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Stewart Anderson

Six Sigma

The Economics of Lean Production

Paring down drives profits up

Published: Monday, January 23, 2012 - 11:18

What is the economic rationale for pursuing lean production? Much of the lean literature is concerned with the nuts and bolts of lean, and the economics of lean are somewhat less publicized. This article attempts to redress that imbalance, albeit in a very condensed way.

Firms employ capital and labor to transform their raw materials into their output goods and services. The inputs of capital and labor are the so-called factors of production. This is given as a firm's production function, Q = ƒ(X1X2, ..., Xn), where Q is the output quantity, and X1X2, …, Xn are quantities of factor inputs, such as capital, labor, and raw materials. A firm's production function specifies the firm's output for all combinations of inputs.

Through a simple thought experiment, we can think of the firm as a large production process that takes the factor inputs and uses them to transform raw materials into output products and services (see figure 1). Note that this model applies equally well to nonmanufacturing firms, although these firms may transform things other than raw materials into outputs:


Figure 1: Factor inputs used to transform raw materials into output products and services

A firm's production function describes how much output can be produced with a given combination of inputs. If we consider that the goal of a firm is to maximize its profitability, firms should always strive to be efficient in their operations. In economic terms, efficiency is thought of in two ways:

Technical (or technological) efficiency. Technical efficiency is achieving the maximum output possible from a given set of inputs. If a process is producing the maximum amount possible, given its labor and capital, then that process may be said to be technically efficient.

Economic efficiency. Economic efficiency is concerned with more than just technical efficiency. Economic efficiency is concerned with allocating resources wisely so as to minimize the costs associated with using a given combination of inputs to produce a given output. If a firm's goal is to maximize its profit, then the firm should consider which technically efficient processes best achieves that objective. An economically efficient production system is one that best allocates resources to produce output at the least cost.

Achieving improvements in technical efficiency requires improving the technical means of production. These improvements may consist of changes to the methods and technologies used in production so as to obtain the greatest output from a given set of inputs. Lean production has a role to play here as many of techniques and tools of lean are designed to reduce or eliminate the waste and nonvalue-adding activity which prevents a process from realizing the maximum output from a given set of inputs.

Economic or allocating efficiency, on the other hand, is essentially a strategic question. What businesses should the firm be in? What markets and customer groups should it be serving? What products and services should be supplied and in what quantities? What inputs does the firm require, and how can the cost of these be minimized? Which capabilities and processes are required to serve customers, and how should these be designed and configured? These and other questions are strategic in nature and determine in large measure how a firm will allocate its resources so as to be economically efficient in its chosen business.

For a firm, the issue of profit maximization seems, on the surface, straightforward. Profit is given by the following simple equation: P = TR­ –­ ­TC, where P is a firm's profit, TR is the firm's total revenues, and TC is the firm's total costs. Profit maximization is not simply about maximizing revenues and minimizing costs. Rather, it is an optimization exercise that recognizes the interdependency between revenues and costs: As a firm increases its output to sell more and increase revenues, it also increases costs. The key question in this interdependent relationship is what happens at the margin—i.e., how do revenues and costs behave with each additional unit of production? For most firms, profits are maximized when marginal revenues equal marginal costs.

A basic tenet of lean production is for a firm to operate its production processes synchronized to the rate of customer demand—the so-called takt time. This concept is not at odds with achieving technical efficiency. For example, using group technology or cellular manufacturing techniques to create work cells staffed by only the amount of labor needed to run the cell at the takt time achieves the objective of technical efficiency—i.e., the maximum output of product needed by the marketplace is produced with the minimum amount of labor as a factor input.

Another way to look at this is through the lens of the marginal product of labor. The marginal product of labor is the addition to output produced by each additional worker. In a lean cell or flow, the marginal product of labor is maximized relative to the amount of labor used in the cell—through work balancing, only that amount of labor needed to produce output at the required rate is used.

With respect to economic efficiency, lean has a role to play in designing and optimizing value chains to operate the least total cost. In the long run, a firm's production costs almost always decline when the scale of the firm's operation increases—the so-called economies of scale. There are several reasons why this is so. One is that production flows can be organized in a more efficient manner when greater quantities of output are being produced. Another is that larger production volumes allow a firm to take advantage of the opportunities afforded by greater task specialization. Lean can help firms achieve the cost reduction benefits normally associated with economies of scale through realizing economies of flow—i.e., using the least amounts of capital and labor to transform raw materials into output goods and services.

In economic terms, profit maximization in the short run is the process by which a firm determines the price and output level that returns the greatest profit. The general rule is that a firm maximizes its profit by producing that quantity of output where marginal revenue equals marginal costs. The profit maximization issue can also be approached from the input side by determining what the profit maximizing usage of the variable input is. To maximize profits, a firm should increase usage up to the point where the input's marginal revenue product equals its marginal costs.

In the short run, at least one of a firm's factor inputs is fixed, meaning it is invariant to the output quantity produced. Because lean can help a firm to achieve technical, and to some degree economic, efficiency, a firm can lower the costs associated with its variable factor input, thereby achieving a lower cost per unit of output. More precisely, a firm can shift its average total cost of production curve downward, thereby lowering the firm's break-even point.

Text Box:

Figure 2: A firm is profitable in the short run for an output quantity for which its average total cost curve (ATC) lies below its demand curve (D)

In the diagram in figure 2, a firm operating in an imperfectly competitive marketplace is profitable in the short run for an output quantity for which its average total cost curve (ATC) lies below its demand curve (D). The profit-maximizing output quantity is Qp, where marginal revenue (MRp) is equal to marginal cost (MC). The firm charges the price (Pp) where this quantity intersects the firm's demand curve, and earns a profit that is the difference between the price charged and the average total cost of production (ATCp).

When the firm undertakes lean production, the average total cost curve shifts down, mainly due to technical efficiencies gained, and this results in lower factor input costs (see figure 3). This increases the firm's profit at the profit maximizing quantity.

Figure 3: When the firm undertakes lean production, the average total cost curve shifts down

Since, in the short run, it is usually a firm's labor costs that are the main variable cost, this exposes a dilemma for many firms: How are the labor resources that have been freed up from lean initiatives to be used? In trying to answer this question, it should be noted that labor costs are only reduced when a firm issues smaller and fewer paychecks. Freeing up labor in one area of a production system only to absorb it elsewhere does not reduce a firm's total costs. Many sins have been committed through accounting allocations that disguise the fact that some process improvements resulted in no reduction to a firm's total costs because the labor freed up was redeployed elsewhere in the firm.

Part of the answer to this question may lie in effectively balancing two different concepts: efficiency and equity. Firms must, of course, strive to be economically efficient producers, but the achievement of that efficiency should not come at the expense of a net benefit to the firm as a whole. If lean initiatives result in downsizing and layoffs, mainly absorbed at the functionary level, the efficiency that a firm is striving to achieve may be undone due to a lack of morale and a withholding of contribution on the part of the remaining employees. In other words, to ensure sustainable improvement, a firm may have to be willing to trade off some loss in efficiency in return for the welfare and well-being of its members.

Where possible, firms should try to use freed-up resources elsewhere. For the capacity-constrained firm, this is often not too difficult because resources are scarce to begin with. For the demand-constrained firm, however, it is a more challenging issue. Demand-constrained firms, by definition, need to stimulate market demand, and this often requires specialized skills and competencies that are quite different from those possessed by employees who may be freed up from shop-floor process improvement initiatives. Often, this skill and competency gap cannot be surmounted by training, and the firm finds itself having too much of the wrong kind of resource.

My own perspective on this issue is that, rather than trying to solve the problem of what to do with excess resources freed up from lean, a firm should try to avoid this dilemma in the first place. If a firm is demand-constrained, implementing lean is often not the appropriate place to start generating improvement. In this case, a demand-constrained firm needs to refocus strategically and think through how it will generate additional demand and revenue. In economic terms, there is little point in a firm trying to optimize its supply curve when it does not understand, or know how to exploit, its demand curve.


About The Author

Stewart Anderson’s picture

Stewart Anderson

Stewart Anderson is a partner with Anderson Lyall Consulting Group, a Toronto-based consulting and advisory firm that helps firms develop their competitive advantage. Anderson’s background and expertise includes competitive strategy and value chain engineering. He has advised companies in the manufacturing, service, and contract manufacturing industries. Anderson is completing his bachelor of arts in economics and he is a certified trainer in lean manufacturing principles and techniques.