After years of trashing Return On Investment – the DuPont ROI model, in particular – as a measure of manufacturing success, or as the decision making criteria for manufacturing analyses and investments of any stripe – I received an email from a reader the other day asking, if not ROI then how would a potential investor look at a manufacturing company? What are the measures of the business to gage their 'leanness'? I thought I'd share my answer here with everyone, and see what the rest of the lean community thinks.
The biggest problem with the ROI logic – other than the blatant violation of Einstein's not everything that can be counted counts and vise versa adage, is that it treats inventory and cash as equals – it doesn't matter whether you have a thousand dollars in cash or a thousand dollars in inventory … therefore cycle times don't matter … therefore lean manufacturing has no economic advantage.
The financial record I would look for includes:
Consistent, positive cash flow from operations, and a strong cash position. I would expect a lean manufacturer to be self-funded for just about everything except, perhaps, for huge outlays such as acquisitions or building new plants.
I would expect significantly better inventory turns than the industry average, and would expect a track record of continually improving inventory turns as cycle times continuously shrink. Of course what constitutes lean inventory turns depends on the industry and the structure of the business. A company constantly expanding into other countries and exporting to those subsidiary companies is going to have an ever growing pipeline, which will be a constant pull against inventory reduction. The point is that I would look for high inventory turns, or a very good, short term explanation for the lack of them. Long cycle times (manifested by low inventory turnover) is fundamentally incompatible with excellent manufacturing.
I would look for lower GSA (General, Selling & Administrative) expenses than the industry average. If available, I would look for the operating overheads in general, to be lower than the competition. The lean company is focused on eliminating non-value adding expenses, and should have a very high percentage of value adding expenses to their total expenses. While the non-lean company bludgeons direct labor and the suppliers, low GSA is an indicator of a company that truly understands the concept of value adding.
On the non-financial side, I would expect the company in which I I invest to:
Be quite vertically integrated. No one can outsource their way to excellence – having someone else provide the janitorial service, shovel the snow and cut the grass and the like are OK – but the core manufacturing should be done in house.
I would expect a long track record of stable employment – no layoffs. I would look for very low employee turnover and a wage structure higher than the local average for similar work.
I would look for senior leadership with strong technical orientation. In looking around the table when the senior staff meets, I would hope for more than half of the folks there to come from engineering, manufacturing and supply chain backgrounds; rather than finance and marketing.
That's about it. Of course if I were to go into a company as a consultant I would look for a lot more than this, and I would look at these things in a lot more detail. As an investor, however, with limited access to the company's detailed operations, these are the criteria I would look at very hard before I put my money in on the promise that the company is 'lean'.
Did I miss anything?
Jamie Flinchbaugh says
Bill,
I think the biggest problem, or perhaps the meta-problem, is the desire to have that one best metric. There is no such thing. Every metric is an abstraction. It only tells a part of the story. Even at a profit level, EBITDA tells a different story than Net Income tells a different story than Operating Income. The world just isn’t simple enough to find that magic metric to measure everyone on.
Thanks,
Jamie
Jon Miller says
Goodwill. Being loved by society, not monetary value of a logo. However you can measure it, this is the only thing that keeps you in business in the very long haul.
Michael F. Martin says
The biggest problem with the ROI logic – other than the blatant violation of Einstein’s not everything that can be counted counts and vise versa adage, is that it treats inventory and cash as equals – it doesn’t matter whether you have a thousand dollars in cash or a thousand dollars in inventory … therefore cycle times don’t matter … therefore lean manufacturing has no economic advantage.
Actually, cycle times can be counted. They’re just not in standard balance sheet and income statements. The mathematical reason for this is that one represents a snapshot in time and the other a time-integrated average.
Upon first reading about lean accounting a couple years ago, I was struck by its emphasis on frequency-averages.
http://brokensymmetry.typepad.com/broken_symmetry/2008/06/cost-accounting.html
To put this in terms that should be accessible to any audiophile, we need a spectrum analyzer to be included in our financial statements. Both the time-averaged costs and frequency-averaged cycle times matter to free cash-flow.
Another way to say the same thing — can you drive a car with only a speedometer? Yes. But if you have both a speedometer and a tachometer, you’ll drive better.