Organizational Opportunities from the Frontline Story 20: Challenging the Cost Mindset | Operational Excellence Quick Hits
Quick Hits share weekly tips and techniques on topics related to Operational Excellence. This week’s theme relates to contributors to organizational beliefs. We hope you enjoy the information presented!
In today’s session, we’re gonna continue on a series on organizational opportunities, stories and lessons learned from the frontlines. Today’s story comes to us from a manufacturing company, it was a make the stock environment. And the company had seen increases in demand and was struggling to meet the demand. And simultaneously build finished goods inventory has to be able to ship and deliver orders within 24 hours. So our goal was to be able to ship any order within 24 hours. So of course, production cycle is longer than 24 hours, we got to hold inventory. So we decided to hold inventory and finished goods to be able to ship from there immediately.
So once we got the production system stabilized, the constraint was internal to the organization. So we got the constraint identified, and then how did we change the mindset to increase the capacity further without increasing operating expense. So that’s our story for today.
So some information about the company A company that had an internal constraint, it was a process that had three operations linked together and production. So it required two operators to run that cell. The output per day, the cell average about 33,000 units across three shifts, there was an alternate method to run the parts which included an offline operation requiring two operators to run the first operation, a second offline operation requiring one operator and a third offline operation requiring additional two operators.
The first offline process ran at 50% of the speed of the cell, and a 50% of the volume. So the capacity was 25%, of the cell operation. And the second third, offline operations had about the same capacity as the cell in terms of output per hour. In addition, the company sales were about 60 million materials represented about 20% of the revenue, and the profit margin was about 10%. Approximate ran through the cell represents 60% of the company’s revenue, what was the impact on cost of parts per run using the alternative method, and what’s the impact on profitability if we utilize those less effective methods for producing the parts as additional capacity through the constrained operation?
So the first thing we want to do is look, look at it from a cost perspective. So this is shifting the mindset, looking at cost versus throughput. So if we look at the primary cell, and we look at the pieces per hours produced, convert that to hours per piece, look at the direct labor hours for P, so we’re taking the hours per piece times the number of workers in that cell, or the operation, we multiply that cost times $20 an hour, so I just use that numbers to get a baseline to do this calculation, if we say overhead is that 275% of the direct labor costs was a cost.
So if we look at it, they could run based on the data, 1300 75 parts per hour, we take that two hours per piece, and then we won’t play by the number of people in that cell, then we won’t play by the $20. And so we add the overheads. So the cost for that operations, just under 11 cents. Now if we look at three operations, so Senator burning through that cell, we can run it through three offline operations. And if we look at that, because of capacity is one quarter, one quarter of 375 was 343. And if we take the hours per piece, the labor, multiply it out, we get 43 cents to run that are across that operation. And then we add the other two operations. And so what we get is to produce the parts across the cell, it adds to the cost about 11 cents.
Now, that’s not all the other costs of the operation, we’re just looking at this isolated process. And if we took and run those parts across the three cells offline, it comes to about six to six. So you see the increase in costs to run those offline processes, including labor and overhead. Now, we look at it from a throughput perspective, using less effective resources, because that sells a lot faster. And we go to the offline operation, what impact does that have on the company?
So the sales before we use this offline operation was about 60 million materials at 20%. So it’s 12 Moon material. So our throughput is our sales minus our totally variable cost of materials. So our throughput value is about 48 million. We knew their net profit was about 10%, which is 6 million. So then I back in the operating since the operating expense has to be about 42 million.
So now, what additional increases can we get if that’s the constrained operation by using those offline operations 60% of our volume goes through that cell. So if I offload that work, If I can get another 25%. So I took 60% of 60 times 25% gives us about 9 million increase in revenue. Now I gotta take out the material costs for that 20%, general cost is 1.8 million, our throughput goes to 7.2 additional 7.2 million, no operating expense increase. So our net profit increases by 7.2 million.
So the result was, the sales went up to 69 million material costs 13.8, throughput 55.2 net profit 13.2 and a quarter $2 million operating expense, we didn’t increase operating expense at all. So you can see the impact on profit more than double. So what’s the mind shift here? So we don’t manage according to costs, or we look at the impact of costs will use less efficient processes. And what’s the impact on profit? It’s a much different picture.
So if we look strictly at cost, the additional cost to run those parts on the less effective process was 50 cents, which is the 450% increase over the 11 cents. Now, what’s the impact on profit profit increase from 6 million to 13.2, a 220% increase in profit.
So how can that be, so we better utilize our resources, the excess capacity from nine constraints move people to the constraint area to run that less effective process to make profit or go out the door. And that to build excess inventory in the nine constrained areas. So if you have constraints and and constraints, what you have to by definition, you have protective capacity, utilize that protective capacity to use that capacity, less effective resources that can help support flow through the constraint. That’s the message here.
So we talked about the chain analogy multiple, multiple times. And the chain analogy is, our goal is to strengthen the chain that make the chain lighter, so by strengthening the chain that increases the profitability of the company. Making the chain lighter does not necessarily translate into increased profitability, and sometimes it can hurt profitability if we cut costs, and reduce capacity as a result of our cost-cutting activities.
So our goal is to do more changeovers running smaller batches on nine constraints, and that does not affect costs at all. But it helps improve flow, utilizing less effective resources that improve flow to the constraint improves the profitability. Using lean techniques and the constraint to increase the overall process effectiveness improves organizational profitability.
So if we look at it, costs don’t change. When we do more Change Overs, run smaller batches and use less efficient resources. So don’t look at costs in isolation. Don’t allocate cost of products, look at the total cost of operating the business and understand the contribution margin, which is the value-added portion that each of the products contribute. And also look at the incremental margins. If I increase sales, through better utilization of our resources, that’s incremental margin. So what you’ll find is the incremental margin is the throughput or contribution margin of those additional products. So understand the effect flow has on profitability by measuring throughput, the rate at which we generate contribution margin.
So understanding the use of less effective resources, utilizing less efficient resources on the constrained area will not increase cost. It will increase throughput of the entire system and improve profitability. Utilizing less efficient resources on nine constrained areas will not increase cost and protect the constraint from starvation. So that’s our session for today. Thanks for joining again, visit our website. Connect with me on LinkedIn. Visit our YouTube channel where we have lots of videos and mind shift change to get breakthrough improvement.