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Jason Furness


Three Scenarios for Financials-Based Improvement

Are the desired changes actually worth the effort?

Published: Thursday, April 13, 2017 - 12:01

In a previous column based on our recent book, Manufacturing Money (Amazon Digital, 2015), we explained how to maximize ROI. Here we describe some changes that business owners and managers can make on their way toward becoming a Black Belt in a manufacturing and distribution business.

Before any changes occur inside any of our clients’ businesses, we collaborate with them to understand the possible financial impact of the changes in as much detail as possible before we begin. This is done for two reasons.

1. We want to establish a current “measure of success” so we can have fast feedback about the results of our actions. If you are doing any sort of improvement project that is unable to rapidly show an improvement (e.g., days, or a few weeks) in the financial performance of the business, then I have to say that it may be the wrong program for your company, or it is not being executed correctly. The measures of success will help you confirm this along the journey. Long gone are the days where you could undertake a two-year program of “cultural change” and accept that there will be no financial benefit for at least 18 months.

2. Before beginning, you really should determine if the desired changes are actually worth the effort. If the changes you wish to make are only going to have a marginal effect on the financial performance of the business, then why bother? It is extremely good business to sit down and “war game” the impact of the changes before you start.

We will now war game some scenarios.

Scenario No. 1: Stock reduction, how it’s often done

Stock reduction is a great way of rapidly lifting your return on investment. It is often done; I have done it many times in the past and will do so again in the future. However, a word of caution: Reducing stock in isolation of other business processes can have disastrous financial effects and even larger impacts on other areas of the business.

This is a common scenario. I have been through similar scenarios, and you many have also:

Example Co.’s head office has decreed an immediate 50-percent drop in all stock levels. The CFO has been monitoring the stock levels, and from the balance sheet they can see there is $100K being held in stock. They wish to free up $50K of this value. Purchasing is instructed to restrict raw materials purchases. Operations is told that it must still supply all of the orders. Sales is often kept unaware of the decision because it really is an operational issue.

There are no changes to the way operations processes the orders or materials; everyone is told to work harder and get better.

In the beginning there is no real difference. Some processes slow down or are idled to allow the stock to be consumed. Labor levels are not changed because the rate of production is expected to return to normal once stock levels are reduced. Other overheads do not change, and neither does freight. The time it takes for an order to move from the beginning of the process through to the warehouse for dispatch is unchanged.

The first sign of a problem is that customers who are used to ordering from the finished-goods stock place an order, and instead of the warehouse being able to dispatch the order immediately, it must to wait for stock from production. This means that the lead time from order to delivery has increased. The protective buffer of finished goods has been reduced, which was the intent, and now customers will receive goods only after their orders have been processed.

Customers that have been used to receiving product within the normal lead times start to complain. They will ring their sales representative, who may be unaware of any changes. The noise from the sales rep makes its way up the chain, and then back down again to the production manager. The production manager says that they need to purchase more raw materials in order to refill the stock levels.

Customers are unhappy and vocal. Sales are irate because they can’t book a sale without an invoice, and you can’t create an invoice without stock. Production is being kicked everywhere. Sales have been missed; the company has been unable to invoice $50,000 in sales due to its inability to supply.

Figure 1: Financial statements, before stock reduction. Click here for larger image.

Figure 2: Financial statements, after stock reduction. Click here for larger image.

Figures 1 and 2 compare financial statements for Example Co. to illustrate effect of the stock reduction. You can see that net profit before tax has reduced, cash flow has reduced, sales have reduced, return on sales has reduced, ROI has reduced, and the standard product cost/unit has increased.

This was not the intent of the exercise.

Without a change in the fundamental process by which production occurs, the stock level cannot be maintained at this low level while maintaining high customer-service levels as before.

Decisions will need to be made. Either stock levels will be returned to previous levels, or customer service levels will be allowed to decline—and no one is happy. Customers will look at alternatives. The production manager has a miserable life; at the next operations review, the production department will be castigated for the low service levels and the increased costs.

However, stock reduction that drives greater customer service and improved profitability, while simultaneously reducing costs, can be achieved, as scenario No. 2 describes.

Scenario No. 2: Stock reduction, the right way

Example Co. seeks to improve its return on investment by reducing the cash held in stock. The company is adamant that this change must not have any negative impact on its customers. In order to have a lower level of cash tied up in the order-to-delivery process without hurting the customers, the speed of the order-to-delivery process must increase.

Figure 3: Financial statements after stock reduction, the right way. Click here for larger image.

The financial statements can be seen in figure 3. Again, you see the reduction of the raw materials purchasing, and the drop in stock. However, the financial metrics all improved, as did cash flow.

The key driver of this was that the changes were implemented without reducing sales. Hurting sales is absolutely unacceptable.

Scenario No. 3: Buying new equipment

A common scenario is that a business makes a decision involving the purchase of new equipment. The motivations for buying new equipment can be many. Reducing costs, improving efficiencies, and opening new market opportunities are among the most common reasons.

Should the company buy the new piece of equipment?

The only sensible answer is, “It depends.”

The company should make sure it models the impact of the new piece of equipment through the financials, and make the decision that way. I have seen it happen too often—a “rush of blood to the checkbook” during a machinery exhibition or over a very nice dinner and a few bottles of red.

Figure 4. Buying new equipment.

Figure 4: Buying new equipment. Click here for larger image.

In this scenario, we will build on the original model (refer to figure 1, Before stock reduction). A piece of equipment will cost $50K that is paid in cash, a $10K reduction in labor costs is expected, and a scrap reduction that would reduce raw material purchases by 5 percent, or $20K.

As you can see in figure 4, during the first year, the financial performance deteriorates. This is not surprising, really, because the cash outflow ($50K) is greater than the savings. In this case I would be dubious about buying the equipment; cash flow is reduced, and net assets increase. However, the longer-term cash flow benefits of the equipment might outweigh the initial negative cash flow impact, but this would have to be assessed carefully on a case-by-case basis.

We have looked at three scenarios, constructed financial statements for a fictional company, and calculated some measures of financial performance that consider the global performance of the business. You should now be able to perform simple “what if” analysis about the financial effect of the strategies and actions you plan to undertake, ideally before financial commitments are made.

Financial statements are most  effective when used as “global” measures. That is, they look at the entirety of a business operation. This is what shareholders care about, and it is what CEOs and CFOs care about. But this global perspective can be caught up in an apparent conflict of the same CEOs and CFOs, who feel the need to control down to the business-unit and even individual levels. Their desire is to monitor, control, and judge the performance of individuals so as to drive performance even higher. This desire leads to creating a whole suite of detailed measures to give them the feeling of being in control at a detailed level, and providing a simple and clear way to assess individual performance.

The whole thing is an illusion. The premise is false.

The premise is that by measuring small, detailed performance in all areas, and improving those local measurements, the company will improve improvement throughout the enterprise. This is such an erroneous perspective that it is worthy of its own special-edition program of Mythbusters.

Here are examples of the measures I am talking about:
• Sales margin
• Efficiency
• Purchase price of components and products
• Just about any form of standard cost accounting
• Almost anything to do with transfer pricing

Making operational decisions using these measures in isolation from global financial statements is incredibly risky and almost certain to cause the enterprise to lose money. Linking bonus payments to achieving specified levels for these measures in isolation from each other and the global performance of the business is a recipe for civil war.

I have seen CEOs make decisions using these localized, specific measures to:
• Accept an order from a customer.
• Reject an order from a customer.
• Make vs. buy analysis
• Change component sourcing practices.
• Open/close a factory.
• Invest in new equipment.
• Invest in new products.
• Invest in product A instead of product B.
• Hire or retrench employees.

I have also seen these decisions made correctly and executed well so that the business creates more operating cash flow, and the enterprise value is increased.

I have seen these same decisions made, based on the effect of a single, isolated measure, that literally waste millions of dollars of shareholder value and precious management capacity.

Here are some examples of how this behavior plays out. I am sure you can relate to some or all of them.

Sales margin
Sales director: I need to achieve 25-percent margin on this product, or I will buy it from an outside supplier, not from our factory. My bonus is paid on my margin numbers, and I cannot lift prices, so you have to drop your transfer price.

Plant manager: If you buy elsewhere, I will reduce my costs, but not all of the overhead will be eliminated from the business. The burden on all products will increase, and that means the transfer price on all other products will go up, which will reduce your margin even further.

Plant manager: I am measured by my plant efficiency and my cost per unit of production. We need to make and sell more of the high-volume products and drop the niche, low-volume, complex variants.

Sales director: Are you nuts? The margin on the low-volume niche products are double the standard product, and the selling price is massive. We need the variety in order to give a range of options to the distributors and the clients. I cannot hit my targets if we only make the high-volume variants. We will lose sales.

Change component supplier
Purchasing manager: I am measured on the total purchase price per unit, and I can re-source this part to a new supplier I just visited, saving 3 cents a unit, or $60,000 a year.

Supply chain manager: I am measured on the total value of stock, and this re-sourcing means I have to add $100,000 to my stock holding when I am required to reduce my total value in stock by 5 percent this year. I also don’t know if this supplier is reliable. If we run out of this part, the air freight cost will kill my budget.

Plant manager: Your last “cost saving” re-sourcing caused me to run out of parts, and I couldn’t produce that particular variant for two weeks. I am measured by plant uptime and product availability, and you killed me.

I could go on. I am certain that you can relate to some, or all, of these scenarios and probably add some examples of your own.

All of these problems and conflicts waste time, money, management capacity, and have the potential to annoy the market. Who needs to worry about competitors when we are being so self-destructive?

These conflicts are between well-intentioned people who want the business to succeed and to be likewise successful in their personal careers.

The measures for their personal success are flawed and cause them to take actions that compromise the business performance both locally and overall. This is not their fault. These people have different goalposts at which they are being required to aim. How can any group of individuals who are aiming at different goalposts possibly work together as a team?

How much of an improvement could we make to our businesses if our behaviors were aligned instead of in conflict?

Solving the measurement paradox

How do we align people’s align behavior to the global improvement of the business? The solution is simple; however, simple isn’t always easy to implement, and it will require managers and leaders to have more effective, holistic discussions about the effect on globally based measurements. Some will make it; some won’t. The ideal solution will at least have the following characteristics:
• Drive enterprise value upward.
• Align behaviors to focus on agreed common goals.
• Cause individuals to collaborate for personal gain as well as the organization
• Provide individuals with a viable path for personal success.
• Promote and permit accountability for behavior and performance.
• Reduce poor decision making.

This is an excerpt from the book, Manufacturing Money (Amazon Digital Services, 2015) by Jason Furness and Michael McLean. See article on Manufacturship blog.


About The Author

Jason Furness’s picture

Jason Furness

Jason Furness, CEO and founder of Manufacturship, is an executive coach who provides lean manufacturing training and lean consulting in a pragmatic, hands-on way that gets clients results in a fast and sustainable manner. Furness oversees the development and delivery of Manufacturship’s curriculum, leads the mentoring of business owners and managers, and sponsors all client projects. During his 20-year career he has led 30 transformation projects for small and medium-sized enterprises. Furness is the co-author of Manufacturing Money: How CEOs Rapidly Lift Profits in Manufacturing (Amazon Digital Services, 2015).