I get lots of questions about metrics. We seem to be a culture obsessed with measuring things, and the idiotic notion that we can't manage anything we can't measure seems to be a hard one to shake. Far better would be to embrace the wisdom in the adage that hung on Einstein's wall: "Not everything that counts can be counted; and not everything that can be counted counts."
Nevertheless, there is one number – a percentage really – that goes a long way toward quantifying whether the business is getting leaner or not. It is the measure of value added expenses to total expenses. If the business spent $20,000, for instance, and $12,000 of it was on value adding things while the rest was on management, supervision, material handling, inspection and generally pushing paper around, the Lean Ratio would be 60%; or it could be expressed as 3:2 if you like looking at numbers that way better.
I like the percentage approach better because it is easy to graph and track month to month and year to year to see if the business is actually making progress toward the elimination of waste. Note that it is a useless benchmarking tool. The fact that one company may have a 60% ratio while another has a 45% is meaningless. All that matters is that the 60% company become a 61% company then a 62% and so forth.
It seems pretty straightforward. The objective is to continually improve the percentage of money spent on useful endeavors - making sure more of it is gong to things customers perceive to be of value and worth paying for, and less of it to waste. The rub is that very few companies really know what adds value and what does not, as important as it is to know. One of the most important, interesting, and probably contentious discussions you and your management team can have is the one needed to build consensus on defining value adding.
The big problem with defining value adding versus non-value adding seems to be psychological, rather tha intellectual. The CFO of a big publicly traded manufacturer recently told me they had defined all payroll expenses as 'value adding' because they did not want anyone to be upset with the implication that they were not valuable. An admirable sentiment, perhaps, but it utterly destroys the purpose. That seems to the common theme that everyone runs into. Everyone in every department is convinced that they are the ones really adding value. If you are going to have any chance of getting it right, everyone needs to know that all people are valuable, but much of the work is not in the eyes of the customers.
I can't tell you any universal rules for identifying what creates value in your company. Each organization needs to decide that for itself. I can tell you, however, that nothing in the SG&A category is likely to create value. Sales and marketing and logistics/shipping are generally not value adding. Materials handling, quality inspection and fixing broken machines is not of much value. Much of the money spent on packaging is not really adding value beyond the minimum necessary to protect the product and communicate what's inside the box. But again, you have to figure it out for yourselves and it requires really knowing your customers and what they want.
Optimizing any other financial measure doesn't count for much if you are not tracking this one; and if you want to know whether you are really getting leaner or not, tracking the Lean Ration over time is about the only sure-fire way to tell.
Curtis Lane says
Great post very interesting and helpful.
Dan Markovitz says
I’d love to see individuals — not just companies — analyze how the value added ratio of their own daily activities. I know I keep climbing onto the same soapbox, but it drives me crazy when I look at the pure waste of time from stupid meetings, searching for information, responding to email, recovering from interruptions, etc.
Paul Todd says
Just as in creating a Value Stream Map, I agree it is useful to think in terms of value-added and non-value-added when looking at expenses, but it must be kept in perspective. I have seen VSM teams get in heated debates about how to categorize a four minute activity, neglecting the three week delay elsewhere on the map. I can forsee companies manipulating and agonizing over their expense ratio to the point they lose sight over what it was intended to accomplish.
Jamie Flinchbaugh says
Excellent. I think the main point is the Einstein quote, one of my favorites to bring out to help me explain that measurement isn’t the holy grail of all things important.
I’m not sure there is one most important ratio, because as I’m sure you would agree any measure if elevated too high can be manipulated. I can drastically improve that number for example but cutting out all employee development and product development, but clearly that would come back to haunt me. Over the long haul though, the rate of improvement of this ratio is a great fundamental of real improvement.
Ratios on the whole are a much better way to measure direction and progress as a vector than absolutes. Absolutes are often influence by many other things and don’t take into account the purposeful action. Tom Johnson wrote about this significantly in the book Profit Beyond Measure (http://www.theleanlibrary.com/profit-beyond-measure/).
Thanks for a great post.
Jamie Flinchbaugh
http://www.jamieflinchbaugh.com
Tim McMahon says
Great post. A lot to think about on value add vs non-value added. I especially liked your comment “Everyone in every department is convinced that they are the ones really adding value. If you are going to have any chance of getting it right, everyone needs to know that all people are valuable, but much of the work is not in the eyes of the customers.” These are words we all need to espouse when making improvements. It is at the heart of respect for people.
I am not sure many would be willing to admit that S&M is non-value adding. I suppoese there is a big difference in wishing they added value and the reality of customer point of view.
Jason M says
There are too many “yes” men on this website. I think from a pure manufacturing perspective, then yes, functions like marketing don’t add “value” from a customer’s point of view. But that provincial view point doesn’t consider the fact that a product of true value won’t sell if no one knows about it. Yes, yes, I know a good product sells itself and word-of-mouth is best advertising and doesn’t cost a dime. But often times good products need an inital push to let the world know of its existence. The world is a big place! Once people know about it, they buy it, love it, tell their friends about it, they buy it…and the rest is history. But don’t disparage functions like logistics and marketing because they don’t fit neatly into the lean community’s strict definition of value. I am a believer in Lean but from looking from the outside in, there is way too much groupthink going on here.
Bill Waddell says
Jason,
In a hypothetical world, Product A and Product B have exactly the same attributes and quality. Product B, however, costs $1 more because the maker has a much bigger advertising budget. Are you willing to pay an extra dollar for B as a result?
Same with logistics. Two products exactly the same, except B costs $1 more because it was made 2,000 miles further from you than A. Will you pay $1 more for it simply for that reason?
Of course the answer is no. The price you are willing to pay is purely a function of the attributes and utility of the product. Any other expenses the maker incurred in putting that product in front of you are not your problem and they are of no concern to you in making the buying decision.
Value is not determined by the manufacturer, nor does a “provincial thinker” like me decide what is value adding and what is not. Customers make that decision, and the company assuming customers will pay more because of the cost of their ad campaign, or the cost of their long distance logistics is making a big mistake.
Ron Pereira says
Interesting post, Bill. I am, however, struggling with one sentence in particular, namely:
“Sales and marketing and logistics/shipping are generally not value adding.”
I am with you on logistics and shipping. Transportation waste is and always will be pure muda.
But I am not sure I completely agree that sales and marketing can or should be referred to as non value added (even generally speaking).
Case in point your one day assessments.
I am sure your service brings tremendous value to your clients.
And I am sure most of them are glad they found you on this website via the ad to the right or some other website such as your own.
In other words, this “sales and marketing” tactic of ads and underlined hyperlinks in articles you write pointing people back to your website seems to be value added in the eyes of a potentially happy customer… else they may never find you… meaning value never had a chance to be created.
It’s a bit of the chicken or the egg really.
What do you think?
Jason Morin says
You missed the entire point of my post, Bill. I may buy Product B only because I don’t know about Product A. And who says Product B has a bigger price tag because the company spends a lot in advertising? The company that makes Product B may have more efficient operations and thus can afford a bigger advertising budget without raising the price. Or they may have thinner profit margins.
I’m not dismissing the fact that the customer, and only the customer, defines the value of the product. But what good is a good product if no one knows about it? Please answer that. No one likes SG&A, but to believe that all SG&A doesn’t serve a purpose is wrong. You have to sometimes spend money to help *deliver* the value and help customers *learn” the value that exists within your product. While it’s important to ask questions like “does this bring value to the customer is important”, to dismiss other functions is a little arrogant.
Martin B says
“the company assuming customers will pay more because of the cost of their ad campaign… is making a big mistake.”
Tell that to the people at Coca Cola.
One reason you feel good after drinking a Coke is because their advertisements are designed to make you feel part of a big, happy, fun community when you drink a Coke. So the ads *have* added value to your user experience.
Paul Todd says
And so begins the anguished debate that “my function is more value-adding than yours”, to be played out across every organization that attempts to define such a ratio. If it’s constructive, this conversation will lead us to Peter Drucker’s 55 year-old questions: What is our business? Who is our customer? What does our customer value?
Al says
Everyone – please separate the issue of “is it necessary?” from “will I pay for it?” Of course I need to know about your product – but if offered an opportunity, I won’t pay for your ad (unless of course it’s a brand proclaiming t-shirt – but then I’m paying for the shirt, not the original product). I will always pay for a feature I want.
Jim Fernandez says
Is there value in advertising? Depends on the product. If I saw my favorite basketball player wearing “XYZ” tennis shoes in a advertisement, I might buy a pair. And if I purchased the shoes, I would want everyone else to see the ad also.
Bruce Baker says
Bill,
I agree that S&M does not add value in the eyes of the customer unless the result of the marketing is too create a perceived value that is not utilitarian in nature. Some products have snob appeal. These are special case veblen goods and probably outside the scope of your post. But I don’t think you addressed Jason’s point. In his model he might not of even known about product A because nothing was done to promote it. Although, I believe that S&M is non-value added, and that your logical construct that no rational actor in an economic transaction would spend money on an ‘equivalent’ product, I don’t necessarily agree that all actors in the market are that rational. They may not have enough information (maybe they were influenced by advertising). On logistics, I have paid more money for a pizza delivered to my house. Not ALL customers see ALL logistics as nva.
Bruce Baker says
Ron,
On all shipping and logistics being waste – I mentioned pizza delivery in a post above. A more serious example would be a “hot-shot” automotive parts delivery distributor. These are distributors who will immediately deliver an auto part to a jobber (installer). Many installers are willing to pay for this service. They may (or may) not stock parts for a 03 Camry because they work on them a lot. They might stock parts for my 80 Geo (NUMMI) Prizm so they might be willing to pay a premium to have a ‘warehouse” distributor “hot-shot” the part out. I used to think logistics were axiomatically waste but after working process improvement in automotive aftermarket I’m not sure anymore. I think it is a good general belief, but it is still a paradigm that needs to be challenged in each specific case.
Philip Neukom says
Strickly speaking, you are correct. Value is what the customer will pay for.
But it is hard to find anyone inside an enterprise that is willing to be so strict. And then the politics and knives come out. In that case arguing about what is value and to whom is most often a waste of time.
A company has to decide for itself what it will define as value-adding and non-value adding.
You might look at working capital productivity ratio. It was defined and explained originally in Fortune, believe it or not. Sorry I can’t find a link but it was before the explosion of the internet.
Lean companies turn over their working capital much quicker and use much less working capital than non-lean companies. We’ve used the measure to get a gauge of how lean a company is and how good management is at shepherding capital.
So tracking the WCPR over time and making sure it is getting smaller means the company is getting better.
Michael Bremer says
I look at this a little bit differently. Here is an excerpt from our new book “the Improvement Trap” to be published in the Spring.
Who adds value inside a business? In a manufacturing company, value is added by:
•the design engineers who create the new product;
•the people in operations who change the form, fit, and function of raw materials and transform them into a product;
•and the people who sell the product.
Everyone else in the organization should be supporting those three groups:
•Marketing is intended to help sales sell.
•Supervision in a factory is intended to remove barriers that make it difficult to turn raw materials into finished product.
•Financial and management reporting should help design engineering, operations and sales create more value.
•And leadership should create an environment where all of these players can do the best possible job.
The further leaders move an organization away from “creating the actual ‘real value’ for the key 20% of customers,” the more those leaders jeopardize that organization’s future, and the organization begins to live in the moment, off of its legacy investments in knowledge, skills and capabilities.
Sales does add value. It is more difficult to measure than making a physical product. For example; picture a complex capital equipment sale. Sales adds value in this instance by gathering the right customer requirements, for design engineering to use and for the folks in operations to make it. There are a host of things that can inhibit value creation. Sales gets the wrong requirements, they are not talking to the buying decision maker, etc. One way or the other they are either adding or inhibiting value
Philip Neukom says
Here, here, Michael!
No sales no business or no value to maximize.
Bill Waddell says
I think you guys are missing the fundamental point. Are sales necessary? Of course. Are they valuable to the company? Absolutely.
Do additional sales make your product more valuable to an individual customer? Abolutely not. Is the customer willing to pay more for your product in order to subsidize your need to sell more? Of course not.
Value added to the customer is not a function of the value an activity may have to the company. And it is not a function on whether the activity is necessary.
Investments in sales are necessary to the company and they add value to the company – but they are waste as far as the customer is concerned.
Michael Bremer says
Bill….with all due respect….I think you are missing the important point. You state, “Is the customer willing to pay more for your product in order to subsidize your need to sell more? Of course not”
This is not about additional sales, it is about ‘the sale’ to one customer. And do these activities add or not add value in that single interaction? Customers are willing to pay in some instances.
If it is a complex sale, when the sales person works with the customer to determine their real requirements, or if the customer has overstated what they need and the sales person can show them a less expensive alternative that meets their needs….As a buyer, this Adds Value.
Do organizations typically have an effective way to measure this…nope.
The same with Design Engineers. We have all discussed how 70% to 80% of the cost is locked in at the design stage. If those engineers can design something for me (the customer) that will cost me 50% less, would I pay for that? Absolutely! Think about Webster Plastics when they moved to selling ‘engineered solutions’ for products they could manufacture. In this instance, design engineering definitely adds value. If it is a commodity product then the engineering is necessary but does not add value…it has to be taken in context.
Customers would/could consider these activities as necessary. We are not talking about sales of commodity products in this example, or simple products that have little differentiation.
Now if you say, “this is difficult to measure, and most people don’t look at the world this way” I’m 100% in agreement. But I believe it is important for us (and organizations) to be able to get a better grip on the value generated and the value destroyed by those functions. They can generate value for customers, equivalent to the value produced in operations that customers would pay for. Sales and Engineering can also destroy value when they get it wrong. Which unfortunately happens all to often. If customers buy those products, they are paying way more than they should have.
This is not a defensive statement about ‘my function adds value.’ And I believe it totally fits with your idea of the ‘lean ratio’…interestingly I had written something along the same lines in ‘the Improvement Trap’ I supplemented it with your definition.
Given your writing about the problems with out sourcing and the whole idea of a value added ‘lean ratio’ this could be an important component. How can an organization reposition sales and engineering so they are actually adding value, and are not merely necessary?