotely possible, but then at that point we really didn’t understand the real nature of waste. (Spoiler alert: from 1991 to 2000 we had an average a 14 percent annual labor productivity gain.) 

Productivity is the relationship of the output of any process and the resources consumed in creating that output. In this context, resources mean all resources…materials, people time, energy, supplies, etc. Thus, it’s possible to improve the productivity of all resources. When we do an improvement event (kaizen) some of the improvements result immediate cash savings and show up in the financial statements quickly…i.e. are true “cost reductions.” Some examples are quality improvements that reduce scrap and therefore material usage. If a company has a scrap rate of 5 percent and materials comprise 60  percent of cost of sales, gross profit can be improved by three percentage points if quality is improved and scrap eliminated. If an improvement event reduces the amount of office supplies that are used, this results in a quick cash saving and an improvement to the bottom line. At Wiremold we reduced the cost of office supplies by 48 percent.

Improvements in labor productivity is different. In The Lean Strategy, a new book, my co-authors and I discuss how one of the realities that the lean strategy makes executives face is the fact that most of what they think they know about what is happening in the company is wrong. In a multi-layered company, with executives far removed from the actual work being done, they are dependent upon what they are told is happening.  And in most companies the “bad news” is filtered out as it flows from the shop floor to the “C” suite, so executives don’t know the truth. The lean strategy requires executives to stop making decisions based on what they think is happening (based on bad or incomplete information) and go to the gemba to actually see what is happening. When they do so and ask the right questions, they begin to understand that the people doing the work know what the problems are and have some pretty good ideas about how to fix those problems. They also begin to understand that their own role is to support the people doing the work in finding workable solutions to fix quality, eliminate non-value adding activities, shorten lead times, etc. All aimed at improving value for the customer.

Because the people doing the work are the primary resource for improving productivity, it is imperative that the CEO gives everyone the assurance that no one will lose their employment as a result of productivity improvements. Their “jobs” will probably change over time, but they will have a job. It is because of this assurance that productivity gains created through kaizen do not reduce costs. Since the people are still on the payroll after kaizen, total people costs remain the same. As a result, we get the discussion described at the beginning of this article. What the executives don’t understand is that labor productivity gains just free up capacity. The traditional thinking executive cannot tolerate the thought of having reduced the need for people without actually reducing the number of people (i.e. layoffs). They view this as unnecessary costs. The lean thinking executive looks at this the source of growth and future profitability improvement. They recognize that by eliminating activities that don’t add value they reduce the amount of time it takes to do everything and that time can be strategically used to differentiate their company from their competitors. In effect, time is the currency of lean.

In the context of the lean strategy, how do we convert productivity gains into profitability improvement? The people doing the work did their job: they created the productivity gains. Now the executives need to their job to “actualize” those gains. At Wiremold, we actualized our gains into 13 percentage points of additional gross profit by doing all the following:

  1. Sell more. This is the best way to actualize productivity gains into profit improvement. Since we already have the people and the production facilities, the only significant additional production cost of the next unit we sell is its material content. Everything else (Sales minus Materials, which in accounting parlance is called “value added”) improves gross profit. In order to sell more, we used time to create a competitive advantage. For example, we reduced the lead-time for most of our products from weeks to days and used that ability to show our customers how our “rapid replenishment system” allowed them to inventory less of our product thereby freeing up their cash.  We aggressively improved our new product development processes, reducing the lead-time for new products (concept to launch) from years to months. This allowed us to satisfy our customers with a stream of more innovative products that our competitors could not match. And all of this growth was “self financed” by our productivity gains. Some of our plants were able to more then double their volume with the same number of employees.
  2. Reduce overtime. If the company is incurring significant amounts of overtime (and we were), this time represents additional Full Time Equivalent employees (FTE’s). And those FTE’s are expensive since overtime is paid at premium rates. By reducing FTE’s we eliminate those expensive hours and actualize the productivity gains into profitability improvement.
  3. Hold on to attrition. When someone quits or retires, make it very, very difficult to replace those people. Although we assured people that no one would lose their employment as a result of productivity gains, we did not guarantee a fixed level of employment. When people voluntarily leave the company and are not replaced, that actualizes productivity gains.
  4. Insource work. If the company is having work done by a vendor that it is capable of doing itself, bring the work in-house. By insourcing you capture the vendor’s profit for yourself. You have the capacity that was freed up by productivity gains and even if you have to buy some minor equipment to support the insourcing it’s generally worth it. For example, Wiremold made power strips in various configurations.  One of the variables was the color and length of the power cord. Three colors and three lengths. Accordingly, we had nine SKU’s that we had to buy and store. In order to insource, we had to buy a small machine that would mold the plugs onto the end of the cord (six at a time) at a cost of $25,000. However, this allowed us to only inventory three reels of cords (one for each color) and then cut them to length and mode the plugs onto them within the flow line based on actual customer demand. This significantly reduced both the cost of the cord sets and the amount of inventory we had to carry.

When I teach a workshop, I ask the participants if their companies require that the “cost/benefit” be calculated for every kaizen event. Almost all of the hands go up. I then tell them “don’t do it” because most of the improvements will be in the form of labor productivity gains that will not result in an immediate profit improvement. By quantifying these gains into dollars they are raising expectations that next month’s profit will reflect these improvements. Naturally, the response that I get is “But I can’t refuse to quantify that. If I do I’ll lose my job.” So in the face of that reality, I tell them that when they return to their companies they need to educate their executives about (a) the strategic nature of lean and it’s ability to be disruptive and create sustainable competitive advantage, (b) the nature of labor productivity improvements (i.e. they increase capacity) and (c) the four things those executives must do to actualize the improvements into additional profits.

Orest (Orry) Fiume is the retired CFO and Director of The Wiremold Company. Orry led Wiremold’s conversion to lean accounting in 1991 and went on to install lean accounting at more than 20 Wiremold acquisitions. He is co-author of the 2004 Shingo Prize winning book “Real Numbers: Management Accounting in a Lean Organization” and co-author of the book "The Lean Strategy," published in June 2017.