Like most major change initiatives, going lean rarely looks good from the start. The operating efficiencies come quickly, yet sales and profits — for a while — get worse. The solution? Adopt a new financial reporting method that captures what’s really happening in the business.
Several years ago, a Pennsylvania manufacturer of industrial sensors — we’ll call it Caspian Corp. — launched an ambitious effort to become a lean enterprise in hopes of achieving higher quality, lower costs and better customer service. Management’s goal was to eliminate all unnecessary expenses and surpass its leading competitors in terms of productivity and efficiency. During the first six months, Caspian, whose total annual revenues were about $225 million, achieved significant operating improvements. Product lead times to customers and on-time delivery performance were up sharply. Over the next six months, operational performance continued to show impressive gains, and the vice president of operations was pleased. Meanwhile, customer service was making significant strides as well, and with greater efficiencies the company was able to reduce the number of direct labor employees involved in production. Payroll savings in a single value stream alone amounted to more than $40,000 per month — around 20%. However, the CFO saw a radically different picture. During the same initial months, she saw no financial improvement at all: Sales were flat, and costs didn’t decline. During the second half of the year, Caspian’s revenues actually fell by 17%, and profits declined by an even bigger percentage. The CFO was baffled: The sales forecasts had looked encouraging, and the operations people had talked about significant savings. What happened? Unfortunately, she was at a loss to explain the disparities to the company’s board or to outside investors. Caspian’s management spent the next 12 months attempting to generate stronger results. Previously, the company had deliberately kept inventory levels high to ensure that customers would be well served. Now seemed like a good time to cut inventory — something the CFO hoped would lead to financial gains. With less inventory, she looked forward to having more cash on hand. In addition, she anticipated that quality improvements would pay a nice dividend in terms of lower materials costs. She certainly wasn’t prepared for more bad news: Despite higher productivity and efficiency, Caspian’s profits remained lower than they were before the company began its transition to lean. Return on sales fell from 7% to zero. At this point, the CFO and CEO were ready to pull the plug on the lean program and go back to the “good old days” of mass production. They simply couldn’t afford more surprises, no matter the “success” of the overall effort.