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.