Synchronous Management Principle 14: Measures of Performance | Operational Excellence Quick Hits

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

Speaker 1: (00:06)
In today’s session, we’re going to continue on the concept of synchronous management. Today’s session is the last session in the series of 14 different principles. Today’s 14th principle talks about operational measures, and the statement says, “Throughput should be going up, inventory should be going down, operating expense should be going down, ideally, all at the same time. However, it is possible and maybe even desirable to have one of these measures go in the wrong direction in order to improve another one.” So let’s dive into this a little bit deeper. So first of all, let’s talk about throughput. So throughput is a rate that the organization generates money through sales. So it’s not putting products in the inventory, it’s selling the products going out the door or the services being provided. That’s throughput.

Speaker 1: (00:56)
How we calculate that is we take the raw material that goes into the product or service, and we subtract that from the selling price. That’s the easiest way to do it. The exact term is calculating by subtracting the totally variable cost from the selling price. If we take the selling price, minus the totally variable cost, that gives us the throughput when we get sales for those products or services.

Speaker 1: (01:21)
So the totally variable costs that increase as a result of producing one more unit of output. So that’s what totally variable costs are. And manufacturing, if typically raw materials, freight paid by the company, commissions, and outside processing. So those are the only totally variable costs I’ve ever found. Next, let’s talk about operating expense. So operating expense is all the money that the company spends to convert inventory into throughput. So it’s basically all the money the organization spends to keep the doors open. It can be calculated by taking all the expenses, direct labor, indirect labor, salaries, taxes, insurance, benefits, rent utilities, all those things that the company spends to keep the doors open, it’s called operating expense.

Speaker 1: (02:09)
And lastly, investment. So investment is all the money that is tied up in the organization that convert raw materials into finished products and sell them. So it’s just summing the total assets plus the raw material cost of inventory. So the reason we use raw material costs of inventory, because that’s truly the investment because the value added components described as labor overhead, and those that are included as part of the operating expense, not part of the inventory. So don’t allocate costs to the inventory when you figure out your inventory investment.

Speaker 1: (02:41)
So what are the measures of effectiveness? So when we look at applying these measurements in the organization, whether it’s to the strategy or improvement initiatives or daily activities, our measures of effectiveness are applied to the company as a whole and in the context of how they relate to profits, cash flow, and return on investment. The two measures for net profit and return on investment are net profit is our throughput minus our operating expense and return on investment is to change in throughput minus the change in operating expense, divided by the change in investment.

Speaker 1: (03:19)
So when we’re calculating the impact of improvements, of course, we’re looking at it from a global perspective, not a local perspective. Our two global measures are changing throughput, change in operating expense. We can get the net impact on profit by looking at the change in throughput minus the change in operating expense, and of course, return on investment, is that net profit divided by the change in investment. So let’s look at some examples. So let’s take our first scenario here. So our sales in the current organization, our course 100%, our totally bearable costs are 30%. Our throughput then becomes 70%, sales minus totally bearable costs. Our operating expense to convert the inventory into throughput is 65%. So our net profit’s 5%. So let’s say we go and make an improvement in throughput by 25%. So of course, our total variable costs go up by 25%. So that’s 37 and a half percent. Our throughput goes to 87 and a half percent. And let’s just say in this example, our operating expense goes down by two and a half percent. So our net profit goes to 25%. So it goes up 5X.

Speaker 1: (04:30)
Now, another scenario would be okay, our operating expense doesn’t go down, our operating expense actually goes up. So it goes up by two and a half percent to 68 and a half. What’s the impact on net profit? Net profit goes to 19, which is still almost a 4X improvement in net profit. So now let’s look at that from a return on investment perspective. So let’s just do scenario one. Let’s just say throughput at 17 and half percent represents $475,000, operating expense of two and a half percent worth $250,000. And in this case, our inventory has to go up. So let’s just say we want to take and make some strategic investment in inventory because of supply chain issues, increase our inventory by half a million. So in this case, we do the calculation and our return on that investment of increasing inventory by a half a million is one and a half years.

Speaker 1: (05:28)
Now scenario two, same thing, our throughput’s going up by 17 and a half percent. Our OE goes up in this case, we need to add extra operating expense to get that improvement in throughput. So our operating expense goes up to 250,000. Let’s say our investment in inventory, we reduce inventory by a million dollars. What’s the impact on that? So our impact on that is less than a quarter of a year.

Speaker 1: (05:57)
So if you look at your organization, you want to look at these three measures, and ideally, they want to be going throughput up, operating expense down, investment and inventory or capital equipment going down. If that isn’t possible, you might want to increase one of the operating expense investment to increase throughput at a faster rate. So that’s our series on synchronous management. I hope you enjoy the series. Hope you learn something. Next week we’ll start a new series on a different subject. So thanks everyone for joining these sessions.