Organizational Opportunities from the Frontline Story 19: Challenging the Cost Allocation Mindset | Operational Excellence Quick Hits

Quick Hits share weekly tips and techniques on topics related to Operational Excellence. This week’s theme relates to challenging the current mindset. We hope you enjoy the information presented!

In today’s session, we’re going to continue on the series of lessons learned from the frontlines focusing on organizational opportunities. So today’s story comes to us from a manufacturing company. And this story is about the cost allocation mindset and how the cost allocation mindset can distort our decision making.

So this company is a manufacturing company, a job shop environment, that’s engineer to order. So that means job shop that every job going through is different. And so the company when I looked at their orders that they were releasing, for the specific engineer to order jobs, they would release more units into the system and what the customer had ordered. And like, Oh, why are you doing that? And they’re like, oh, because we need to account for scrap and set up problems. And, you know, we just do extra pieces, so that we ensure that we meet the customer demand.

But when I looked at the effects from the business at the same time, their finished goods inventory was increasing. And they had more and more late orders that they were dealing with. So what was the current mindset that was in place? And then what was the mindset that needed to be in place? Let’s talk about change in paradigm.

So first of all, what I want to do is talk about what their belief was, and then how I had to challenge that belief system. And so when I said to them all it’s like, I’m seeing your finished goods inventory go up. And so that means that these extra parts that you’re producing, not all of them are shipped to the customer. So those must be going into finished goods. Like yep, that’s correct.

So I’m like, Okay, so these extra parts are going into finished goods. What do you do with those, they’re like, oh, so we hold on to them. And then if the customer happens to reorder that same job, we get really happy because those parts are free. And we get to send them to them. And so they’re 100% profit. Like, really, I like free stuff.

I had an example of one job that they ran. And so they had an order for 10. They made 15, five extra parts. And I put the job with a couple extra parts, like three parts that made it through, so he got 13 on the order. And so those three go into inventory, and they said those three parts are free.

And so one of the things I learned from Dr. Goldratt is like, Okay, let’s take their logic, and let’s amplify the situation and see if the logic still works. If it works with an amplified situation, then the logic is correct. If it doesn’t, then there’s something flawed in the logic.

So I’m like, Heck, I like free stuff. So instead of producing 15, let’s produce 100. And then we’ll have 90 free ones at the end. And they’re like, well, that doesn’t work. So I’m like, so why does it work for three, but not 90? So you can explain that to me? You’re like, well, that’s a good question. And they said, well, first of all, if we did 90 Extra, since they were passing on all the cost to produce the 15 to the customer. That’s why they thought it was free. And if we produce 100, the material that we have to buy for that order is more than what we’re getting paid for the job. So it’s like, okay, so maybe they’re not free.

But we look at it, what was their paradigm. So they said, Oh, we want to strive to meet the customer demand and make a profit, right. That’s our goal. So in order to do that, we need to increase the order size, to control and minimize costs. Because each time we have to set up, and then we only have to commit to to make those products are more expensive, because we’re allocating costs to the product. And if we make 15, the parts are cheaper per piece. And we charge the customer for all the parts, so those extra ones are free. Okay, so that was the logic.

But what happens is, when we start doing that, then there’s a real fact is work is focused on items that are not needed at the expense of items that are needed in the short horizon. So we’re making stuff to put into stock when we’re not meeting the customer’s existing demands. So the late orders were increasing and work in process and finished goods were increasing. Well, those are both increasing at the same time, we’re not making the right stuff. So then the outcome of that is the amount of work in processing keys creases, and then we also see quality increases when we see more work in process.

So then resources spend more time on non value added activities such as expediting, and then delivery performances reduced, costs increase the profits are reduced. So that’s negative effect of what we’re trying to achieve a meeting the demand and making a profit.

Okay, so what was the mindset? The mindset was in creasing the batch will absorb more cost. Okay, so this cost absorption issue. So it’s like I spread the cost over more and more parts, right? If I spread the cost over more and more parts, the parts become cheaper. And if I charge the customer for all those costs around those 15 parts, they have extra, those extra parts are free. So when we look at traditional batch and queue, typically what we see is the product goes through multiple steps. And then in any system, we’re probably going to have one bottleneck or pacesetter operation. So what happens in this case, we get a bunch of work build up on this operator for, we feel pressured to run larger batches, because it’s like I got this work pile in front of me, if I do more setups, it’s going to take more capacity, creating a bigger pile, so I need to run bigger batches so I can get more efficient and produce more units, and then get up my utilization.

So then what happens is we produce items that aren’t needed at the expense of the ones that are or making stuff at the medium and long horizon at the expense of stuff that is needed in the short horizon, then there becomes a mismatch between sales and operations, and an expedite increase, quality decreases, and then our investment in cost, such as material over time and etc, increase so that in their traditional batches Q, this is a typical things that we’ve see.

Now, what is the change of paradigm that’s needed. So to ensure we meet customer demand and make a profit, we should only produce two items in the short horizon. And the mindset is decreasing the batch size increases flow. So if we decrease the batch size we’re going to produce only for the short horizon, then work is focused on the items that are needed in the short horizon. The amount of work in process decreases quality issues decrease, resource sources spend more time on value-added activities, or the delivery performance is improved, and costs reduced, and profits are approved. So the effect that we’re looking for is all stemming from this mindset of increasing the batch size reduces costs because it absorbs more cost.

No, the mindset needs to be decreasing the batch size increases flow. So we’re looking at the impact of batch size and change over decreasing the batch size and increasing the number of Change Overs will have no effect on the cost of the organization. So contrary to popular belief, it will not affect the cost, especially on nine constraints. And under constraint. If it does become an issue where we reduce capacity that we have techniques like SMAD to apply to improve the change over time to increase the utilization.

Second, it’ll reduce the lead time within the organization. Third, it’ll improve the quality. Fourth, it’ll improve flow birth, it’ll provide focus where to it’s important to reduce change over six, it’ll free up cash seven, it’ll improve customer satisfaction. So these are positive effects of reducing batch size and going with smaller batches to create flow.

So what’s the change in mindset? So number one, don’t allocate costs to the product. Don’t allocate costs to inventory. If you do so, it’s going to distort your decision making and create many undesirable effects for your organization such as long lead times, late delivery performance, excessive expediting, excessive overtime, increased quality issues, and cash becomes a scarce resource.

This is our session for today and the cost allocation mindset we need to get rid of that mindset change that mindset. If we do we get positive effects for the organization. Hope you enjoyed the session connect with me on LinkedIn. Visit our website subscribe to our YouTube channel where we have lots of videos on my shift necessary to create a high performing organization.