When Clinton ran for President the first time, he had a sign posted at his headquarters that said, "Its the Economy, Stupid!". The purpose was to keep him focused on the only issue his managers thought really mattered in the campaign. They felt he needed such a reminder to keep him from wandering down all sorts of rabbit trails on various social issues that would have no bearing on the outcome of the election. Mangers – especially senior ones – in manufacturing companies might want to try the same approach. Lean manufacturing is first, last and everywhere in the middle about cost.
Way back in the 1880’s Andrew Carnegie constantly pounded into the heads of the management of his steel company the principle that pricing and volume are outside of the company’s control – they fluctuate with the economy and the whims of customers. Cost, on the other hand, was completely within the company’s control. Therefore, the only sure way to business success was absolute control of costs and constant pressure to reduce cost whenever they could. Now I would hardly hold Carnegie up as an example of lean manufacturing success. He was more the poster boy for incredibly dismal labor relations (although he did come up with a pretty innovative cost-price idea – he paid skilled worker a base rate plus a premium that was based on the average selling price the company got for a ton of steel. When the price was down, employees made the base rate; when it was up, they earned a pretty good wage.)
The point is that this central focus on cost control and reduction is an old business model, that has proven to work quite nicely. Henry Ford took it one step further by using cost reductions to fuel price reductions, which fueled even greater volume increases. Toyota has codified the Carnegie principle with their often repeated equation, PROFIT = (PRICE-COST) X VOLUME. This is diametrically opposed to the widespread American notion today that COST + PROFIT = PRICE.
What makes the American concept ‘work’ is the layoff. Companies can set prices each year based on their planned cost plus the needed Return On Sales, or margin, then take a pretty fixed price list out to the market. When the market won’t buy, they just lay off the people until the market comes around. Not only does that approach not work too well, it makes lean manufacturing impossible. The Toyota cost reduction focus, coupled with pricing that fluctuates with the market, is what makes stable employment possible. When the market is unreceptive to Toyota prices, they cut the prices – not the people. By stabilizing the people, lean manufacturing and continual cost reduction are possible.
Of course, most American manufacturers believe they already have a cost reduction focus. After all, they close plants and layoff people all the time – and that reduces costs. True enough, but it also reduces volume and so alienates the workforce that lean will never happen. Worse, it is a reflection of the fact that ‘cost’ in the American management mind has become synonymous with ‘workers’. Direct labor payroll is the single target of just about every cost reduction effort – that and trying to squeeze another percent or two from the suppliers.
There are a whole lot of other costs out there – overhead costs – that usually blow five or ten bucks for every dollar in direct labor cost, but overhead tends to get scant attention. Turning the whole thing around by having the direct labor people and their associated costs become fixed, then using them as a weapon to help gut the overheads, is a strategy that has worked pretty well for Toyota for a long time. It worked pretty well for Henry Ford, and even for old Andrew Carnegie.
Isn’t it sad that, in order to find effective manufacturing management examples in America, we keep having to haul out the names of guys that have been dead for almost a century? Even sadder is going into a company that is trying to become lean and finding out that the people from marketing and accounting are not part of the effort, at all. Without them on board, committed to the PROFIT=PRICE-COST principle, lean just ain’t gonna happen.
Mark Graban says
Thanks for the history lesson, I didn’t realize the part about Carnegie and the profit/cost equation. It’s really frustrating how often you hear companies complain that they “have to” raise prices because raw material costs went up. I try to point that out, when I see it, on my blog.
Chet Frame says
For the last twenty-one years I have worked most of the time in Mexico with Maquila operations. Companies have moved their operations here to reduce their cost (to your point only Direct labor). They never look at the overhead cost of the move or what they do to that cost once they are here. Labor in most of the plants is about 7% of the product cost while Overhead averages between 35% and 40%. It was that way before they moved to Mexico and it still is that way.
Many of them have seen the light, however, and they are moving to China to reduce their costs even more.
Bill Waddell says
Mexico really blew a golden opportunity in my opinion. They had all of the business for ten or fifteen years, and largely failed to leverage it into a manufacturing sector of their own. The problem is that they lured all of the companies who were tunnel visioned on cheap labor, but that can’t last. They have all moved on to China and; when Chinese labor goes up a few cents, everyone will pack up and move on to the next place. The cheap labor crowd hasn’t even begun to look at Africa – there are people there who will probably work for nothing, just for a roof over their heads for 10-12 hours during the rainy season.
China is developing its own manufacturing, however. When those in pursuit of cheap labor bail out, China will have enough manufacturing of its own to keep its economy going. Mexico acted like the maquila run would last forever and is paying the price.
Ed says
Bill,
What happens under the PROFIT = (PRICE-COST) X VOLUME model when a market saturates and volume increases are no longer possible?
Bill Waddell says
When volumes are level and price increases are no longer possible, the competitor with the lowest costs wins. Volume and price pressures always affect everyone in the market the same. The only thing a company completely controls is its cost.
Play it any way you want, but in the long run, the lowest cost producer is always the most profitable producer.
Phi says
When I first entered the work world in the mid-1970’s, I joined a highly successful and huge multinational petrochemical company. My first manager, a great mentor and teacher, talked about facilities the company had moved offshore and out of the states. I presumed this was done to reduce costs by paying foreign rather than American union workers, so I asked how things went.
He told me that the company saved little or nothing because they needed more managers per worker to get work done than was required in the states.