As we move into 2008, the U.S. economy is slowing down and the debate among economists seems to be whether we are going to experience a recession or just a slowdown in growth. The sub-prime crisis and tightening credit markets make it more difficult and more expensive for companies to raise capital, so what can a manufacturer do these days to finance necessary growth?
Companies that follow a continuous improvement agenda have discovered a ready source of capital to finance growth: harvesting cash tied up in inventory. Some people look at inventory as necessary for customer service, but customers don't care if an order is filled directly from your manufacturing operation or from a warehouse, and it's more cost efficient shipping directly from operations.
The question is how to harvest this source of cash. As those involved in continuous improvement will tell you, it's not just a matter of delegating it to your manufacturing folks to implement lean tools. A sustainable commitment to reducing inventory -- including raw, WIP and finished goods -- is really a commitment to change the way you do business and it affects almost all of your business processes.
As many companies have discovered, the journey can be well worth it in reduced costs, generation of cash for growth, improved customer service, higher quality and the ability to compete in global markets. Your production operations have to become flexible to produce small batches -- down to lot sizes of one in some cases -- to be able to manufacture exactly what your customers want, when they want it and in the quantity ordered as cost effectively as your old batch operations. Your supply chain also needs to change to be able to deliver materials and components in the exact quantity required and when your operations need them. Even your distribution channels need to change to move from a build-to-stock business of standard products to a build-to-order business that allows you to customize your products to specific customer needs.
As you embark on this transformation, think about your management accounting system. Many of the metrics that conventional accounting systems use drive decisions that are counterproductive to implementing continuous improvement actions and lean business processes, and need to be changed to reinforce these efforts. Where and how does inventory show up in your current management accounting system? Is it an asset or a liability (bankers call it an asset but lean practitioners look at inventory as a liability), and how should it be used in evaluating management performance? Some organizations use an EVA (economic value added) approach to include a portion of the inventory value in the capital employed by an operation when evaluating managers' performance. If you measure and reward managers based on metrics like labor productivity, maximizing production output or machine utilization and things like purchase price variance (PPV) for purchasing agents, you're creating incentives to increase inventory instead of harvesting the cash from it.
Your CFO should also be involved with your continuous improvement strategy because they will see things happening to your income statement like increasing cost of goods sold, reduced margins and profitability as inventory of work-in-process and finished goods are reduced. Even though cash flow looks much better and the need for borrowing working capital is reduced, it has some short-term negative impacts on your conventional accounting P&L, and your CFO needs to know it's coming.
The continuous improvement transformation journey is not easy for organizations and it takes a lot of hard work from everyone, but the elimination of waste from your business processes and the resulting increase in free cash flow, quality, customer service and profitability make the effort worth your consideration. Besides, in this era of the sub-prime crisis and tight credit markets, is there a better way of funding growth and new product development than harvesting the cash already tied up in your own inventory?
Ralph Keller is president of the Association for Manufacturing Excellence, an organization dedicated to cultivating understanding, analysis and exchange of productivity methods and their successful application in the pursuit of excellence. He has been an operations practitioner for the past 35 years.