Organizational Performance Part 56: Understanding Organizational Profitability | Operational Excellence Quick Hits
Quick Hits share weekly tips and techniques on topics related to Operational Excellence. This week’s theme relates to company profitability. We hope you enjoy the information presented!
Speaker 1: (00:06)
In today’s session, we’re going to continue on the mindset change necessary to get breakthrough improvement in an organization, and today we’re going to talk about improving company profitability.
Speaker 1: (00:17)
The mindset that I see in a lot of companies is that if we do more changeovers, we run smaller batches, and we use less efficient resources to produce our product or service, that our costs are going to increase, and if our costs increase, then that’s going to reduce company profitability. But if we allocate costs to the products, what that does is that artificially reduces margin on products when more changeovers orders happen, batch sizes are reduced, and work is performed on less efficient resources.
Speaker 1: (00:49)
When we look at that, we say, “Okay, how can we change the mindset?” I want to use the chain analogy to explain how an organization acts and performs. In the chain analogy, if we look at a physical chain, the physical chain is made of dependent processes that are dependent on the next process in line. We have dependencies on the chain. We also have interrelationships. So actions in one function can cause negative or positive reactions in other functions.
Speaker 1: (01:25)
If we look at ways we can measure the chain, there’s two distinct characteristics. The first one is the weight of the chain. The weight of the chain acts like cost in an organization. So each of these links represents a department. If I just take the cost of each department and look at it to operate that department, what I can do is I can add those up to get the total cost to run the business. Cost acts like weight of the chain, and it follows the additive rules. Cost of one department, plus the cost of the second department; when we add all those up, it’s the cost to operate the business.
Speaker 1: (02:06)
The other way I can measure the chain is by its capacity, and that’s the ability to generate throughput. How is the capacity of the chain determined? If I look at the capacity of each department, capacity doesn’t follow the additive rule. Capacity is determined by the capacity on the weakest link. How many weakest links in a chain?There’s only one weakest link in a chain. We can look at that in terms of value stream. So if there’s multiple value streams in an organization, there can only be one weakest link in each value stream.
Speaker 1: (02:40)
So what implications does that have for us when we’re trying to drive profitability of the organization? If I look at the chain and I look at strengthening the chain or weakening the chain, of course, the goal of every organization is to make the chain stronger, not make the chain lighter. I want to say that again. The goal of every organization is to make the chain stronger, not to make the chain lighter. Making the chain lighter is sort of a cost cutting mentality. Making the chain stronger is strengthening that weakest link.
Speaker 1: (03:14)
So what are some actions we can do to lighten the chain versus strengthen the chain?
Speaker 1: (03:19)
If I want to lighten the chain, one of the things I can do is I can remove a link from the chain. If I remove that link, that’s like outsourcing work to an external provider.
Speaker 1: (03:30)
How else can I make the chain lighter? I can reduce the capacity of each link. So I can shave material off of each link and make each link’s capacity smaller. That’s equivalent to laying off people in the organization.
Speaker 1: (03:44)
I can also replace a link with a lighter material that has the same strength. That’s like investing in new technology or buying a new machine or hiring a new resource that has greater capacity.
Speaker 1: (03:56)
How do I strengthen the chain? If I look at that, I can increase the utilization and capacity to the weakest link. So that’s looking at the weakest link and understanding how can I get more through that process of the weakest link.
Speaker 1: (04:10)
Or if I could get paid more for each unit that goes through that resource. So if I look at how I’m pricing jobs, and I have jobs that go through that weakest link, how can I get paid more for each unit that goes through that resource? And I can utilize less efficient resources to support the weakest link.
Speaker 1: (04:30)
Those are the three things I can do to strengthen the chain, the three things I can do to make the chain lighter. Of course, you can see they’re totally different actions. And our goal again, is to strengthen the chain, not make it lighter by trying to cost cut.
Speaker 1: (04:46)
If I look at improving the company profitability, how can I do that? I can strengthen the chain. One thing we do understand is doing more changeovers and running smaller batches on non-constraints does not affect cost, but actually improves flow. So all these links that are larger than the weakest link, if we can get smaller runs through that and get flow going, that actually helps flow, but doesn’t affect cost.
Speaker 1: (05:15)
Utilizing less effective resources by improving flow through the capacity constraint resource, or the constraint, actually improves organizational profitability. And utilizing lean techniques on the constraint to increase the overall process effectiveness also improves organizational profitability.
Speaker 1: (05:35)
If we look at this, one thing we need to understand is costs don’t change due to more changeovers, smaller batches, and using less efficient resources. Don’t allocate cost of products; look at the total cost of operating the business and understand the contribution margin, or what we call, value added of each product. Then understand the effect flow has on profitability by measuring the throughput, which is the rate we generate contribution margin or value added, moving that through the constraint operation.
Speaker 1: (06:07)
And lastly, flow as the primary means to drive improved business performance, always reduces cost as a secondary benefit. And then reducing costs as a primary means to drive business improvement almost always reduces flow. And of course, if we reduce flow, that results in increased costs.
Speaker 1: (06:28)
That’s our lesson for today. This is our last session in the Organizational Performance series. I hope you enjoyed it and hope you learned something, and we’ll be launching a new series here shortly.