Flow Based Performance Metrics | Operational Excellence Quick Hits
Quick Hits share weekly tips and techniques on topics related to Operational Excellence. This week’s theme relates to Organizational Performance Part 4: Flow Based Performance Metrics. We hope you enjoy the information presented!
Speaker 1: (00:06)
So in today’s session, we’re going to talk about effective decision-making and how measuring performance is aligned with effective decision-making. We’re making the right decisions based on flow based metrics, not cost reduction metrics. The key here is we’re looking at flow. The financial and performance measurements need to be in support of the goal of the organization. These measurements are to navigation tools that keep the company on course in order to reach its destination or end goal.
Speaker 1: (00:41)
Therefore, when designing the organizational measurement system, we must have a clear understanding of the goal in order to make the right measurements to meet its purpose. What is the goal of any organization? If we look at for-profit companies, what is the goal? Of course, if you’re for-profit, profit is a goal of the company. But it’s not the only goal. The primary goal is to make money through maximizing profits, cashflow, and return on investment. We’re not just focused on profits.
Speaker 1: (01:14)
We also need cashflow. I always say cash is king. Without cash flow, the company can’t survive long-term. We must focus on cashflow and return on investment. If we’re going to make an investment decision, we want to make sure that that investment gives us a proper return. These three measurements, because they all involve flow, we want to understand how we actually measure these. The global measures for a company should be throughput, operating expense, and investment.
Speaker 1: (01:48)
These are the elements that affect profits, cashflow, and return on investment. These are the global measurements in which improvement initiatives and daily activities are measured against in order to meet the goal to make more money. So let’s talk about throughput. Throughput is the rate at which money is generated through sales. Census are great. It measures flow. We’re looking at how much value added is generated over a period of time.
Speaker 1: (02:15)
In simplest terms, it can be calculated by subtracting the raw material costs from the selling price over a certain period. You can look at a week and say, okay, how much throughput did we generate in the week? But in exact terms, it’s subtracting the totally variable costs from the selling price. What is totally variable costs? Those are costs that increase as a result of producing one more unit. Therefore, I’ve only seen four elements of totally variable costs, which include raw material, freight, if you’re paying the freight, commissions, and outside processing.
Speaker 1: (02:51)
All other costs are included in operating expense. Operating expense is the money that we spend to convert inventory into throughput. It’s calculated by adding up all the costs to keep the doors open, such as direct labor, indirect labor, salaries, taxes, rent, utilities, tooling expenses, insurance, and so forth. We can look at some period and determine how much is the operating expense for the same period that we’re measuring the throughput. Last is investment.
Speaker 1: (03:24)
It’s all the money tied up in the organization that convert raw materials into finished products and then sell them. We look at the total assets owned, which include, of course, buildings and equipment and so forth, but also includes raw material and finished goods inventory. But when looking at material and finished goods, we don’t add labor and overhead to the cost of inventory. Since those are part of operating expense, they’re not included in the inventory number.
Speaker 1: (03:53)
Our global measures need to be in perspective of strategy, process improvement, and daily activities. They need to be company-wide in the context of how they relate to profits, cashflow, and return on investment. The three key measures are net profit, which is the throughput rate, which is the rate we’ve generated value added over some period minus the operating expense for that same period. Next is return on investment. So again, we’re looking at throughput minus operating expense divided by the investment.
Speaker 1: (04:27)
We’re looking at the throughput over some period, the operating expense over that same period, and then what was the investment for that period. And to get to payback, we’re looking at the change of those three elements. If we take this change in throughput minus the change in operating expense, divided by the change in investment, then we get our payback period. So again, the goal isn’t to reduce costs. The goal is to increase flow and increase throughput.
Speaker 1: (04:57)
If we increase throughput at a faster rate than operating expense, the payback will always be positive. Then you’ll just have to ask yourself, how long a payback period am I willing to accept? If throughput is going up at a faster rate than operating expense, so operating expense can go up, but we want to make sure that throughput goes up at a faster rate to get a positive payback.
Speaker 1: (05:20)
These three global measures help us make decisions on a daily basis, and they’re flow-based metrics that help us as we make improvements to flow, understand how the company is performing.