Real vs Fictitious Improvement

A firm I visited with the other week took delight in showing me some of the shop floor improvements they had made. And it looked impressive – improvements in setup reduction, workplace organization, and flow improvements. Questioning revealed some deeper problems, however.

When I asked if the firm had reduced the number of workers, the answer was that it hadn’t – the same number of production associates were still employed by the firm. When I asked if sales had increased as a result of the improvements, a similar answer: sales were at the same level as before; however, they had freed up some floor space,  they were changing the equipment over faster, and the better flow meant they were accumulating “better levels” of finished goods inventories.

The conclusions I made from these simple questions were the following:

1. The firm’s total revenues were unchanged.
2. The firm’s total variable costs were unchanged.
3. The firm’s total fixed costs were unchanged.

Bottom line: despite the improvements, this firm had not improved its profitability (Profit = Total Revenue minus Total Costs.

Sadly, this picture gets replicated in many firms: process improvements do not result in better economic performance. In some cases, economic benefits that are claimed as a result of improvements are fictitious – they are the result of changed accounting allocations or costing practices.

Real improvement results in economic, not technological, efficiency. Improvements must shift a firm’s supply and/or demand curves. If that doesn’t happen, it wasn’t real improvement and it won’t improve the firm’s profitability.

Simple Economics and Lean Production

Over the years, I’ve come to adopt a basic operating practice: the economics of a firm first, and improvement tools and methods second. I’ve done this for several reasons. First, because I want to avoid falling into the trap of using tools and methods without knowing if they are appropriate or suitable. And, secondly, because I want to have a framework for analysis which allows me to think through a firm’s situation and problems, and which will give me some way to predict the impact of my interventions on a firm’s costs, revenues, and profits.

Without knowing about Lean, if one has a good foundation in microeconomics, one can logically arrive at Lean-type thinking. Profit maximization implies cost minimization, so when working to improve a firm’s profits, one needs to think about getting behind the firm’s supply curve to start working on making its production technology more efficient and effective. This naturally leads on to looking at the sources of variable costs in the short run, and how to improve the marginal product of labour. From here, we can then get into the sources of inefficiency and begin attacking those systematically – things like defective production, setup and changeover times, machine availability, inventories, etc.

What I try to avoid in all of this is using “Lean” as a hammer with which to attack every type of problem within a firm. We really do need to get beyond the current mania and fixation on “labels” and begin thinking more fundamentally and coherently about business problems. For me, placing things in a microeconomic context works, and gives me a framework for analysis without trapping me within the confines of a toollbox or label.

Production Costs

A firm’s production function defines the relationship between the quantity of inputs the firm uses and the quantity of output it produces. A firm’s production function underlies its cost structure.

More particularly, in the short run, because at least one input is fixed (usually capital), the production function shows the relationship between the variable input (usually labour) and the quantity of output.

What’s really important here is the  marginal product of labour (MPL) – the additional quantity of output that would result from using one more unit of labour. There are usually always diminishing returns to using more of the variable input – as each additional unit of the variable input gets less of the fixed input to work with, the marginal product of that input declines.

Since variable costs (the cost of the variable input) depend upon the quantity of output produced, an economically efficient production system would always minimize the amount of variable input needed to produce the desired input quantity. Another way of saying this is that each unit of the variable input employed must have as much of the fixed input to work with as possible. Simply put, the MPL is higher when any given unit of labour has more of the fixed input to work with.

Because total costs are the sum of fixed and variable costs, the slope of a firm’s total cost curve gets steeper as output rises. Why? Because of diminishing returns to the variable output – more labour (and hence more cost) is being incurred, but the marginal product of that labour is decreasing.

When we talk about waste and non-value adding activity, we are really talking about those activities which prevent a unit of variable input from maximizing its use of the fixed input. For example, when workers have to set up machines, those workers cannot work with the fixed input to produce output. As a result, variable costs are increased and the MPL is decreased.

A production function can be looked at in two ways. One way is to consider, from the total set of all technically feasible combinations of inputs and output, which combination produces the maximum output for a specified set of inputs. A second way is to view the production function as the specification of the minimum input requirements that are needed to produce designated quantities of output, given the available technology.

As I noted in the previous blog, because firms are profit-maximizing entities, for any given quantity of output a firm must strive to implement an economically efficient production technology where costs are minimized. If costs are not minimized, then profit is not being maximized. This is the whole rationale for the continuous improvement of a firm’s production technology.

Machines and Workers

Observing processes that use machines together with workers is often an enlightening experience. To be sure, the usual problems can often be seen: high setup times, unplanned stoppages, defective production, etc. Yet, in almost every case, there is a deeper issue that goes unnoticed: the wasteful use of the human resource.

When workers are brought together with machines, in the short run we are really bringing together a variable input (labour) with a fixed input (the machine, which is physical capital). Since the machine is the cost of a fixed input (a sunk cost if you will),  it is the cost of the variable input – the worker – which is critical when one is trying to minimize the costs of production.

Firms are profit maximizing entities. To maximize profit, for any quantity of output, costs must be minimized – if a firm is producing its output without minimizing its costs, it cannot be maximizing its profit.

Because fixed costs in the short run are really sunk costs, cost minimization really means minimizing variable costs. Since labour is usually a key variable cost, a key question to ask, therefore, is what are workers doing when they operate machines? If we are using more variable input than we need to work with the fixed input, we really have an inefficient production technology.

Many firms focus on setup reduction. Setup reduction supports small batch processing and allows a firm to move through a mix of products easily because changeover times are low. It also reduces the variable cost (labour) that is required to work with the physical capital to enable it to become productive.

However, we should look beyond setup reduction for opportunities to reduce variable costs. To accomplish this, we should be looking at what the worker is doing once the physical capital (the machine) is working.

All too often, we see workers setting up machines, starting the cycle, and then doing little else while the cycle runs to completion. This is an inefficient and unproductive use of the variable input and drives up costs. Economic production where costs are minimized requires that operator time be separated from machine time – while machines are running, operators can do other things. Such separation can be achieved by adopting cellular manufacturing principles and modifying equipment to make it less dependent upon close operator attention (for example, installing automatic load/unload).

Many production environments use machines which have a high degree of automation and, once set up, are able to run without close attention by the operator. Depending upon the length of the cycle time (the time during which value is being added), workers can use this time to perform other tasks, perhaps setting up or running a similar machine which is located close by.

This insight is at the root of cellular manufacturing and autonomation – two lean production concepts which can reduce the amount of variable input required, if applied intelligently.

In a capacity-constrained environment machines should be working productively as much as possible. These machines should be attended to by the least number of workers possible. Setup times should be low, but firms should keep in  mind the potential for further reducing variable costs beyond just achieving lower setup times.  As much as possible, workers and machines should be decoupled to permit greater utilization of the variable input, thereby reducing the amount of variable input needed along with its cost. Economic production results when costs are minimized, not when output is maximized.

Clusters and Externalities

Particular areas or regions within an economy often have groups of firms specializing in the development and production of a particular product located close together – industrial clusters, as they are called.

While it seems logical that firms engaged in producing similar products might want to locate together, the deeper economic reason for doing so is the fact that externalities are created. These externalities are primarily the result of the free flow of ideas that occurs between member firms in the cluster. These externalities are knowledge spillovers that result from research and development activities among the firms. This externality is further reinforced by worker mobility and concentration within the cluster region – when workers change firms or meet casually, ideas and knowledge are more likely to be exchanged and discussed.

The presence of a signficant group of firms having a common focus within a region gives rise to a common skill set among workers that the cluster members find valuable. These common skills create an additional externality that is another source of advantage to the cluster.

It is the total set of externalities working together which allows the cluster members to enjoy cost reductions and a higher rate of product development than they would otherwise.

Wrong-Headed Notions of Efficiency

Most firms strive to be efficient in their operations. Few, however, distinguish between technological efficiency and economic efficiency.

Technological efficiency is when a firm strives to produce the most output with a given set of inputs. Economic efficiency, on the other hand, is when a firm produces its output at the least cost.

Because firms are profit-maximizing entities, profit maximization implies economic efficiency. If a firm is nor producing its output at the least cost, then it is not achieving its profit-maximizing potential.

Consider a firm that makes widgets and has the choice between making the widgets in either a  manual labour and some equipment, or in a plant which has more automated equipment and fewer workers. Either of these production systems could be deemed to be technologically efficient, provided there is no waste. However, neither would necessarily be economically efficient.

Firms should consider which of the production systems they could choose to employ is the most economically efficient. the one which is the most economically efficient will be that which produces output at the least cost.

The current acceleration of the use of robotic technology in manufacturing plants is due to the fact that this technology has now become economically efficient. Until relatively recently, robots were quite expensive – firms that employed them could not produce at the lowest cost as it was still more profitable to use labour in place of robots. Now, robotic technology has reached the point where its cost does support economic efficiency and increasingly firms can be expected to move in this direction.

When firms downsize, they are really revealing their lack of economic efficiency. The fact that they could produce their output with the excess labour means that they were not operating with economic efficiency.

Economically efficient supply always involves making choices about how best to combine labour with capital so that costs are minimized.

Diminishing Returns

Total costs in a business are composed of fixed and variable costs. These costs are attributable to the costs for fixed and variable inputs. The total cost function for most businesses is non-linear, as costs are subject to the law of diminishing returns. That is, as a firm increases its use of one factor of production while others remain constant, the output will decrease after a certain point.

For example, consider the two most basic and common inputs for most firms: labour and capital. Labour is a variable cost in the short-run – the quantity of labour employed will vary according to a firm’s output. Other short-run variable costs include raw materials and energy, Capital, in contrast, is a fixed factor in the short-run – firms cannot readily adjust the size or number of their plants and facilities, etc. As the variable factor (labour) is added to the fixed factor (capital), a firm’s output will rise and then eventually fall. It will fall because, at a certain point, there will be too much labour and it will be inefficiently combined with the fixed factor input, causing output to fall.

Unless a firm is going to eliminate all of its fixed costs, variable costs usually have the greatest potential for cost reduction in a firm. Lean production methods can allow a firm to reduce the amount of variable input it requires to achieve a given level of output. Using less variable input reduces the costs associated with this category of input.

At Anderson Lyall Consulting Group, we have developed a framework for analyzing, modeling and predicting the impact on profit from using Lean methods to reduce variable costs. While cost reduction is important, it is not the only factor that should be considered : depending on a firm’s situation, increased revenues through higher sales volumes may also be achievable. With any improvement intervention, the focus should always be on impacting a firm’s bottom line, not on using tools or a toolbox. Improvement must always be rooted in economics because firms are profit-maximizing entities.

Stewart Anderson

stewart@andersonlyall.com

www.andersonlyall.com

Creating Customers

Walking into Chapters last evening and seeing the size of the business books’ section reminded me of the sheer volume of business information available. There is something on just about every business topic you could imagine, and then some.

Yet is this a good thing? Often, our quest for business knowledge takes us down compartmentalized paths where we can easily forget what the real purpose of a business is: to create and keep customers (Peter F. Drucker).

I am almost tempted to offer a truism, Anderson’s Law, if you will: if whatever you are going to do in your business helps you to create and keep a customer, then it is right and good.

Too often, we forget about creating and keeping customers. Many business decisions and actions seem remote and unconnected from this basic purpose. Yet, if we do not keep that end in mind, we can quickly find ourselves trapped in a cul-de-sac where we are no longer connected to the real purpose of a business.

All business decisions and actions should be rationalized according to how well they help fulfill Drucker’s dictum. If any course of action you are contemplating taking has little or no obvious connection to helping your business create and keep customers, then maybe it’s time for a rethink.

Segmentation

There are differences between customers and customer groups (market segments). When a firm serves all its target segments with the same uniform product, it fails to exploit these differences. In addition, because all the segments are served with the same product, segments which incur a higher cost to serve are “buried” due to cost averaging.

Identifying the differences in costs to serve and user needs between segments allows a firm to improve its profitability. Segments with specialized needs (and therefore higher costs to serve) can be served with a product or service more tailored to those needs, extracting a price premium in the process. Segments with particularly high costs to serve and limited volumes can be identified and perhaps dropped from the customer portfolio.

How a firm segments its market is critical to profitability. Standard methods of segmentation, such as grouping customers by industry, may obscure the particular needs of a customer group. If an entire industry is using the same method of segmentation, this problem may be pervasive, leading to unmet or underserved needs. Using a different method of segmentation can open a new window on these needs and provide significant opportunities for differentiation.

“Average” segmentation leads to average costing and average pricing. Profitability is diminished by failing to offset higher costs to serve with a price premium. This is a trap to avoid.

If You’re Going Lean…

…then I want you to show me explicitly how you are going to improve your firm’s profitability with Lean. No, I don’t mean by telling me about all the great tools and techniques of Lean – I want to know how you will change your firm’s supply and/or demand curves in a way that improves profitability.

This is a deep question that goes right to the heart of the economics of a firm. If we are going to change some aspects of a firm’s business system, we need a microeconomic  framework for analysis that allows us to predict what the impact on profit will be. If we can’t do this, we are only playing games and guessing.

Why is profit important? Simply because profit is what sustains a firm, and firms are profit-maximizing entities.

Lean should impact on a firm’s production function, inputs and costs – the stuff that determines the firm’s supply curve. It may also impact the firm’s demand curve. A good microeconomic framework allows us to analyze these changes and predict how profit is likely to be impacted. Not only that, the framework allows us to assess progress along the way and determine what changes might need to be made in the implementation.

Too much Lean is implemented without being grounded in a microeconomic framework. It becomes a technical exercise and people are seduced by the attractiveness of the tools and techniques. Let’s not forget that the tools and techniques serve a purpose and that their application should positively impact and help sustain a firm’s bottom line. So, what’s your microeconomic framework for analysis when it comes to applying Lean?

Stewart Anderson

stewart@andersonlyall.com

http://www.andersonlyall.com