Financial Performance in the Life Sciences: Costs Are Moving from an Afterthought to the Forefront

Changing market conditions, increased competition from generics, difficulty bringing new products to market, high regulatory costs, etc. are putting intense pressure on life sciences companies. The recent headline in the Wall Street Journal, “Drug Maker Wyeth May Cut 10% off Work Force Over Three Years,” (1/25/08) is just the latest in a string of news reflecting the economic realities facing this industry.

The article mentioned Effexor, one of the Wyeth’s leading drugs as facing generic competition. In a coincidence of geography, Effexor is manufactured in Ireland, which was the setting the day before for a talk given by James O’Sullivan, Managing Director of Menawat & Co. Ireland at a MESA International working group meeting hosted at Bausch & Lomb in Waterford. James’ research focused on the opportunities of MES in contributing to financial and other performance in the life sciences (see presentation).

Traditionally, reasons to implement MES include: optimizing production efficiencies for increased profitability, increasing asset utilization by reducing downtime and unscheduled maintenance, improving product quality, and reducing waste. Yet, in the life sciences, there are more compelling reasons to implement MES.

Historically, companies have approached enterprise IT solutions, whether MES, PLM, etc. with a tactical mindset. However, in today’s intensely competitive global environment, the expectations of the returns on such investments are changing dramatically. Tactical improvements are often no longer enough to justify such investments; they must also help the company achieve its strategic priorities. Choosing the right tactical path is still imperative, but it is critical to frame the opportunity in the larger strategic context to be successful from a business perspective – and to receive the project funding.

The most striking revelation of James’ research is the true cost reduction opportunity of MES solutions in the life sciences. If you look at the “Cost to Add Value” (direct costs minus materials) in industrial manufacturing, it represents about 44% of the business. This presents a large field of opportunity to optimize production, quality, costs, and so on. Even a small change can have significant improvement implications due to the size of the improvement pool.

In contrast, the Cost to Add Value in the life sciences shrinks to approximately 10% of the business. Other cost drivers, such as increased R&D and regulatory requirements expand dramatically compared to other industries. In other words, once you design the process, make the capital investments, and obtain certification, the research shows that 90% of the costs are outside of manufacturing. Thus, the promise of a “big” cost improvement may not percolate up given the small opportunity relative to other cost drivers in the organization.

Implications for Life Science Companies: Optimize the Business not Operations

Forward thinking companies are elevating MES, PLM, and other related investments into strategic advantage. Compliance and product development are prime examples. MES and PLM represent significant investments, and their potential value expands vastly when couched in terms of strategic priorities. For example, reducing service and warranty costs, improving traceability, increasing speed to market, and so on are “business” issues of central importance to corporate management, which transcend plant level operational issues.

This kind of integrated business thinking (i.e., strategic + tactical = success) can be a challenge for operational personnel who have not traditionally been pressured to think beyond their local domain. These are not simply efficiency tools that reduce process, supply chain, and product development costs. They support regulatory and strategic priorities. It appears that MES and PLM vendors are catching on to this new message and are beginning to talk about how they serve the business goals, not simply how their tools help plug local tactical gaps.

What are some of the “takeaways” for operational managers? Think in terms of planning and aligning investments to strategic value. Right size deployment and support efforts and costs to where they will have the greatest business impact and avoid investments that will not provide sustainable business improvement. To do so, one must validate the business value before implementation. Most importantly, maintain a clear focus on the business objectives before, during, and after installation. This will help facilitate a change in thinking from process improvement to optimizing the business. Profit Mapping provides a structured and holistic approach for accomplishing all of the above.

MESA International’s rapidly expanding membership is perhaps a reflection of this new integrated thinking. For instance, what does the term MES mean to you – Manufacturing Execution System? MESA is short for Manufacturing Enterprise Solutions Association. If we take their lead and substitute the word Enterprise for Execution, Manufacturing Enterprise System (MES) takes on a completely new strategic meaning – one that companies can choose to ignore at their own peril.

Look for an expanded business optimization talk for the life sciences by James in the April timeframe in Ireland. It promises to generate some lively discussion.

It seems that the more things change from industry to industry, the more the fundamental competitive issues remain the same. At least, that is what the life sciences industry is painfully discovering about their costs and business improvement opportunities.

Adam Garfein

Is There a Future for Lean?

We often get asked, “What’s beyond Lean?” or meet managers who say “When we started doing Lean we were way ahead of the pack. But now our competitors are doing it too, so how do we get back in front?”

What this tells us, is some people believe just using Lean tools makes them Lean, and if that’s so, then they’ve missed a key point. Initiatives like Lean and Total Quality are slow and steady approaches based on the principle that doing the right thing at the right time will lead to greater value.

The fact is that Lean has been approaching something of a crisis for quite awhile. Operations people continue to drive the effort, but business managers, with responsibility for making profit have lost faith because they can’t see results on the bottom line, and they don’t have the thirty years it took Toyota to beat the competition. They need more money NOW.

Your gut feeling will tell you that reducing waste and saving time have to be good. Right? Shutting the machine off when you’re not using it reduces the utility bill. More automation reduces direct labor cost. So where’s the “disconnect” with profit?

But think about it. Does a lower utility bill really have visibility in the overall cost? Did we shed direct labor when we hired automation engineers to support the new robots? Did that project solve an obvious difficulty that needed to be solved right now? If the answer to questions like these is “no”, then there’s your disconnect.

If we assume a solution, or even pick the Lean tool to solve a problem, before viewing that problem in its business context, then we’re going the wrong way. To avoid disconnect, look for the immediate, accurate match between a business unit goal and your Lean project, and if you can’t find one, forget it.

The good news is, that if you laser target an explicit business objective with every Lean initiative, every time, you will see the bottom line results, and fast. But if you haven’t established that direct relationship between your project and that objective, then you shouldn’t be doing it.

It turns out that running your business by rules of thumb like, “more efficiency means less spending” or, “lower inventory means increased cash flow”, is just plain dangerous. Because if you’re not addressing the most pressing issues facing the business right now, then you’re the one wasting time and resources.

Making that connection consistently is a talent we must add to our skills list with a matter of urgency.

Oh, Lean has a future all right, but only if we to do it with the “paranoia” of making sure that every project has that one-to-one match with the achievement of a clearly stated business objective.

James O’Sullivan

Lean, Total Quality, and Real-Time Enterprise Initiatives: Are They Having the Desired Impact on Business Performance?

The majority of manufacturing companies are pursuing strategic initiatives to improve business performance. They range from traditional Lean and Total Quality programs, to include a more recent IT-driven focus on creating a Real-Time Enterprise (RTE).

Despite the widespread adoption of such initiatives, recent research shows that companies do not make full use of the many core practices associated with these programs. This is the conclusion of a study conducted over the summer of 2007 on behalf of the Manufacturing Enterprise Solutions Association (MESA) by Julie Fraser at analyst firm Industry Directions.

The report indicates that while significant progress is being made, piecemeal implementation of the available fundamental practices from performance improvement programs is hindering companies from realizing the full potential of these initiatives.

While there is a rich and proven body of “best tools and practices” to call from, companies are struggling to piece together the right combination of core practices from a smorgasbord of improvement programs and options that will work best for them. The complexity inherent in choosing the right menu for one’s company and competitive circumstances is evidently causing many companies to leave unrealized performance gains on the table.

Out of 40 surveyed practices covering all three performance improvement areas, only four practices are used by all of the companies. These widespread practices include:

• 5S workplace organization (Lean)
• Standardized work or method sheets (Lean)
• Corrective action and preventive action (CAPA) (Total Quality)
• Kaizen (Lean and Total Quality)

Clearly, this research reflects the popularity of Lean and Total Quality. It also highlights the challenges managers have in selecting the right tools to implement for their organization. The MESA research focused, for instance, on a subset of 12 Lean practices. In our own research, we have identified over 50 different Lean tools. Can the essence of Lean and quality principles be boiled down to four key practices? It is a stretch by any imagination to respond with an unequivocal “yes.”

Six Dimensions Help Increase the Likelihood of Success of Strategic Initiatives

Whether your strategic improvement initiatives include Lean, Six Sigma, Total Quality, RTE, or something else, you can help improve the likelihood of success by attending to a number of key issues from the outset. We have posed these dimensions in the form of questions to illustrate the importance of integrated thinking.

The answers will be unique to each company and competitive circumstances. There are not necessarily any right or wrong answers. Yet, in general terms, the richness of practices deployed in each dimension have enormous performance improvement implications.

Are your improvement initiatives:

Focused on the Business Objectives? A full 80% of respondents report that having metrics aligned with the business needs make them more effective. Of this group, it is unclear what portion of activities are directly tied to the business objectives.

Systematic? Does the organization have a systematic way to implement each improvement philosophy according to the unique circumstances of the company and business opportunities? Many companies simply pick and choose among practices to implement without an overall framework to ensure (a) that the practice is best suited for the particular situation and (b) the overall success of the program.

Integrated? Nearly half of respondents indicate that departmental metrics are commonly in conflict, and about one quarter are in conflict between management levels. Among the companies with more than one metric conflict, employees can find themselves in situations where ill will develops due to working towards conflicting goals.

Holistic? Are improvement programs properly integrated within and between the different approaches, and with other functions of the business? Do they enhance overall business performance or simply produce isolated improvement and/or difficult-to-sustain change?

Dynamic? How do improvement initiatives account for a dynamic market and operational environment? How do they deal with changes in product demand and complex operational dynamics on the plant floor? The MESA survey, for instance, highlighted that a large portion of companies do not adjust metrics to keep pace as business needs change, increasing the risk that their metrics become irrelevant.

Customer Focused? The Total Quality findings were striking for their disconnection with customers. “Another surprise is the limited use of customer-defined quality and value practices, which are a foundation for ensuring that quality programs are implemented in areas that matter to the market.”

Profit Mapping addresses the gaps highlighted above head on. It is a complementary approach. You can keep doing what you are doing. However, if a strategic initiative falls short in a dimension, we advise embracing appropriate change in core practices to overcome the deficiency and realize the full potential of the improvement effort.

Incorporating Profit Mapping into existing strategic initiatives takes management vision and leadership.

“While many have declared their intention, manufacturing companies must now show the vision and leadership to change processes, mindsets and supporting technologies to reliably achieve ongoing improvements across their organizations.” MESA, 2007

Rigorous implementation of strategic initiatives has produced significant gains over the years, yet much work remains. If it were easy, we would all be reaping the full benefits and have probably moved on to tackle other sources of competitive advantage by now.

Adam Garfein

Winning at Continuous Improvement: Balancing Cost and Process Efficiency

Much has been written over the years about the difference between doing the right things versus doing things right. This is the effectiveness versus efficiency challenge. The legendary management thinker, Peter Drucker captured the essence of this challenge in his famous observation, “There is surely nothing quite so useless as doing with great efficiency what should not be done at all.”

Through a multitude of educational, cultural, and work experience factors, operational managers are taught to focus on the efficiency side of the competitive equation. Efficiency improvements hold an “unquestioned” position in the business improvement toolset. In improving process efficiency through lean, Six Sigma or other approach the assumption is that one need only to wait for the positive business results to accrue. Create a better process and good things will follow for the organization and customers – at least that is mindset. Build it and they will come in the form of happier customers and increasing profits.

This kind of thinking is based upon a dual assumption that continuous improvement is both the right thing to do and that it will produce the desired business results when all is said and done. As for the former, continually striving to improve operational performance is without a doubt a fundamental and essential business function in an ever more competitive world.

The second part of the assumption is the source of much discussion, debate, and disappointment – but usually not until after a gap emerges between the expectations of the particular improvement effort and the outcomes. Unlike in the movie Field of Dreams, building it is not assurance that “they” will come. In the present context, “they” refers to the appearance of each and every mandated business objective, including financial performance.

Over the years, many senior and middle-level managers have experienced firsthand the meaning of Drucker’s quote. They embraced lean principles and tackled quality problems with abandon. Waste was banished from the organization or at least controlled. Product quality rose dramatically. Yet, despite doing all the right things, many organizations failed to prosper from these investments, and some even failed precisely because of their emphasis on continuous improvement at the expense of other things they might have done to improve competitiveness.

Focus Continuous Improvement Efforts to Where They Will Have the Greatest Business Impact

With objectives in hand, managers embark upon a journey to change the organization.

Let’s look at a specific tool to illustrate a central improvement challenge facing organizations today. Kaizen blitz events (also known as Kaikaku events) are an extremely popular part of the lean toolset. Whereas continuous improvement is a systematic longer-term proposition, a Kaizen blitz is designed to create rapid change. In a bout of highly focused activity everyone associated with the process or department follows a typical pattern — ideation, analysis, future state mapping, and collecting the “best” idea(s) to move forward.

Often, the result is a re-arrangement of a product line or work area. Sprinkle in a change or two in policies to sustain the new way. In doing so, Kaizen events often produce “visible” improvements. Again, this is good. But, is it an outright win or simply a “pyrrhic victory” where the cost savings are not worthwhile for the invested effort?

A fundamental challenge, not just with Kaizen, but in any system is, how do you know which of the collection of good ideas are the “right” ones to implement given your unique situation? In fact, how can you confidently determine whether any of the ideas should be implemented at all? Sometimes taking no action is the best option – but this can be difficult in a culture where an action consistent with the operational philosophy (although misguided) is better than none.

The message is one of caution. It is imperative to understand that any continuous improvement tool can give you a sense of victory when you can actually be “losing.” In this context, losing is defined as successfully achieving a portion of the business objectives (e.g., process efficiency), but not all of them (e.g., financial, customer, growth).

Is process efficiency or quality improvement sufficient? The answer is “no” unless the continuous improvement effort is firmly tied to cost and any other internal or external factors deemed important by the organization.

As Peter Drucker presciently noted decades ago, better tools are needed if we are to transform a process efficiency concentration into a business effectiveness mindset.

“…yet our tools—especially our accounting concepts and data—all focus on efficiency. What we need is (1) a way to identify/priorities the areas of effectiveness (of possible significant results), and (2) a method for concentrating on them.”

That’s the role of Profit Mapping…

Adam Garfein

Business: A Living Dynamic System

Does a dollar saved by efficiency improvement of a process have the same value to the organization as another dollar saved elsewhere say in labor, marketing, or accounting? The answer to this question is: it depends. It depends on many factors and the reasons are not only unique to the organization but also to the current situation. The value of the savings achieved at one part of the business is different depending on where it was saved, when it was saved, and what other consequences result from it. Consequently, more of the same cost savings, which benefited the company bottom-line once, may not have the same effect ever again.

The value of one dollar in cost savings changes as it bubbles through the organization. It may either increase or decrease. Rarely will it maintain its one dollar value on the financial statements of the strategic business unit. The change in its value depends on the various interactions among the different business functions and their current status. For example, savings by off-loading work to increase efficiency are either reduced or lost by an increase in the overhead. One can not add the savings in individual components for the overall gain.

A business is not a random bag of individual functions put together. It is more than a collection of operations, accounting, marketing, sales, and so on. All functions connect with each other to create an ongoing business. Unless all perform collectively for the good of the organization, the business can not flourish; in fact, it would deteriorate. A business is a living dynamic system.

Improving a dynamic system

A system is a connected network of various entities, not a mere collection of individual components. It has built-in influencers that either amplify or attenuate, but surely manipulate, the response of an individual component to any stimulus. The stimulus may result from external factors such as changes in market demand, or from internal decisions to improve financial performance, meet regulatory compliance, and the like.

Any stimulus or cause to one of the components creates an effect, which in turn becomes the cause to other components, and so on. The chain continues to build resulting in a cascade of effects. Unfortunately, just because a component has already been influenced by another cause does not exclude it from being stimulated again, resulting in feedback and stimulating that component repeatedly.

Let’s consider an example. The objective is to reduce cost by $1 million. This could be achieved by one of many ways. The company could implement continuous improvement (such as lean, six sigma, flexible processing, etc) to enhance process efficiency, move operations to a low labor cost region, force suppliers to reduce their prices, reduce sales and marketing efforts, reduce IT infrastructure, eliminate new product development projects, and so on. As evident from this list, all are possible options but none are confined enough to be isolated from other parts of the business. Each has multiple consequences and affects the overall business in complex ways.

Another characteristic of the above options is that their payoff and influences on other parts of business are not at the same time. Each component reacts differently over its own time frame. Before the dynamics of an effect die out, a new cause may, and it often does, arise further complicating the dynamic response of the system. For example, eliminating new product development projects would bring cost savings right now but would adversely affect the business in the future for a lack of new products.

Need for a systematic approach

Efficiency enhancements by continuous improvement approaches generally do not result in long term financial or other benefits unless the operational influences are permanently modified. For example, reduction in inventory brings about a one time benefit unless the role of inventory is changed in the business. Unless the system that caused the bloated inventory in the first place is changed, the reduction in the holding cost would be short lived. Only when it would no longer be possible to let the inventory to increase again without affecting the rest of the operations, the cost savings would become sustainable. This is one of the most significant deficiencies of continuous improvement efficiency initiatives. A change that produces a one time, non-repeatable gain does not contribute to sustainable improvement.

Each component of the system reacts to any stimulus in its own characteristic way. Responses to distinct causes, generally, are not the same. In fact, systems exhibit different responses to the same cause depending on their current situation. The magnitude and the type of the cause along with the current state of the component define the response. If the finished goods inventory is high and the management decides to suspend production of some products due to a lack of raw material availability, the business may not suffer the consequences. Conversely, the business would suffer loss in sales with a lean inventory situation – different response for the same cause depending on the current situation.

Many proponents of continuous improvement methodologies, such as lean, take an enthusiastic approach of doing the right things, yet not allowing any financial levers to guide their thinking. They argue that financials are the result and should not factor into the means. This argument assumes a direct and linear relationship between efficiency improvement and financial gains. Experience shows otherwise. The interconnectedness of the overall system moderates this relationship. Cost savings bubble through the organization in different and constantly changing ways. Consequently, efficiency improvements, although noble things to do, achieve mostly short term gains and fail in the longer run for a lack of a clear financial insight.

Managing a business – a dynamic living system – is to device a moderate path between two extremes: being overly bloated or too lean. Arriving at the right balance requires a clear acknowledgement of risks, and an intimate knowledge of how various stimuli affect the individual components of the business and the resulting cascading effects on the strategic business unit.

Without a systematic approach to ascertain the current status of the system and then to change it, which is to redesign the activities requirement to execute the necessary processes, long term sustainable gains are impossible. In other words, the interconnected influences among the various components of the system have to be reorganized to attain lasting benefits. It is not sufficient to identify the interconnections. It is imperative to also understand the magnitudes of responses in order to meet specific business objectives. Good managers instinctively understand this reality.

Anil Menawat

Building a Profitable and Sustainable Lean Organization with Profit Mapping

One of the enjoyable aspects of our work is that we interact with a wide array of people in companies, ranging from the executive suite to the front lines. This is a great opportunity to understand the pulse and priorities in organizations from a number of often differing perspectives. Not surprisingly, Lean is one topic with a great deal of mindshare in companies today – and the focus of this article.

The range of opinions and comments we hear about Lean is quite fascinating. On the one hand are the “motherhood and apple pie” perspectives. For these practitioners, Lean is the be all and end all solution to their operational and business challenges. On the other extreme are those that definitively claim that “Lean doesn’t work.” Many more organizations are between the two ends of the continuum, including those who are just beginning their Lean journey and do not have enough data points to quantify their successes or disappointments.

Lean is a driver to improve your business just as Information Technology is a facilitator. Neither is the end game. Lean principles and tools are a wellspring of good ideas and practices. Keep in mind that even if Lean is a stated business objective for your company, it is to achieve a larger objective. Lean is one of many and not the only objective. You have other important objectives such as profitability, customer satisfaction, and so on.

You have to balance Lean with all the other unique objectives and priorities within your company. In fact, regardless of the specific strategy, successful companies emphasize building agile, profitable, and sustainable organizations to capitalize on ever changing opportunities in the global economy. Lean happens to be a part of this larger puzzle. Profit Mapping helps companies achieve their larger goals in conjunction with Lean, if Lean is desired. The goal is not to seek Lean impact, but the impact of Lean on the business objectives.

Lean principles are without question helpful to organizations that wish to reduce various forms of waste and deliver value to the customer. The plethora of Lean tools attests to its popularity. We have compiled upwards of 50 Lean tools available to the practitioner. Some of the more popular tools are 5S, Kaizan, Value Stream Mapping, Kanban, and Poka Yoke.

There are so many tools such that practitioners can get bogged down in tool implementations while losing sight of why they are using them. This is a forest and trees issue. How do you know what tool(s) make the most business sense to use for your company? When should they be used? What will be the overall impact of the outcome on the business? These are but a few important questions for any process improvement approach.

Fundamentally, Lean principles are sound. The challenge is in knowing how to translate sound principles into precise actions that make the most sense for your organization. Yet, actions alone are not enough. Every Lean action must be prioritized and directly connected to achieving your company’s overall business objectives.

In practice, what works for one company is not guaranteed to work for you. Each company has different products, processes, customers, strategies, and so on. Moreover, these factors are constantly changing. That is, your company will always differ in ways, large and small, from others.

You are not operating in a steady-state business environment. The business factors are constantly changing within and around your company. Copying the best practices from yesteryears of other companies is not enough; you have to know why those practices would be better than what you are currently doing given the unique capabilities and constraints of your company.

Since the business environment is inherently dynamic, both internally and externally, how should companies guide their Lean efforts – to ensure success from the outset? This creates a sizable challenge for knowing how, where, and why to implement any particular Lean tool in ways that will create the biggest business impact for the investment in time and effort. This requires the benefit of a structured methodology such as Profit Mapping to help you focus, prioritize, and align your Lean efforts with your business objectives.

Profit Mapping is an intuitive, systematic, and forward-looking methodology for business execution. It is a structured yet flexible approach that is highly complementary to Lean efforts. Specifically, Profit Mapping enhances Lean in the following ways:

• It integrates multiple perspectives, including cost, so that managers can assess the profitability of their Lean decisions. This gives managers critical insight that also helps avoid implementing Lean in ways that could potentially destroy profitability.

• It connects Lean thinking and tools to the business objectives by identifying the parameters that managers can control.

• It shows the impact of any particular Lean project or action across the business, not just in isolation of that segment of the process.

• It creates a roadmap to the desired future Lean state showing the precise steps and actions that will achieve the business objectives. If the future state is not achievable, it can show you what additional process changes, resources and/or investments are required to get there. No other methodology can do this!

• It helps identify which Lean tools are most appropriate to use in any given circumstance.

• It helps extend Lean into situations where multiple products are produced on the same line.

• It helps dynamically adjust and prioritize Lean efforts in relation to changing internal and external factors.

Lean is a way of thinking and Profit Mapping is the execution tool that helps you get the most out of Lean by connecting your efforts to the business objectives and quantifying the financial implications of your actions. Profit Mapping provides critical insight into which Lean actions will be effective and which will not. If your Lean actions are not producing the desired effects, Profit Mapping also shows you how to quickly correct course, avoiding mis-implementation of Lean principles.

Lean is a terrific way to come up with good ideas for reducing waste and focusing on value from the customer’s perspective. But Lean alone is not enough in today’s intensely competitive and dynamic business environment where companies must compete against world prices.

You do not have the luxury of implementing Lean programs and actions, and hoping they will have the intended business impact sometime down the road. You need to know now and in advance if and how successful your Lean initiatives will be for the overall business, not just on a process efficiency. Profit Mapping helps you do this.

Adam Garfein and Anil Menawat

Why Current Approaches Fall Short in Creating a Profitable Future

The chairman of a mid-size manufacturer recently confided in us the essence of his company’s cost and operational performance improvement mindset. For us, “The process is not dictated by the present. It is dictated by the needs of the future.” He went on to explain how “continuous improvement” does not provide enough competitive bang for the buck; he is most interested in “breakthrough improvements” that provide customer and profit returns that sustain the company’s success.

Such breakthroughs can come from manufacturing advancements, product design, process re-design, and so on. Regardless of the source of the innovation, the innovation must be converted into a profitable customer focused operation. Otherwise, the business cannot survive over the long term.

Today, most companies try to create their future by looking into their past and extrapolating what they find into some sort of concocted view of the environment of the future. Unfortunately, such approaches are inadequate for the task because they (1) do not account for the different conditions of the future, (2) rely on steady-state analytical approaches that incorrectly assume that the business and operational environment does not exhibit variability (3) rely on standard costing, which does not work well for understanding the past (as it has to be corrected by variance analysis), and is therefore even less effective for understanding the future, and (4) lack a systematic implementation methodology that connects specific management actions to achieving the business objectives.

Profit Mapping is a proven management decision tool that overcomes these shortcomings. It:

• Integrates advanced functional (domain) analysis within current constraints
• Emphasizes process dynamics over steady state approaches
• Uses activities-based resources and financials instead of standard costing and variance analysis
• Looks into the future rather than data-mining the past
• Connects controllable actions to strategic objectives
• Constructs a roadmap to achieve the strategic goals

Profit mapping virtually eliminates decisions that have adverse effects on your business. It helps you correct your situation immediately and guides you to where you want to go, like a GPS navigation system.

Adam Garfein and Anil Menawat

Pressure on Prices: How will you Respond?

Here is a timely article written by Anil Menawat on how companies respond to pricing pressures. It highlights the challenges companies face in becoming more cost competitive in the context of a multi-product and high-variability demand environment. The article was originally published in the January 2006 edition of the Next Generation Manufacturing eJournal.

Pressure on Prices: How will you Respond?

Increased telecommunications technologies are making it easier for customers to shop globally for lower prices. While customers everywhere are enjoying more options and lower prices, here in North America, raw material and energy costs are rising, creating unprecedented challenges for manufacturers. Only a select few are able to pass the increased cost to their customers while most are sacrificing profits to stay in the game. How will you respond to this power shift?Before we begin I would like to say that I am honored as well as delighted on the invitation to be a part of this eJournal. The suggestion of exploring ideas that go beyond the applicability of the “Toyota Production System” is refreshing. In my opinion, this is a very important topic in multi-product and variable-demand environment often found in the SMB (small and medium-sized business) sector.

Where is the Opportunity?

When manufacturers are unable to pass the increased cost to their customers, they usually adopt one or both of the following strategies:
(1) To reduce the internal costs of producing products and services, and
(2) To discontinue the unprofitable products, services, channels or customers.
In either case, they first need an accurate measurement of costs to determine true profit margins for each product and service. Without a true assessment of the costs it is difficult to identify where the opportunities lie and what can be done about them. Furthermore the interest is less in what their costs were in the past and more in what they will be in the future for them to stay competitive.Most companies focus on tracking past performances and then tend to extrapolate from that to forecast future operational requirements and capabilities. Unfortunately, your past performance, no matter how successful, was based on different work requirements, demands, customer needs, and market conditions. Operating approaches and strategies that may have helped you in the past may not produce the desired result in the future because the environment has changed. In multi-product environments where demand fluctuates routinely, such as in high-variety and low-volume scenarios, this is an everyday event.Measuring revenues is not a problem but getting true cost of each product and service is.

Most companies keep good accounting data and the problem is not in adding up the cost. The problem is in distributing them to each product and service. If your product mix, demand volumes, and how you produce your products or services do not change significantly then you can use standard costing with variance analysis to get a fairly good assessment. But, that is not the environment in which the typical SMB operates. The high variety of products and fluctuating demands make the standard cost data misleading. The per-piece cost for each unit of product depends on the dynamics of the operating environment on the shop floor at the time that piece was produced. The product mix and the demand volumes impact the activities required to meet the demand. The activities composition plays the most important role in how to absorb the costs – in particular the costs of technology, capital investment, back office, design, maintenance, holding inventory, etc.

Today your operational environment is different from when the standard cost structure was developed. Today the product mix is different, the demand volumes are different, and in many cases, the policies and procedures are also different. A considerable constitution of the activities by people and machines required to deliver the products or services is new. Most companies in the SMB sector do not have the resources to update their cost structures frequently hence we find them to be out of date in great majority of situations. In some cases we have seen standard cost information to be more than several decades old. Clearly the company made a different set of products back then, than it does today.For the sake of discussion let us assume that we can overcome all these inadequacies, but the main problem still remains that this is historical information and not forward looking into the future. In your quest to respond to the price pressures when you make any significant change in your operating dynamics, you will be operating in a new and different environment. Your decisions on what to do must be made with the cost structures based on the yet unknown future. If they are based on the past cost structures then you are more than likely to go off course.

Uncertainty engenders partial solutions and misapplications

When faced with the rising pressure on prices, we find that managers often jump to conclusions – improve process efficiency, improve throughput, reduce inventory, reduce labor cost, outsource to a cheaper producer, etc. These are good things to do per se, so long as you are taking the cost out of the system and not merely shifting it to another area. In majority cases we find shifting costs to be the more common response. But, more importantly, the elimination in cost must be significant enough to make an impact. Very often managers forget to ask the four basic questions:

• Can it be done? Is it possible? If not, then what additional capabilities are needed?
• Will it be profitable?
• What is the impact of my decision across the product mix and the functional capabilities of the organization?
• How do I get to my desired future (the roadmap)?

In the absence of answers to these questions, the environment is fertile for half-baked ideas based on correlative thinking and rules-of-thumb, and misapplications of sound principles. Let us consider the implications of this uncertainty. The results are far reaching that affect not only the accountants and senior managers, but also the operations personnel. Process managers are asked to redesign the process and policies that will reduce costs and increase profits in future based on historical information. Without a reliable framework they do not know for sure whether their solutions will bear any fruit. They are left to use vague guidelines, which depend on inaccurate information, without questioning the accuracy and accepting on faith. They shoot in the dark and hope to kill. Misapplications are rampant throughout industry.

An example of misapplication and shifting costs

Let’s consider an example of a truck power-train component supplier. The company manufactured twenty four product families with several hundred individual SKUs. The demand of various products varied from a paltry 2 units for some to several thousand for others over a four-week long period. The plant operated in a batch fashion with two primary routings but no direct connecting flow between workstations. In other words, each work station continued to produce until it ran out of work to do. The plant financials were good with overall net income at almost 7% of sales. Unfortunately, WIP piled up everywhere. Management decided to convert the batch operation into a flow line to improve efficiency and reduce WIP.

Using an aggregated constraint capacity analysis tool they were convinced that their plan was feasible. They sized the buffers based on historical performance and line balancing showed a lot of promise. They estimated the WIP to decline precipitously with overall increase in bottleneck efficiency. Using the standard costing model, adjusted for the expected improvement in efficiency, they believed they were going to save a lot of money.

The reality unfortunately was not as they expected. Reduced WIP choked the flow and the machine utilization rates suffered significantly reducing the overall throughput by about 20%. The financial result was a disaster; the overall net income fell to negative 3% of sales. They not only lost on the bottom line but they also lost on the top line since they could not produce enough to meet the customer demand and had to outsource to fill the gap.

The problem was not in their objectives but in their analytical tools and the applicability of the principles. They were attempting to squeeze a square peg in a round hole. The problems emanated from two causes:

1. The processing requirements at workstations depended on individual product type, and

2. They did not understand how the machine failures would impact the dynamic interactions throughout the process.

If the processing requirements at workstations in a line depend on each product then with each change in product batch the dynamics of the entire line changes. Not having large enough buffers (WIP) in between workstations to attenuate the dynamics of the process flow caused the line to experience significant amount of blockage and starvation. They could not anticipate this because they used a static model of aggregated constraint capacity. These are steady-state models and cannot show the dynamic effects. A dynamic analysis was required for the job. Furthermore, they used the standard cost data from history but the activities composition was so different in the flow line that the old cost structure had no applicability at all.

Response to price pressures

The above situation is a common occurrence in any multi-product shop with high-demand variability. Static capacity models and standard costing or machine run-rate approaches to calculate individual product costs are not valid methodologies. Decisions made using these approaches will always be wrong. You may find partial successes but will never be able to tap your full potential. The activities based cost and management (ABC/M) techniques can help but only after the fact. After all, ABC is an accounting device and not a management tool to create the future. A similar situation would rarely exist in a low-variety with long-run setting. The solution requires a tool that assesses the dynamic changes in the process and the corresponding activities composition to build the resource requirements and financials for the future environment.

Profit Mapping is a tool for aligning operations with future profit and performance. It focuses on the activities performed by people and machines to improve process effectiveness and growth. Here we construct an activities composition of the process, understand the dynamics of how it changes over time, and tie this information to the resource requirements and the cost to produce products or services. As business conditions change – such as changes in product mix, demand, product or service delivery capabilities, vendor performance, business strategy, etc. – Profit Mapping reassesses the resource requirements and cost/profitability implications of the new and changed activities composition. The capability of Profit Mapping is in its ability to directly connect the controllable parameters to the business objectives within the capabilities and constraints of your organization. It is a radical yet intuitive enhancement to operational decision making process that is equally suitable from executive to shop floor decision making.

In subsequent issues of this journal I will explore with you several real-life examples of using Profit Mapping. We will identify parameters that we can control within our capabilities and constraints to reach our financial as well as other business objectives. This is one of the fundamental principles of the Profit Mapping methodology. In applying Profit Mapping we take an agnostic view towards the improvement philosophy and evaluate the consequences of decisions, irrespective of their origin or basis, from the process, resources and financial perspectives. Our focus is not on what happened in the past but to look forward to the future.

I believe the complexity in multi-product and high-variability in demand environment is immense where traditional single-focus methodologies and generic guidelines are not acceptable. A systematic approach focusing on the business goals – not on the intermediary issues such as efficiency, throughput, inventory levels etc. – is imperative.

Dr. Anil Menawat is the founder of Menawat & Co.

Welcome to the Profit Mapping Blog

Anil Menawat and I are pleased to announce our entry into the world of blogging. Our mission is to help raise awareness of Profit Mapping by sharing information and resources on how Profit Mapping drives cost and operational effectiveness for both manufacturing and services companies.

Profit Mapping enhances any strategy, improvement framework or measurement approach. It complements what you are already doing and provides the equivalent of a GPS navitation system for the business. Profit Mapping is the only approach that can guide you with precise steps and activities leading to the desired results.

We are currently preparing several articles that explore in more detail how Profit Mapping enhances leading improvment approaches. Our first article will address Lean principles. This will be followed by a Six Sigma article. Others will follow. We will post these articles on the Menwat & Co. web site when they are ready.

Please let us know about your significant business challenges. We look forward to discussing them in this blog.

In the meantime, please take a look at Anil Menawat's recent article, Pressure on Prices: How will you Respond?, from the JobshopLean journal. This is a timely article on the need to become more cost competitive in today's global business environment.

You can find more information about Profit Mapping and how it works at our web site and in our book, Profit Mapping: A Tool for Aligning Operations with Future Profit and Performance, from McGraw-Hill.

Regards,

Adam Garfein