determining the financial value of implementing lean

The plant was indanger of beingclosed. Given

stiff competition andrelatively poor overalloperational and finan-cial performance inthe eyes of the corpo-rate executives, therewas little that was immediatelyobvious that could be done tosave hundreds of manufacturingjobs. The plant manager hadheard about just-in-time manu-facturing and the benefits asso-ciated with its proper implemen-tation—lower manufacturingcosts, lower inventories,increased manufacturing flexi-bility, increased quality, anddecreased lead times.

The plant manager decidedto implement just-in-time, orlean, manufacturing in her plantagainst the will of the corporateexecutives. Adjusting productionto meet demand and desiredinventory levels rather than tothe expected output levels calcu-lated by the accounting numbers,the plant’s unit costs began toincrease along with pressure toclose the plant. Knowing thatshe was doing the right thing,the plant manager stuck to herguns, fully expecting the

improvements to be realized in areasonable amount of time. Inthe end, not only did her plantmeet corporate expectations, butshe also exceeded her ownexpectations and created a fewjobs rather than causing hun-dreds to lose theirs.

This is a relatively commonstory for those who have imple-mented lean, including the com-pany that created the concept,Toyota.1 In a crisis situation orwith a truly transformationalleader who is interested inimplementing the essence oflean, turnarounds (at best) andsignificant improvements (atleast) are available as a result ofa full and effective implementa-tion. Lean is about getting moreout of one’s resources, whichleads to increased output atslower rates of investment ingrowing markets or the ability tomeet relatively constant ordeclining demand with fewer

resources than other-wise needed. Thiswould lead one tobelieve that there aresubstantial benefitsavailable to thoseimplementing lean—the most salient beinglower costs and

improved cash flow. Why, then,are there hurdles that make thedecision to implement lean sucha challenge? Many finance andaccounting personnel do not seethe improvements or improve-ment opportunities in their num-bers, while many of those whowant to implement lean have adifficult time quantifying thebenefits that they know exist.

Lean is not unique when oneconsiders the way in which itwill improve operational andfinancial performance. Lean canbe a direct source of improvedoperational performancebecause, by design, it improvesefficiency and effectiveness.This is enabled by focusing onthe identification and elimina-tion of waste in all forms, result-ing in operations that canachieve more with relativelyfewer resources required. Thisimprovement in operationaleffectiveness is often mistakenly

Lean is about getting more out of a company’sresources, which leads to increased output atslower rates of investment in growing markets orthe ability to meet relatively constant or decliningdemand with fewer resources than otherwiseneeded. © 2006 Wiley Periodicals, Inc.

Reginald Tomas Yu-Lee

Determining the Financial Value ofImplementing Lean

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assumed to create direct finan-cial value, which lean will notdo in most cases. Resources thatare more efficient are not neces-sarily cheaper.2 Increasing theefficiency of a salaried or anhourly worker will not reducehow much they are paid, and thepay is what affects cash flowfrom an explicit costperspective.3 Instead, it positionsmanagers to make decisionsregarding the input and outputlevels that do have a directimpact on cash flow.4

Most managers will agreethat implementing lean tech-niques in a manufacturing orservice environment makessense conceptually. Meet-ing demand with thefewest required resourcessuggests operational andfinancial efficiencies thatmany stakeholders andmanagers alike seek. Addi-tionally, such companiesoften have the option ofsharing the benefits with cus-tomers and consumers directlyas lower prices, and indirectly asimproved delivery or quality, forinstance. Although one can agreethat the notion of lean operationsmakes sense and is a good strat-egy in general, many companies,managers, and others responsiblefor implementing lean are con-strained due to the difficulty ofcreating and documenting thevalue proposition.

The main source of the con-straint is the practice of usingfinancial statements and thetechniques used to calculate theirdata as a basis for calculatingcost and cash flow improve-ments. For example, cost vari-ances are often determined bycomparing the calculated actualcost and the expected or stan-dard-type cost. Allocation tech-niques are used with both stan-dard costing approaches and

activity-based costing. This prac-tice can lead to misrepresenta-tion of costs and a misunder-standing of the cost dynamics ofa given situation.5 This leads totwo negative results. The firstand most common is the expec-tation that costs have truly gonedown due to greater absorption.In reality, however, the amountof money truly spent has notdecreased and, in many cases, ithas increased. The second is thebelief that income statement val-ues are actually tied to cashflows, which, in most cases, theyare not. Since the cost of sales orthe cost of goods sold representsmoney already spent, there is no

assurance that said money wasspent in the same period that therevenues are received. And thefewer inventory turns, the longerthe time difference betweenspending money on capacity,including materials, and sale ofthe resulting product.

UNDERSTANDING THE LEANVALUE PROPOSITION

Understanding the conceptu-al components of the value cre-ated by implementing lean isstraightforward. As suggestedpreviously, lean is responsiblefor many benefits that are usual-ly operational in nature andenables others that are financial.However, the techniques andbusiness theories typically usedto calculate operational andfinancial improvements are oftenincapable of explaining the truesource of the improvements.6

Understanding the anatomy ofproductivity increases andexplicit cost and profit dynamicsmakes the nature, magnitude,and improvement opportunitiesvery clear.

PRODUCTIVITY INCREASES

Companies are composed ofcapacity in the form of space,labor, equipment, technology,and materials.7 These forms ofcapacity have the same basicproperty—they are all purchasedin anticipation of use, whichsuggests that it be available foruse in some regard. These capac-ity entities, called static capacity,

are the fundamental build-ing blocks of an organiza-tion. Each operation iscomposed of some combi-nation of static capacity,and a process is a combina-tion of operations. A person(labor) in an office (space)on a computer (technology)

consuming paper stock (materi-als) on a check printing machine(equipment) may be an operationin the accounts payable process.It is up to the management in theorganization to determine howeffectively it is used so that theorganization realizes its financialand operational goals.

Static capacity represents theinput component to capacity and,as such, the primary costs asso-ciated with capacity. When con-sidering the components of thecost of goods sold (COGS),most of that which is allocatedto the cost of a product is laborand materials. Sales, general,and administrative costs (SGA),too, are composed primarily ofstatic capacity costs. This sug-gests that a large percentage ofan organization’s costs are staticcapacity costs and that a compa-ny’s cash flow dynamics can beunderstood by modeling the cost

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DOI 10.1002/jcaf © 2006 Wiley Periodicals, Inc.

Understanding the conceptual compo-nents of the value created by imple-menting lean is straightforward.

dynamics of capacity. Dynamiccapacity represents the outputcomponent of capacity. Eachcapacity entity enables sometype of output or usage informa-tion. The output component forspace may be how many officescan comprise the available spaceor how many products can beproduced or stored in a particu-lar area. For equipment, it maybe how many products can becreated over a certain period oftime. For those who work aneight-hour day, their output mayvary from day to day or hour tohour during the shift.

Increasing productivity ofteninvolves increasing the dynamiccapacity of an individualentity, operation, orprocess. Training mayallow an individual to per-form his or her job better,leading to increased outputat the same level of input.Similarly, improved processlayouts or shortenedmachine set-ups allow for moreoutput in the same space oramount of time, respectively.The conclusion is that productiv-ity increases are good forimproving output, but it is theinput component of capacity thatdetermines operating costs.8

Therefore, productivity increasesthat increase output rarely leaddirectly to cost savings, and leanis such a productivity enhance-ment tool. Techniques such asredesigning manufacturing cellsimprove the utilization of spaceand position managers to reducethe number of laborers requiredto produce products, but leanitself will not create new posi-tions, job descriptions, or lay offthe workers. Additional manage-rial steps are required to achievethe benefit and they may betaken or not. Similarly, theimproved utilization of spacewill not reduce lease costs. It

positions the company to getmore output from the existingspace, which, in certain circum-stances, leads to increased salesfrom increased output.

EXPLICIT COSTS AND PROFITS

To understand the directimpact of lean on cash flow, onemust look at explicit costs andprofits rather than those reportedon the financial statements,because income statements donot report costs accurately andthe timing of reported cash flowsmay not be synchronized withactual cash flows.9 The result isthat the income statement, on

which many cash flow and netpresent value approaches arebased, is not an accurate repre-sentation of cash flow. This leadsto a breakdown in the logicalrelationship between profits andcash flow. Cash flow at the endof a period should logically beequal to the sum of the cash atthe beginning of the period andthe profits of the period. If acompany had $10, sold $5, andspent $3, the resulting cash flowshould be $12. This only hap-pens when the profit is calculat-ed from activities in one period,but if the money had been spentpreviously, as is the case withCOGS, there is no assurance thatthe change in cash would be $2.

To understand explicit costs,consider drawing an imaginarybox around the entire company.This is the cost-revenue border.When money is spent, it crossesthe border and is therefore con-

sidered an explicit cost. The rea-son the border cannot be drawnaround a department or a divi-sion is that money can leave onedepartment or division foranother, but the company stillhas the same level of cash. Dol-lars that come into the borderare considered revenues. Withthis definition, profit and cashflow are reunited, maintainingthe mathematical and logicalrelationship between the two.The definition also creates aclear relationship between staticcapacity and costs. Salaries arecosts that are based on anagreed-upon amount and areusually independent of what the

person does on a minute-by-minute or hour-by-hourbasis.

This definition alsomakes the improvementsthat lean can enable veryclear. One must simply askthe question “How are wespending less money?” to

determine the cost reductionenabled by the improvement.Techniques such as 5-S, singleminute exchange of dies(SMED), total predictive mainte-nance (TPM), kanban, manufac-turing cells, and others put man-agers in a position to reduce theamount that they spend to pro-duce parts and to run operations,but there is not a one-to-one cor-relation between the implemen-tation and the financial results.Managers can implement lean,move individuals out of manu-facturing, and reduce the amountof static capacity required tomaintain a level of production,but if the same static capacityinfrastructure exists for the com-pany, its explicit costs willremain the same. To reduceexplicit costs in this context,managerial decisions must bemade that specifically reduce themoney spent on static capacity,

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© 2006 Wiley Periodicals, Inc. DOI 10.1002/jcaf

Increasing productivity often involvesincreasing the dynamic capacity ofan individual entity, operation, orprocess.

not change how the capacity isemployed.

To quantify the lean valueproposition, it is important tounderstand how lean createssome benefits and enables others.

CREATED BENEFITS

From a capacity perspec-tive, lean attempts to helporganizations get the most outof their static capacity. This isdone by first focusing on theoutput expectations, followed byreducing the amount of staticcapacity required to achieve theoutput. The metaphor often usedis one of a lake that has a num-ber of boulders of variousheights in it. The bouldersrepresent inefficiencies inoperations, while thewater level in the lake rep-resents inventory. At highwater levels, the hiddenboulders suggest that highinventory levels hide ineffi-cient operations. As the waterlevel declines, it exposes theboulders, largest first. An exam-ple is long equipmentchangeovers. When an operationhas two months of inventory,one may not see the wasteinvolved with having shift-longchangeovers. However, withonly a few hours of inventory,the problem is exposed. It isalso true for hiding poor qualityby maintaining high raw materi-al or work-in-process invento-ries. Many companies maintainextra raw material inventories incase there are quality problemsor they start with batch sizesthat are larger than the ordersize, anticipating “fall-out” orpoor quality products resultingfrom normal processing. Thenegative impact of this practiceis larger than many often con-sider. One may assume that ifthere is a 10 percent defect rate,

one adds 10 percent to theorder. But one must divide, notmultiply, by the defect rate toachieve the desired output, lead-ing to requirements thatincrease at a much faster thanlinear rate.

An objective of lean is tocontinue to find ways to achievethe desired levels of output withthe minimum amount of capacitynecessary to do so. This willultimately lead to three ways thatimplementing lean can have animpact an organization:

• cost reduction,• cash flow improvement, and

• operational efficiency/effec-tiveness improvements.

Although the list may notappear to be mutually exclusive,realization of any one term cantheoretically exist without hav-ing an impact on the others. Forinstance, a company can spendcash building an inventory offinished products that have notbeen sold. Although the calculat-ed unit cost may be reduced, thelack of a revenue source sug-gests that cash is in a net nega-tive position as a result of thedecision. Similarly, a companycan get more output from aprocess through operationalimprovements and not spend lessmoney on the organizationalinfrastructure associated withperforming the work. In thiscase, there are operationalimprovements that are not real-ized as true financial benefits,

such as when back-office effi-ciency is increased.

REDUCING COSTS USING LEANTECHNIQUES

Lean can position companiesto realize both generally accept-ed accounting principles(GAAP)-based cost reductionsand explicit cost reductions.However, the greatest opportuni-ty for overall cost reduction like-ly comes from the reduction ofexplicit costs rather than thereduction of GAAP costs due tothe process of realizing GAAPcosts and the nature and require-ments of reducing explicit costs.

A GAAP-based cost reduc-tion, especially the cost ofgoods sold, is one that iscalculated based on thetechniques allowed byGAAP, which involves costallocations. An explicit costreduction represents a situ-ation where a company

actually spent less money. Thetwo are different primarilybecause GAAP cost reductionsare not necessarily true costreductions despite the fact thatthey can be reported as such andare considered reductions bymany in the financial communi-ty. Consider any type of processthat involves the consumption ofmaterials or utilities where thereis an increase in output. Many ofthe capacity costs such as laborand space are fixed with respectto any output level because thebasis for their cost is indepen-dent of output. A person whosesalary is $10 per hour is paidthat regardless of how manywidgets she processes. With anincrease in output, capacity costsare primarily fixed, but varyingcosts representing the consump-tion of materials or utilities cre-ates an environment whereexplicit costs increase as output



An objective of lean is to continue tofind ways to achieve the desired levelsof output with the minimum amountof capacity necessary to do so.

increases. Hence, explicit costsincrease with increased output.Since GAAP allows for the allo-cation of costs, a different costdynamic results. GAAP costscan show a cost decrease withincreased production, since theallocation process may cause theincreased output to consume lessof the capacity costs on a per-unit basis, which leads to a lowercalculated unit cost.

The distinction between thetwo is critical when consideringthe cost impact of implementinglean. Many managers encounterroadblocks when trying to deter-mine the GAAP-based improve-ments in cost performancebecause lean techniquesoften require the adoptionof a philosophy that runscounter to that created byGAAP accounting. From aGAAP perspective, produc-ing at a rate that is slowerthan standard will bereflected as a cost increasebecause there are fewer productsto absorb the fixed capacitycosts, which creates the negativevariance. From an explicit costperspective, producing at a ratethat is slower than standard willnot be reflected as a costincrease because it only consid-ers actual changes in spending.If the labor costs are the same onan hourly basis and fewer mate-rials are consumed, less moneyis spent overall to reach thedesired output level.

This results in two chal-lenges that managers will facewhen implementing lean. Thefirst challenge is which costdynamic will be used for deci-sion making. The negative vari-ance will not look as good onthe income statement, but thepositive impact is that lessmoney will be spent to achievethe desired level of outcome.The second challenge is realiz-

ing how to document andachieve the savings. This will bediscussed later in the article.

IMPROVING CASH FLOW USINGLEAN TECHNIQUES

Many look to changes in theincome statement to determinethe cash flow impact of opera-tional changes. For example,measures of free cash flow andnet operating profit after tax areoften calculated from values onthe income statement. However,the income statement is not aneffective representative of cashflow. The primary reason is thatthe timing of cash flows reported

on the income statement isinconsistent with the actualoccurrence. Consider the grossmargin, which is the differencebetween revenues and theCOGS. This measure is designedto determine the profit made onthe products sold. The revenuecomponent of the equation isrealized for the reporting period.However, the cost of sales couldhave happened well in advanceof when the products have beensold.

The COGS comes primarilyfrom the balance-sheet inventoryvalue of the item sold. Items infinished goods inventory havehad balance-sheet value added tothem as they progress throughthe stages of transformationfrom being raw materialsthrough being a work inprogress, until becoming a fin-ished good. The money used tobuy the capacity that created the

inventory and was allocated toits balance-sheet value was spentat the time the product wasbeing transformed. Since it takestime to manufacture productsand since money left the compa-ny at the time it was responsiblefor paying its capacity costs, theflow of cash will likely haveoccurred long before the productrepresenting the work is sold.Since the values reported in aperiod likely come from previ-ous spending periods and sincethe current spending will likelyshow up in future periods, theincome statement is a question-able source for cash flow infor-mation.

Another reason that theincome statement is a badsource of understandingcash flow is that the valueand meaning of the COGSare questionable. As men-tioned earlier, allocationcreates the perception thatincreasing output can lower

the contribution that each itemsold makes to the COGS,because each good sold whenincreasing output is absorbingless of the fixed cost. However,from a cash flow perspective,increased output will increasecosts.

From a financial perspective,the source of cash flow improve-ment enabled by lean and,indeed, most types of increasesin operational efficiency andeffectiveness comes fromincreased margins created by aslower increasing cost curve andnot by a cost curve that decreas-es. Efficiency in this milieuresults from gaining moredynamic capacity from existingstatic capacity, which suggeststhat more output can be createdand decisions associated withincreasing capacity can be post-poned. Considering the former,the impact is that if the products



…the timing of cash flows reportedon the income statement is inconsis-tent with the actual occurrence.

are sold, the company increasesits revenues at a faster rate thanits costs increase, leading toincreased explicit profit and,therefore, cash flow. Consideringthe latter, output levels can bemaintained and sometimesincreased without an investmentin additional capacity, which willhelp an organization maintain orimprove their cash flow position.

INCREASED OPERATIONALPERFORMANCE

The primary benefit fromimplementing lean in manufac-turing or nonmanufacturingenvironments is the operationalimprovements that theconcepts create andenable. In a lean environ-ment, finding and elimi-nating waste are sine quanon for an effective imple-mentation.10 Organizationsthat implement lean prop-erly seek to rid themselvesof all superfluous activities,movement, paperwork, space,materials, and production,because in the realm of lean,waste consumes financial andoperational resources unneces-sarily. The result is purposeful,value-adding work and only therequired level of dynamic capac-ity from the organization’s staticcapacity. Without waste, organi-zations are positioned to pur-chase only the capacity that theyneed to meet expected outputlevels. Capacity will not be con-sumed processing unneededwork or work that may ultimate-ly need repair or rework or bediscarded due to poor quality.

Waste elimination will gen-erally lead to more efficient andeffective operations and process-es. It must be noted that lean byitself may not lead to an opti-mized level of operational per-formance. By definition, opti-

mized performance results frommanaging constraints and work-ing to achieve an absolute maxi-mum (output or sales) or anabsolute minimum (input or stat-ic capacity) objective. There isnot a provision in lean thatinvolves making managerialdecisions that allow for the prop-er management of constraints orthat support constraints, as onewill see when using techniquessuch as Goldratt’s Theory ofConstraints. However, this doesnot mean that there are not sub-stantial operational improve-ments that companies will findin both business and manufactur-ing processes.

Organizations that imple-ment lean have the opportunityto achieve any of, or all of, thethree types of benefits—reducedcosts, improved cash flow, andimproved operational perfor-mance. One can either assumethat the implementation will leadto improvements that are desir-able in both magnitude and cate-gory or be diligent about under-standing and defining how theresults will be achieved. Under-standing how lean improvesprocesses and the managerialdecisions enabled by theimprovement will allow for aproject plan that is deliberate interms of identifying the size andsource of the improvement. Bydefining the improvement oppor-tunity and then properly calcu-lating and documenting what isrequired to achieve the improve-ment, managers will increase thelikelihood that they will be able

to document and describe thedynamics of the improvement.The output can be used as aninput source for a project justifi-cation, project plan, or objectiveplan for those responsible forimplementing lean. The informa-tion can be used to set expecta-tions and can act as milestonesachieving the value that imple-menting lean can create for theorganization.

DEFINE THE IMPROVEMENTOPPORTUNITY

Defining the opportunity iscritical in terms of understandingthe scope of what is available and

to set expectations regard-ing what is to be achievedand how. This processinvolves three steps thatwill clearly state the specif-ic outcome expected,explain the role that leanhas regarding creating thebenefits or enabling them,

and define what is necessary toachieve the benefit. Stating thespecific objective creates a targetthat implementing lean will have.There might be multiple targets,but the most important aspect isto define what the expected out-come of implementing lean is.The role involves how the out-come will be achieved. In mostcases, lean is not the primarydriver of the improvement; it isan enabler. This suggests thatbenefit realization will involvemore than just implementinglean; subsequent steps must betaken to realize financial bene-fits. Once the role of lean isunderstood, documenting thespecific steps that are necessaryto achieve the benefit will helpclarify the scope of the work thatwill be required. This will setexpectations that will allow man-agers to decide what aspects areto be implemented and to assess



Waste elimination will generally leadto more efficient and effective opera-tions and processes.

the uncertainty associated withachieving the benefits.

What Is the Objective of theImprovement?

Lean techniques should notbe the objective of an improve-ment. Set-up reduction, forinstance, should be a tool to helpimprove operations by increasingpart-to-part manufacturing flexi-bility, to aid reducing batch sizesand the amount of work-in-process inventory, to reducemanufacturing lead time, or toreduce the amount of staticcapacity required forchangeovers. It should not be theobjective itself, because thecontext for why it shouldbe implemented can belost. Without the context, itwill be difficult to identifywhere the follow-on bene-fits resulting from theimplementation can occur.As suggested earlier, thereare three primary benefits con-sidered here that lean willenable—cost reduction, cashflow enhancement, or opera-tional improvement. The specificobjective should be determined,and when there are multipleobjectives, priorities reduce con-flict that may occur.

How Will Lean Facilitate theImprovement?

In the context of creatingimprovements, lean will eitherenable the creation of financialbenefits or create them directly.In most cases, lean will createextra dynamic capacity, whichallows more work to be createdwith the existing amount of stat-ic capacity. More output—inmost cases, except when the out-put leads directly to increasedsales—will only position thecompany to make decisions that

will reduce costs through thereduction of static capacity. Asan enabler of cost reduction, theobjective is to determine howlean will improve the dynamiccapacity and to determine howthis improvement in dynamiccapacity will enable the reduc-tion of static capacity.

Each entity, operation, orprocess will have at least onemeasure of dynamic capacityassociated with its static capaci-ty. Lean will typically increasethe value of dynamic capacity,which leads to the potential toreduce static capacity or costs.This reduction in static capacityis usually not something that

happens automatically. Instead,managers are required to makechanges to their practices to takeadvantage of the improvementopportunity. If an organizationhas five people who process 20customer service calls each andtheir output is increased 25 per-cent, the dynamic capacity of thegroup is now 125 calls versus100. The organization maychoose to eliminate one of theemployees, therefore reducing itscustomer service labor capacitycost. Lean does not lead to thereduction in labor; it enabled themanager’s decision that did.

This is more often than notthe path to cost reduction withlean. Because lean increasesdynamic capacity, managers caneither maintain the existing staticcapacity (no cost change),reduce the static capacity (costreduction), or increase staticcapacity (cost increase), which is

not usually a sensible choice butis a choice nonetheless. It is sel-dom that lean leads directly toimproved financial benefits.When increasing throughput, theincreases only matter when theincreased production is sold.Even the value of inventoryreduction is a function of thechoices made regarding how theinventory is reduced and not thefact that it can be reduced usingtechniques such as kanban.11

Improvements to other areas ofworking capital such as accountspayable and accounts receivable,such as strategies to lengthenpayables and to shorten receiv-ables or collect them more effec-

tively, are enabled by lean,not directly created by it.The primary source ofdirect financial improve-ments created directly bylean is through increasingthe number of salableproducts. This happenswhen the process reduces

the lead time involved with cre-ating products or increases thedynamic capacity of the process-es’ output.

This is why it is difficult todetermine the value of imple-menting lean. The benefits areoften one, two, or more stepsfrom the implementation. Thetechniques improve the utiliza-tion of static capacity, but theoperating infrastructure, which isthe basis for static capacitycosts, though more efficient,often remains.

To What Extent Will There Bean Improvement?

As suggested previously,most of the financial improve-ments will involve changes inthe static capacity of operationsand processes due to the creationof excess dynamic capacitythrough efficient operations. The



In the context of creating improve-ments, lean will either enable thecreation of financial benefits or cre-ate them directly.

next question is, to what extentwill there be an improvement?Many companies that implementlean seek the benefits but maynot follow through with what isnecessary to achieve the results.In one case, a company wantedto implement lean workplaceorganization techniques and leanmaintenance techniques but didnot want to reduce its workforcefor fear of lack of buy-in or sab-otage. In another case, it wasagainst company policy to laypeople off when implementingproductivity-enhancingapproaches. Clearly, such pro-grams support maintaining apositive working environmentbut they will not be able tocreate true reductions inlabor capacity costs if theworkforce is still intact.

Managers should havea feel for the steps thatmust be taken to realize areduction in static capacitycosts. If space is used moreeffectively, how will the need touse less space translate into leas-ing less space or paying less forthe space it leases? If materialsare utilized more effectively,how will this be translated intopurchasing fewer materials?However, cost reduction is onlyone aspect. When consideringoverall cash flow enhancements,how can improvements in spaceor material utilization translateinto increased sales?

In many cases, there is anuncertainty factor that isinvolved. If lean increases theability to produce more salableproducts, the question is, howmuch of that which can be pro-duced will be purchased? Thisuncertainty may have a signifi-cant impact on the value calcu-lated and realizable by imple-menting lean. It would beirresponsible for a manager toassume that all production can

be translated into sales in mar-kets other than those where thecompany is resource-constrainedin a market where there is strongdemand for its products.

DOCUMENT THEIMPROVEMENT OPPORTUNITY

Once all of the informationabout the changes is gatheredand understood, the final activityis to calculate the benefit basedon the anticipated changes to theorganization. There are threesteps to this process. The first isto decide what will change; howwill the organization, process, oroperation be different as a result

of the interaction between it andthe lean implementation? Thesecond is to document the opera-tional impact of the changes.Since operational improvementswill become the basis forchanges that enable financialimprovements, the extent towhich operations are improvedmust be clearly documented andunderstood. The final step is todetermine the financial impactthat is available to the organiza-tion based on what is differentand the operational impact thatresults.

What Will Change?

Determining what willchange requires an exercise ofdocumenting the present andcomparing it to a projectedoperating environment in thefuture. Defining a future operat-ing environment and comparing

it to today will create gaps thatwill represent the manifestationof implementing lean in theorganization. Attention shouldbe paid not only to the opera-tional changes but also the req-uisite policy and proceduralchanges that will be necessaryto support the new operatingenvironment. There are a num-ber of tools that will help thisprocess. To consider and createa future, the work by ShigeoShingo provides detailed sup-port for many lean principles,from set-up reduction to pro-duction scheduling to his con-cept of zero quality control.Shingo operated as a consultant

to Toyota as they createdjust-in-time and has anumber of books out thatdefine ways to implementlean in organizations.12

Scenario planning is aprocess that will help cre-ate a picture of thefuture.13 It not only

enables the design of the future,but also allows for stress testingof the future by applying vari-ous inputs to see how theprocess holds up. For instance,a future production system canbe tested by assuming a fluctu-ating rather than constantdemand pattern, productchanges, or changes in thestructure of a supply chain.Depending on the results of thestress test, the future operatingenvironment can be updated toprovide whatever capabilitiesseem reasonable.

Another tool that can aid inthe process is capacity mapping.Capacity mapping defines thestatic and dynamic capacity ofthe current state, transitionstates, and future states.14 Inclear terms, it shows how thestructure and capabilities of theorganization’s capacity changeand helps create a picture of the



Managers should have a feel for thesteps that must be taken to realizea reduction in static capacity costs.

operational changes that willresult from the implementation.

What Will Be the OperationalImpact?

Capacity mapping is aneffective tool to understand anddocument the operational impactof implementing lean. Whendocumenting the static anddynamic capacity for a process,certain process characteristicscan also be defined at this time.Key measures such as lead time,waste, and cycle times all resultin and from the capabilities ofthe organization and its dynamiccapacity. These measures arecritical to understand becausethey will likely become the tar-get measures for implementinglean. As the future state isdesigned and mapped, proposedprocess measures can be project-ed based on the new static anddynamic capacity measures.They may not be precise, as theyare forecasts, but they are gener-ally accurate, since they use thesame fundamental data as thecurrent state maps; how muchoutput can the given level ofinput create?

What Will Be the FinancialImpact?

The financial impact will bedetermined by considering thedirect operational impact and thechanges made to the organiza-tion to achieve other benefits.The primary financial benefitswill result from reductions instatic capacity or the price paidfor static capacity. Organizationsmust also consider secondarybenefits such as reductions inaction costs and improvementopportunities made availablethrough the improved manage-ment of working capital. Explicitcost dynamics (ECD) is a power-

ful and highly effective toolbecause it forces the considera-tion “How are we spendingless?” and also considers thenegative side of the equation.For instance, if inventory reduc-tion is the plan and there aresales incentives involved withencouraging sales, the financialimpact of the incentives is con-sidered too so that it can becompared to the anticipatedimprovements.

As suggested previously,uncertainty must be consideredbecause it impacts the likelihoodthat the benefits will beachieved. This can be reflectedby lowering the benefits, or,when performing a net presentvalue analysis, the discount fac-tor can be increased to reflect alower likelihood that the specificvalue will be achieved.

RECOMMENDATIONS

When using this process, itis important to keep the follow-ing in mind. First, do not over-state the expected improvementsor value. Be realistic about whatis possible and what the organi-zation is willing to do. Second,do not use GAAP as the basisfor identifying improvements. Itis clear that, for most companies,the value must end up on anincome statement and will, inmany cases, impact the balancesheet. However, since they arenot tied directly to cash, theirrole in determining how cashand cash-based profits willchange should be limited. Tohelp gain a more realistic under-standing of the financial impactcreated, period revenues andcosts should be compared andtaxed to come up with a morerealistic after-tax cash flow.Third, do not assume thatimprovements just come. Expectthere to be a plan to achieve

each major benefit that goesbeyond “implementing lean.”Once targeted kanban inventorylevels are set, for instance, thecompany must still determinehow it is going to lower itsinventory levels. Finally, imple-ment lean holistically. Manycompanies fail when implement-ing lean out of context, takingcertain aspects of lean andassuming that it and it alone cre-ates the improvements. Lean isthe interaction of many tech-niques that operate synergistical-ly to create a highly efficient andeffective enterprise.

NOTES

1. Ohno, T. (1988). Toyota productionsystem: Beyond large scale production.Cambridge, MA: Productivity Press;pp. 1–3.

2. See, for example, Yu-Lee, R. (2003,January-February). Don’t miss the bot-tom line with productivity increases.Industrial Management, pp. 8–13.

3. Ibid.4. Ibid.5. For discussion, see Yu-Lee, R. (2002,

June). Time is not money. IIE SolutionsMagazine, pp. 30–35.

6. See, for example, Yu-Lee, R., & Loren-zl, H. (2001, October). Broken promis-es: Why organizations fail to achievebusiness case results. IIE SolutionsMagazine, pp. 26–32.

7. See, for example, Yu-Lee, R. (2002).Essentials of capacity management.New York: Wiley; p. 28.

8. See note 2.9. For discussion, see Yu-Lee, R. (2004,

March/April). Managing around theunit cost. Industrial Management, pp.8–12.

10. Shingo, S. (1989). A study of the Toy-ota production system. Cambridge,MA: Productivity Press; pp. 76–82.

11. For discussion, see Yu-Lee, R. (2004,September/October). Inventory is notcash. Industrial Management, pp.8–15.

12. See note 10.13. Schrage, M. (2000). Serious play: How

the world’s best companies simulate toinnovate. Cambridge, MA: HarvardBusiness School Press.

14. Yu-Lee, R. (2005, July/August). Mar-gin management: More than a notion.Industrial Management, pp. 21–26.





Reginald Tomas Yu-Lee is president of the Yu-Lee Company in Atlanta, Georgia, and author of Explicit CostDynamics: An Alternative to Activity-Based Costing (Wiley, 2001) and Essentials of Capacity Management(Wiley, 2002). He is also an adjunct professor of business administration at Tennessee Tech University.

determining the financial value of implementing lean

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