The Economics of Lean Production

Quality Digest has just ran my recent paper, The Economics of Lean Production (

A few additional comments to that paper are in order. First, lean adherents don’t like to position lean as a cost reduction exercise. Rather, they like to think of it as increasing a firm’s ability to add value. Yet, the economics of lean are truly grounded in improving profitability by reducing a firm’s average total cost of production, as my paper shows.

Lean adherents get confused by equating adding value with eliminating waste. reducing or eliminating the non-value adding activity in a process or system does not necessarily improve its ability to create additional value. Value is a strategic concept, not an operational one.

Secondly, I’d add that the danger with approaches like lean is that fundamentally every lean initiative is an attempt to copy what someone else (Toyota) has done. This goes against thinking, inquiry, and learning. The tools and techniques of the Toyota Production System (TPS) are solutions that Toyota developed to address a specific business problem. If you don’t have that problem, those tools and techniques may not be applicable in the same way as they were for Toyota.

Having said this, lean as a philosophy and set of principles is valuable – provided it is approached in the right way. Organizing your business around value and the capabilities needed to create value can point in the direction of appropriate lean tools to use. But let’s not confuse strategy and tactics.

Rereading Keynes

Keynes should be required reading for any serious student of macro. Keynes’ General Theory is not an easy read, but the insights are brilliant and logical reasoning a joy to follow.

Today Keynes is held by the establishment to be all about deficit spending and left-leaning ideas. Actually, the contrary is true, as anyone who reads the General Theory will conclude. Keynes did advocate government spending as a way out of recessions and depressions, but he also advocated fiscal prudence and, dare I say it, austerity, in good times.

In addition, anyone who thinks Keynes was a left-leaning socialist would do well to read the following excerpt:

In some other respects the foregoing theory is moderately conservative…. The State will have to exercise a guiding influence on the propensity to consume partly through its scheme of taxation, partly by fixing the rate of interest, and partly, perhaps, in other ways. Furthermore, it seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment…. But beyond this no obvious case is made out for a system of State Socialism….

[If we] succeed in establishing an aggregate volume of output corresponding to full employment as nearly as is practicable, the classical theory comes into its own again…. [T]here is no objection to be raised against the classical analysis of the manner in which private self-interest will determine what in particular is produced, in what proportions the factors of production will be combined to produce it, and how the value of the final product will be distributed…. [T]here is no objection to be raised against the modern classical theory as to the degree of consilience between private and public advantage in conditions of perfect and imperfect competition…. When 9,000,000 men are employed out of 10,000,000 willing and able to work, there is no evidence that the labour of these 9,000,000 men is misdirected. The complaint against the present system is not that these 9,000,000 men ought to be employed on different tasks, but that tasks should be available for the remaining 1,000,000 men. It is in determining the volume, not the direction, of actual employment that the existing system has broken down….

[T]he traditional advantages of individualism will still hold good. Let us stop for a moment to remind ourselves what these advantages are. They are partly advantages of efficiency — the advantages of decentralisation and of the play of self-interest. The advantage to efficiency of the decentralisation of decisions and of individual responsibility is even greater, perhaps, than the nineteenth century supposed…. [A]bove all, individualism, if it can be purged of its defects and its abuses, is the best safeguard of personal liberty… greatly widens the field for the exercise of personal choice… best safeguard of the variety of life… the loss of which is the greatest of all the losses of the homogeneous or totalitarian state. For this variety preserves the traditions which embody the most secure and successful choices of former generations; it colours the present with the diversification of its fancy; and, being the handmaid of experiment as well as of tradition and of fancy, it is the most powerful instrument to better the future.

Whilst… [the policies I recommend] would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism. I defend… [them] as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative.

For if effective demand is deficient… the individual enterpriser who seeks to bring these resources into action is operating with the odds loaded against him. The game of hazard which he plays is furnished with many zeros, so that the players as a whole will lose if they have the energy and hope to deal all the cards. Hitherto the increment of the world’s wealth has fallen short of the aggregate of positive individual savings; and the difference has been made up by the losses of those whose courage and initiative have not been supplemented by exceptional skill or unusual good fortune. But if effective demand is adequate, average skill and average good fortune will be enough…

Plan-Do-Fix or Plan-Do?

Much of the difficulty with change that I see in organizations I visit is related to the inability to adequately plan for change. Poor planning up front results in poor execution with a resultant need to spend time fixing what should have been foreseen in the first place.

Planning is a management function. Before one can plan, however, one needs to understand what it is that is being changed and why. This is where most change planning goes awry.

Japanese firms, like Toyota, front-load their change process by spending, what seems to Western firms, an inordinate amount of time to investigate problems and plan the needed changes. This approach pays huge dividends, however, because when it comes to execution, the right solution to the right cause has been identified and thoroughly planned in terms of implementation. It is rare in firms like Toyota to see an improvement team spending time fixing problems which are due to poor planning.

For the Western mindset, the Japanese approach to change and improvement seems slow and bureaucratic. Western managers like to “get things done” – to impel people into a frenzy of action, no matter whether that course of action is the right one or not.

At Toyota, employees are trained to solve problems in the work and implement solutions in a structured way. The Toyota A3 process provides that structure and guides employees in the think-through of problems and solution implementation. Most importantly, the A3 process shows management that the problem has been thoroughly investigated, and the root cause understood, so that solution planning can be undertaken in confidence. When management is not satisfied that adequate investigation and thinking has been given to a problem at hand, or that the solution developed may not necessarily be the best one, employees are urged to go back and restudy the problem to craft a superior solution

The net result of this approach is that, at Toyota, most change and improvement initiatives consist of Planning and Doing, with no back-end time spent fixing things which should have been caught in the planning process. Sometimes you have to slow down in order to go fast!

Retail Hell Redux

The airing of CBC’s Marketplace on Friday night highlighting the appalling customer service in Canada’s retail stores highlights what we here at Anderson, Lyall Consulting Group have known for several years: retailers have lost all touch with their customers and what they value.

While Marketplace was useful in detailing examples of poor customer service, the program showed the symptoms, not the causes.

After viewing Marketplace we ask, how can firms like Wal-Mart, Canadian Tire, and Zellers so lose touch with their customers and what they value that they are prepared to risk the very sustainability of their businesses? The blame for this must be laid squarely at the feet of top management. If top management does not care how it creates and keeps customers, there is little that lower-level employees can do.

This is a strategic issue. Poor customer service results from a firm’s top management failing to define and embrace the firm’s purpose and translate that into an effective business strategy that aims to create and retain customers. Too many retailers are pursuing a race to the bottom by competing with each other on price without having in place a value chain that enables the low-cost structure that in turn enables low price. Under such a simplistic strategy, customers must suffer because firms must trim costs directly related to customer service in oder to price with the industry cost-leader.

What the Marketplace program showed is that there is a limit to how much a retailer can cut costs before directly harming customers. Due to the uniformly low-level of customer service, customers are seeking value other than low price. Retailers need to think through what the differentiated value is that they need to innovate and provide to create and retain customers. Low prices achieved through non-existent customer service is no longer good enough.

Pricing Axioms

Determining the price at which a good or service is offered for sale is one of the most important decisions for a firm.There are many different inputs into the pricing decision: price relative to costs; the frequency of price changes; pricing relationships between different products; etc. With good decision-making, pricing can be an important competitive weapon. On the other hand, bad pricing decisions can erode a firm’s competitive advantage and its profitability.

Good pricing decisions flow out of a sound and comprehensive understanding of a firm’s economics. Below are some pricing axioms that can be used to guide pricing decisions:

  • A key ingredient in a pricing strategy is a forecast of competitive responses from current and future competitors.
  • Price cutting is a more effective strategy for goods and service which have elastic demands.
  • Information symmetries about prices in a marketplace erode the effectiveness of a firm’s pricing strategy.
  • Excess capacity and large inventories favour price cutting.
  • Smaller competitors benefit more from price cutting than the dominant firm in an industry.
  • Price cutting is a more effective strategy for firms which possess a cost advantage.
  • Penetration pricing, based on moving down the experience or learning curve, work best when the firm has a first mover advantage.
  • Threats to cut pricing will work best when industry exit costs are high.
  • Holding down prices through limit pricing can deter entry by signalling that a firm has lower costs than it actually does.

Thoughts on Austerity

Economist Don Drummond, tasked by the Ontario government to make recommendations for reducing the provincial government’s budget deficit, has served notice that his forthcoming report is likely to engender an angry response from the public. Reading between the lines, Drummond is serving notice that he will be proposing deep program and spending cuts which will not be to everyone’s liking.

Drummond’s mandate did not include examining tax increases. While he acknowledges that tax increases should be discussed, the fact remains that his recommendations will be almost exclusively biased towards austerity.

There are a few points to be made here. First, as Drummond acknowledges, increasing taxes to offset deficits is likely to be a disincentive to striving for greater efficiencies in the provincial public service – the waste will be left “baked in”, so to speak, and covered up with increased revenues from taxes.  In a word, with higher taxes, it would be business as usual in provincial public service operations.

Secondly, if the above proposition is true, so then is its corollary in the private sector. Reducing corporate taxes is likely to be a disincentive for firms to strive for greater efficiencies – firms can increase their NOPAT and retained earnings without doing anything else other than simply paying less taxes.

The concept of efficiency needs to be understood and communicated with much greater precision of meaning than it currently is. When we say something needs to be made more efficient, we need to be clear about we mean. Do we mean producing more output with the same inputs? Or producing the same output with less inputs? And what inputs, specifically, do we mean to reduce?

This is critical, because in the majority of cases, in both the private and public sectors, the greatest input factor cost is labour. So, when we are talking about efficiency increases we are usually talking about reducing labour costs, which can only be achieved by either reducing salaries or downsizing, either through layoffs or attrition. Since wages are sticky due to employment contracts and the like, layoffs are likely to be the preferred methods of achieving lower labour costs.

In the public sector, it is difficult to see how these efficiencies can be obtained without program reductions or cuts necessitated by downsizing. Surely the time has come for honest and open discussion about what austerity really means and what its implications are. Covering up the real implications of austerity under the code word of “efficiency” is both deceptive and dishonest.

Form Must Never Drive Function

How is your firm structured and organized? I’m willing to bet your firm is likely to be organized around departments and functions – the purchasing department, the finance department, the admin department – the list is almost endless. Yet, consider how work flows through a typical firm – the execution of work usually requires resources drawn from various departments working together. In word, work flows through processes, not departments or functions.

Organizational structure is a key determinant of the economic performance of a firm. Where the focus is on managing departments and functions, a firm is likely to pay an economic price in lessened efficiency due to the miscoordination which results when work crosses departmental boundaries. Departmental walls represent boundary constraints on the efficient execution of work.

The form (structure) of an organization should always be subordinate to function (what the organization needs to accomplish). Where form assumes primacy it constrains the execution of work and results in silos led by turf tyrants. This is economically inefficient and ineffective.

Organizational structure should be designed by considering what functions the firm needs to carry out. Function should always drive form, in other words.

Japanese firms offer an interesting study in contrasts which achieves greater economic efficiency. While Japanese firms often have taller hierarchies and greater apparent centralization than Western firms, they place much more emphasis on delegation and de-centralized decision-making than Western firms. This follows from their superior understanding and appreciation of process over form – an appreciation that enables them to execute work more efficiently and effectively than most Western firms.