by Art Byrne
I guess that might sound a little goofy. Certainly, for the traditionally run batch company it won’t make any sense at all. To them the balance sheet is just something that exists based on the nature of the business or the industry you are in and there is not much you can do about it. It certainly has nothing to do with earnings. To grow earnings, they believe you should focus on growing sales and lowering costs. Don’t worry about the balance sheet it will take care of itself.
Like so many other things the lean company sees this in the exact opposite way from the traditionally run company. Lean leaders can agree that growing sales and lowering costs will lead to higher earnings. At the same time, they understand that the best way to achieve this is by focusing on the balance sheet. This is just a logical extension of the lean companies focus on removing waste from all its processes in order to deliver more value to the customer. Waste can and does occur in every process, but the accumulated total of this waste is reflected most clearly on the balance sheet. You could say that the balance sheet is where waste goes to die.
Once you can understand that it is much easier to put your focus on the balance sheet in order to grow earnings. For example, the strategy of any lean company can be driven by two key measurements.
1] 100% on time customer service
2] Inventory turns
Both of these measures support the idea of growing sales and lowering costs in order to drive earnings. The company with 100% on time customer service will, over time, always take market share from the company that only has 95-96% customer service. Also having this as a key goal supports the lean focus on delivering more value to your customers. The lean company makes its decisions based on whether or not it will deliver more value to the customer. The second of these key measurements, inventory turns, is the driver of both better customer service and lower costs. Inventory of course is a balance sheet item. But because it is also the key to earnings growth the lean company understands that this is where the focus should be.
But why? The traditional company sees inventory as a necessary evil in order to provide a high level of customer service. “You can’t sell from an empty wagon” is the basic mentality here. The lean company on the other hand sees inventory as “the root of all evil” as it is the number one waste in Taiichi Ohno’s list of seven wastes. Its mere existence is just to cover up all of the other wastes that exist. It is there “just in case” which of course is the opposite of “just in time.”
So lets look at this more closely. Say we have two companies, Company A and Company B. Company A turns inventory 3x and Company B turns inventory 20x. Who do you think has the lower costs? Who do you think has the shorter lead times? Who do you think has the better quality? Who do you think has the better customer service? These are not trick questions but the traditional manager might be a little confused as to what is the right answer. Perhaps his company has been doing ok with 3x inventory turns. In addition he would consider the idea of 20x inventory turns so impossible for his company that he could dismiss it out of hand.
The answer of course lies in understanding what has to happen to go from 3x inventory turns to 20x turns. This can’t happen by itself and it can’t happen over night. Lots of waste has to be removed from every process to get to 20x turns. Start with set up reduction. If you have 2-3 hour set up times on most of your equipment you will be forced to produce in big batches which drives up inventory. If you get all set up times into the single digit [under 10 minutes] your batch sizes will decrease and your inventory will drop.
"Like so many other things, the lean company sees this in the exact opposite way from the traditionally run company."
The move from batch to flow will also reduce inventory as you will start to get closer to the lean ideal of “sell one - make one.” This along with set up reduction will reduce your lead times from 6-8 weeks to 1-2 days. This will drastically improve your ability to deliver value to your customers. It will also allow you to gain market share and improve your sales growth. Every time your competitor with 6-8 weeks lead time stumbles your 2 day lead time will allow you to gain market share at full book price.
Creating flow and a value stream organization will not only lower your inventory but as a side benefit it will lower your costs and improve your quality. In my experience it is common to see a 10x improvement in quality by moving to flow production and away from batch. This happens because you now have all the production steps in line with a very short lead time so when a quality problem occurs you can understand all the reasons it happened and get a permanent solution. Moving to flow from batch will also lower your costs. It is common to see a reduction in the number of operators needed by over 50%.
Removing inventory forces the organization to figure out how to live without it. More waste must be removed to maintain production and customer service. You can no longer live with unplanned machine down time. You have to have a close relationship with your suppliers for them to keep up with you with daily deliveries. You can’t tolerate defects. In addition as inventory is removed space will be freed up. The lean company with 20x inventory turns will typically require 50% less space than the competitor who turns inventory 3x. This is another big cost reduction that will occur by focusing on inventory turns, i.e. your balance sheet.
For traditional companies the mentality is that to lower costs you have to spend money. In other words lowering costs is capital intensive. With lean, however, the opposite is true. Moving to lean is a big cash generator while at the same time lowering costs. As an example lets say we have a company with $100 million in inventory turning at 3x. Look what happens as inventory turns improve.
Inventory Needed at Various Inventory Turns
3x = $100 Million
10x = $30 Million
20x = $15 Million
Of course all of this freed up cash can be reinvested in things like new products or acquisitions to help you grow earnings. The balance sheet can finance a lot of growth.
Of course inventory and inventory turns are not the only thing you should look at on the balance sheet. Accounts Receivable are another potential source of growth capital. This is often overlooked as “gee, we can’t do anything about that.” But this is not so. At Wiremold we had the same sales terms as everyone in the electrical industry. Technically this was 2% ten, twenty fifth prox. That meant that if a distributor orders by the 25th of the month they could get a 2% discount if they paid by the 10th day of the following month. This forced about 50% of our shipments into the last day of the month and caused a lot of problems for both us and our distributors.
It also resulted in 45 day sales terms that often got stretched to 60 days. For us trying to ship 50% in the last week of the month made it impossible for us to level load our plants and become lean. It also prevented us from delivering more value to our customers. Our solution was to offer a higher discount, 5%, if they paid us every 15 days. We let our distributors choose either the 2% or the 5% discount. They all picked the 5%, which we were able to offset with a one time 5% price increase, and paid us in 15 days. This cut our receivable days in half and freed up a lot of cash for acquisions and new products. Its more important contribution, however, was allowing us to level load our factories, lower our costs and deliver more value to our customers with shorter lead times and better customer service.
Summary
Unlike the traditional company, the lean company focuses on improving its balance sheet in order to drive lower costs, better quality, shorter lead times and better customer service. Try it you’ll like it!
First published on Lean Enterprise Institute’s The Lean Post
Art Byrne is the retired CEO of The Wiremold Company where his lean strategy increased enterprise value 2,467%, boosted sales from $100 million to $400 million, improved productivity by 162% and made dramatic gains in lead time and inventory turns.
He is also the best selling author of The Lean Turnaround and The Lean Turnaround Action Guide.