The Lean River System – Part 3: A Financial Model

The Lean River System – Part 3: A Financial Model

Now that we have identified that a “river system” is a very good model for helping us conceptualize and understand what a “Lean system” looks and behaves like, how do we begin to quantify this concept in terms of some group of measurables? What can we measure to determine if we are making real progress in our efforts for a Lean transformation? What can we use to help us make good decisions? Since most of us are in, or firmly attached, to the business world, why don’t we start out with a financial metric?

Aaagghh!!!

I know, I know – I have recently covered Ohno’s aversion to cost accountants in his operations. In his mind they were close to the devil. And most of us in our earnest attempts to do the right things in implementing Lean, have run into at least one roadblock put up by those finance guys. Hell, there is a whole enterprise built up around “Lean accounting” just to get around this kind of problem. And I will be spending plenty of time in upcoming posts about the best non-financial metrics (the best metrics period, in my opinion) for assisting us in our Lean journey.

But what if I told you that there is one financial metric, a metric that is in every finance guy’s tool chest, that will not only quell most Finance Department objections to good Lean practices, but will also help us all make good Lean system decisions? Interested?

Let’s go back in time to what is known as the “Roaring 20’s” in the Western world. According to Wikipedia “it was a period of sustained economic prosperity”. Also, “the era saw the large-scale use of automobiles, telephones, motion pictures, radio, electricity, refrigeration, air conditioning; commercial, passenger, and freight aviation; unprecedented industrial growth, accelerated consumer demand…”. This was the time when “flow” was discovered in American manufacturing – remember the name Henry Ford?  This was the time when Lean was first born.

At this time there was a fellow named F. Donaldson Brown who was an electrical engineer, turned explosives salesman, turned accountant and now Treasurer for a company named E. I. du Pont de Nemours and Company, commonly referred to as DuPont. In 1920 DuPont took over another struggling company named General Motors. Brown is now known as the father of modern management accounting (as opposed to what we predominantly use today, cost/financial accounting). His most significant accomplishment in that field was the creation of what was known as the DuPont Analysis (also known as the DuPont identity, DuPont equation, DuPont Model or the DuPont method).

And what do we know this Donaldson Brown, DuPont innovation by? We know it as “Return on Investment” or ROI.

But at that time ROI was much more than the calculation we use to justify the purchase of a piece of equipment or to justify a building expansion. At that time ROI was the cornerstone of management accounting for the entire business enterprise. Here is the DuPont ROI equation:

dupont (2)

Source

The bottom row is what we all know as the “Profit and Loss Statement” or P&L. The top row is what we all refer to as the “Balance Sheet”, which is unfortunately all but ignored by larger companies today (and that is a problem for Lean). But the DuPont ROI requires that the company consider its cash flow (earnings/net income/profit) as a function of its total cash invested. ROI is the profitability/productivity of the system’s current cash investment.

The income statement (yet another name for the P&L) measures the cash “flow” into and out of the system while the balance sheet measures the cash “stock” inside the system. And if you consider “system” to be our river system, I think you all know where we are going with this. But we will continue on with ROI for now.

ROI is the product of two ratios:

ROI = (Earnings/Sales) x (Sales/Total Investment) = (Earnings/Total Investment)

The first ratio, Earnings/Sales, is the life blood of our business financial world today. That is what drives stock prices. During “earnings season”, these are the only two metrics that show up on CNBC’s bullets at the bottom of your TV screen. This is what drives decision making in the boardroom and on the shop floor. This is IT!

The second ratio, Sales/Total Investment, is something that you have to calculate yourself, if you are diligent enough to have the company financial statement handy. Take Sales from the P&L and Total Investment from somewhere in the balance sheet, divide the two, and Voila! But “Voila!” What? For most people, and unfortunately for most companies, there is no “Voila!”…. just silence. This is one reason why Lean and the finance guys sometimes butt heads.

But let’s go into a little more detail about Total Investment. From the DuPont equation, Total Investment is the sum of Working Capital and Permanent Investment (plant, property, equipment, etc.). Working Capital is the sum of inventories, accounts receivable and cash. While Permanent Investment is what it says, permanent, Working Capital is something that can vary on almost a daily basis. This is something we can actively manage. This is something that we should actively manage – but usually don’t.

If we remove Permanent Investment from the DuPont equation the “Turnover” calculation becomes “working capital turnover”, which is a close approximation to what we in the Lean world know as “inventory turns”. This is a very important metric. Here is what Art Byrne says in his excellent book The Lean Turnaround:

“I would argue that what you do to increase inventory and working capital turns is exactly what will drive up your earnings. High inventory turns are the hallmark of companies with good quality, strong productivity, low scrap, less space, shorter lead times, and other such advantages. Improving the working capital items on your balance sheet is what enables the company to deliver value to your customer, which in turn drives earnings.”

Increased inventory turns “will drive up your earnings”? How does that work? Does that make any sense at all? Yes, it does work and it also makes a lot of sense. But most of you already know that. I will demonstrate this, using the ROI equation, in a later post where I discuss “Time” and “Little’s Law”.

So, F. Donaldson Brown has given us a very useful financial metric to measure the overall performance of our businesses. It combines the two key financial entities, the P&L and the Balance Sheet, so that all aspects of business performance can be monitored in one metric. And by splitting this metric into two components, “earnings per sales” and “working capital/inventory turns” we can better determine what and where in our business operations, changes in ROI can be and are driven. This is completely missing with today’s singular emphasis on GAAP financial reporting.

Just to be clear, I have no inherent problems with GAAP in itself. It serves a very important role in standardizing the financial reporting of various, diverse, business entities for the investment communities at large. But it is designed to deliver information valuable to the outside world. ROI is designed to deliver information that is valuable to those inside of the business entity itself. GAAP is a “financial accounting” tool. ROI is “management accounting” tool – a skill that is on the wane.

If you want to better understand the historical importance of the DuPont ROI equation and the role of GAAP in destroying this tool over time, I highly recommend the book Demand Driven Performance by Debra and Chad Smith. But this book covers much more than this topic. It also does a superb job of emphasizing the importance of “Time” in optimizing total business performance. I will probably be referencing this work in several upcoming posts.

I will apply the DuPont ROI model to our Lean river system analogy in the next post.


4 thoughts on “The Lean River System – Part 3: A Financial Model

  1. Inventory turns relate strongly to the supply chain if Raw and Finished Product inventories are accounted for. In fact, this was the “awakening” I got in the 1990’s about how Purchasing had been slotted into a tactical “piece price reduction” role when it could/should be considered very strategic. Very few CFOs either get this or will acknowledge it. I’ve actually had fairly contentious discussion with CFOs who believed that Inventory (in any form) represented an asset, not a cost. And it was unreasonable to thing we could support high Customer Fill Rate targets without building ahead for the sales season. I think it was Dilbert’s pointy haired Boss who once said “I know that sales are slow but we have a lot of assets (Finished Goods) so we’ll be alright— we just need to sell them.”
    Paul

    1. Since I started down my Lean/TPS journey I have had very similar, frustrating, conversations with several CFOs (and at least one CEO). But my discussions were usually focused on labor and overhead variances as a result of reducing inventories (selling inventory rather than making inventory). I wish I knew then what I know now about using ROI on a corporate-wide, system-wide basis. CFO’s cannot deny the existence of ROI as a fundamental financial metric. The conversation would have gone more like: “If I cut our inventories in half, I will double our manufacturing ROI. And by the way – what do you want to do with all that leftover cash?”. You could have made the same argument based on improved supplier performance resulting in lower raw material inventory (and finished goods if your in-house plant was already Lean).

  2. A lot has structurally changed in manufacturing since the 1950s. My vote for the biggest change to impact ALL aspects of manufacturing is the transition OEMs have made from doing their own primary manufacturing — they used to want to make the parts they used in the manufacture of their products — to not wanting to make the capital investment required for doing so, i.e. meaning, buying the needed parts from suppliers. In the 50s it was not uncommon for 30% to 40% of an OEM’s COGS to be in the cost of the purchased parts. Now its in the high 60% range. In fact, I was involved in the start-up of a factory where 92% of the COGS was in the cost of the purchased parts, i.e. receive, assemble, ship!
    Another change associated with this is that in the old days OEMs used to buy “raw materials”. Today the purchases are anything but “raw”, instead including highly processed assemblies and components. My frustration is that over the period of this transition the fundamentals of the Purchasing profession really haven’t changed. This hurts Lean, since the Lean focus for most OEMs is internal, rather than along the entire value stream. And today there are no well founded road maps for doing Supply Chain Lean, at least that I’ve seen, other than what I tried to lay out in my IW series.
    I can’t really blame Lean Practitioners for this since until Purchasing changes its overall focus from one of “lower piece prices” to one of “Lean supply chain performance” it will continue to drastically limit the potential of Lean’s impact. So, I agree with what you are saying regarding Inventory Turns. But in the purchasing world, if you don’t get piece price reductions, you don’t keep your job. And a total focus on reducing piece prices often runs contradictory to increasing overall lean-ness. Sorry for the rant!

    1. It’s a rant worth taking! I hope more people listen. You opened my eyes a little more. Most of the companies I worked for did not have long complex supply chains. These companies were usually based on in-house proprietary technologies that did not lend itself to outsourcing, due to both a lack of outside technical capabilities and strict internal confidentiality requirements. We primarily bought true “raw” materials from suppliers. But if we did buy outside technology, we never had “price” as our primary criteria – we wanted “know how”. We would pay more for more “know how”. We would not buy less “know how”, no matter the price. But most of these companies also had the luxury of very high manufacturing margins. And a 60-90% COGS for purchased components was inconceivable.

      But from what I have read, you did break the mold with your MCT focus with suppliers, both within Deere and with your MEP efforts. You are to be commended. I hope more people take notice. Your last 7 part IW series laid the challenge out very nicely.

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