Posted by: knightbird | February 8, 2015

The Compounding Detriment of Waiting to Implement Lean Improvements

I am writing this Post without reference to a specific company, but I do have knowledge of circumstances from a company on which this discussion is based.

A general rule of thumb for lean implementations done correctly is that you should gain improvements in cost and productivity in the area of 50%. Many leaders that I tell this to are skeptical. They have no experience in true operations.

A business loss has a compounding effect that is not reflected on a profit and loss statement, and that is the lost opportunities generated by that loss. What are those lost opportunities?

First is the actual loss. If $10 million is lost in year one of a five year period of analysis, we can make an assumption that the loss will impact the company for years. $10 million is just gone. If we expect to make a profit of 10% on our invested capital, we have just diminished our earnings capability for the next 4 years by $4.641 million. The original $10 million loss has ongoing consequences. We cannot recover from that loss. We now have $15.641 million less than we would have had without the loss. The loss of $10 million, not realizing the $1.0 million we should have earned on it, and the compounding losses based on the $11 million we lost in the base year are considerable. We can never recapture that value.

The same is true when we consider the detrimental impact of failing to make improvements in our ongoing performance. Let’s assume we have $100 million of revenue in our business, and we expect a 10% average annual return-$10 million in earnings. If we can achieve a 10% gain in productivity that reduces our costs by the same amount of 10% (assuming no new revenue), we now attain $10 million of additional earnings. We have the same level of loss by failing to be as efficient as we can be. In other words, we only realize $10 million in earnings when we should be realizing $20 million. In this scenario, management has failed you. Yet we don’t base our rewards on an analysis of what could be, but only what is.

The skeptics among you say it’s not possible to gain 10% in productivity. I say you don’t know enough to make that claim. The math is sound in both cases. In the loss scenario, if our assumptions are correct about the average annual rate of return, you know the loss is $15.641 million. I have reported that Virginia Mason Medical Center went from a negative fund balance (their profitability measure as a non-profit) in 2002 to over $40 million in positive fund balance in 2008. And Alaska Airlines has reported that every 1% increase in productivity yields $11 million in profit. Both companies have been engaged in Lean management since 2002 and 2004.

When you put the two measures together, we have been royally screwed. By losing $10 million in the base year, and by failing to achieve a 10% productivity gain, we have doubled our losses in the five year period of time. Our lost opportunities, real and unrealized, exceed $30 million. Yet all we do for the next year after the $10 million loss is celebrate any turn around that might have happened. 5 years later, we don’t even recognize that we could have had over $30 million in benefit.

This happens every year to companies that lose money, and fail to implement Lean Management. Why do we reward executives for this kind of poor performance? I have to say I can’t explain why. If an executive has not implemented Lean in their business, we are rewarding them for managerial incompetence.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Categories

%d bloggers like this: