Where the rubber really hits the road
August 9, 2013
We all know about situations in which we spend money and yet nothing improves or even gets worse. But when you do continuous improvement right, you’ll get better financially and see a strong return for that investment.
As I noted in the previous column, the first condition that must be met for real improvement to happen is the will to improve. I also stated that the will to improve must be backed up by the will to invest in continuous improvement. We all know about situations in which we spend money and yet nothing improves or even gets worse. But when you do continuous improvement right, you’ll get better financially and see a strong return for that investment.
This column will cover what I mean by investment, why and how to make it, how much is typically required for sustainable continuous improvement, and how to measure the effectiveness of your efforts. But we’ll start with why improvement is simply a must for all businesses.
The answer is very simple. Costs tend to rise on a regular basis, especially costs related to energy, regulation compliance, and other input costs such as skilled labor. Further, raw materials are a large percentage of total costs for fabricators, and the entire raw material supply base is managed to regulate capacity to maintain margins. These costs, while highly variable, tend to trend upward slowly over time. It’s good practice to assume that on average your total costs will rise by 2 to 3 percent per year in periods of low inflation.
When you itemize them, these cost increases don’t seem to be too much of a big deal. But in total, they can wipe out 50 to 100 percent or more of your profitability in a couple of years. What’s worse, your customers don’t really empathize. Offsetting the increases is your responsibility, especially when material costs are rising very slowly.
So improvement is a must simply to avoid serious deterioration of company profitability. But there is another reason. If your competitors are making moves to improve their cost base (and at least some of them are), failure to at least match their efforts eventually will put you at a structural competitive disadvantage. That’s not good. In fact, this state is often disastrous, especially for companies that have high customer concentrations, with just a few customers making up a majority of revenue. Most fabricators fit into this category.
So the reasons are pretty profound. You need to continuously improve to survive. It’s that simple. Now comes the dichotomy.
For every other company activity fundamental to survival—sales, production, cash management, quality—there is some sort of focused, organized, and managed manner of ensuring that critical tasks are accomplished. The reason is very clear: Failures in these functions are almost instantly life-threatening.
But for the improvement task, which is every bit as important if you intend to be around for long, many companies really have no organized, managed way to systematically accomplish any real improvement, at least beyond the typical investment in machinery and equipment. I believe the reasons come down to the following:
So if the primary condition for improvement is the will to improve, then a primary condition for “getting the will” is being aware that you need to bring continuous improvement front and center. Maybe the following example will help. It sure did for me when I was a rookie general manager.
If you have a $6 million company with an operating profit (excluding depreciation expense) of 8 percent, then your cash costs are 92 percent, or $5,520,000. A rule of thumb is that if you do nothing, you must expect those costs to rise by 2 to 3 percent per year, or $110,000 to $165,000. To be safe, you have to at least offset these increases by some sort of improvement package. And that’s before word comes in about new pricing your competitors are tossing around. Excluding material costs (say, 40 percent of sales), the cost base that you must improve upon is $5,520,000 less material costs of $2,400,000. That equals $3,120,000. So the minimum improvement target is $110,000, or 3.5 percent of your total costs excluding raw material. Again, this is before customers and competitors have their say. I submit that this minimum annual improvement bogey is not going to happen reliably without an organized, managed, and invested approach.
What happens if you do nothing? In three years or less your operating profit, including depreciation expense, is about zero. In four years or less, your cash profit, which excludes depreciation expense, also vanishes. In fact, your company value in just one year has dropped dramatically, as has your attractiveness to lenders.
So improvement management is a critical function. Now, what about the investment part? There are three types: investment in time, cash, or both. Continuous improvement often requires both, but generally investment in machinery and equipment (M&E) is heavy on cash, and investment in people and processes (P&P) is biased toward time.
Investment in M&E is “lumpy.” You make it all at once and then reap the benefits over time. A typical major M&E investment, focusing just on cost reduction and viewed over an eight-year period, yields a typical ROI of around 20 percent, including the benefit of selling the machine after the eighth year.
That’s sturdy, for sure, and should be included in your improvement arsenal. Its primary advantages are in unit cost reduction, but the benefit is marginal in total process cycle times, asset turns, or some other critical metrics, unless you also make improvements in the overall processes employed. At the bottom line, some of the gross cost benefits are somewhat reduced because of depreciation expense.
To really improve, companion investments must be made in process improvement. This involves people, what they do, and how they do it. The cash ROIs (again, just on a cost-reduction basis) are usually 2 to 4 times the typical M&E ROI, and if well chosen, they do have significant impact on cycle times, asset turns, and the like. Look for initial returns of about 40 percent per year, improving to about 60 percent over time. And they add zero to the fixed-cost portion of your total costs. This is a very good thing when revenue can vary significantly. Furthermore, these investments usually have very positive effects on intangibles such as morale and turnover.
What kind of investments are we talking about? To get started, assume that you allot 3 to 4 percent of your total people time to work on improvement. (Firefighting doesn’t count!) As benefits accrue, this time will naturally and economically increase to 10 percent or more. The investment of 4 percent of a person’s time in a year is about two weeks.
To jump-start the process and for training and expertise, you can assume cash investments of around 0.5 percent of sales per year.
These investments, if done well and followed religiously, will more than offset the cost creep. They will add to the bottom line and your overall competitiveness. They are truly the most robust of your investment package. They represent the best practices of the best companies.
There are lots of opportunities in people and process improvement. It encompasses material movement; changeovers; workplace organization; information integrity and flow; scheduling; and even how you market, sell, and account for costs. It’s a target-rich environment.
The measure that gauges how effective your improvements are primarily includes the bottom line. Others should be ROI calculations using the net present value method (more on that in a future column), asset measures, customer satisfaction metrics such as on-time delivery, and various unambiguous efficiency measures.
I hope I have given you some motivation to translate your “will to improve” into the “will to invest.” Future columns will address some methods of organizing and managing those investments—and where to start.