RESEARCH – Every advocate of lean with a skeptical boss has been asked “What’s the ROI of lean?” at least once. This landmark article explains that lean can indeed help us to achieve a superior ROI, so long as we view it as an all-encompassing strategy rather than a simple tactic.
Words: Orest (Orry) Fiume, author and former VP of Finance and Administration and Director of The Wiremold Company - with Michael Ballé, Daniel T Jones, and Jacques Chaize
Wiremold, featured in the seminal book Lean Thinking, is the classic lean success story. Using lean as their main strategy, Wiremold leaders were able to increase the value of the company from $30 million to $770 million in 10 years, through both internal growth – by developing their people – and external acquisitions – honing their lean turnaround skills. Although Wiremold’s lean journey is well known and has been amply documented, a key part of the story has, to date, not been told: the Financial Director’s perspective.
Indeed, this reflects a larger knowledge gap in the lean movement. No one disputes that lean works, sometimes spectacularly (as in Wiremold’s case). And yet, it remains hard as ever to convince mainstream financial managers to adopt lean thinking. A large part of the reason, we believe, is that lean’s financial story remains to be explicated, which is our intent in this research article.
Art Byrne, retired CEO of The Wiremold Company and author of The Lean Turnaround, is fond of saying, “The winners will be those companies that focus on their processes, not their results.” Implied in this statement is that in order to focus on processes, a company has to reorder the importance of its metrics, with operational metrics moving to the forefront and traditional, financial, and result-oriented metrics taking a back seat. It’s not that Art was not interested in achieving good results. He was. But he knew that in order to achieve them you had to focus on the physical changes that create financial performance improvement. He came to Wiremold confident in the fact that lean is a strategy, not a manufacturing tactic, and every process in the company had to conform to lean principles.
From Art’s arrival in 1991 to the sale of the company in 2000, the company achieved remarkable results:
In spite of the extraordinary results that Wiremold and other lean companies have achieved, there is still widespread skepticism about Art’s focus on process as a driver of financial results.
Many consider that one of the ultimate “results” metrics is Return on Investment (ROI). This single number attempts to reflect the results of a company’s efforts to effectively utilize its investments to achieve maximum benefits (return). The most used ROI calculation is depicted in the classic Dupont Model (E.I. DuPont de Nemours & C0, Inc; “Guide to Venture Analysis,” 1971):
Since ROI is a single number that reflects the results of virtually all the activities within the company, it cannot be improved directly, which would be like trying to increase the speed of your car by tweaking the speedometer needle. It can only be improved by improving the inputs into the calculation (i.e. the items described at the lowest level – right-hand side – of the model).
The ROI model is so pervasive in business that it is often applied in selecting individual investments choices in the belief that if each investment yields a satisfactory return, then the return on the whole enterprise will be satisfactory. (Note: Internal Rate of Return (IRR) or “payback” models are sometimes used as substitutes for ROI.) Unfortunately, life often gets in the way and the ROI achieved is less than that promised. Once this happens, pressure is created to “improve” it. Since the investment has already been made (the machine is already bought, the acquisition has already been made, etc), the traditional way to improve ROI is try to “increase” the benefits, which usually translates into a reduction in costs, which in turn is usually translated into pressure to reduce “headcount,” since that is seen as the easiest cost to reduce with the most immediate impact on increasing the return on the investment – on paper.
Of course, if you slash operating costs to improve the return on the wrong investment, chances are you’ll further deteriorate the outcome sought out of the investment and have precisely the opposite effect, although it might show up in a different place in the accounts. A hard lesson of lean is that by making processes work as they should and learning to make them more flexible, the investment itself is rarely needed.
The real question is not “Can ROI and lean co-exist?” but “Can a lean strategy improve the chances of achieving a superior ROI?” And the answer is an unequivocal “yes”.
As we look at the diagram of ROI, we see that it is earnings as a percentage of sales multiplied by turnover. On a day-to-day basis, this revelation is not very useful. We need to step back to some primary school mathematics to see what this means.
ROI = Earnings/Sales x Sales/Investment
Thus, ROI is influenced by, (1) Sales, (2) Earnings and (3) Investment. Please note that Sales is in both the numerator and denominator of the equation, thereby giving it extra weight. The early history of Toyota was not “How do we reduce costs?” Rising out of the ashes of World War II, the question was, “How do we increase production to meet increasing demand using the existing investment?” This was not a financial (ROI) question, but a matter of logistics. Toyota wondered, “How do we increase the flexibility and velocity of production in order to meet increasing demand without new investment, because we don’t have any money to invest?”
The answers they came up with created an approach that focused on the knowledge of the people doing the work to eliminate work that did not add value for the customer (waste) thereby providing a source of growth from the same assets – both people and facilities. Whether they thought about the effect this would have on “ROI” is debatable, because they were clearly focused on doing the things that were necessary for their survival: satisfying the customer with limited resources. The net effect, however, is that they discovered a new “lens” with which to view virtually everything that impacts ROI. And because of the multiplier effect embedded in the ROI formula, they created a way to get exponential increases in ROI. Each of these things is discussed below.
Looking at the ROI formula, we begin with Earnings as a percentage of sales, which is the results of Sales minus Costs divided by Sales. And Costs is the sum of materials, “labor,” overhead and delivery, whether those costs are classified as production, sales, or administrative. In other words, it is Earning Before Interest and Taxes (EBIT). Let’s start with the Costs elements.
Accountants like to classify costs as production, sales, administrative and “other.” In reality, incurred costs are materials, people, facilities (buildings and machines) and other. In addition, many manufacturing companies still use standard cost accounting as their management accounting system.
Materials: In most companies, the production process generates a considerable amount of wasted materials. Such waste may occur because of poor product design or poor manufacturing practices, or both. Either way, materials are wasted. However, in many organizations, this is not recognized as the accounting system builds a “yield” factor into the material standards, based on historical averages. As long as the company stays close to that historical average, the accounting system shows little, if any, material usage variances. In other words, the waste has been institutionalized by the standard cost system and the small “variance” leads one to believe that there is “no problem.” If the typical manufacturing company’s material costs are 60% of cost of sales, and scrap is 5%, eliminating that scrap can improve cost of sales, and EBIT, by 3 percentage points. For most companies, this not insignificant. How do you achieve “right the first time” in order to reduce scrap? In a batch model lots of defective product can be made in a single process step, but not discovered until that batch is used in the next process step, which can be days, weeks, or even months later. By that point, thousands of items may be defective and in need of rework, if possible, or thrown away. As time goes by, the cause of the defects often becomes impossible to determine. When a lean strategy is used and flow lines are established, a defective product is discovered immediately and the amount of material wasted is close to zero since the stop-the-line discipline requires that a countermeasure be put in place before production can resume. Lean improves product quality exponentially and virtually eliminates wasted materials thereby improving the “earnings” element of ROI.
People: Although accountants in many manufacturing companies like to say that “direct labor” is less than 10% of their total costs, the reality is that the total “people cost” is the number one cost,, whether it is called “direct”, “indirect”, “sales” or “administrative.” Most companies do think of people as a cost. There are many historical reasons for this, but the bottom line is that this way of thinking has been codified in accounting rules. From an accounting perspective, many people are classified as a “period cost,” a “variable cost,” or a “flexible cost.” And since that’s how people are accounted for, that’s also how they’re treated. Almost every company says some variation of “people are our most important asset,” but when you see how they treat their employees, you realize that those are empty words. The historical management approach to people is to treat those cost as “variable” and to “right size” the workforce (hire/fire) in order to maintain people cost as a constant percentage of sales. In a people-centric company, people are the only asset that can appreciate. They are a Human Resource Capital. Other capital, such as buildings and machines, depreciate over time. Because lean creates a learning environment and people’s skills increase, people become more valuable. They learn how to improve their own work to eliminate the time devoted to non-value-added activities and free up their own capacity to do more value-added work. Lean empowers people to change the historical equation. People “cost” can be maintained as a constant amount so it becomes a variable percentage of sales. Because lean is a growth strategy, as discussed below, much of the increased demand can be satisfied by the existing workforce. Labor cost becomes a lower percentage of sales and profit improves. The definition of productivity is the quantity of output versus the quantity of resources required to produce that output. Over 10 years, Wiremold doubled the size of its West Hartford plant’s business without increasing the number of people employed in the factory. By teaching its people how to identify and solve problems, it achieved a continuous stream of annual productivity improvement in its people resource. The majority of the 13-percentage-point increase in Gross Profit at Wiremold, as shown in table above, was achieved by growing the business without increasing the number of people.
Facilities (buildings and machines): The annual period cost of facilities is merely an accounting phenomenon. The real cost is reflected in Investment and the period cost is a calculated depreciation of those investments based on their estimated useful lives. We will leave the discussion of facilities for the discussion of Investments below.
Other: This catchall category is made up of the true overhead items (e.g. supplies, energy, insurance, property taxes, etc). In total, the true overhead cost usually represents the smallest category, but can still yield significant cash savings. For example, and this is typical of many companies, each department at Wiremold purchased its own office supplies, with one person in each department responsible for this task. When these people were asked to participate in a kaizen event to look at supply usage with a goal of reducing their cost by one-third, the team’s improvement efforts resulted in a 48% reduction in the cost of supplies. There are many other examples of improvements in the use of these other resources and the amount of time spent on improving any one of them will depend upon its importance to the individual business. For instance, energy costs are substantial to a foundry and will be subject to considerable improvement efforts, whereas they are of lesser importance to some service companies and will have a much lower priority.
As a growth strategy, lean focuses on the regular, and relatively rapid, introduction of new products. Although growth can be achieved by winning market share from competitors (an expensive method since it can lead to price wars), the preferred method is to increase the size of the market via new products of higher value to customers and capture all of that market growth. When Art Byrne came to Wiremold, he established several goals, one of which was to double in size every three to five years: half by organic growth and half with selective acquisitions.
In actual fact, the company doubled in size in four years, again in another four years and was on its way to doubling the third time when it was sold in 2000. Wiremold focused on improving two complementary processes simultaneously: production and product development. It realized that if customers don’t believe promises of quality and delivery are fulfilled, they won’t listen to the story about new products. So the goal was to “fix the base” (i.e. customer service, production, logistics, etc) and accelerate new product development. By “improving the base,” its quality improved and “on time delivery” of less than 50% improved to 97%. Customers were then willing to listen to the new products stories. Thanks to the adoption of Quality Function Deployment (QFD), the new product introduction cycle went from years to months. Over time, the rate of product introduction speeded up from 2 to 3 per year to 4 to 5 per quarter. Wiremold went from a historical growth rate that was geared to GDP growth (typical of the US electrical industry) to accelerated growth. It made the size of the pie bigger. And yes, it also took some market share from competitors by developing products that offered more value for customers. When you look at the ROI formula, Sales is in both the numerator and denominator of the equation. Therefore, the need to accelerate sales growth is imperative.
Investment is comprised of Working Capital plus Permanent Investment (buildings and machinery). How can a lean strategy have a positive impact on each of these inputs?
Although the accounting definition of working capital is Current Assets minus Current Liabilities, as can be seen from the Dupont formula, for all practical purposes working capital is accounts receivable plus inventories minus accounts payable. Almost everything else in working capital is the result of some accounting rule (e.g. prepaid insurance, deferred taxes, etc).
Accounts receivable: If you were to ask most CFOs if they know what their accounts receivable days outstanding are, they can probably tell you off the top of their head without referring to any reports. However, if you ask them what they should be, based on the company’s sales terms, they will look at you with a blank stare. And there is no accounting report that will give them the answer. It is not uncommon to find companies with the number of days outstanding 50% or more than they should be, based on their payment terms. They consider that normal. When a company focuses on the root causes of late payment, it discovers that a small portion of it is caused by customers either in financial trouble or “stretching” out payment. The bigger part stems from customers that don’t pay on time because of a problem that the company created and has not solved yet. These problems are normally invoice discrepancies, short shipments, wrong product shipped, damaged product, etc. When the people working in the processes that cause these defects are made aware of them, and they are taught how to change their processes to eliminate those problems, customers pay on time. A medical equipment manufacturer, once it focused its attention on accounts receivable, reduced the number of days outstanding from 57.8 to 43.3 over an 18-month period: an improvement of 25%, generating a significant amount of cash.
Accounts payable: of course, a well-known way to reduce the cash drain of working capital is to delay payment to suppliers – something we see happen every time there’s an industry downturn. However, this is also the best way to lead the business into bankruptcy by disrupting the supply chain with unreasonable cash pressures. Good relationships are critical to have suppliers adhere to the just-in-time supply chain ideal of 100% on-time-delivery with as little inventory as possible, so increasing accounts payables is simply not a lean option and not considered here. If we expect vendors to deliver quality product on time, we need to pay on time.
Inventory: Even though inventory is classified as a current asset, for many companies it could be considered as part of its permanent investment (similarly to plant and equipment). For example, Wiremold’s historical inventory turns were 3.3 to 3.4 times. Even though the specific items in inventory sold (at sharply varying rates), the total amount of inventory on hand at any given time was about the same. We accepted it as normal.
In a traditional batch-and-queue environment, large quantities of individual parts are created or worked on at each step in the process. These large batches are typically moved to work-in-process storage areas between processes, resulting in products that have total processing time measured in minutes but that can take weeks to go from raw materials to finished goods. When Wiremold reorganized into value streams and moved equipment into flow lines within those value streams, the inventory between process steps was not needed. As discussed above in the section on materials, not only did this adjustment improve quality, but it also reduced the amount of inventory held throughout the process.
Wiremold’s lean strategy resulted in dramatic reductions in inventory levels. Its largest division, the Wire Management division, carried finished goods inventories because its distributors expected immediate shipment upon placing an order. In spite of this, inventory turns improved from 3.3 times to 18 times. That represents approximately a three-week supply of raw materials, work-in-process and finished goods on hand. Some of its other divisions, which supplied products to OEM customers and therefore carried no finished goods, had inventory turns in excess of 30 times. With regards to our ROI discussion, reducing inventory reduces investment.
Improving working capital by reducing accounts receivable through better handling of on-time-delivery and reducing inventories by making production processes more flexible (on-time-delivery improvement and inventory reduction go hand in hand in a lean transformation) often has a dramatic impact on the cash position, as the money used to finance the receivables and inventory is released. This cash windfall is usually the earliest sign of lean progress, and comes in handy to sustain further improvements. For instance, if in 1993 Wiremold would have had the same inventory turns that it had in 1990, it would have had $16.7 of inventory. Instead, the inventory had reduced to only $5.6 million, thus freeing up $11.1 million.
Permanent investment consists of machines and buildings and, although this is often forgotten, is at the heart of Toyota’s just-in-time thinking. Kiichiro Toyoda coined the term “just-in-time” in English in devising new ways to increase production without using more investment and specifically sought to realize his belief that “the ideals conditions for making things are created when machines, facilities and people work together to add value without generating any waste.” Just-in-time is a countermeasure devised to reveal wasteful use of investment, which, in turn, reveals that much of labor productivity is a result of investment productivity (and not the other way around).
Machines: For the past one hundred years or so, manufacturing has been driven by the ideas of division of labor (developed by Fredrick Taylor) and economies of scale. Both of these ideas have been codified in the modern standard cost accounting system that most manufacturing companies use.
The economies of scale thought process says, “If we can produce more units in less time, we can reduce the cost of the item and therefore justify a lower selling price.” In order to achieve this, companies invest in bigger and bigger machines capable of running at faster and faster speeds.
The lean thought process says, “Let’s build only what we need, only in the amounts that we need it and only at the time that we need it… and let’s do it in a flow that avoids work that doesn’t create value for our customer.” When we think this way we realize that most of the large machines (affectionately called “monuments”) are overkill for the task at hand.
During its lean journey, Wiremold encountered many examples of investment overkill. Here are three examples:
One of the fallacies that exist is the belief that a lean transformation is very capital intensive. In fact, this is what I initially believed myself, based on a prior bad experience. The first improvement kaizen that I was on after Art Byrne joined the company had a goal of reducing the setup time on a punch press from 90 minutes to 10 minutes. In the course of a five-day kaizen the team reduced set-up time on that punch press from 90 minutes to 5 minutes and 5 seconds, and only spent $100.
That doesn’t mean that all improvements are “capital free.” As can be seen from the Round Line example above, over a period of several years Wiremold spent $72,000, mostly on substituting over-sized equipment with right-sized equipment. However, this investment facilitated significant productivity gains (from eight people to one person), improvements in quality, reduced space consumption, reduced inventory, and reduced lead-time – allowing for improved customer service on a real just-in-time basis.
There is an interplay between human capital and machine capital. The normal justification for automation is the elimination of people costs. The ROI of the new machine is based on (a) less “direct labor” and its associated costs (like benefits), combined with (b) reduced piece costs based on higher machine speeds (i.e., more parts per hour). However, things are not always what they seem. In the 1990s, I visited the Stanley Tools plant where they made measuring tapes, one of their highest volume products. It was a “fully automated” assembly process and didn’t require any direct labor. However, during my visit, the machine was not running and there were two mechanics and two engineers working on it. When asked how much downtime they had on the machine, one of them said, “About two-thirds of the time.” Full automation generally introduces a level of complexity that creates costs that are hidden by the accounting system. In this case, the manufacturing engineers and mechanics were accounted for as “overhead” and their cost spread around the entire plant via overhead allocation formulas. The real cost of running that machine was hidden, but everyone thought it was wonderful because it did not require any “direct labor.” Many companies have experienced the pain of inflexibility that full automation brings. In spite of this, they still use faulty ROI calculations to justify expensive automation solutions that fail to deliver as promised.
Traditional management theory, with its focus on specialization, vertical organizational structures, economies of scale, and manufacturing planning software, drives overinvestment. Standard cost accounting reinforces this type of decision-making and hides the real problems that are created.
Buildings: Lean companies free up so much space within their facilities (thanks to flow processes that require less inventory) that they quickly discover they can grow the business well into the future without adding any new buildings. This falls into the category of “investment avoidance,” but in the long term can have a significant impact on the company’s total investment base, and therefore ROI.
In summary, how does a lean strategy work to improve a company’s ROI?
Adopting a lean strategy enables a company to improve the utilization of every element that goes into the ROI metric calculation. This strategy generates enormous amounts of cash. Naturally, if it just stays in the bank it’s not providing a lot of additional benefit. In fact, total investment stays the same: it’s just that more of it is in cash. As mentioned at the beginning of this article, the second leg of Wiremold’s growth strategy was to double in size every three to five years. This was achieved through accelerated new product development and selective acquisitions and is the right way to use the cash that is generated.
Time is the currency of lean. When we talk about the waste of “labor,” we are talking about the waste of time, the waste of capacity. As we eliminate the sources of wasted time we free up people and machine capacity, so that when sales volume increases we have the means to satisfy that demand without having to hire more people or buy new machines as soon as we would have otherwise. We have made our existing capital structure – both human capital and machine capital – more productive, which finances growth. With this in mind, there should be no doubt left that lean is a growth strategy that provides exponential increases in ROI.
Orest (Orry) Fiume was vice president of Finance and Administration and a Director of The Wiremold Company, West Hartford, Connecticut, which gained international recognition as a leader in lean business management in "Lean Thinking." Orry led Wiremold’s conversion to lean accounting in 1991 and developed alternate management accounting systems that supported the company’s entire lean business efforts. He has studied lean production in both the U.S. and Japan and has been a guest speaker at conferences around the world. Orry is the co-author of the 2004 Shingo Prize winning book Real Numbers: Management Accounting in a Lean Organization.
Michael Ballé is co-founder of the Institut Lean France. An associate researcher at Telecom ParisTech, he holds a doctorate from the Sorbonne in Social Sciences and Knowledge Sciences. Michael is a best-selling author and an engaging speaker, and managing partner of ESG Consultants. He also works as a lean executive coach in various fields, from manufacturing to engineering, services to healthcare.
Daniel T Jones is co-author of the seminal books The Machine that Changed the World, Lean Thinking and Lean Solutions; and co-founder of the lean movement. He is founding chair of the Lean Enterprise Academy in the UK.
Jacques Chaize is ex-CEO of Danfoss Socla, co-founder and vice president of SoL France and author of Quantum Leap.