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?
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:
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.