Continuous Improvement -- The Financial Impact of Continuous Improvement

Lean champions in organizations are constantly asked to justify their continuous-improvement (CI) efforts in the terms that management understands best -- money. When trying to put together a justification for a major continuous-improvement program that will take many years and involve a substantial investment, it's often difficult to get an organization's executives to sign up for this investment based on faith that it's the right thing to do. The data shows the majority of North American companies that begin a CI initiative fail to achieve the anticipated results and end up dropping the project like a religion-of-the-week program. As a result, there is often a stiff headwind for approval based on these executives' past experience with these initiatives. So how do you convince the company's leadership that the investment should be made and there will be a substantial ROI on the project?

I have seen a number of different algorithms that attempt to justify improvement efforts using surrogate measures such as OEE improvements, scrap reduction, productivity improvements and the like, but these are all after-the-fact measures, not measurable predictors that can be used to justify a transformation project. In the past couple of years, I have presented to audiences on the subject of "The Financial Impact of Lean Transformation" using data from other companies that have been successful in their continuous-improvement efforts. Financial results of companies like Danaher and Toyota are public record and show the results that these companies have achieved with their lean transformations. Other data is available from consulting firms and other public companies that indicate the financial impact to organizations. This data on what others have realized with CI initiatives can help you justify your project.

Interestingly, this data shows that most people are far too conservative in estimating what is possible, based on the actual results that others have achieved. In the case of Danaher and Toyota, a couple of key pieces of data are their stock appreciation and EBITDA over a period of 20 years. For both companies, their stock-price appreciation averaged 15% per year over this period and their EBITDA growth averaged 20% per year over this extended period. Based on data from some consulting firms I know, the average improvements for their clients show results like 90% reductions in lead time, 50% improvements in productivity, 80% reductions in quality defects and scrap, 75% reductions in space required and over 80% reductions in inventory investment (both WIP and FG). How would your leadership like to achieve financial performance like that? The AME Institute underwrote a new website (www.leanroi.org) that has more information on the financial justification for CI initiatives. All it takes is the will to make the investment and, most importantly, the leadership commitment from top management, visible to the entire organization, to initiate the project and see it through. If the leadership is not actively and visibly supporting your CI projects, don't even start because they won't be perceived as important by the organization and won't be sustainable.

A downside that you need to be aware of is that a lean transformation will have a significant negative short-term impact on some externally reported financial measure such as margins and profitability. In your CI program, you reduce your WIP and FG inventory by cutting your production volume schedules, and this will result in fewer direct labor hours being earned on your standard cost system. This will result in under-absorption of your overhead, which will reduce margins, productivity and profitability in the short term. While it will have a very positive impact on cash flow, your CFO may raise red flags about the negative impact your program is having on the organization's financial performance if not properly forewarned. You also need to let your bankers know what you're doing so they aren't surprised when the assets (inventory) decline on your balance sheet. If you have separated your public accounting (GAAP) from your management accounting system and are using accounting-for-lean measures internally, the internal results will look very good, however. Remember that CI initiatives are focused on value add for customers so businesses can grow, but the measures that management use are focused on financial performance -- so talk their language to get their approval for CI investments.

Ralph Keller is president of the The AME Institute and former president of the Association for Manufacturing Excellence.