In
my last posting we talked about a regional building products manufacturer that
had purchased an automatic case packing machine and how using cost accounting
to make decisions jeopardized their business.
In this posting I want to continue the discussion about this same
company after it was purchased by one of the Giants of this industry. This example is again, taken from a wonderful
book by Debra Smith, The Measurement
Nightmare – How the Theory of Constraints Can Resolve Conflicting Strategies,
Policies and Measures.
As
I said in my last posting, a year later this highly successful regional
building products manufacturer was purchased by one of Giants in the building
products industry (identified in this posting as Giant). They were purchased because their product was
carried in Giant’s retail stores as a premium brand, delivered to Giant’s
distribution center on time, and customers requested it because of its
reputation for high quality at a reasonable price. Debra explains that this purchase began the
demise of a great little company and all the reasons why they had been acquired
were immediately in jeopardy. Why, Debra
asks? Giant’s accounting information
used for decision-making and measures did not jive with the acquired company’s
TOC environment.
Debra
explains that during the due diligence, before the acquisition, when Giant’s
accountants snooped through the books of the company to be acquired to decide
if the company really is what it had claimed to be. It seems that both companies purchased
chemical raw materials from the same national source, and Giant purchased vast
quantities of these chemicals. Both
companies were shocked to see that the small company’s cost for raw materials
was 8% less than Giant’s best price from the same supplier. The supplier explained that the price had
been negotiated because the smaller company always paid within 10 days of
receipt and Giant never paid in less than 60 days. This time difference required the supplier to
borrow money for 50 days longer to do business with Giant. It seems that Giant had adopted a policy to
maximize return on cash and did not pay any vendor in less than 60 days. The average earnings on the cash invested by
Giant was about 5% annually. The sorry
part of this is that based upon the chemical component of raw materials at only
5% of total operating expenses, 8% would have increased their bottom line by
over $12,500,000!
Another
decision that Giant had made which had major negative ramifications was their
decision to impose across-the-board cost cutting and headcount reduction in
which all divisions shared equally in absorbing a major reduction in income due
to the loss of a major national retail chain.
This decision, Debra explains, ignores a basic principle of physics and
TOC – if you decrease the ability of the weakest link you decrease the ability
of the entire organization. The small,
recently acquired division was on track with 25% annual growth and was shipping
every unit they could produce. Their
growth hwas based upon their demonstrated ability to meet customer demand with
a quality product and short turn-around from order to delivery. Debra explains that many of their national
accounts were new, and a continuing business relationship was dependent upon
delivery of promises made regarding on-time delivery. In addition, the new division had no excess
layers of management to cut, and they could not induce their suppliers to
reduce raw material prices; in fact they had just sustained the 8% increase in
raw materials mentioned earlier. This
left them with three options:
1.
Reduce the sales force.
2.
Reduce direct labor.
3.
Reformulate the product, sacrificing
some quality features for lower cost ingredients.
Any
of these options would seriously compromise the division’s ability to meet its
aggressive sales-growth targets and would harm throughput and net profit in
both the short and long run. This is
clearly an example of the result of companies losing sight of the fact that a
company is a chain of dependent events.
The across-the-board cuts in this example blatantly ignored the obvious
and compromised the ability of the company to make money in the future!
In
summary, Debra tells us that when the finance department maximized their use of
cash, the company missed maximizing the overall return on investment to the
business. By maximizing the case-packing
and labor efficiencies the company eliminated the bottleneck, reduced total
throughput, and spent $250,000 to do it.
By imposing an across-the-board cut, the constraining resource is cut
equally with every other area.
Negatively impacting the constraining resource negatively impacts the
division’s ability to generate throughput.
The cost cut successfully derailed the new division’s sales and profit
plan for the year and seriously jeopardized all of the features that were
attractive to Giant in the first place.
I
hope you enjoyed this series of postings about performance metrics. In my next posting I’m going to shift gears
and focus on a series of articles on healthcare. In particular, with the implementation of the
Affordable Healthcare Act right around to corner, there are ramifications for patients,
hospitals and healthcare facilities that the public needs to know about. It is my belief that TOC can help overcome
many of these.
Bob
Sproull
3 comments:
Bob The objectives of TOC and LEAN are the same but they approach things from a different point of view.
TOC's focus is on systems not processes whereas Six Sigma is about process improvement. Where in your blogg do you highlight these significant differences?
Jim, it doesn't matter whether it's LinkedIn or Facebook or my blog....you always find some kind of fault or nitpicking item to comment about. You are clearly known for this and you have been discussed privately.
The fact is, you can use any of the three or a combination of the three to improve processes. But thanks for your comments Jim....always happy to receive them and share them with others.
I gotta have Debra's book. It sounds good.
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