Organizational Opportunities from the Frontline Story 17: Challenging the Cost Savings Mindset | Operational Excellence Quick Hits
Quick Hits share weekly tips and techniques on topics related to Operational Excellence. This week’s theme relates to organizational beliefs. We hope you enjoy the information presented!
In today’s session, we’re going to continue on the series on Organizational Opportunities: Stories and Lessons Learned from the Frontlines. So today’s story comes to us from a manufacturing company. They were a mix of make to order and engineer to order. And the company was dealing with a lot of quality defects and a lot of production pressures to meet demand. And one of the sister companies had purchased a new piece of equipment for one of the steps in the process based on cost savings. So they were one plant and a big corporation, so the corporate said, “Hey, you should look at this same machine for your plant.” So they went through and they justified the equipment based on savings, they purchased that equipment, installed it, and what was the overall savings for the company? So today’s session is on Challenging the Cost Savings Mindset.
So when we look at measuring cost savings impact, typically how it’s done is we look at the process improvements. A lot of people believe that the process improvements of individual process steps equals the overall company performance improvement. So I want to challenge that mindset. So a lot of times the methods for measuring process improvements are a cost accounting methods. So what we do is we determine the cycle time of the current process, we look at the new machine, we say, “Whoa, the new cycle time of that new machine is a better cycle time.” And then we calculate the number of units produced over the year and say, “Okay, reduced cycle time on that new machine times the number of units produced is going to give us a total hour savings for the year.” Then we’d look at the hourly wage of the people, the fringe benefits and so forth, we calculate the labor savings, and then of course we apply the overhead of that process, and then we calculate the total savings by the labor savings plus the overhead savings based on that new machine.
And then of course, we look at the investment and then we calculate the return on investment calculation based on those savings. So that’s traditionally how it’s done. What was the expected result they were looking to get from this new machine purchase? First of all, the labor expense and the overhead expense would be reduced because of the improved cycle time. Next, there’d be material and labor that would be saved as a result of improving the quality, so they expected the first pass quality to go up, and then the total output of units produced and shipped would increase. So that was the cost savings that was expected as a result of purchasing and installing the new machine.
So what was the actual results from installing the new machine? So labor expense didn’t change because there was nobody laid off as a result of the purchase. So labor expenses don’t go down from the company perspective unless you’d lay somebody off. Second, overhead was not reduced because the operating expense as a result of putting that new machine in was not affected. Material costs were only marginally improved because the first pass yield of the system was only slightly improved due to the dependencies. So if I improve the yield on one process, that yield doesn’t translate into the same improvement of yield for the system because of the dependencies. So we need to multiply the first pass yield of that improvement times the first pass yield of all the other processes to see what the overall impact was. And in this case, it was just a slight improvement.
And so, the output of the system wasn’t improved because it wasn’t a constraint of the system, and so they just increased the capacity and created more protective capacity in the system. And because this machine was for a high volume process and they were more of a job shop, the setup time actually increased as a result of putting the machine in. And then what they didn’t realize is that they had to buy a bunch of consumables to run this new machine, and that wasn’t accounted for in the original cost savings. So when we look at tackling the impact of improvements, we want to measure improvements from the global perspective, not the local perspective. So there’s two global measurements that we’re looking at for process improvements, and first is the throughput, so what’s the change in throughput of the system, and then what’s the change in operating expense of the system.
And of course, to get the net profit impact, we take the change in throughput minus the change in operating expense. So remember, the goal isn’t to reduce operating expense, the goal is to increase throughput at a faster rate than your increasing operating expense, that’s a totally different mindset. So we can have operating expense go up, as long as throughput is going up at a faster rate, it’s a positive impact for the company. Now, when we look at return on investment, we want to measure also the return on investment from a global perspective, not a local perspective. And so again, we have the two measurements, throughput and operating expense, but now we’re going to look at the change in investment. And the return on investment impact is the net profit, which is the change in throughput minus the change in operating expense divided by the change in investment.
And investment is the assets in the company, so of course we’re going to increase the investment of that purchase. But if our inventory goes down and we look at inventory as an asset and we reduce the inventory, that also can go towards the impact on calculating the ROI. So when we measure investment impact, we want to look at the process improvement, and the return on investment, we’re looking at that process improvement, it affects the overall company performance. And if that calculation of return on investment is in within the acceptable timeframe, that’s an acceptable decision.
When we’re making improvements, it should meet one or more of the following criteria. One, it improves the flow rate of the entire system. So that means throughput of the system increases through sales, also, it reduces the overall lead time. Two, it reduces the operating expense. So that means the cost on the income statement after the investment is less than the cost on the income statement before the investment, and it improves the first patch quality of the system, so the total first patch quality yield increases. And it reduces the total inventory investment in the organization. So what we want is it needs to meet one of these criteria or several of these criteria that we could calculate the return on investment impact.
So our conclusions here, number one, no cost savings were realized. Two, the throughput was reduced. Three, the quality was only improved slightly, but the equality improvement was less than the throughput reduction, so the net effect was negative throughput. Our lesson here is don’t justify investments based on cost savings calculations, and don’t allocate cost, you need to measure impact from the system perspective.
So that’s our session for today. Thank you for joining. If you want to connect with me, connect with me on LinkedIn, also visit our website and subscribe to our YouTube channel. At our YouTube channel, we have lots of videos about mind shift change and necessary conditions to achieve high performance.