While speaking at the Machine Tool Industry Summit in Goa the other day, I was asked a question. The question went something like this, “Kaizen teams calculate and show financial benefits when they complete their projects. They look logically correct, but the benefits don’t seem to show up on the balance sheets. Where is the disconnect?” That was a brilliant question – obviously from a sufferer! I wish more people would come up with such questions, and challenge the Kaizen®/ Lean community.
I gave a truncated answer due to constraints of time. It left me dissatisfied & I am sure it only provided a partial answer to the questioner. This is an extremely important question for all Kaizen®/ Lean practicing organizations & as Kaizen®/ Lean professionals it is our duty to try and provide a satisfactory answer.
Let us focus our attention on manufacturing & let us start from the beginning:
Kaizen®/ Lean is all about identification, step by step reduction & (eventually) elimination of muda from processes (or Value Streams). As we reduce muda’s of motion, transportation, waiting, inventory, rework, over-processing & overproduction – we end up with some improvements, which typically result in the following benefits:
- Lower inventory
- Higher manpower productivity
- Lower space
- Lower rejections
- Lower Lead times
In a nutshell, for the same output we end up using reduced inputs. Hence, output remaining the same, we release some resources. Some released resources lead to a one-time benefit& others lead to recurring benefits.
One-time benefits occur in some cases. Examples:
- After Seiri, surplus material becomes available for sale
- Improved OEE eliminates the need to invest in a new equipment
- Released space eliminates the need to invest in some area of new land & building
The first example provides some cash in hand. Therefore, it is visible in the balance sheet as ‘other income’. The other two ‘prevent’ investments, but are invisible in the balance sheet!
Recurring benefits can be classified into three categories:
CATEGORY ONE –
CAPACITY(release of these resources will not show up in P&L until the released capacity is put to use productively)
1.1 Manpower:We always strongly recommend that manpower released from Kaizen® projects should never be let go/ laid off (that is suicidal since it would hit morale & kill Kaizen® straightaway). As the still manpower remains on the rolls, its’ cost remains within the balance sheet & does not show up in the P&L.
1.2 Space: Space is a costly resource. But empty space has no entry in the balance sheet & will not show up in P&L
1.3 Equipment: Often, during stabilization phase, we also end up improving OEE of equipment, because unstable equipment obstruct flow in a cellular layout or a line. Once again, machine capacity is freed up. While it is a tangible improvement, it will not show up anywhere in the P&L (This cost is a sunk cost, & appears in the balance sheet as ‘depreciation’. As we all know, depreciation does not change with better or worse utilization of equipment!)
Traditional accounting systems do not recognize how efficiently or how inefficiently these resources are used! That is a fact of life. However, common sense does tell us that none of the above resources are free!
When will any benefit show up?
Answer – Only when the freed up resources are utilized to produce & sell more products, the increased revenue will show up as a higher top-line & increased bottom-line! (Please refer to ‘IMPORTANT’ at the end of this write-up).
CATEGORY TWO-
INVENTORY(Release of these resources will show up in P&L with a time-lag)
When inventory is reduced, in the first years of Lean implementation it shows up in the Balance Sheet as consumption & gets included in ‘Cost of Goods Sold’ (if they are sold, & not scrapped!). In traditional accounting system inventory is an ‘asset’ & the value of inventory held is used by banks as one of the inputs to determine an organization’s ‘credit limit’ for financing working capital. When the inventory gets reduced, banks threaten to reduce your ‘credit limit’.
That makes the CFO very unhappy.
If the CEO & CFO are on board with the Kaizen®/ Lean journey, they will know that reducing credit limit is not an unmitigated disaster, because that reduction will result in reducing ‘interest costs’ on the next balance sheet! But this years’ P&L shows no benefit at all! It only shows additional cost burden of the ‘Consultant’s Fees’!
Unfortunately, the CFO is mostly not on board. He finds this the second strong reason to become very unhappy!No wonder the CFO’s don’t support Kaizen®/ Lean!
The benefit will appear in P&L ONLY WHEN working capital loans from the bank are reduced (interest rates remaining the same!). However, sometimes these benefits get offset by some other invisible increases (that the Kaizen® teams are unaware of) –
- increase in interest rates or
- increase in accounts payables due to market conditions/ competition or
- inflation.
If this be the case, and the CFO has never been on board, we have an anti-Kaizen® CFO for life! Nothing you say or do will convince him otherwise!!
When will any benefit show up?
Answer – Only when the working capital bank loans are reduced. That can start happening, say 2 years after the kaizen® projects have been successful& have an adequate cumulative effect!
CATEGORY THREE-
MATERIAL YIELD:(This benefit shows up on P&L almost immediately)
Yield can improve by reducing material waste or reducing scrap generation. Such improvements reduce effective material consumption directly.
When will any benefit show up?
Answer – Immediately! In the very first P&L – but only if it is substantial enough!
So, if we want friendly CFOs, we have two options:
- Keep them on board from inception of the Kaizen®/ Lean journey
- Get substantial returns from projects of category three (which is not always practical!)
The good news is that Kaizen®/ Lean practitioners have recognized these problems/ infirmities globally. The entire body of knowledge covered by ‘Lean Accounting’ addresses these issues & has come up with simple, elegant solutions that will not let us go astray. It is strongly recommended that CFOs of practicing companies are exposed to these practices early in the Kaizen® journey. Help is available. In November 2013, a colleague of our friend Brian Maskell published a new book:
The Lean CFO:Architect of the Lean Management System by Nick Katco.
IMPORTANT:
Before I conclude, there are two secrets that the entire Kaizen®/ Lean community should be aware of:
ONE – All of the above that we discussed, is based on the assumption that market demand is static. While that is true for some industries, we are operating in growing economies in India, Africa & Middle East. Released capacities can quickly be used to meet increased market demands in terms of volumes & variety of products. Financial returns from increased output (from the same resources) would be far in excess of pure savings accruing from Kaizen® projects!
TWO – Even if the demand is static in some cases, there are opportunities to in-source (reverse of out-source) some inputs currently bought out & try to use up the released capacity to leverage the calculated Kaizen®/ Lean benefits.
CONCLUSION: The objectives of Kaizen®/ Lean practices & the CFOs are aligned. We need to co-opt CFOs as natural partners in this journey.
By Mr. Vinod Grover
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May 22, 2014 at 12:39 pm
There is one more reason of not showing the Kaizen benefits in the bottom line and i.e. in some other areas of company’s operations there is increase in cost e.g. energy cost or freight cost etc which nulify the effect of saving in productivity or material saving etc. In today’s competitive world, price reductions are given to customers due to benefits from Kaizens and in such cases the bottom line does not changes.
June 2, 2014 at 7:12 pm
You are absolutely right Satish. In the above write-up, we had tried to cover the first aspect pointed out by you through the following sentences:
QUOTE
Sometimes these benefits get offset by some other invisible increases (that the Kaizen® teams are unaware of) –
– increase in interest rates or
– increase in accounts payables due to market conditions/ competition or
– inflation.
UNQUOTE
Some supplier-customer contracts do have a built-in clauses about sharing of benefits; many others do not. A good contract works on the principle of win-win, which means the cost reduction benefits are equitably shared by the supplier & the customer, thereby benefitting both.
Also, one supplier may have a benefit sharing contract with one or two customers, not with all. Therefore, he shares some, not all the benefits.
Lastly, in some relationships, such a sharing arrangement is a condition for remaining a supplier. In that case, retaining a customer is, by itself, a business benefit – as long as profitable!