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 Proving
Continuous
Improvement with
Profit Ability

Russ Jones

ASQ Quality Press

Milwaukee, Wisconsin
American Society for Quality, Quality Press, Milwaukee 53203
© 2008 by ASQ
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Jones, Russ, 1932–

Proving continuous improvement with profit ability / Russ Jones.
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 Table of Contents

Note to the Reader . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix

Acronym List . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi
Chapter 1 Double Your Return on Assets Percent . . . . . . . . . . 1
Sources of Knowledge for this Book . . . . . . . . . . . . . . . . . . . . . 3
To Business Owners and Managers . . . . . . . . . . . . . . . . . . . . . . 4
Chapter 2 The Seven Critical Business Elements . . . . . . . . . . . 5
The Seven Areas. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Chapter 3 Seven Project Groups for Project Teams . . . . . . . . . 17
Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Chapter 4 Seven Project Groups You Can Start Today . . . . . . 31
Project Group: Maximize Employee Asset Utilization . . . . . . . 32
Project Group: Increase Sales and Market Share. . . . . . . . . . . . 33
Project Group: Reduce Expenses per Sales Dollar . . . . . . . . . . 34
Project Group: Reduce Lead Times . . . . . . . . . . . . . . . . . . . . . . 35
Project Group: Reduce Setup Costs . . . . . . . . . . . . . . . . . . . . . . 36
Project Group: Maximize Capital Asset Utilization . . . . . . . . . 37
Project Group: Control the Customer Invoice
Collection Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
What Comes Next? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Chapter 5 Project Evaluation and Project Goal Setting . . . . . . 41
Worksheets for Gathering Financial Data . . . . . . . . . . . . . . . . . 42
Project Evaluation Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
ROA Improvement Goals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Chapter 6 Empowering Employee Teams. . . . . . . . . . . . . . . . . . 61
Seven Realities to Internalize . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Get the Most Out of Employee Assets . . . . . . . . . . . . . . . . . . . . 64

v
vi Table of Contents

Team Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
Employee Gain Sharing Incentives . . . . . . . . . . . . . . . . . . . . . . 70
Chapter 7 More About Project Evaluation and Ranking . . . . . 73
Using Profitability to Prioritize Projects . . . . . . . . . . . . . . . . . . 73
Use of Actual Confidential Financial Numbers . . . . . . . . . . . . . 74
Using Your Company’s Business Cycle to Time Project
Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Make Use of the 80/20 Rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Chapter 8 Projects to Reduce Total Expense per
Sales Dollar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
A Few Accounting Truths. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Segregating Budget Line Items. . . . . . . . . . . . . . . . . . . . . . . . . . 82
Lean Waste Discovery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
Lean Improvement Building Blocks. . . . . . . . . . . . . . . . . . . . . . 95
Chapter 9 Projects to Reduce Lead Time and Inventory . . . . . 99
Document Customer and Manufacturing Lead
Time Mismatches. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
Reduce Manufacturing Lead Time. . . . . . . . . . . . . . . . . . . . . . . 104
Reducing Distribution and Service Business Lead Time. . . . . . 115
Apply Lean Value Stream Mapping . . . . . . . . . . . . . . . . . . . . . . 119
Chapter 10 Projects to Reduce Setup Cost and Inventory . . . . 129
Setup Cost and Commonsense Lot Sizing . . . . . . . . . . . . . . . . . 129
Financially Sound Lot Sizing . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
Product and Process Design to Reduce Lot Sizes . . . . . . . . . . . 140
Lean Quick Changeover Concepts . . . . . . . . . . . . . . . . . . . . . . . 144
Lean Cell Design and Implementation . . . . . . . . . . . . . . . . . . . . 149
Supplier Setup Cost Control and Reacting to Price Breaks . . . . 155
Dispose of Surplus Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Chapter 11 Rationalizing a Material Control System. . . . . . . . 161
Rationalizing a Material Control System . . . . . . . . . . . . . . . . . . 161
Improving Inventory Control . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
Production Control Improvement . . . . . . . . . . . . . . . . . . . . . . . . 181
Charting Material Control System Performance Evaluation . . . 193
Chapter 12 Linking Continuous Improvement With
ISO 9000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
Chapter 13 Projects to Increase Market Share . . . . . . . . . . . . . 213
Companywide Marketing Planning . . . . . . . . . . . . . . . . . . . . . . 213
Market Coverage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
 Table of Contents vii

Marketing Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222

The Marketing Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
Increasing Market Share Through Acquisitions. . . . . . . . . . . . . 234
Placing a Value on a Business . . . . . . . . . . . . . . . . . . . . . . . . . . 238
The Acquisition Team and Process . . . . . . . . . . . . . . . . . . . . . . 245
Improving Customer Service . . . . . . . . . . . . . . . . . . . . . . . . . . . 251
Chapter 14 Plotting Your Economic Business Cycle . . . . . . . . . 257
A Business Cycle Pictured As the Percent Rate of Change . . . . 257
Reasons to Plot Your Business Cycle Each Month. . . . . . . . . . . 258
Calculate and Plot Your Company’s Business Cycle . . . . . . . . . 259
Interpretation of a Business Cycle Picture . . . . . . . . . . . . . . . . . 260
Company Decisions During Each Business Cycle Phase. . . . . . 260
The Calculation and Plotting Process. . . . . . . . . . . . . . . . . . . . . 263
Leading and Following Economic Indicators . . . . . . . . . . . . . . 266
Chapter 15 Continuous Improvement versus Creativity . . . . . 269
Chapter 16 Seven Sources of Entrepreneurial Innovation . . . . 271
The Three Groups of Knowledge Resources . . . . . . . . . . . . . . . 272
Managing Entrepreneurial Innovation . . . . . . . . . . . . . . . . . . . . 273
The Business X-Ray . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
The Seven Sources of Innovation . . . . . . . . . . . . . . . . . . . . . . . . 275
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
 Note to the Reader

I
t may appear at first glance that this book is primarily oriented toward
manufacturing businesses. You may have gotten the same impression
if you’ve implemented lean manufacturing, Six Sigma, or ISO 9000
quality standards. Be assured that I also focus on service businesses and
distributors as well as those companies that include some elements from all
three categories.
For example, in Chapter 5 I provide two different forms for gather-
ing the financial data required to understand and apply concepts in the
other chapters. One form is for a manufacturing business while the other is
more suitable to a distribution or service business. Chapter 1 speaks more
directly to this issue and the third section of Chapter 9 is specifically dedi-
cated to distribution and service businesses.
All forms and charts in the book are intended to be used by you as a
starting point to design your own forms that more closely resemble your
current financial statements.
Throughout the text I have also tried to point out which chapters or
sections of chapters have little value for a distribution or service business.

ix
 Acronym List

12MRT—12-month running total

CNC—computer numerical control
EBDA—earnings before depreciation and amortization
EBIT—earnings before interest and taxes
EBITDA—earnings before interest, taxes, depreciation, and amortization
EOQ—economic order quantity
I CARE—information understood, courtesy, attention to details, responsi-
bility, every time
MEP—Manufacturing Extension Partnership
NIST—National Institute of Standards & Technology
P&L—profit and loss
ROA—return on assets
ROC—rate of change
SE&A—sales, engineering, and administrative (expenses)

xi
 1
Double Your Return on
Assets Percent

T
his book presents an innovative approach to continuous improve-
ment, entrepreneurial innovation, and business knowledge not found
in any other source. The primary innovations are:
• There are only seven critical business elements in which financially
sound improvements are found.
• Value analysis oriented verb/noun phrases are used to
discover and name projects from each of the seven critical
business elements, based on percentage return on assets.
• A project evaluation form is used to financially rank projects to
define which ones will most greatly increase the profitability of
the business.
• There are three groups of knowledge resources that must be
managed separately, but still integrated, with their own policies,
practices, and performance measures:
– First, the operations personnel, who deliver the lowest-cost,
highest-quality products and services 95 percent on time.
– Second, continuous improvement teams, who use the seven
business elements to discover, evaluate, and implement projects
to double the return on assets (ROA) percent.
– Third, the managers, who are assigned to extend the life of the
business by using seven sources of entrepreneurial innovation.
Almost any manufacturing, distribution, or service business can double its
return on assets percent within a three- to five-year period if it concentrates
its best knowledge resources on the seven key business elements:

1
2 Chapter One

• Increase market coverage to increase sales dollars

• Reduce labor and nonlabor expenses per sales dollar
• Reduce lead times to minimize work-in-process inventory
investment
• Minimize product and component inventory investment by
reducing manufacturing and purchasing setup costs to reduce
lot sizes
• Maximize capital asset utilization
• Control the customer invoice collection period to minimize
accounts receivable investment
• Maximize employee asset utilization by using project teams for
the seven project categories and train them to identify, evaluate,
and implement projects
A manufacturing business has more opportunities to impact the ROA
percent than a service or distribution business. However, all have similar
financial measuring tools and similar activities performed by personnel
with similar knowledge and experience.
As you read these pages you may say, “This is simple stuff that most of
our personnel already know.” To this I would reply, “I agree.” Someone in
your company probably knows most of what is included in this book. How-
ever, I’ve organized it in a way I wish someone had shown me when I was a
young college graduate entering the business workforce.
These pages contain practical business knowledge that can be taught to
employees at every level and in every function or department. I will show
where employees interact within the seven key financial areas and how each
decision they make has either a negative or positive impact on the size of
profit, asset investment, or the percentage return on the investment in four
assets: work-in-process inventory, component and product inventory, capi-
tal assets, and accounts receivable.
I focus on the financial aspects of the seven business elements because
every hour, every employee, in every job, at every level, makes one or more
decisions that have some impact on one or more of these seven financial
measures. Therefore, why not fill their minds with the basic knowledge that
leads directly to the right decision?
I’ve chosen to encompass each chapter within the phrase, “company-
wide continuous improvement” because that’s the most effective way to
bring together various other improvement tools such as lean manufacturing,
ISO 9000, Six Sigma, and total quality management.
 Double Your Return on Assets Percent 3

SOURCES OF KNOWLEDGE
FOR THIS BOOK
The author obtained a bachelor’s degree in mechanical engineering from
Oklahoma State University. I am a licensed professional engineer in the
state of Oklahoma. My initial business training was as a manufacturing
and design engineer before spending several years as a manufacturing and
quality manager. I served as a materials control manager during the design
and implementation of a new material control system. In the latter half of
my career I gained valuable experience as a business planner in a division
of a very profitable corporation, PACCAR, Inc.
The knowledge included in this book comes from:
• Dale Morgan and Willis Allen of Gilbreath’s ([Link].
com), a training and consulting firm with many years of
experience in training personnel for team building, customer
service, ISO 9000, and driving companywide continuous
improvement to the bottom line.
• Pat Patton and John Williams of Hunt, Patton & Brazeal
([Link]), a consulting firm with many years of
focus on mergers and acquisitions, sources of funds for growth
and acquisition, and searching for management and technical
knowledge resources.
• Richard Kerndt and Mark May of The Richmark Group
([Link]), who provide consulting related to sales
growth planning, with a focus on increasing market share by
increasing market coverage.
• Robert VanDeMark’s books about material control principles,
which provide the old-fashioned arithmetic that must be used by
the simplest or most sophisticated modern material control systems.
• William Schubert, a mathematician/economist who showed me how
to use rate of change arithmetic to graphically picture the business
cycle for any business so that marketing and financial decisions can
be made six months to one year sooner than competitors.
• The U.S. Department of Commerce, National Institute of Standards
and Technology (NIST) Manufacturing Extension Partnership
(MEP) ([Link]), the home page for lean manufacturing.
For lean training you need to contact a lean trainer or lean
consultant. I include an interpretation of lean principles only
as a tool to discover more projects.
4 Chapter One

• Peter Drucker, a teacher and author who published 39 books

between 1939 and 1999 about how the knowledge workers in a
business can become more effective managers. His thinking has
become a part of my business thinking process and is scattered
throughout this book. In Chapter 16 I include some things I
have learned about systematic innovation that can give an
entrepreneurial flavor to any enterprise.

TO BUSINESS OWNERS AND MANAGERS

This book is written for businesswomen and businessmen who recognize
that their knowledge and career is itself a business that they must manage
effectively. It’s for those who want their career to be the most rewarding,
both financially and in terms of self-satisfaction. It’s for people, both expe-
rienced and inexperienced, who see themselves on a mission to be a change
agent and a champion of improvement projects. It is designed to harness the
unique knowledge of a large group of knowledge workers to achieve really
big results, such as doubling the ROA within three to five years of continu-
ous improvement project implementation.
It’s dedicated to those who yearn to achieve extraordinary financial
results in a business. I use very simple everyday arithmetic and vocabulary
to show how to identify the seven critical business elements within your
own business that need to be managed through continuous improvement.
This book can become your training manual to educate individual
employees at every level to discover and implement a vast number of finan-
cially justified projects that focus on the seven critical business elements.
I believe that this book will make employees at every level better busi-
nessmen and businesswomen.
Three of the reasons most continuous improvement, lean manufactur-
ing, and Six Sigma programs fail to deliver good financial results are:
• They fail to invest in a few additional personnel to discover,
design, and implement improvement projects.
• They fail to train personnel with knowledge about the seven
sources of financially sound improvement.
• They don’t have a financial tool to tell management and project
teams which projects will deliver the greatest increase in
profitability in the least amount of calendar time.
One goal of this book is to dramatically advance the Profit Ability of its
readers.
 2
The Seven Critical
Business Elements

T
here are seven broad business and financial elements, depicted
in Figure 2.1, at which continuous improvement projects must be
directed to maximize profitability. I will use this graphic to prove
this point.
The purpose of this chapter is to support the concept that concentrating
your knowledge workers on the seven areas of improvement will result in
the biggest and quickest increase in profitability of the business and Profit
Ability of a broad range of your employees.

THE SEVEN AREAS

Block 1: Increase Return on Assets

I will convince you that employee teams can discover and implement proj-
ects that will double your ROA from one economic business cycle to the
next. Start by asking, “How do we increase return on assets?”
First, I will often mention the economic business cycle, in which every
business experiences a high and a low in sales dollars every three to five
years. During a complete business cycle, businesses record bigger profits
and a higher ROA percent when annual sales are at a peak. That’s because
fixed costs and capital assets are being utilized more efficiently.
On the other hand, the year when annual sales are deep in the valley,
we expect the ROA to be lower because fixed costs and capital assets are
being underutilized.
When I mention ROA, I mean the average ROA over an entire busi-
ness cycle. Since business cycles range from three to five years in length,
I encourage that your overall financial improvement goal cover three to

5
6 Chapter Two

1. Increase
return on assets

2. Maximize 3. Minimize
net profit asset investment

4. Increase 5. Reduce 9. Minimize

sales expenses per inventory
sales dollar
6. Increase 10. Reduce
market share lead times

7. Increase 11. Reduce

market coverage setup costs

8. Develop a 12. Maximize

marketing plan capital asset
utilization

13. Reduce
accounts receivable
investment

14. Maximize
employee asset
utilization

Figure 2.1 The seven broad business and financial elements at which
continuous improvement projects must be directed to maximize
profitability.

five years. In Chapter 14, I show you how to calculate the historical busi-
ness cycle of your own company.
Second, let me show you the formula for ROA percent used in this
book in case you’ve forgotten it or have never learned it:

Net profit dollars

Return on assets percent =
T otal of four assets dollars

The four assets are work-in-process inventory, component and product

inventory, capital assets, and accounts receivable (shipments to customers
for which you haven’t been paid).
This formula joins together net profit and asset investment. I use the
ROA percent to measure continuous improvement results because it helps
you determine whether the net profit and asset investments are in balance.
 The Seven Critical Business Elements 7

Block 2: Maximize Net Profit

I place blocks 2 and 3 side by side to get across the point that both the
net profit (recorded in the profit and loss statement) and asset investment
(recorded in the balance sheet) are dependent on each other, both by formula
and as a practical fact. This is important since every employee, in every
function, at every level, and every hour, makes decisions that affect one or
both of these measures, whether or not they or management realize it.
For example, every capital investment creates an expense for deprecia-
tion on one hand but, on the other hand, hopefully reduces an offsetting labor
expense. The codependence of net profit and asset investment is the reason
why I use the verb/noun combinations maximize net profit and minimize
asset investment. Throughout the following chapters, over and over, I will
make statements that illustrate the codependence of these two measures.
Let us briefly examine the formulas that relate to net profit so that
we have a common language. All employees who participate in continuous
improvement projects need to keep in the back of their minds that net profit
is the result of sales (or shipments) minus all expenses:

Net profit = Sales dollars − Total expense doll a rs

Total expense dollars
Net profit percent =
Sales dollars

That leaves only increase sales and reduce expenses as possible verb/noun
combinations to identify and evaluate continuous improvement projects to
increase net profit.

Blocks 4, 6, and 7
I’ve asked the question, “How do we maximize net profit?” It’s natu-
ral to say “increase sales” and “reduce expenses” as shown in blocks 4
and 5. However, we will see that the key to increased sales is increased
market share and that increased market share comes from increased mar-
ket coverage.
These facts are illustrated by the following Richmark Group graphic
(Figure 2.2). The five market coverage areas are:
• Product coverage
• Price coverage
• Distribution channel coverage
• Promotion coverage
8 Chapter Two

• Brand coverage
I will go into greater detail about market coverage in Chapter 13. For now,
all I want to do is plant the seed that market coverage is the key to increas-
ing sales by increasing market share. To see this picture more clearly I must
again bring up the subject of the economic business cycle, which occurs
every three to five years in almost every business. The reason I must plant
the two seeds of market coverage and the economic business cycle in your
mind is that the only sales increases that are permanent from year to year
are those that occur every year from annual market share increases in every
phase of the business cycle.
Perhaps a picture of the business cycle, which we describe in greater
detail in Chapter 14, will give you a handle on it, since we mention it so fre-
quently (see Figure 2.3).

Analytical Assessment of Market Share

• When selling through indirect channels (who carry competing brands), there are
five coverage measurements
• When selling through indirect channels (who are exclusive), there are four
coverage aspects (that is, brand coverage becomes 100 percent)

Product management issues

Product
coverage
Distribution channel marketing factors
Portion not
covered Price
(wrong type,
size, design, coverage
materials, Distribution
and so on) channel
Portion for coverage
lower-priced
products
Portion Promotion
of the Portion not coverage
seen by your
market Portion channels
“covered” of the Brand
by your market Portion Portion they coverage
lose to
existing segment that your another
products that is distribution
premium channels Portion that
Portion your competitor
price, see your gets
Your quality, (that is, are distribution Portion of your
share or value aware of channels distributor’s Your
of the or bid on) win business that sales
you get
market
Total market $
(All products, all
types, all vendors)

Figure 2.2 The five market coverage areas.

Source: The Richmark Group ([Link]). Used with permission.
 The Seven Critical Business Elements 9

Rate of Change
Prosperity

Growth Warning

Recession Recovery

Depression

Cyclic Phases

Figure 2.3 The economic business cycle.

I make a big deal out of market share increasing during every phase
of the business cycle because if you aren’t confidently investing in greater
market coverage each year, you won’t maximize or double your company’s
net profit and ROA within three to five years.
It’s critical that you get the message that you must be implementing
continuous improvements during every phase of your company’s business
cycle. This is because the average ROA improvement from business cycle
to business cycle will become a source of investment funds for long-term
improvement projects within the seven key business elements.
In a 2007 issue of PACCAR World, Mark Pigott, the fourth-generation
chairman and chief executive officer of PACCAR, unveiled plans for a $400
million truck engine manufacturing and assembly plant in the southeast
United States. He said, “PACCAR’s outstanding profits, excellent balance
sheet, and intense focus on quality, technology, and productivity enhance-
ments have enabled the company to consistently invest in products, services,
and processes during all phases of the business cycle.”
In a nutshell, this quote by Mark Pigott delineates the success we hope
you will incorporate into your business by implementing the concepts pre-
sented in this book.

Block 5: Reduce Expenses per Sales Dollar

This is the second critical business element on which you must concentrate.
Teams of knowledge workers can continuously lower this ratio from month
to month when sales are both high and low during a business cycle. You
must reduce expenses for both labor and nonlabor costs per sales dollar,
10 Chapter Two

primarily because your customers expect you to raise prices at a rate lower
than inflation.
The ratio or percent “Expense dollars ÷ Sales dollars” is used to
show project teams that if this percent doesn’t become smaller from year
to year, for both labor and nonlabor expenses, there can’t be an increase in
net profit.
Sales and expenses are codependent on each other. This is because
each business has both fixed costs and variable costs. In the peak phase of
the business cycle, net profit shows a dramatic improvement because there
are fewer fixed costs per sales dollar. In the valley phase of the business
cycle, net profit is dramatically lower because fixed costs are a greater per-
centage of total expenses. A review of the line items in your annual budget
will tell you whether fixed or variable expenses offer the greatest opportu-
nity to reduce total expenses.
The main point I would make to you and your employees is that you
need a measurement that shows the percentage relationship between sales
and expenses from month to month. You could use many different measure-
ments as a way to discover new improvement projects or as a way to mea-
sure improvement from year to year:
• Labor expenses ÷ Sales
• Variable labor expenses ÷ Sales
• Fixed labor expenses ÷ Sales
• Nonlabor expenses ÷ Sales
• Variable nonlabor expenses ÷ Sales
• Fixed nonlabor expenses ÷ Sales
• Total expenses ÷ Sales
• Total variable expenses ÷ Sales
• Total fixed expenses ÷ Sales
• Manufacturing direct labor ÷ Sales
• Setup direct labor ÷ Sales
• Overhead labor ÷ Sales
• Administrative salaries ÷ Sales
In Chapter 8, I show ways to segregate the expenses in your profit and loss
statement, and in your operating budget, to discover projects that find the
most fruitful places to focus your knowledge workers on ways to improve
 The Seven Critical Business Elements 11

these ratios. Even if your customers don’t come out and say it, your best and
most loyal customers expect you to reduce your expenses fast enough so
that your prices increase at a rate lower than inflation. You owe this to them
just as your suppliers owe it to you.
The section in Chapter 8 about lean waste discovery, and Chapter 3,
which lists many verb/noun combinations to name projects, will help you
identify waste.
By now you have noticed the mention of verb/noun or verb/phrase
combinations. This is an easy way to name projects as you keep asking the
question, “How do we . . . ?”

Block 3: Minimize Asset Investment

Now let’s look at the company’s asset investment side of the ROA formula
by asking, “How do we minimize asset investment?” The investments to
minimize, if they exist in your particular business in any significant dollar
amounts, are:
• Work-in-process inventory
• Component and assembled product inventory
• Capital assets—land, buildings, and equipment
• Accounts receivable—what your customers owe you for products
or services you have delivered
Remember, in blocks 2 and 3 we are looking for the best financial balance
between net profit and asset investment. I will show that there are only a
few things on which you must focus improvement projects to effectively
minimize these investments.
You will see that most investments in capital assets, which bring
advanced technology into your manufacturing processes to lower setup
costs and lead times, can be expected to lower your investment in inventory
more than they increase your capital investment.

Block 10: Reduce Lead Times

We could say “reduce work-in-process inventory.” However, that doesn’t
directly identify the kinds of projects required.
Many knowledge workers have never been told that work-in-process
inventory is controlled by manufacturing lead time. They may even think
that order quantity may help determine the size of this investment. The same
thing is true with your suppliers’ and customers’ employees. In Chapter 10,
12 Chapter Two

I show you a simple formula to prove my point. I will show you and your
employees many places between the receiving dock and the shipping dock
where lead times can be eliminated.
In Chapter 11, I will show you how to evaluate a material control
system to identify problems that keep you from reducing lead times. This
is an aspect that isn’t normally included in most lean manufacturing or Six
Sigma programs.
One simple measure will tell you if you have serious lead time or mate-
rial control problems. If your percent of customer orders shipped on the
original date accepted by your customer is very much less than 95 percent,
I would ask you to look at Chapters 9 and 11 about lead time and material
control. I particularly encourage you to use start dates of manufacturing
operations for production control scheduling rather than a due date for com-
pleting each part or each processing operation.
See the section in Chapter 9 about lean value stream mapping to deter-
mine if you have a considerable amount of paperwork processing that needs
a shorter clock or calendar processing lead time. Go to the lean Web site
([Link]) to learn more.

Block 11: Reduce Setup Costs

For ROA increases, you must reduce setup costs for both component and
assembled product, and for both manufactured and purchased components,
so that your inventory investment for these items will be minimized.
For block 11, we could use reduce component inventory or reduce
assembled product inventory, but that wouldn’t directly identify the right
kinds of projects. What is specifically required is reduction of setup costs.
If you’ve implemented a lean manufacturing program you may have
already done considerable setup cost or setup time reduction.
If your business is one that has a promised customer order delivery
lead time that is shorter than your purchased material lead time plus manu-
facturing and assembly lead times, you are forced to carry an inventory on
some components or assembled products to meet your customers’ on-time
delivery demands.
Chapter 9 details how to eliminate much of this mismatch between
your customer order delivery lead time and the current lead times required
to buy material, process it into components, and assemble these compo-
nents into a finished product.
Until you solve this lead time mismatch, you must invest in a certain
amount of inventory of both components and/or assembled products. In
Chapter 9 I show how your material control personnel can make a cycle
time chart for each major assembled product so they can quickly identify
 The Seven Critical Business Elements 13

which component lead times are forcing the necessity of inventory, which is
equal to a certain amount of investment measured in days or weeks.
Another reason to focus your personnel on setup cost reduction is
because this will show them that lot size, or order quantity, controls the size
of component inventory and assembled product inventory:
• The size of your inventory investment for each component is
one-half the lot size you authorize for that component multiplied
by its unit cost. After you total this value for all components, you
have a very good idea about your total inventory investment for
all components.
• Lot sizing is a financial decision and not a manufacturing
decision only.
• Design a lot sizing formula that balances the component inventory
investment with the setup cost that employees are currently
required to live with.
• Relate existing programs for lean manufacturing with the realities
of being forced to maintain an inventory to meet on-time customer
delivery requirements.
• Identify the costs in your operating budget that relate to
setup costs so a financially sound lot sizing formula can be
designed.
• Evaluate your material control and purchasing systems to help
employees make financially sound decisions from hour to hour.
• Use your financial data to evaluate investments in tooling,
manufacturing cells, or capital equipment to reduce setup costs.

Block 12: Maximize Capital Asset Utilization

You must minimize the investment in capital assets by maximizing the

utilization of equipment and facilities. Maximizing the utilization of equip-
ment and facilities is what happens at the peak of your economic business
cycle. At the peak of your business cycle, you have your highest percent of
capital asset utilization, your highest level of sales, and the maximum level
of net profit, which results in the ROA percent being at its highest during
the business cycle.
When sales are at their peak during a business cycle, the most highly
utilized pieces of equipment may be what limit the company in making on-
time delivery of products. This is when well managed production control
14 Chapter Two

systems, reduction of lead times, and reduction of setup times may be the
most urgent project implementation activities.
At the peak of your business cycle, use the material control system
described in Chapter 11 to identify and monitor the most highly utilized
equipment and be prepared to shift manufacturing hours to alternate pro-
cessing methods, add additional shifts, or move work orders to suppliers
who have appropriate, capable equipment and quality controls.
In Chapter 11, I will show you how to get the most out of existing capi-
tal assets and, using the plotting of your own business cycle, when to invest
in new capacity and when to eliminate excess capacity.
I will also show you how to measure utilization percentages in total
and for individual pieces of equipment.

Block 13: Reduce Accounts Receivable Investment

Do this by controlling the period of time between invoicing for product or
services and the receipt of payment (accounts receivable collection period).
In other words, if your contract with a customer requires them to pay within
a certain time period, you should expect them to pay by that date, just as
they expect you to deliver on time and just as your suppliers expect you to
pay them on time.
Some customers may habitually pay late, thereby increasing your
accounts receivable investment. This may be their way of forcing you to
invest in their business. Your financial systems should easily identify these
customers so you can control them.

Block 14: Maximize Employee Asset Utilization

You must increase sales without increasing total personnel expenses at the
same rate, as we suggest in block 5. This doesn’t mean you pay lower wages.
It means you pay higher individual wages to retain personnel that you train
and empower to utilize themselves effectively and creatively.
To double your ROA, you must continuously train and empower the
broadest possible range of employees to discover, design, and implement
continuous improvement projects. With this book you can provide your
knowledge workers with enough information about finances and basic busi-
ness principles to help them concentrate their minds on one or more of the
seven critical business elements.
If I’ve convinced you to approach companywide continuous improve-
ment by concentrating on these seven very broad areas, this should encour-
age you to invest in and assign the appropriate knowledge resources to one
or more projects for each of the seven critical elements.
 The Seven Critical Business Elements 15

I must impress upon you that these teams must be allowed “quality
time” during every phase of the business cycle if you expect to double your
ROA within three to five years. There’s little difference between capital
investment and knowledge investment when it comes to investing to get a
big financial return from continuous improvement.
 3
Seven Project Groups for
Project Teams

H
opefully I’ve shown you a new way to see continuous improvement,
in financial terms, as a companywide effort. I’ve also introduced
you to the concept of verb/noun or verb/phrase combinations to
discover and name broad groups of projects. Now we will move on to the
next logical step by showing you how to explode these seven broad project
categories into a great number of less broad groups and then into specific
projects.
The seven broad project categories previously listed are:
• Increase market coverage to increase sales dollars
• Reduce labor and nonlabor expenses per sales dollar
• Reduce lead times to minimize work-in-process inventory
investment
• Minimize product and component inventory investment by
reducing manufacturing and purchasing setup costs to reduce
lot sizes
• Maximize capital asset utilization
• Control the customer invoice collection period to minimize
accounts receivable investment
• Maximize employee asset utilization by using project teams for
the seven project categories and train them to identify, evaluate,
and implement projects
I will expand the above list slightly before exploding each of the seven proj-
ect groups into more specific team projects. But first, a brief review.

17
18 Chapter Three

OVERVIEW
How Do We Name Broad and Specific Projects with
Verb/Noun and Verb/Phrase Combinations?
We ask the question, “How do we . . . ?” as in Figure 2.1.

How Do We Increase Return on Assets (ROA)?

Blocks 2 and 3: We maximize net profit and minimize asset investment.

How Do We Maximize Net Profit Dollars by

Increasing Sales Dollars?
Blocks 4, 6, 7, and 8: We increase market share percent by increasing
market coverage, as defined in Chapter 13. Focus on the 20 percent of the
models, product lines, and market segments that make up 80 percent of
the sales dollars.

How Do We Maximize Net Profit by Reducing

Expenses per Sales Dollar?
Block 5: Reduce labor and salary dollars per sales dollar.
Block 5: Reduce nonlabor overhead dollars per sales dollar. Segregate
and focus on the 20 percent of the budget line items that make up 80 percent
of the expense dollars.

How Do We Minimize Asset Investment by

Minimizing Inventory Investment (Block 9)?
Block 10: Reduce lead times to reduce work-in-process inventory
investment.
Block 11: Reduce setup cost to reduce lot sizes and reduce average
component inventory quantity levels. Focus on the 20 percent of compo-
nents that make up 80 percent of the inventory investment dollars and focus
on the lead time mismatch between customer order lead time and prod-
uct processing lead time. I explain this lead time mismatch in detail in
Chapter 9.
 Seven Project Groups for Project Teams 19

How Do We Minimize Capital Asset and Accounts

Receivable Investment?
Block 12: Maximize capital asset utilization percent for the 20 percent of
the individual assets that make up 80 percent of the investment dollars.
Block 13: Control the customer invoice collection time period stated in
the contracted agreement. Focus on the 20 percent of your customers who
force you to invest in their business by paying later than agreed.

How Do We Maximize Employee Utilization

(Block 14)?
The chances of doubling average ROA over a three- to five-year business
cycle is very slim if you don’t invest in and empower your companywide
knowledge resources in a team in one of the seven project categories.

How Do We Explode These Seven Project Groups

into More Specific Projects?
Gather a group of employees together in a room with bare walls, with a pack-
age of sticky notes large enough to write down a verb/phrase combination.
Then, looking at any one of the seven project groups, have the group start
writing down verb/phrase or verb/noun combinations by asking the ques-
tion, “How do we . . . ?” for that particular project group. Stick that sticky
note on the wall. Then, for each of the verb/noun combinations you record on
a sticky note, keep asking the question “How” and place it by its appropriate
sticky note until you get to a more detailed project name, such as a part
number, to which you can assign a project team.
For each new verb/noun combination, ask the question “Why?” to see
if you’ve selected the best words for the preceding verb/noun. If not, try a
different verb/noun combination that more precisely answers both the how
and why questions. Apply team brainstorming to get closest to the core
verb/noun combination.
At some point the only right answer to the how question is, “We don’t
know how.” This is a signal to schedule training. The chances are that there
is a place in this book where I have the answer to that question.
The remainder of this chapter is a list of verb/phrase and verb/
noun combinations for each of the seven project groups. Use them to prompt
combinations that more precisely fit your business, or that fit improvements
you are already planning or implementing.
20 Chapter Three

If you have enough personnel, you can assign a team to make a list of
verb/phrase combinations for each project group. If you are a smaller com-
pany, you may have to work on only one or two project groups at a time.

How Do We, Inside and Outside of Sales and

Marketing, Increase Market Share?
One important point about this list of verb/phrase combinations is that
company functions not directly connected with the sales and marketing
function have a big impact on increasing market share. Any department that
assists on-time delivery, consistent quality, and cost control, so that prices
aren’t increased as fast as inflation, can add to or defend market share every
year and in each phase of your company’s business cycle.

To Increase Product Coverage

• Design new products
• Acquire another company/competitor
• Acquire another product line

To Increase Price Coverage

• Redesign the existing product line to reduce cost
• Acquire an accepted low-cost product line
• Create a new line that is private-labeled

To Increase Channel Coverage

• Change channels
• Add more distributors
• Pull more through existing distributors

To Increase Promotion Coverage

• Improve delivery and advertise it
• Telemarket products and services
• Change advertising to emphasize customer financial benefits
• Increase advertising
• Target specific industries
 Seven Project Groups for Project Teams 21

• Improve distributor training

• Provide the sales force with better targeted selling tools

To Increase Brand Coverage

• Increase sales force contact
• Change the discount structure

To Estimate Market Share

• Assess market coverage position
• Assess competitors’ market coverage
• Analyze the market
• Segment markets
• Enter new market segments
• Segregate distribution channels

To Compose a Marketing Plan

• Include key customers in planning
• Plot the company’s business cycle
• Document customer order processing time
• Shorten customer order processing time
• Measure customer satisfaction
• Improve customer satisfaction
• Improve after-sale service

To Include Other Functions in Marketing Planning

• Approve credit in advance
• Consider advance payment for slow-paying customers
• Drop slow-paying customers
• Implement material control improvement
• Improve delivery performance
• Deliver customer orders on time
22 Chapter Three

• Document on-time delivery percent

• Design product components for shorter lead time
• Evaluate order driven pull systems
• Evaluate forecasting use
• Document customer order/manufacturing lead time mismatch
• Improve quality consistency
• Implement ISO 9000
• Control costs/prices so they increase at a rate lower than inflation
• Divest part of business (for example, abandon some products)

How Do We Reduce Expenses per Sales Dollar?

This includes both labor and nonlabor expense reduction that can be found
in the line items of the annual budget.

To Segregate Budget Expenses

• Segregate using the 80/20 rule
• Track labor dollars per sales dollar
• Track nonlabor dollars per sales dollar
• Track overhead dollars per sales dollar
• Evaluate projects by ROA
• Prioritize projects by ROA
• Segregate material costs using the 80/20 rule
• Segregate inventory-carrying line items in the budget
• Segregate setup line items in the budget
• Identify major paperwork costs
• Document product standard cost
• Segregate overhead expenses
• Minimize tax expense
• Rationalize interest expense
 Seven Project Groups for Project Teams 23

• Segregate depreciation expenses using the 80/20 rule

• Segregate insurance expenses using the 80/20 rule
• Segregate material handling expenses
• Segregate personnel expenses
• Segregate sales, engineering, and administration (SE&A) expenses
• Segregate direct labor costs
• Segregate indirect labor costs
• Analyze scrap costs
• Analyze rework costs
• Identify quality costs
• Track quality costs
• Rationalize use of purchasing quantity price breaks
• Document cost of the annual physical inventory
• Use cycle counting to keep accurate inventory records
• Document setup cost ÷ direct labor cost percent

To Implement Six Sigma and Lean Concepts and

Eliminate Waste
• Eliminate waiting waste
• Eliminate transportation waste
• Eliminate processing waste
• Eliminate inventory waste
• Eliminate defect waste
• Eliminate motion waste
• Eliminate people waste
• Document non-value-added waste
• Improve workplace organization
• Utilize cleaning as inspection
• Inspect at the source
24 Chapter Three

• Implement, schedule, and perform preventive maintenance

• Improve processing scheduling

How Do We Reduce Lead Times?

Remember, the reason you need to reduce processing lead time is to reduce
work-in-process inventory investment. This includes reducing the mismatch
between customer order processing lead time and manufacturing lead time
to reduce component inventory investment.

To Document Current Lead Times

• Calculate customer order processing lead times
• Calculate current component processing lead times
• Document processing queue times
• Calculate assembly lead times
• Document purchasing lead times
• Document paperwork lead times
• Plot product cycle times
• Shorten purchasing and raw material lead times
• Shorten component processing and assembly lead times
• Shorten packaging and shipping lead times

To Improve the Material Control System

• Improve inventory and production control
• Improve process scheduling
• Calculate manufacturing capacity
• Classify equipment utilization percent
• Calculate safety allowance
• Expedite purchased items by safety allowance
• Maintain processing routers
• Schedule shop orders by start date
• Expedite shop orders by start date
 Seven Project Groups for Project Teams 25

• Decide on a component reorder calculation

• Schedule setup/changeover preparation
• Prepare setups in advance
• Improve cycle time/lead time mismatch
• Implement receiving and receiving inspection cell
• Include suppliers on project teams

To Define the Lean Value Stream

• Perform process mapping
• Document process flow
• Implement visual displays and controls
• Identify product families
• Implement product family cells
• Implement paperwork cells
• Document the current process in a flowchart
• Design the future/ideal flowchart
• Implement the future flowchart
• Solve upstream quality problems
• Coordinate product and process design

How Do We Reduce Setup Costs?

Remember, the reason to reduce or eliminate setup cost is to reduce lot sizes
so component inventory investment will be minimized.

To Design a Lot Sizing Formula

• Calculate lot sizes
• Balance setup costs with inventory carrying cost
• Minimize component inventory investment
• Minimize lot sizes
• Reduce setup cost
26 Chapter Three

• Calculate the inventory carrying cost

• Calculate manufacturing setup cost
• Calculate the purchasing setup cost
• Document the item-by-item setup cost
• Document most recent usage history and lot sizes
• Document component unit cost
• Calculate lot sizes for purchased item quantity price breaks
• Identify families of parts
• Calculate lot sizes for part families processed together
• Implement cellular component processing
• Invest in tooling for setup reduction
• Design setup cost and time out of components
• Design for fewest number of parts in each assembly
• Design for fewest number of operations
• Separate external and internal setup
• Complete external setup ahead of the next setup

How Do We Maximize Capital Asset Utilization?

There is a linkage between capital processing equipment utilization and a
good material control system. This is reflected in some of the verb/phrase
combinations:
• Calculate machine utilization percent
• Classify equipment by utilization percent
• Document plant capacity
• Identify processing equipment bottlenecks
• Identify overloaded processing equipment
• Schedule/perform preventive maintenance
• Improve processing accuracy with preventive maintenance
• Match machine capability/accuracy to design requirement
 Seven Project Groups for Project Teams 27

• Relate plant capacity to the business cycle

• Provide special schedule control for high utilization percentages
• Farm out processing for low utilization percentages
• Sell off underutilized, expensive equipment
• Sell off/rent underutilized space

How Do We Control the Accounts Receivable

Collection Period?
For every day a customer pays later than agreed, operating or investment
cash is reduced and is limited for other continuous improvement invest-
ments you need to be making, particularly in extra personnel who can be
assigned to teams for improvement projects.

To Improve the Collection Period

• Approve credit in advance
• Compare terms with actual results
• Consider advance payment from slow-paying customers
• Provide financial advice to slow-paying customers
• Provide special higher pricing to slow-paying customers
• Provide high-interest loans to slow-paying customers
• Consider dropping slow-paying customers
• Build control into the marketing plan
• Build improvement projects/action into marketing plans

How Do We Maximize Employee Asset Utilization?

Remember, your employees are individual businesses. To earn the highest
wages they must lower their cost and increase their knowledge. To make
them most Profit Able, you must invest in their Profit Ability training.

To Accomplish This
• Decrease percent salary and wage dollars ÷ sales dollars
• Take inventory of employee knowledge that your business needs
28 Chapter Three

• Identify knowledge gaps

• Hire people based on new or specific knowledge needed
• Schedule training for specific knowledge needed
• Train employees to be businessmen and businesswomen
• Promote from within your trained knowledge resources
• Train for promotion
• Empower employee assets
• Manage change
• Identify and encourage change agents and champions
• Organize project teams for each of the seven business
elements
• Assign the best knowledge resources to the most profitable
project
• Train employee teams
• Build employee teams
• Invest in time for teams to implement improvement projects
• Invest in time for teams to increase the ROA annually
• Improve company information on financial performance
• Encourage individual creativity
• Encourage team creativity
• Recognize high contributors
• Allow peers to recognize and encourage high contributors
• Implement financial incentives
• Consider proven gain-sharing plans
• Retain your knowledge resources with competitive wages
In this chapter I’ve demonstrated the vast number of verb/phrase combina-
tions that can be generated by asking the questions “How?” and “Why?”
The goal is to save you time as you look for both broad and specific proj-
ects in each of the seven critical business elements. As you read the rest of
this book, keep a note pad handy to compose a verb/noun or verb/phrase
 Seven Project Groups for Project Teams 29

combination that fits improvements you want to make in your company or

in your individual life or career. Then take action to invest the necessary
time to implement some improvement every day.
Life, and your job, will be much more enjoyable if you don’t put it off
and if you don’t stop fighting for changes and improvements your gut tells
you to make.
 4
Seven Project Groups You
Can Start Today

A
few key planners, decision makers, or project teams may have
already identified and implemented several obviously good proj-
ects that happen to fall within each of the seven project groups.
More than likely, some knowledge resources may already be assigned to
each of these seven improvement project groups.
In fact, you and your personnel may be saying, “We don’t have a prob-
lem discovering enough projects. Our problem is having enough human
resources with spare time to design and implement projects we are rela-
tively sure will increase profit.” If this is your response, it shows that you
don’t yet understand that to double ROA will require you to systematically
invest in enough people resources to specifically do continuous improve-
ment work.
In the next chapter I ask you to prove financially how much profit,
investment reduction, or ROA increase the potential projects will yield.
Then I will provide you with a form that will help you financially evalu-
ate and rank each project you discover. For now, I want to provide you with
some additional thoughts about discovering and naming projects within the
seven critical business elements.
Your personnel already know most of what I will reveal to you in
this book. About all I do for you is to organize what you know and what
I know so you can get started today. Time is slipping away and so is your
increased profit.
Even before team training starts, there’s no reason why you shouldn’t
assign a change agent or champion to get continuous improvement started
in a big way. The longer you wait to add the necessary knowledge resources
to get started, the more of your future net worth you are allowing to waste
away. You’re also allowing competitors to get a jump on you with their own
continuous improvement.

31
32 Chapter Four

Continuous improvement will be hard work, but it won’t be as hard as

you are working now. And even if you invest in a few additional employees
up front to get started on a more broadly focused continuous improvement
process, you will eventually require fewer employees per sales dollar than
you do now. Having various projects that involve a high percentage of your
personnel will turn their going to work each day into a game for which they
will now have a measurable way to keep score.
Now let’s just casually walk through your facility to see how easily we
can discover projects in each of the seven project groups that are crying out
to be improved.

PROJECT GROUP:
MAXIMIZE EMPLOYEE ASSET
UTILIZATION
Set a goal to reduce personnel salary and wage costs per sales dollar by 10
percent over three to five years’ time.
A logical starting place is to invest in training projects that increase the
utilization of the creative talents of your human assets. If you don’t have a
formal training schedule that links with one or more of the seven project
groups, you have found one logical starting place.
Even if you are already using project teams, they can be continuously
improved. If you don’t have at least one team, with the right knowledge
resources, working on each of seven improvement areas, you have discov-
ered one of your most important projects.
Next, ask if the improvement process requires that each team has a
step-by-step schedule. Just as you schedule customer products and services
to deliver them on time, you need a schedule to be sure that human resources
are available and scheduled to complete improvement projects on time to
meet ROA improvement goals.
This is logical since every project will be evaluated to prove that it will
yield a measurable ROA increase. To fail to deliver profitability improve-
ment on time is just as bad as not delivering products and services on time.
Just as with products and services, failure to provide adequate capital
investment and personnel will put you behind schedule. Failure to invest
money and knowledge resources in improvement projects will delay ROA
improvement.
This project group might be given the responsibility to schedule
employee training and monitor project completions for each of the project
groups.
 Seven Project Groups You Can Start Today 33

Measure the companywide ratio of salary and wage costs divided

by sales for the past three or four years. Ask if there is a current goal to
improve it. If you aren’t currently using this measure, what better project
can you quickly implement to communicate the trend?

PROJECT GROUP:
INCREASE MARKET COVERAGE
AND SALES DOLLARS
Set an initial goal to increase sales at least 10 percent by increasing market
share and coverage over the next three- to five-year business cycle.
More than likely, your business plan or marketing plan has a goal to
increase sales dollars. I don’t want to mince words about increasing sales
or increasing market share; if you have a specific plan to increase market
coverage, the chances are favorable that you will increase both sales and
market share. The key is, do you know for sure that each part of your mar-
keting plan will increase the ROA? If you don’t have a marketing plan that
invests in more coverage, better on-time delivery, improved quality, and
expense reduction, you don’t have a complete marketing plan.
In the next chapter I will show you how to determine whether the
investment to increase market share will increase ROA. In Chapter 13, I
show you how to estimate your market share and the share of each competi-
tor by estimating the market coverage of each business. Also in Chapter 13,
I will show you what I think a marketing plan should look like.
You already have a supply of knowledge resources doing certain things
to increase sales. This group probably has a formal marketing plan to get the
required results by a certain time. I can suggest some specific things this
team can do to build a team that might expand the scope of the marketing
plan and improve the chances of success. Three examples will explain the
things I suggest.
First, I will attempt to convince you that your marketing team needs
to include members and projects from other company functions such as
design engineering, quality, product cost reduction, processing cost reduc-
tion, on-time delivery, and customer satisfaction. If customers are consid-
ering increasing your market share from them, they expect new products
and services to be available when promised. They expect your company to
reduce costs so prices to them increase at a rate less than the rate of infla-
tion. They want consistency and predictability in products and services to
improve so they will know that your quality program is really working for
them. They expect you to reduce lead time for customer order delivery.
34 Chapter Four

I believe that your marketing plan should schedule improvement in these

company performance areas and should involve personnel in these func-
tions. This is an improvement that will support greater market share.
Second, I will attempt to convince you that you won’t have sales
increases throughout each economic business cycle if you don’t plan to
increase market share by naming projects to increase your coverage for
products, price, marketing channels, promotion, and your brand label. In
Chapter 13, I will show you numerically how each percent of increased
coverage will result in a predictable percent increase in market share.
Third, also in Chapter 13, I will show your marketing team a sample
marketing plan that they can use to generate ideas for additional marketing
projects that can be evaluated for their ROA contribution.
Ask the marketing team for the current specific sales increase goals
and what specific plans and actions are being implemented. Ask where
you are in your business cycle. Ask about the level of customer satisfaction
and the most important things your customers are asking them to improve.
Ask to see the marketing plan and check it to see if it includes projects to
increase market coverage so that market share will be increased. Check
to see if appropriate projects are included for non-sales personnel to reduce
lead times and improve on-time delivery, and whether goals are set to raise
prices at a rate lower than inflation.

PROJECT GROUP:
REDUCE EXPENSES PER
SALES DOLLAR
Set a goal to decrease nonlabor material and overhead costs per sales dollar
by 10 percent over the next three to five years.
Your annual budget plan is a good starting place for projects to reduce
labor, material, and overhead costs, even if you haven’t implemented team
training. All of these expenses, listed as budget line items, are the detailed
expenses you will subtract from annual sales to determine your annual
profit. As expenses go down, profit goes up.
Your employee teams can start by looking at the 20 percent of budget
line items that account for 80 percent of the total expenses. In one day (like
today), you can discover enough projects to evaluate and implement very
soon. The point is, there will never be a shortage of improvement projects.
Your task is to invest in personnel to evaluate and implement them.
In every chapter of this book I will show you other fertile places to dis-
cover a massive number of profitable projects.
 Seven Project Groups You Can Start Today 35

As an experiment for the team assigned to this project group, take the
word/phrase list in Chapter 3 for “How do we reduce expenses per sales
dollar?” and see how many match with improvements you already have in
the back of your mind but just haven’t made the decision to invest in the
time for your best knowledge resources to work on them.

PROJECT GROUP:
REDUCE LEAD TIMES
Set a goal to cut work-in-process inventory in half by reducing various
lead times.
The primary goals of lead time reduction are to reduce inventory of
work-in-process items and to shorten your customer order lead time so you
can give customers better service than your competitors. You do this to help
increase sales, particularly during the peak of your business cycle.
Lead time projects should require an evaluation of your customer order
processing and material control systems. The time spent processing new
customer orders and the lead time control provided by your material control
system will give you some of the easiest projects to implement. In Chapter
11, I will show you a step-by-step process that can guide you through the
evaluation of your current material control system. A simple test to deter-
mine whether this evaluation will increase your sales and ROA is to just
make a quick estimate of the percentage of times you ship on the date prom-
ised to each customer. Anything less than 95 percent tells you that this is a
project screaming to be given some attention.
As an experiment for this project team, use the appropriate list of
noun/phrase combinations in Chapter 3 and take a casual walk through
your facilities.
To shorten customer order processing lead time, count how many dif-
ferent people and departments the paperwork passes through before a pur-
chase order or shop order can be released. Determine how many days are
consumed to do this paperwork and information processing. Less than one
day should be a normal expectation.
To minimize work-in-process inventory, ask if shop orders are sched-
uled by start dates or due dates for each operation. Ask how many shop
orders have been started before or after their specified start date. Count
how many shop orders are in queue and not being processed. Ask how
queue times and processing lead times are determined and whether these
lead times are realistic or predictable. Count the number of shop orders
that have due dates older than the current date. Determine whether behind-
36 Chapter Four

schedule shop orders are expedited by counting the number of processing

hours, by machine, that are behind schedule or whether current orders are
just shuffled to solve the most urgent customer delivery problem. Find out
who in the company understands that in-process inventory is controlled by
in-process lead time. Ask how many people do some expediting of customer
orders. Find out who understands that all expediters can be eliminated and
that their activities are a symptom you need to evaluate to improve the
material control system and reduce lead times.

PROJECT GROUP:
REDUCE SETUP COSTS
Set a goal to cut setup costs in half.
One easy test to discover how important setup cost reduction will
be for manufacturers is to estimate what percent of direct labor hours are
used for setup of direct labor operations. This is particularly critical for
component manufactures in both your shop and your suppliers’ shops. If
the percent is as much as 10 percent, setup cost reduction projects can make
big reductions in your inventory investment. The reason for this inventory
reduction is that lower setup cost results in smaller lot sizes, which means
fewer dollars invested in inventory.
The reason I encourage you to include your suppliers in setup reduc-
tion projects is that their setup costs affect the size of your inventory
investment. The way to know that this is true is to see how many of the
components you buy from a supplier have quantity price breaks. The reason
they give you price breaks is because they have setup costs for which they
require you to pay.
Until you and your suppliers implement projects to reduce setup costs,
you will never maximize your ROA. In Chapter 10, I show you how to
determine the price break (or lot size) that is most financially sound.
This brings up another project I encourage you to implement as quickly
as possible. You need a financially sound formula to calculate lot sizes
in your own shop. Lean manufacturing courses encourage you to reduce
changeover costs so you can manufacture components in lot sizes of one.
This isn’t practical for businesses that don’t have mass production lines.
Most small manufacturers are forced to produce in reasonable lot sizes
because they haven’t been able to cut setup costs on all components.
In Chapter 10, I will show you the requirements for a formula to calcu-
late lot sizes that will minimize your inventory investment and maximize
your ROA.
 Seven Project Groups You Can Start Today 37

For this project group, a casual talk with your personnel who perform
setups and a casual talk with your personnel who set lot sizes will reveal the
best starting point for this project team.
Find out what is being done now to minimize raw material inven-
tory. For manufacturing businesses, raw material can be moved directly
from receiving to where it will be processed. Determine how soon the raw
material will be consumed. Ask whether raw material delivery appears on
process routers with a start date the same as the start date of the first pro-
cessing operation.
Ask what is being done to minimize component inventory, both pur-
chased and manufactured. For manufacturing, get a feel for what percent-
age of direct labor hours are used to perform setups. For manufacturing,
distribution, and service businesses, get a feel for the amount of compo-
nent inventory on hand. Ask how purchased and manufactured lot sizes
are determined. Ask how much it costs to process each purchase order and
shop order. Find out who knows that component inventory is controlled by
manufacturing and purchasing setup costs. Find out who knows that there is
a purchasing setup cost and how to calculate it. Find out how much knowl-
edge and money is being invested to reduce setup times. Ask personnel in
product and process design how they systematically design setup time and
cost out of new or existing parts. Determine the level of knowledge about
lean manufacturing and cellular processing for both product and paper-
work. Get a feel for how many weeks’ supply is carried on the 20 percent of
components that make up 80 percent of the inventory investment.

PROJECT GROUP:
MAXIMIZE CAPITAL ASSET
UTILIZATION
Set a goal to increase capital asset utilization five percent.
Every percent you increase the utilization of capital assets is the same
as getting that amount of production capacity at zero cost.
You may also have expensive pieces of equipment that you only use on
one shift. Most stockholders would consider that to be underutilization of
their investment. This kind of underutilization may be justifiable for short
periods of time when you are expecting increased sales soon.
However, there are other projects that will be implemented within the
preceding project groups that will increase the utilization of existing capi-
tal investment and delay the time when new investment will be required.
38 Chapter Four

These other projects will also be like getting new equipment or space for
free. Here are only a few examples:
• If over the next three to five years you implement enough
projects to absorb 15 percent to 25 percent more sales dollars,
it will be like getting 15 percent to 25 percent more capital
equipment for free. I believe this is an improvement you should
expect. I know that this book will show your employees more
than enough projects so they can make it happen.
• If over the next three to five years you implement projects to
significantly shorten lead times so that your customer order
delivery time is reduced, you can expect them to yield increased
market share, which will occupy some of the underutilized
capital assets.
• If you implement projects to shorten lead times for manufacturing
or assembly operations, every day that you eliminate from the
current utilization of that asset will be equal to one day of
production from that asset at no new investment.
• If you implement projects to shorten paperwork or information
lead time in office or data processing operations, you can expect
to delay the buying of new capital equipment.
• Every time you implement a financially justified project to
reduce setup cost by one hour, you have gained an hour’s worth
of production capacity for that piece of equipment.
This project team can discover projects they won’t find in any other way
by going into the shop or office and talking to the people who operate and
schedule the use of each major capital asset, including office, warehouse,
assembly, and manufacturing floor space.
Determine what procedures are currently used to increase equip-
ment utilization. Identify the most highly utilized equipment. If data isn’t
currently available, make a guess about utilization rates. Ask how preven-
tive maintenance is used to maintain the statistical capability of precision
machines in comparison to their capability when new. Ask if utilization
rates are used to load and schedule processing steps. Ask if there is equip-
ment and floor space that is seldom used and how much it costs to main-
tain it, to heat and cool it, and how much it costs in terms of insurance and
taxes.
 Seven Project Groups You Can Start Today 39

PROJECT GROUP:
CONTROL THE CUSTOMER INVOICE
COLLECTION PERIOD
Set a goal to get all customers to pay within one or two days of the date you
and they agreed on when you accepted their order.
The marketplace usually determines the contracted length of time
between the day you issue an invoice for goods or services delivered and
the day you receive payment. The reason customers are tempted to take
too much time to pay is because they want to force you to invest in their
inventory so they will have a higher ROA. If you want to recover this invest-
ment from them so you can increase your ROA, or use the cash to implement
improvement projects, you must find a way to get them to live within the
contracted collection period to which they agreed when they placed their
order with you.
There may be some competitive reasons why you tolerate late payment
from some customers but there is never a good financial reason. Sometimes
you find that even without the sales you get from them, you will have a
higher ROA if you allow your competitor to take their business. This is the
reason why I will provide you with a project evaluation form to help you
make these thorny financial and customer relations decisions.

WHAT COMES NEXT?

Now that we’ve looked at the seven critical business elements and the seven
project groups from several different perspectives, we need to move on to
the next basic step.
In the next chapter I will present a form to evaluate and rank each
project you have named with a verb/noun combination. Completing this
form will help you to know which projects in each of the seven project
groups will increase your ROA the most and the quickest.
I will also provide you with a similar form that can be used to set
annual ROA percent improvement goals or longer-term goals for a three- to
five-year business cycle.
 5
Project Evaluation and
Project Goal Setting

N
ow it’s time for me to prove my claim that you can double your
ROA in three to five years if you organize your best knowledge
resources into project teams and make time and money available to
them in every phase of the business cycle.
There are three purposes of this chapter:
• First, I provide a sample form for gathering financial data that
will be used in the following chapters.
• Second, I will show you a simple way to evaluate each large and
small project to determine whether the project will cause the
ROA to go up or down.
• Third, I show you how to do the calculations to set your own
improvement goal for each of the seven project groups, and for
overall improvement.
This chapter includes seven forms that you can customize to fit your
own business:
• Worksheet for gathering financial data for a manufacturing
business.
• Worksheet for gathering financial data for a service or
distribution business.
• Project Evaluation Form to determine how much an individual
project will increase the ROA.
• The first of four worksheets used to set a goal for each of the
seven project groups. In each worksheet there is a column for each
of the seven project groups. These individual columns will also

41
42 Chapter Five

serve as a guide to completing the Project Evaluation Form for a

project in that particular project group. The first worksheet is for
Increase Sales and Reduce Salary and Labor Cost.
• The other three worksheets are for Reduce Overhead Costs and
Reduce Lead Times, Reduce Setup Cost and Increase Capital
Asset Utilization, and Reduce Invoice Collection Period. The last
column is the accumulated total for all seven groups.
The first two worksheets are to help you gather your own company data to
compare with our sample company.
Completing the sample project evaluation form for each of your proj-
ects will make sense after we’ve gone through the next four worksheets.
Notice that all seven worksheets have 24 lines and that the line descrip-
tions are the same except for the second worksheet for gathering financial
data for a service or distribution business. We will focus our explanation of
these forms on a manufacturing business because we need to cover manu-
facturing setup costs and lead time issues. Even some service businesses
may have some manufacturing elements, for example, a rain gutter business
that makes its own guttering components.
If you decide to evaluate and prioritize projects, you will want to make
your own forms that conform to your own financial statements. You may
also need to segregate some costs into additional budget line items. For
example, if you don’t separate setup costs from other direct labor costs, you
will limit the information that your reduce setup cost team needs to make
their contribution.

WORKSHEETS FOR GATHERING

FINANCIAL DATA
We encourage you to use one of these two forms (see Figures 5.1 and 5.2)
to see how your business compares to our sample company. We suggest that
you complete one when sales are at their peak during a business cycle and
another when sales are at their lowest during the same business cycle. This
won’t take much time and it will tell you two things:
• First, you will quickly get an idea about the length of your normal
business cycle.
• Second, you will see the difference in your ROA for high and
low sales years. This will give you a feel for how much different
these years would be if you increase your market share for future
business cycles.
 Project Evaluation and Project Goal Setting 43

Worksheet for Gathering Financial Data

Manufacturing

% of Sample Your
Line Data description sales data data

1 Total sales 100% 10,000,000

2 Purchased materials and parts 30% 3,000,000
3 Setup—direct labor 1% 100,000
4 Run—direct labor 6% 600,000
5 Indirect labor 6% 600,000
6 Manufacturing salaries 6% 600,000
7 Manuacturing non-wage overhead 21% 2,100,000
8 Less total manufacturing expenses 70% 7,000,000
9 SE&A salaries 13% 1,300,000
10 SE&A overhead 7% 700,000
11 Less SE&A expenses 20% 2,000,000
12 Net profit before tax 10% 1,000,000
13 Asset investment:
14 In-process inventory 7% 700,000
15 All other inventory 23% 2,300,000
16 Capital assets 56% 5,600,000
17 Accounts receivable 14% 1,400,000
18 Total assets 100% 10,000,000
19 ROA percent 10%
20 Number of employees 70
21 Investment per employee 143,000
22 Sales per employee 143,000
23 Total salaries and labor 3,200,000
24 Wage expenses ï sales 32%

Figure 5.1 Worksheet for gathering manufacturing financial data.

All of these forms combine elements from your profit and loss statement
and four of the investments from your balance sheet.
You will notice that the form for a service or distribution business
includes a line called gross profit. You will find it helpful to add this
44 Chapter Five

Worksheet for Gathering Financial Data

Service and Distribution

% of Sample Your
Line Data description sales data data

1 Total sales 100% 10,000,000

2 Purchased product 50% 5,000,000
3 Gross profit 50% 5,000,000
4 Payroll expense 9% 900,000
5 Payroll tax and fringes 3% 300,000
6 Auto and travel expense 6% 600,000
7 Promotion expense 5% 500,000
8 Contract expense 3% 300,000
9 Purchase order setup costs 3% 300,000
10 Administration and operations expense 8% 800,000
11 Depreciation expense 3% 300,000
12 Total operations expenses 40% 4,000,000
13 Net profit before tax 10% 1,000,000
14 Asset investment:
15 Inventory 60% 6,000,000
16 Capital assets 26% 2,600,000
17 Accounts receivable 14% 1,400,000
18 Total assets 100% 10,000,000
19 ROA percent 10%
20 Number of employees 70
21 Investment per employee 143,000
22 Sales per employee 143,000
23 Total salaries and labor 3,200,000
24 Wage expenses ï sales 32%

Figure 5.2 Worksheet for gathering service and distribution financial data.

same line to the other forms so you can evaluate various product lines or
market segments by their gross profit contribution. This will help you
to decide if your ROA would increase if you abandoned a product line or
market segment.
 Project Evaluation and Project Goal Setting 45

PROJECT EVALUATION FORM

Figure 5.3 shows an example of the form you should use to determine how
much each individual improvement project will increase the ROA. Each
year, based on the past year’s actual budget numbers or your current year’s
budget plan, you will enter the correct values in the sample data column
and calculate the appropriate percent of sales for each line. These two col-
umns become your current base for evaluating proposed projects.
Then, for each proposed project, you would enter the appropriate
higher or lower value for any of the lines that represent what this financial
statement would look like after the project is implemented. The line you are
most interested in is line 19, ROA percent.
If the new ROA percent is smaller than the base ROA percent, you will
reject the project. If the new ROA is larger than the base ROA percent, com-
pare the ROA for this project with the ROA for all other proposed projects
to see which will have the greatest or quickest positive impact on the ROA.
For example, let’s assume that your base ROA percent is 10.000 per-
cent, the same as in our sample. If you have five projects with new ROA
percents of 10.015 percent, 10.522 percent, 10.120 percent, 10.03 percent,
and 10.501 percent, you will be able to rank them from the highest to low-
est percent. After ranking them, you can then make a commonsense judg-
ment as to which of those with almost the same ROA percent would be the
one you want to approve first. Sometimes a decision might be made on the
availability of the right knowledge workers within a given project group.
To evaluate projects in each of the seven project groups, you can follow
the instructions for the remaining four worksheets about ROA goals.

ROA IMPROVEMENT GOALS

For Increase Sales Column

In our sample business, we decided to implement projects to increase mar-
ket share/coverage enough to increase sales 10 percent. I will show which
of the lines will require some adjustment for any project evaluations that are
designed to increase sales (see Figure 5.4). The calculations are the same
for project group goal setting:
Line 1. The 10 percent sales increase is entered on line 1 for this column.
Lines 2, 3, and 4. For a 10 percent sales increase, it’s reasonable to esti-
mate that product and component raw materials, direct labor for setting
up and running components, and purchased components will increase
46 Chapter Five

Project Evaluation Form

% of Sample Project
Line Data description sales data data

1 Total sales 100% 10,000,000

2 Purchased materials and parts 30% 3,000,000
3 Setup—direct labor 1% 100,000
4 Run—direct labor 6% 600,000
5 Indirect labor 6% 600,000
6 Manufacturing salaries 6% 600,000
7 Manuacturing non-wage overhead 21% 2,100,000
8 Less total manufacturing expenses 70% 7,000,000
9 SE&A salaries 13% 1,300,000
10 SE&A overhead 7% 700,000
11 Less SE&A expenses 20% 2,000,000
12 Net profit before tax 10% 1,000,000
13 Asset investment:
14 In-process inventory 7% 700,000
15 All other inventory 23% 2,300,000
16 Capital assets 56% 5,600,000
17 Accounts receivable 14% 1,400,000
18 Total assets 100% 10,000,000
19 ROA percent 10%
20 Number of employees 70
21 Investment per employee 143,000
22 Sales per employee 143,000
23 Total salaries and labor 3,200,000
24 Wage expenses ï sales 32%

Figure 5.3 Project evaluation form.

10 percent. Therefore, a 10 percent expense increase is added to each of

these lines.
Lines 5 and 7. For this example, I have assumed that indirect labor and
non-wage overhead will increase two percent. For your calculations for
your company, you might want to use a larger percent if you have a logical
 Project Evaluation and Project Goal Setting 47

ROA Goals for Increase Sales and Reduce Salary and Labor Cost

Base data Plus 10% Minus 10%

Line Data description ë 1000 sales salaries

1 Total sales 10,000 1,000

2 Purchased materials and parts 3,000 300
3 Setup—direct labor 100 10 –10
4 Run—direct labor 600 60 –60
5 Indirect labor 600 12 –60
6 Manufacturing salaries 600 –60
7 Manuacturing non-wage overhead 2,100 42
8 Less total manufacturing expenses 7,000 424 –190
9 SE&A salaries 1,300 150 –130
10 SE&A overhead 700
11 Less SE&A expenses 2,000 150 –130
12 Net profit before tax –1,000 426 320
13 Asset investment:
14 In-process inventory 700 70
15 All other inventory 2,300 230
16 Capital assets 5,600 112 –280
17 Accounts receivable 1,400 140
18 Total assets 10,000 552 –280
19 ROA percent 10% 13.5% 13.6%
20 Number of employees 70 75 63
21 Investment per employee 143 143 154
22 Sales per employee 143 141 159
23 Total salaries and labor 3,200 3,450 2,880
24 Wage expenses ï sales 32% 31.3 28.1

Figure 5.4 ROA goals—Increase Sales and Reduce Salary and Labor Cost.

reason to believe it is more accurate. Or you could use a larger percent just
to be more conservative in your estimate.
Line 6. I assumed that for a 10 percent increase in sales, there is no need for
increased salaries for manufacturing managers, supervisors, and technical/
support personnel.
48 Chapter Five

Line 8. This is the total of lines 2 through 7. Though a line isn’t on this
form for gross profit, for the base data column the gross profit would be

$10,000 Total sales – $7,000 Total manufacturing expense =

$3,000 Gross profit ÷ $10,000 Sales = 30% Gross profit

For the 10 percent sales increase the gross profit would be 32.5 percent
because indirect labor and non-wage overhead were only increased two
percent.

Line 9. Sales, engineering, and administrative salaries will not normally

be increased for a 10 percent sales increase. For this line I’ve entered 150
($150,000) as the investment required to increase market share. I’ve placed
the investment on this line to make the point that you can treat an invest-
ment as an expense or as an increase in asset investment (line 13). For
project evaluation or goal setting, treating it as an expense is a more conser-
vative approach because it will result in a lower ROA percent increase than
if it is treated as an investment.

Line 10. I assumed no increase in SE&A overhead. If you have reason to

believe that your project for a market share or sales increase will increase
overhead in any of these functions, not covered by the above $150,000, you
will want to add an estimate so you won’t be disappointed if you don’t reach
your goal. There’s an old adage that almost always fits when you are mak-
ing estimates about any activity that involves time or money. It says, “It
always costs more and takes longer than you plan.” Try to add an extra room
to your house and you’ll never forget this little truth.

Lines 11 and 12. These lines are similar to line 8. You subtract lines 8 and
11 from line 1, total sales, to get an idea about how much profit will increase
as a result of a given project or as a result of the goal you have set for each
project team. In the example for this column, the numbers say a $1,000
($1,000,000) increase in sales could result in a $426 ($426,000) increase in
net profit. The new net profit percent for this one column would be

$1,000 + $426 = $1,426 ÷ $10,000 Base sales 14.6 percent

Line 13. This line for a manufacturer is the same as line 14 on the work-
sheet for gathering financial data for a service or distribution business.

Lines 14, 15, and 17. A 10 percent increase in sales will, at most, require a
10 percent increase in investment for work-in-process inventory, component
 Project Evaluation and Project Goal Setting 49

inventory, product inventory, and accounts receivable for the additional

dollars in invoices shipped to customers.

Line 16. Capital assets won’t need to increase 10 percent for a 10 percent
sales increase. I’ve estimated a two percent increase for more manufactur-
ing capacity. For various projects you may know the exact dollars required.
For setting an ROA percent goal you will have to make an educated guess
based on your equipment or floor space that is most highly utilized. Our
two percent estimate kept line 21, investment per employee, at the same
level so I felt comfortable with that guess.

Line 18. A 10 percent ($1,000,000) increase in sales resulted in a 5.5

percent ($552,000) increase in total asset investment. The value of using
this form, to see the impact of increased sales on the affected financial
lines, should be revealing to you if you haven’t done this sort of analy-
sis before. For line 18, if you don’t maintain a healthy cash reserve, you
may be required to borrow money to achieve each higher level of sales.
This demand for up-front cash for project investment is one of the biggest
reasons why you need to increase your average ROA percent over a busi-
ness cycle. Using all seven project groups to increase your ROA will gener-
ate extra cash for you to grow your market share and drive your expenses
down. The extra cash can also be used to increase your capital assets for
equipment and tooling to reduce your inventory investment. You can almost
always expect a capital investment to reduce setup and lead time to be much
less than the inventory it eliminates.

Line 19. This is the project evaluation and ROA percent goal you are look-
ing for. The base ROA percent for our sample is 10 percent. In the increase
sales column, when you divide line 12, net profit ($1,000 base + $426
increase = $1,426), by line 18, total assets ($10,000 + $552 = $10,552), you
get a new ROA of 13.5 percent or an increase of 3.5 percentage points. In
other words, for our sample company, a 10 percent increase in sales results
in a 35 percent increase in ROA. Think about this. With only the goal set for
one of the seven project groups, we’re already one-third of the way toward
doubling the ROA percent.

Lines 20 through 24. These are just other ratios to give your project
teams a feel for other ways to measure continuous improvement company-
wide. Before we’re finished with the analysis for all seven columns, we’re
going to see the potential for a 16 percent reduction in line 24, wage (sala-
ries and labor) expenses per sales dollar. This is on the low side of what you
should expect after three to five years of continuous improvement.
50 Chapter Five

For Reduce Salaries Column

In the sample company I decided to set a goal to reduce total employee com-
pensation expenses 10 percent (see Figure 5.4). Our goal isn’t to arbitrarily
cut every employee’s take-home pay. In fact, since we have invested in their
training and business knowledge, our goal is to increase their individual
take-home pay. You may even plan to reward them with some type of incen-
tive bonus to assure that the improvements will be continuous. Your true
goal is to implement projects that will maintain a constant number of cur-
rent employees as you increase sales from one business cycle to the next.
Lines 3, 4, 5, 6, and 9. Total salaries and labor for our sample company
is $3,200 ($3,200,000). A 10 percent improvement would equate to a profit
increase of $320 ($320,000). This could be the result of absorbing 10 per-
cent more sales without adding salary and labor costs. It could also be from
a reduction of labor and salary expenses at the current level of sales. Or it
could be a combination of the two.
Line 12. The new profit would be $1,000 + $320 = $1,320 ÷ $10,000 base
sales = 13.2%.
Line 16. For practical purposes, this improvement, without increased sales,
would eventually allow disposing of something less than 10 percent of cap-
ital assets. Or, if there was an increase in sales without adding additional
personnel, it would be like the company being given more capital assets
for free. For the sample company, and for this calculation, I have estimated
that we would gain a five percent advantage for the future capital assets.
This reduction is equivalent to a new capital asset total of $5,600 – $280
($280,000) = $5,320 ($5,320,000).
Line 18. The new total assets would be $10,000 – $280 = $9,720
($9,720,000).
Line 19. The new ROA percent for this one column only would be $1,320
net profit ÷ $9,720 total assets = 13.6% or an ROA increase of 3.6 percent-
age points.
Line 24. Obviously we would expect this ratio to improve. That’s why I
encourage you to use the ratio of wages ÷ sales to measure the performance
of your personnel on a companywide basis. This 10 percent improvement,
even if part of it were to be paid out as an incentive bonus, would still be
a net financial improvement for the company because of the free capital
assets it would receive. Couple this with reduced scrap and rework result-
ing from an incentive bonus system and the urgency of employees to more
 Project Evaluation and Project Goal Setting 51

quickly implement continuous improvement projects, and a companywide

incentive bonus makes good sense. In Chapter 6, I will explain how to
install a gain sharing bonus plan.

For Reduce Overhead Costs Column

For the sample company, the logic for this column is the same as for the
previous column. I decided to set a goal to reduce nonlabor related over-
head expenses 10 percent (see Figure 5.5). This is the project group that
will rely heavily on segregating out similar or related line items in your
annual budget. This is a good place to apply lean waste reduction concepts
and the verb/phrase combinations you will find in Chapter 8. Some of
these expense reductions will come as a result of specific projects. Some
of them will come from successfully implementing projects from the next
three columns, in which the expenses just seem to magically evaporate.
For example, when you reduce setup costs for manufactured components,
you experience a reduction in lot sizes. Smaller lot sizes means a smaller
inventory investment. When you successfully reduce your inventory invest-
ment and the space required to warehouse it, you end up with lower taxes,
lower insurance premiums, less scrap from obsolescence, lower material
handling costs, plus many other costs you will think of. By the time you’ve
gone through all seven project group goals, you will have a better apprecia-
tion of how these seven key business elements are interlinked.
Lines 7, 8, 10, 11, and 12. These lines will result in a $280 ($280,000)
cost reduction and a $280,000 net profit increase. The new profit for this
column would be $1,000 base profit + $280 = $1,280 ÷ $10,000 = 12.8%.
Line 19. Since there is no change in the base asset investment of $10,000
($10,000,000), the new ROA percent for this column is $1,000 + $280 =
$1,280 ÷ $10,000 = 12.8%, or an increase of 2.8 percentage points. The new
accumulated ROA percent for these three columns is $1,000 base net profit
+ $426 + $320 + $280 = $2,026 ($2,026,000) ÷ base total assets $10,000
+ $552 – $280 = $10,272 or $2,026 ÷ $10,272 = 19.7%. As you can see, we
have set goals for only three of the seven project groups and already we see
the probability of doubling the ROA percent of the sample company.

For Reduce Lead Times Column

It’s not unreasonable for most manufacturing businesses that are currently
carrying inventory to meet customer order lead time requirements to cut
their lead times in half. This column shows only a token amount of possible
52 Chapter Five

ROA Goals for Reduce Overhead Costs and Reduce Lead Times

Minus Minus
Base data 10% 50%
Line Data description ë 1000 overhead lead time

1 Total sales 10,000

2 Purchased materials and parts 3,000
3 Setup—direct labor 100
4 Run—direct labor 600
5 Indirect labor 600
6 Manufacturing salaries 600
7 Manuacturing non-wage overhead 2,100 –210
8 Less total manufacturing expenses 7,000 –210
9 SE&A salaries 1,300
10 SE&A overhead 700 –70
11 Less SE&A expenses 2,000 –70
12 Net profit before tax 1,000 280
13 Asset investment:
14 In-process inventory 700 –350
15 All other inventory 2,300 –354
16 Capital assets 5,600
17 Accounts receivable 1,400
18 Total assets 10,000 –704
19 ROA percent 10% 12.8% 10.8%
20 Number of employees 70 70 70
21 Investment per employee 143 143 133
22 Sales per employee 143 143 143
23 Total salaries and labor 3,200 3,200 3,200
24 Wage expenses ï sales 32% 32 32

Figure 5.5 ROA goals—Reduce Overhead Costs and Reduce Lead Times.

improvement (see Figure 5.5). I haven’t included any increased sales as

a result of a higher percent of on-time delivery of customer orders. I also
haven’t included any expense reductions as a result of shorter lead times
for many material handling activities between the receiving dock and the
shipping dock. No waste elimination has been claimed for such things as
 Project Evaluation and Project Goal Setting 53

inspection of purchased components at the source. The main purpose for

this column is to get you to set a goal for reduction of work-in-process
inventory as a result of reducing specific lead times.
Lines 14 and 15. For this column there will be no change in base expenses
or base net profit. Only the investments will be reduced by improving three
lead time issues.
First, there is often a mismatch between customer order lead time and
manufacturing lead time. Customer order lead time is the number of days
a customer allows between the day you receive the customer’s purchase
order and the day you ship their order. The manufacturing lead time is the
time required for you to purchase material, process components, and assem-
ble the product. The number of days the manufacturing lead time exceeds
the customer order lead time is an indication of how many component items
you must carry in inventory to meet customer delivery promises. The ideal
is to reduce your manufacturing lead time to fewer days than your customer
order lead time, so you can wait until you receive the customer order to
start the manufacturing process. Until this project team can resolve this
mismatch, you must carry inventory on the components whose processing
lead time is more than what the customer will allow. For the sample com-
pany, I assumed that the average component manufacturing lead time is
four weeks longer than the customer order lead time. This requires line 15
to be 4 weeks ÷ 52 weeks = 7.7% of the component inventory. The current
line 15 investment is $2,300 ($2,300,000). The investment reduction would
be $2,300 × 7.7% = $177 ($177,000).
Second, when lead times are very erratic for manufactured and
purchased components, it’s necessary to carry some inventory components
in the form of a safety allowance to assure that customer delivery dates will
be met. For our sample company I decided it was necessary to maintain a
permanent component inventory equal to four weeks’ usage to assure that
customer orders are shipped on time. The investment would be the same
as in the preceding example, $177 ($177,000). In Chapter 11, I show you
how to calculate a safety allowance on each component you must carry in
inventory.
Third, in-process inventory investment is totally controlled by manu-
facturing processing lead time from the day a shop order is started until the
component is placed in stock, transferred to assembly, or shipped. If pro-
cessing lead times could be cut in half, the in-process inventory investment
would be cut in half. For the sample company, line 14 investment would be
reduced $350 or $350,000. The total investment reduction for this column
is $177 + $177 = $354 + $350 = $704 ($704,000). The new total investment
= $10,000 – $704 = $9,296. ROA percent for this column would be $1,000
54 Chapter Five

net profit ÷ $9,296 = 10.8%. As you can see, all three of these lead time
reductions only yield a total new ROA of 10.8 percent. However, the real
payoff from reduced lead times is the high probability that they will increase
market share if your competitors can’t match your improvement. There-
fore, assume that the above three lead time improvements result in a sales
increase of one percent. Based on the results of the increase sales column,
each one percent sales increase would increase the ROA .35 percentage
points from 10 percent base to 10.35 percent. When you test this column in
your own company to establish an improvement goal or to evaluate an indi-
vidual project, consider adding some ROA increase for a sales increase.

For Reduce Setup Cost Column

For the sample company, total expenses for lines 3 and 4 are $700 ($700,000)
(see Figure 5.6). Setup expense ($100) is 16.7 percent of total direct labor
expense. This is probably a high percentage for most manufacturing busi-
nesses. If the percent for your company is much less, you may expect a
smaller ROA increase. In Chapter 10, I show you ways to cut setup cost at
least in half. These calculations for setting an ROA goal are the same as for
evaluating individual projects.
The most powerful way to minimize component inventory investment
is to reduce setup cost. This fact presumes that you use a financially sound
formula to calculate lot sizes. In Chapter 10, I demonstrate that a financially
sound lot sizing formula must be based on setup cost.
You can make a reasonable estimate about how much the ROA would
increase by reducing lot sizes. You need to consider the 80/20 rule. Statisti-
cally, 80 percent of your setup costs come from 20 percent of your compo-
nents. Also, for that reason, 80 percent of your inventory dollars are made
up from 20 percent of your components. Therefore, for the sample company,
we can estimate that if something less than 80 percent of the setup costs
is eliminated, something less than 80 percent of the inventory investment
would be eliminated. For the sample company I assume that a 50 percent
reduction is an achievable goal. Note: purchased components also have a
setup cost or purchase order cost per purchase order line item. In Chapter
10, I will show you how to calculate the purchase order setup cost.
Line 3. A 50 percent reduction in manufactured component inventory
investment will require a 50 percent cut in setup cost expenses on line
3. Therefore we show –$50 ($50,000) in this column for line 3. For this
example we will let the $50,000 expense reduction also include the cost
reduction for purchase order costs, which would actually come out of the
expenses on lines 5, 6, and 7.
 Project Evaluation and Project Goal Setting 55

ROA Goals for Reduce Setup Cost

and Increase Capital Asset Utilization

Minus Plus 5%
50% capital
Base data setup asset
Line Data description ë 1000 cost utilization

1 Total sales 10,000

2 Purchased materials and parts 3,000
3 Setup—direct labor 100 –50
4 Run—direct labor 600
5 Indirect labor 600
6 Manufacturing salaries 600
7 Manuacturing non-wage overhead 2,100 –172.5
8 Less total manufacturing expenses 7,000 –222.5
9 SE&A salaries 1,300
10 SE&A overhead 700
11 Less SE&A expenses 2,000
12 Net profit before tax 1,000 222.5
13 Asset investment:
14 In-process inventory 700
15 All other inventory 2,300 –1,150
16 Capital assets 5,600 575 –280
17 Accounts receivable 1,400
18 Total assets 10,000 –575 –280
19 ROA percent 10% 13% 10.3%
20 Number of employees 70 69 70
21 Investment per employee 143 137 139
22 Sales per employee 143 145 143
23 Total salaries and labor 3,200 3,150 3,200
24 Wage expenses ï sales 32% 31.5 32

Figure 5.6 ROA goals—Reduce Setup Cost and Increase Capital Asset
Utilization.

Line 15. Cutting the setup costs in half will reduce the investment on this
line by 50 percent. Therefore, 50 percent of the line 15 base value of $2,300
($2,300,000) will be shown as a negative $1,150 for this column.
56 Chapter Five

Line 16. You need to recognize that setup cost reductions, to perma-
nently reduce inventory investment, require a one-time investment in capi-
tal equipment and/or tooling. We can conservatively estimate that as much
as 50 percent of the –$1,150 ($1,150,000) reduction in inventory invest-
ment would be invested in capital equipment to get the $1,150,000 reduc-
tion in inventory investment. Therefore, 50 percent of the –$1,150 reduction
(+$575) is added to line 16 to increase the investment in capital assets.
Line 7. Two adjustments need to be made to line 7:
• To be financially precise, the capital asset increase would increase
annual depreciation expenses. I have assumed a depreciation
expense of 10 percent to represent that this $575 ($575,000)
investment would be transferred from an investment to an
expense over the next 10 years. Therefore, line 7 must be increased
by $57.5 ($57,500).
• However, there is an additional expense reduction that occurs
when you implement projects to cut setup cost. In Chapter 10,
I provide a list of expenses for inventory carrying costs, which
will automatically disappear every time you reduce the setup
hours, or costs, on a given component. These expenses disappear
simply because you have a smaller inventory as a result of smaller
lot sizes. These expenses include cost reductions for obsolescence,
material handling, and taxes and insurance for the dollars invested
in component inventory. For most manufacturing businesses the
total annual carrying cost averages about 20 cents annual expense
for each one dollar of inventory investment. We can express this
as 20 percent of the annual inventory value. Therefore, if there
is a $1,150 reduction on line 15 for the inventory investment
reduction for the sample company, there would be an annual
expense reduction of 20% × $1,150 = $230 ($230,000).
Therefore, on line 7 we show + $57.5 depreciation expense
–$230 cost reduction = –$172.5 expense reduction.
Line 12. New net profit will be $1,000 base net profit + $50 setup cost
reduction – $57.5 annual depreciation expense + $230 inventory carrying
cost reduction = $1,222.5.
Line 18. New total assets = $10,000 base – $1,150 line 15 inventory reduc-
tion + line 16 capital assets increase = $9,425 total assets.
Line 19. New ROA percent = $1,222.5 net profit ÷ $9,425 total assets =
13.0% or a 3.0 point increase in the ROA.
 Project Evaluation and Project Goal Setting 57

For Increase Capital Asset Utilization Column

In the preceding two columns, I didn’t claim any ROA increase for the
extra hours that equipment will be available due to shorter lead times, fewer
hours consumed by setup hours, fewer rework hours from improved qual-
ity, better material control scheduling to eliminate cutting approved lot
sizes to meet delivery dates, improved equipment uptime due to preven-
tive maintenance performed at prescribed intervals to prevent breakdowns,
increasing the number of shifts for the most productive equipment, short-
ening setup times by having tooling preset prior to completing the preced-
ing work order, and many other improvements your personnel will discover
through the verb/phrase process.
To show you the ROA goal setting calculations and how to evaluate
individual projects to increase the utilization percent, I have assumed that
this project team, or other teams, will discover enough projects to reduce
capital assets an equivalent of five percent. In other words, project teams
will implement enough projects to absorb five percent more sales without
investing in additional capital asset capacity (see Figure 5.6).
Line 16. Five percent of the $5,600 base capital assets is $280
($280,000).
Line 18. The adjusted total assets will be $10,000 – $280 = $9,720
($9,720,000)
Line 12. There will be no change in the $1,000 base net profit.
Line 19. The new ROA percent for this column only will be $1,000 ÷
$9,720 = 10.3% or an increase of .3 ROA percentage points.

For Reduce Invoice Collection Period Column

The size of the accounts receivable investment depends on how closely the
actual invoice collection period matches with the collection period the cus-
tomer accepts when the order is acknowledged by your company. For the
sample company, to show how the calculation is made, I have assumed that
if it meets the collection period goal, the accounts receivable investment
will be reduced $200,000 (see Figure 5.7).
Line 17. The accounts receivable will be reduced $200 ($200,000).
Line 18. The adjusted total assets will be $10,000 – $200 = $9,800
($9,800,000)
Line 12. There will be no change in the $1,000 base net profit.
58 Chapter Five

ROA Goals for Reduce Invoice Collection Period

and Total of All Goals

Invoice
Base data collection New
Line Data description ë 1000 period base

1 Total sales 10,000 11,000

2 Purchased materials and parts 3,000 3,300
3 Setup—direct labor 100 50
4 Run—direct labor 600 600
5 Indirect labor 600 552
6 Manufacturing salaries 600 540
7 Manuacturing non-wage overhead 2,100 1,759.5
8 Less total manufacturing expenses 7,000 6,801.5
9 SE&A salaries 1,300 1,320
10 SE&A overhead 700 630
11 Less SE&A expenses 2,000 1,950
12 Net profit before tax 1,000 2,248.5
13 Asset investment:
14 In-process inventory 700 420
15 All other inventory 2,300 1,026
16 Capital assets 5,600 5,727
17 Accounts receivable 1,400 –200 1,340
18 Total assets 10,000 –200 8,513
19 ROA percent 10% 10.2% 26.4%
20 Number of employees 70 70 67
21 Investment per employee 143 140 127
22 Sales per employee 143 143 164
23 Total salaries and labor 3,200 3,200 3,062
24 Wage expenses ï sales 32% 32 27.8

Figure 5.7 ROA goals—Reduce Invoice Collection Period and Total of

All Goals.
 Project Evaluation and Project Goal Setting 59

Line 19. The new ROA percent for this column only will be $1,000 ÷
$9,800 = 10.2% or an increase of .2 ROA percentage points.

For the Accumulated New Base

To show the ROA total improvement results for the seven project groups,
we add the results of each line and show the sum in the last column (see
Figure 5.7).
Line 19. The ROA goal we have set for the sample company is line 12
net profit $1,248.5 increase + $1,000 base net profit = $2,248.5 ÷ line
18 total assets $8,513 = 26.4 ROA % or a 16.4 percentage point increase in
the ROA.
The implication of the preceding paragraph is that total assets are $1,487,000
less than the original base of $10,000,000. This implies that the sample
company, in only three to five years, has generated $1,487,000 in cash that
it can use to acquire competitors or to invest in market coverage to increase
market share to grow the business.
However, before spending all that cash and the new annual base net
profit of $2,248,500 per year, we must recognize that the sample company
wouldn’t have made these improvements if it hadn’t invested in the knowl-
edge resources to discover, design, and implement projects in all seven
project groups.
Therefore, let’s look at the worksheet that has the two columns, base
data plus 10 percent sales and minus 10 percent salaries (Figure 5.4). On
line 20 we have assumed that the number of employees in these respec-
tive columns is 70 for the base and 63 for greater productivity. For greater
employee productivity, we assumed it would take seven fewer employ-
ees than the base of 70 after personnel implemented labor cost reducing
projects.
So that we can staff continuous improvement project teams, let’s
assume that we retained all existing 70 employees and assigned seven
of them to work on project teams full time from now on. Based on the
minus 10 percent salaries column, the annual expense (or annual invest-
ment) would be $320,000, the increased net profit we were expecting from
this project. Therefore, if we treat the $320,000 as an annual expense, the
adjusted net profit in the adjusted base column would be $2,248.5 – $320 =
$1,928.5. Then the revised ROA percent would more realistically become
$1,928.5 ÷ $8,513 = 22.7 ROA %, still more than double the original base
of 10 percent.
60 Chapter Five

What is the logical conclusion to draw from these first five chapters?
The sample company can, by investing in continuous improvement proj-
ects, generate enough cash to buy competitors to increase market share or
invest in coverage to increase market share.
The remaining chapters of this book are provided to give you more
detail about things you can build into your company culture to develop
the very best businessmen and businesswomen to staff a rapidly growing
company.
 6
Empowering
Employee Teams

SEVEN REALITIES TO INTERNALIZE

To support my claim that your company’s personnel can double your ROA
over the next three to five years, I will lay out some concepts as if I were
presenting a training program to some employees. I would start by help-
ing them improve their “Profit Ability” the first day they start making the
smallest decisions in your company. As you read through this basic new-
employee indoctrination, you may realize that many of your managers and
key decision makers also need to be reminded and convinced of the truth of
these seven conceptual facts.
Your employee training manual and training course might look some-
thing like the contents of this book.

Reality #1: Every Employee at Every Level Makes

Decisions Every Hour That Increase or Decrease
the Financial Value of One of the Seven Business
Financial Elements

My mission is to transfer from my mind to the minds of your employees

what I have learned through practical application of these financial real-
ities. What I have documented in this book is what I wish someone had
taught myself and my coworkers about the few things on which to con-
centrate our creativity very early in our business careers when our Profit
Ability was very limited. We could have made the business to which we had
committed ourselves much more profitable if our employer had handed us
this book to read and follow as a condition of employment.

61
62 Chapter Six

Reality #2: Employees Must Commit Themselves

to Four Different Sets of Bosses for Their
On-the-Job Education

These four sets are:

• The person who hired you and your peers. They can teach you
everything they have learned in the business world. There’s
nothing like on-the-job training from your boss and peers to bring
theory into practice.
• The stockholders of the business, who have invested a lot of
money to provide you with a job. In the sample company example
in Chapter 5, line 21 it states that the sample company invested
about $140,000 to provide a job for each of its 70 employees.
They’ve invested in your future before you even arrived. Why
shouldn’t you invest yourself in their future?
• Customers are really important too. Without them you wouldn’t
have any company income. It seems logical that your customers
will expect you to improve your quality, customer service, and
on-time delivery, shorten lead times, and keep price increases
at a rate slower than inflation. You also have internal customers
who expect the same things from you, their internal supplier.
• Another “boss” is yourself and your career. For practical
purposes, you are a business. You should have your own set
of verb/phrase combinations for your future. Don’t waste your
career at a place that doesn’t value you enough to train and
empower you. Your salary and benefits represent the sales of
your personal business. Hopefully, you are controlling your
personal expenses so you end up with money you can invest in
stocks of other businesses.

Reality #3: Most of the Knowledge Found in

This Book Is Already in the Minds of Your Personnel
and Procedure Manuals

What is probably missing is that your accumulated knowledge isn’t

organized into a logical process. You may not have a process to focus
procedures and knowledge resources on how to discover and evaluate
continuous improvement projects found in the seven partitions of your
 Empowering Employee Teams 63

continuous improvement treasure chest. Start with this book and fit the
puzzle pieces into a picture that looks the way you want your specific com-
pany to be organized.

Reality #4: Few Companies Can Expect to Maximize

Profitability without Harnessing the Creative Profit
Ability of Employees at Every Level

This reality implies that a process needs to be designed and employees need
to be trained to implement profitable continuous improvement. This con-
cept also implies that team training may be one the first training invest-
ments necessary to accelerate implementation of improvement projects.

Reality #5: Many Company Personnel, Including

Owners, Managers, and Supervisors, Don’t
Pursue Change

For many, change is a scary, unwelcome practice. This book should con-
vince your personnel that the right kind of purposeful change is much more
fun than the status quo. Sometimes top-level managers may not want to see
the current culture change. Your mission, for the good of your business, is
to convince your personnel and managers that applying this book to your
business will result in much less work, much more fun, and much greater
financial rewards than you and they could previously imagine.

Reality #6: Every Companywide Continuous

Improvement Project Requires an Assigned
Change Agent

This individual doesn’t have to be a high-level member of management if

top management is actively committed to the continuous improvement pro-
cess. What you need is at least one individual who is equipped by experi-
ence and leadership to clarify why management and other personnel should
be dissatisfied with the profit results of the current business (even if per-
formance is the best it’s ever been) and excite them about the certainty of
continuous profitability improvement if the change process is implemented.
For practical purposes, this book functions as a change agent by attempting
to make you dissatisfied with the current situation and excite you about how
much better the changed situation will be.
64 Chapter Six

Reality #7: Money and Key Knowledge Resources

Must Be Invested in Every Phase of the Economic
Business Cycle or You Won’t Get Maximum Results
for Continuous Sales and Profitability Improvement
You’ve already read about how all businesses experience an economic
business cycle every three to five years. High ROA and net profit are rela-
tively easy to achieve at the peak of the business cycle when capital equip-
ment and facilities are heavily utilized. In the valley of the business cycle
the opposite is true. The ROA and net profit will be lower because capital
investments aren’t highly utilized.
Therefore, to maximize ROA increases throughout the business cycle,
money and knowledge resource investment must be made throughout each
year of the business cycle to permanently increase market share every year
and to improve the other seven financial areas every year. In other words,
every month of every year continuous improvement projects must be imple-
mented on a planned schedule and must be completed on time.
It may be a big cultural change for your investors to give the same
commitment to continuous improvement when sales are at their peak and
you are tempted to transfer key knowledge resources to get products or
services to customers on time. That’s why you need to invest in dedicated
people you keep assigned to improvement teams in all phases of the busi-
ness cycle.

GET THE MOST OUT OF

EMPLOYEE ASSETS
Note to top management and stockholders: one of the goals of our verb/
noun continuous improvement process is to train and empower employees
to become better businessmen and businesswomen so that as your business
generates enough excess cash to expand your products, market segments,
and distribution channels, or to acquire new businesses, you will have man-
agers and knowledge resources ready to meet the demands of both the cur-
rent and new business.

Measure Employee Value

It may seem to you that this book wants to put a dollar value on almost
everything. That’s the truth. It’s easy to show employees as a dollar expense
in your budget or on your profit and loss statement. It’s not possible to put
 Empowering Employee Teams 65

a dollar value for your employee assets on your balance sheet, although
sometimes you may say your employees are your most valuable asset.
You can certainly claim you are making an investment in your employ-
ees when you provide training for them, even though you may not currently
have a way to prove that you actually got a good return on your training
investment.
However, as I have said before in this book, employee value can be mea-
sured when, as a whole, the percentage for total salary and wage expenses
per sales dollar gets smaller from year to year and from business cycle
to business cycle. This doesn’t mean you arbitrarily cut everyone’s pay. It
means you will individually pay each of them higher wages to retain your
investment in their knowledge inventory. You can use this same measure
to motivate them with financial incentives based on decreased salary and
wage costs and/or on increased ROA. (See Employee Gain Sharing Incen-
tives later in this chapter.)
Therefore, the measure we propose is the companywide percent of total
annual salaries and wages divided by your annual sales.
If for each of the last several years you calculate the percent of total
salaries and wages divided by sales, you may see a similar percent for each
year or you may see a trend that is getting larger or smaller. You may see
the percentage rise and fall as you go through each business cycle. Using
this percent, every employee will be able to put a dollar value on their over-
all total performance and determine whether there is a good reason for the
stability or trend. It will also give them an improvement target as a compa-
nywide team. You should publish it monthly.
Every competitive sports team has a way to measure its team perfor-
mance. This published performance measure will make employment more
of a game by giving your company teams one way to document their part in
the continuous improvement effort.
To cut the percent of total annual salaries and wages divided by annual
sales by one-third its current value isn’t an unreasonable target.

Bring out the Best in People Through

Empowerment
Once you’ve decided to discover projects, and have decided to identify
and name them with verb/noun combinations, it becomes obvious that an
investment in many employee teams will be required to implement projects
as quickly as possible. Chapter 5 shows a simple way to evaluate and pri-
oritize projects to increase your company’s ROA the most and the quick-
est. In each section of this chapter, I want to provide you with some basics
66 Chapter Six

required to unleash the knowledge and creativity of your employees to get

the most out of each of them and each project.
As a result of applying this book, each employee will become an
excellent businessman and businesswoman. You will also discover some
excellent leaders as you empower them by delegating more and more finan-
cial responsibility through project teams and their Profit Ability.

TEAM BUILDING
I have used training material from [Link] for this section of
the book.

Use Project Teams to Manage Change

If you implement the concepts and principles included in this book, you
will need to empower teams. Your company and your employees will expe-
rience significant cultural change.
Natural change agents, or project champions, intuitively know how to
bring about change. They start by making people dissatisfied with how
things are currently. Then they get people excited about the way things can
become. That’s what I’ve attempted to do in this book. I’m trying to make
you dissatisfied with your ROA over the past several years and excite you
about the probability that your current level can be more than doubled.
Ronald Reagan was an effective change agent. In his campaign for
president, he created dissatisfaction by saying our nation was in an “economic
quagmire.” He wanted to make us dissatisfied with the current situation. He
then held out hope that economic change would give the economy a “firm
footing.” The emphasis was on the positive changes, with just the right blend
of dissatisfaction to keep us moving forward. He used the same change agent
tools to make people in the Soviet Union our allies by making “tear down
the Berlin wall” a symbol of the change the two nations must make.
This section provides tools for employees to bring about change more
smoothly. Whether your company is small, medium, or large, you will need
multiple change agents and champions to inspire others to get on and stay
on the road to measurable improvement and excellence.

Use Project Teams to Excite Employees About

Going to Work
There are few things better than having fun at your job and having a mea-
surable sense of accomplishment each day. This comes from knowing that
 Empowering Employee Teams 67

when you discover things that can be done more profitably, you have a
chance to contribute the idea and champion it as your own, or pass it on to
a more appropriate team. And from getting personal recognition from your
peers and internal customers for discovering an idea that makes their job
more effective or more enjoyable.
There’s something special and valuable about receiving recognition
from your peers when you can make their job easier and more produc-
tive. That’s one of my definitions of empowerment. However, your com-
pany must customize a definition of empowerment that fits your company
culture and your combination of personalities.
If employees haven’t experienced empowerment before, they need an
idea about how it feels, what to do differently, and how it will be defined
within your company. They need to know about the responsibilities of del-
egation and what the limits may be. Empowerment and delegation are two
things employees must customize for themselves. I simply remind you to
discuss it among yourselves or contact a consultant for help if you’re not
certain about your conclusions.
Since employee training from each chapter of this book results in
interaction among employees, the training itself and the implementation of
projects can serve as the change agent and give employees a feel for what
it’s like to function in a team.

Build a Coaching Staff from your Best

Knowledge Resources
Use the verb/noun combinations in Chapter 3 to take an inventory of your
knowledge resources. You will be pleasantly surprised at how much knowl-
edge you have at your disposal that is underutilized. Every professional
team has a coaching staff. It isn’t unusual that one of the players also acts as
a coach. With a coaching leadership style, like a professional sports team,
you also create an atmosphere of excellence by trying to beat past records.
For employee empowerment and delegation, using project teams to
yield the greatest financial results, managers and supervisors will need
to give up some of their power and control. This will be a big change for
some. At the very beginning of the change process, it will be wise for man-
agers and supervisors to evaluate themselves to decide if this change will
be so dramatic or traumatic they will no longer enjoy their job. The same
applies to employees who feel intimidated by this kind of change. There
will be some few people who just won’t fit into the new culture, though
some of these employees may have been very loyal in the past. We encour-
age you to consider these possibilities in advance.
68 Chapter Six

Treat Team Building As Continuing Education

If most of your employees haven’t participated in project teams before,
you need to consider, as a minimum, investing in training about the basic
mechanics required for teams to be most effective. You may want to incor-
porate one of your small verb/noun projects into each basic training ses-
sion. This allows team members to get some hands-on training and, at the
same time, pay for the training investment with an implemented project.
Also, consider making team training part of the indoctrination of all
new employees. Your interviewing process for new employees, at every
level, should discover whether potential new employees will contribute to
the team effort and whether they will actually fill gaps in knowledge found
in your knowledge inventory.
Interviewing is particularly critical if you decide to hire a new manager
or supervisor rather than promote from within. After you have taken the
patterns from this book and have customized them to fit your own current
and future company culture, you won’t want a new manager to arbitrarily
make changes without financially evaluating the change. And, if you truly
believe in your ability to double or triple your ROA, or have proven by expe-
rience that it is working, you might want to require potential new managers
to commit to the current pattern until they can use the project evaluation
process in Chapter 5 to prove that their ideas will increase the ROA percent
faster than existing ranked projects.
After you start implementing the suggestions in this book, and as you
go into team-building training of current employees, you need to include
training from some of the chapters in this book. One goal of this book is
to provide project teams with a reference to help continuously identify new
projects and to maintain basic principles and concepts so that projects will
be kept in the best sequence.
Hopefully, you will take the many patterns included in the book and
rewrite them to include the vocabulary of your own company. After all, I
learned them from some other teacher or from the scar tissue of experience.
Each chapter includes knowledge I wish someone had taught me when I was
first hired into a business. Henry Ford once said, “Working in a business
is the best school for business people. The only problem is that its gradu-
ates are too old to practice.” Don’t let that happen to you no matter what
your age.

A Pattern for Your Team-Building Training

In this section I won’t attempt to go into great detail about team building.
I will only give you a brief summary of things included in a course con-
ducted by one training consultant.
 Empowering Employee Teams 69

There are certain dynamics that take place in a team environment,

particularly in team meetings. Personality traits are displayed that might
seldom be seen in normal day-to-day discussions. Normal day-to-day dis-
cussions and problem solving between two or three people are often extem-
poraneous and don’t require a lot of preparation or formal presentation of
facts. These types of discussions aren’t usually designed to cause signifi-
cant change or to implement significant improvements in ROA.
In general, a training pattern for team building should include a few
basic considerations:
• You will want to know enough about various types of
teams so that you can customize the training to focus
on projects that will be generated by your inventory of
prioritized projects.
• Your training needs to allow room for short training courses
about specific knowledge that is new to most team members.
This happens when you have a project generated by the verb/
noun process and you answer, “I don’t know how.”
• Team participants will want to make meetings as short as
practical by following a pattern about how to conduct an
effective meeting. Planning by using an agenda is the best
time-saver to practice. Another time-saver is preparation.
Have team members gather and organize facts in advance
of team meetings. Having the appropriate facts on the table
always speeds up team consensus. Meeting planning also
contributes to the most effective participation by team
members.
• Document the meetings with minutes to make it much easier
to draw conclusions for follow-up, such as assignments to be
completed before the next meeting.

Investing in Team Projects and Scheduling

Project Completions
Controlling a great number of projects and getting them implemented
on time isn’t much different than scheduling customer orders and shop
orders. All required operations need a start date and the investment in ade-
quate human and equipment resources to complete each project step by its
due date.
Unfortunately, almost every business that decides to implement improve-
ment projects fails to invest in enough additional human and knowledge
70 Chapter Six

resources to get enough of the vast number of projects implemented week in

and week out. Managers somehow imagine that the current key knowledge
resources can just implement the projects in their spare time.
However, as production control is used to schedule and ship customer
orders on time, project control is required to complete projects on time.
Every project is like a customer order your customer wants delivered on a
specific date. Therefore, project team leaders should insist that the project
be started on time and that each project design and implementation step be
started on a specified date. Then, as with material control for expediting
product schedules, extra hours, or paralleling and overlapping of project
steps, can be triggered when projects fall behind schedule. Paralleling for
project teams could include breaking the team into parts so several steps
can be performed during the same time period.

EMPLOYEE GAIN SHARING

INCENTIVES
Earlier in this chapter, I encouraged you to measure employee utilization
using the percent ratio of total salaries and wages divided by sales. I also
stated that a 33 percent improvement in the ratio is a reasonable expecta-
tion. This is an excellent measure currently used by many profitable com-
panies to compensate employees for their extra effort and creativity to make
the company more profitable more quickly. In the industry it is commonly
known as gain sharing or the Scanlon plan.
This chapter wouldn’t be complete if I didn’t share this powerful tool
with you. It’s the incentive pay plan I would use if I were going to imple-
ment the culture presented in this book.
You aren’t likely to double or triple ROA if employees don’t put forth
extra effort and creativity to discover projects that will allow you to increase
sales without adding a proportional number of new people. It is less likely
that employees will risk their jobs if they don’t stand a chance of sharing
in the rewards.
The reason I suggest the measurement of total salaries and wages
divided by sales is because, as a group, total salaries and wages is one of the
few things over which employees have complete control. It gives them incen-
tive to implement projects that contribute to sales growth, because greater
sales help absorb current employees as they perform more efficiently. Initi-
ation of an incentive pay system works best when sales are increasing from
one business cycle to the next as a result of increased market share.
Incentive systems should be designed to get employees to do what
management and stockholders want them to do. Therefore it’s logical that
 Empowering Employee Teams 71

you would also want to include an increase of average ROA percent over an
entire business cycle as a part of the performance measurement.

The Incentive Calculation

Incentive bonuses are most effective when paid as frequently as practical,
such as monthly. In a nutshell, the monthly incentive pay should be estab-
lished by setting as the base a business cycle historic percent of annual sal-
aries and wages divided by sales. An incentive bonus should be paid each
month, based on a percent of the amount total salaries and wages are less
than the monthly sales multiplied by the historical base percent. A portion
of the employee bonus is reserved each month in case there are months
when a bonus isn’t earned. At the end of each year, the bonus for the year is
calculated and the reserve is used to compensate the company for months
in which the bonus is negative. If the reserve is a positive number, a year-
end bonus is paid. There are a variety of alternatives and refinements your
company can incorporate into this incentive plan to make it do what you
want done.
A company can’t lose money on this plan because if there are no
savings there is no bonus payment. The primary reasons it fits so well with
the concepts promoted in this book are:
• It accelerates the implementation of profit-improving projects,
increasing the number of projects implemented.
• It reduces scrap and rework because, as soon as the incentive
system is initiated, employees realize that they provide the labor
cost to replace or rework defective parts.
• Inventory will come down more rapidly because employees
will be directly compensated for reducing setup or changeover
labor costs (both direct and indirect).
• Since labor costs will be reduced more than 25 percent, it can
be anticipated that 25 percent more sales can be absorbed
without making additional capital investment to provide the
needed capacity. In other words, 25 percent more capital assets
are made available to stockholders at no cost.
• As projects to reduce lead times are implemented, the reduced
lead time almost always reduces people time and increases sales
due to better on-time delivery.
• As inventory is reduced by reduced setup costs and shorter, more
consistent lead times, less labor and space are required to store the
required inventory.
72 Chapter Six

• As employees are empowered and trained to make better

financial decisions, fewer supervisors and managers are required
and can be reassigned to provide the knowledge resources for
more project teams.
• As projects are implemented to improve the material control
or scheduling control system, fewer people will be needed
for expediting.
• Employee conversations on and off the job will be about creative
ways to eliminate costs and increase sales.
 7
More About Project
Evaluation and Ranking

I
n Chapter 5 I provided a sample form to determine if and how much
a given project will increase the base ROA percent. In this chapter
I make a few more statements that I believe will be helpful in ranking
projects.

USING PROFITABILITY TO
PRIORITIZE PROJECTS
As you realize the large number of projects you will discover, and how
many teams will be working at any given time, you will realize that you
need a simple approach to decide which projects will increase your ROA
the most and the quickest.
By documenting the ROA percent increase, management can prioritize
the inventory of projects to determine which ones have the resources avail-
able for implementation.
You don’t need accounting precision for the dollar values you enter
into this form. You are just using it as a guide to compare one project with
another and to verify whether a project will increase rather than reduce the
current ROA.
Each year your accountant will update the form by entering new num-
bers in each of the lines that include the word “base.” The base values for
each line can be an average of the last three to five years of your most recent
business cycle. These numbers will stay the same all year because they
will be the basis upon which project teams evaluate their proposed projects
and submit them for approval by a designated company leader or commit-
tee. This leader or committee should maintain an inventory of projects by
project group, in priority order, and should compare each new project with

73
74 Chapter Seven

those waiting to be assigned to see where each new project should be placed
in priority sequence.

USE OF ACTUAL CONFIDENTIAL

FINANCIAL NUMBERS
Most company stockholders treat financial numbers as confidential infor-
mation and want to minimize the number of employees who know actual
sales and profitability. However, for project teams to be most effectively
empowered, some financial information needs to be revealed in some form
and in some detail.
Enough financial information needs to be made available to project
teams so that they can financially compare one project with another or to
make a project proposal. One way is to provide appropriate proportionally
understated or overstated financial numbers for project teams to use and
inform the teams that the information is for project evaluation only.
Information for the form needs to be accurate enough to make correct
prioritization decisions. This is a communications issue that will be more
transparent as you implement more projects.
If management is totally opposed to revealing financial data to teams,
designate a person who has the financial facts and have them use the Proj-
ect Evaluation Form to rank projects.

USING YOUR COMPANY’S

BUSINESS CYCLE TO TIME PROJECT
IMPLEMENTATION
I believe that projects should be prioritized by ROA and payout period
measurements so that projects can be implemented every year, even in the
valley of a business cycle. That’s why you should use your own business
cycle as a decision-making tool.
For example, a project might require no new investment because the
team members are already on the payroll and can do the implementation
as a normal part of their workweek. These projects can be implemented
immediately or can be saved to be implemented during the recession phase
of the business cycle.
Another similar example might require the time and knowledge of
a direct worker. In this case, part of the investment would be the cost
of another direct worker to do this team member’s job. Or, in the case of a
design engineer, the investment could be the profit lost because of the delay
 More About Project Evaluation and Ranking 75

in the design or testing of a new product. These are additional reasons for
you to purposefully budget specific numbers of personnel to concentrate
long periods of time on implementing the highest-ranked projects.
Another project might require capital investment for new production
equipment. If this project is discovered as the business is going into a reces-
sion cycle, it can be delayed until capital money is more freely available
just ahead of the growth phase. Over the long haul, your projects should be
generating enough cash that the timing of capital investments will be less
critical.

MAKE USE OF THE 80/20 RULE

You will find that 80 percent of the ROA increase will come from 20 per-
cent of the projects. Usually, this 20 percent of projects will require three
to four years to pay back the investment and will be the projects you should
try to implement just ahead of the growth phase of your business cycle.
The other projects, the 80 percent that will produce 20 percent of the ROA
increase, will usually have payback periods of less than one year.
 8
Projects to Reduce Total
Expense per Sales Dollar

F
inancial facts from your accounting function are some of the most
important tools your continuous improvement teams will use. It’s
like the facts shown in your personal checkbook, which is essentially
a combination profit and loss statement to list expenses and a balance sheet
to show your cash asset balance.

A FEW ACCOUNTING TRUTHS

I will provide your employees with a simplified version of typical formulas
and principles they need to discover and evaluate improvement projects.
Some of these accounting truths will be a repeat or expansion of what has
already been said in previous pages.

Truth #1: Discovery of Continuous Improvement

Projects, and Their Analysis and Evaluation, Don’t
Require Normal Accounting Precision
Accounting is a precise activity which, for legal reasons, requires great
accuracy. Most improvement projects won’t require that precision. Most
projects will require estimates of future events and a variety of accounting
information drawn from accounting budget line items. Once a project idea
is defined, these estimates can be refined as more facts are gathered.
We encourage accountants to participate on teams to improve the
integrity of these estimates. The project itself will raise a flag as more and
more facts are required. As the project is being designed and as its imple-
mentation is being planned, you will know whether more accurate numbers
are needed.

77
78 Chapter Eight

Truth #2: Seven Financial Formulas Are Used to

Understand the Evaluation Process for Projects,
Their Actual Profitability Results, and to Measure
Year-to-Year Overall Performance
Net Profit. In its most simple format, the annual profit and loss (P&L)
statement can be broken into three main parts: sales, expenses, and profit.
#1 Sales dollars – Expense dollars = Net profit dollars
#2 Net profit dollars ÷ Sales dollars = Net profit percent
This arithmetic shows that to improve profitability, sales must be increased
and expenses must be reduced.
Net profit can be expressed as before taxes or after taxes. Most
businesses pay over 40 percent of their profit in taxes. For project team
purposes, it is preferable for you to include some or all taxes as an expense
in the P&L because some of the taxes will decrease as you reduce inven-
tory investment and because there may be a misconception by employees
about how much profit the stockholders are receiving if all tax expenses
aren’t included.
Gross Profit. Three major expenses for manufacturers are MLO expenses
(material, direct labor, and manufacturing overhead). MLO expenses are
often called the cost of sales or the cost of goods sold.
#3 Gross profit dollars = Sales dollars – MLO dollars
#4 Gross profit percent = Gross profit dollars ÷ Sales dollars
Gross profit is an important tool for manufacturing project teams. It shows
which product lines or product models contribute the most to the net profit
of the business. It may tell you which products are designed best so you can
apply those design and processing techniques to products with a low gross
profit. Or, it may tell you which products should be improved or removed
from the product line because their gross profit percent is too low.
The gross profit percent is usually a fairly large percent because most
of a company’s manufacturing overhead costs are included. As you can see,
if you increase your selling prices, gross profit increases. Or, if you reduce
MLO costs, gross profit also increases.
Gross profit percent is important to know if teams decide to create a
project to find any current products or market segments that, if eliminated,
would result in an increased ROA. One project might be to segregate prod-
ucts and market segments into appropriate groups and compare the gross
profit for each group. This analysis might prompt you to raise the price of
some product lines before you arbitrarily decide to eliminate the product
 Projects to Reduce Total Expense per Sales Dollar 79

line. The analysis might also tell you which critical product lines need cost
reduction or redesign investment. By using the 80/20 rule, it might also tell
you from which of the market segments you might get the greatest return on
an investment by investing in greater market coverage.
Return on Assets (ROA). This profitability formula is critical as a
project ranking tool. It forces project teams to consider the impact that
any project will have on the increase or decrease in the ROA percent. Obvi-
ously, you won’t have a profitable project if it increases the net profit percent
but causes a reduction in the ROA percent. For this book’s purposes, only
assets for inventory, capital assets, and accounts receivable are considered.
#5 ROA percent = Net profit dollars ÷ Asset investment
Continuous ROA improvement is the best performance measurement for
the overall continuous improvement program, as well as a measure of how
well the companywide program has minimized asset investment.
Profit and Loss Statement Performance Measurement. You’re rel-
atively sure that cost reduction has done its part if the net profit percent
is continuously increasing over each consecutive economic business cycle.
Two other broad measures are needed to assure that the two main groups of
P&L expenses are both showing improvement.
#6 Total salaries and wages ÷ Sales = Percent performance
and
#7 Non-salary and wage expenses ÷ Sales = Percent performance
If one of these performance measures is outpacing the other, there’s a
good chance improvements are being missed within the lower-performing
measure.

Truth #3: The Annual Budget Plan Is Primarily a Profit

and Loss Statement in Its Most Detailed Format
Expenses for overhead are usually minutely detailed for each function or
department. This is where project teams go to get cost reduction details to
increase profitability.
The key is to discover projects that decrease total wages, salaries, and
all other expenses per sales dollar.
In between the simple net profit formula and a very detailed annual
budget, your project teams will need the accounting function to provide
them with a profit and loss statement that will directly relate to the seven
critical business elements I’ve been emphasizing. This can serve as your
first cut at segregating expenses into a format that will facilitate project
80 Chapter Eight

discovery in the seven areas and assure profitable projects. See the work-
sheets in Chapter 5 for gathering financial data.
Notice that the sample P&L statement in Figure 8.1 is designed to be an
example for a manufacturing, distribution, or service business. The reason
for using one example is to impress upon you that all businesses use similar
financial information.
Each line will be expanded upon in the section following truth #5 in
this chapter. For now, we want to tie the seven critical business elements
in with the appropriate lines on this sample statement.

Line Combination manufacturing/distribution/service profit and loss

1 Sales
2 Material or purchased product, including freight
3 Setup direct labor and/or purchase order setup costs
4 Direct labor applied to raw material or purchased parts
5 Manufacturing overhead or receiving/inspection overhead
6 Gross profit (Consider ranking by product lines or models)
7 Manufacturing indirect labor or distribution/service departmental payroll
8 Other manufacturing salaries or distribution/service payroll tax and fringes
9 Manufacturing non-salary expenses or distribution/service auto and travel
10 Total manufacturing expense or distribution/service sales non-salary
expense
11 Sales and marketing salaries
12 Manufacturing product design expenses or distribution/service operating
expenses
13 Appropriate sales, engineering, and administrative expenses
14 All SE&A overhead (excluding interest, taxes, depreciation, and
amortization)
15 EBITDA/net profit or earnings before interest, taxes, depreciation,
and amortization
16 Interest
17 Taxes
18 Depreciation
19 Amortization
20 Net profit after taxes

Figure 8.1 Sample profit and loss statement with expense categories.
 Projects to Reduce Total Expense per Sales Dollar 81

• Obviously, we want line 1 (Sales) to be increasing from one

business cycle to the next so that line 6 (Gross profit), line 15
(Net profit before taxes), and line 20 (Net profit after taxes), will
continuously increase as you implement profitable projects.
• Lines 2 through 5 are categories of expenses that relate to
purchased and manufactured products. You want to implement
projects and practices that create reductions in these expenses so
you can prove that gross profit is continuously increasing.
• Lines 7 through 10 are manufacturing-related expense categories
for a manufacturer, distributor, or service business.
• Lines 11 through 14 are the unique expense categories for sales,
engineering, and administrative expenses.
• Lines 16 through 19 are expenses that normally appear within
other categories in the P&L. The reason I’ve structured the P&L
this way is so I can show you later in Chapter 13 how the EBITDA
(earnings before interest, taxes, depreciation, and amortization)
can be used to set a market value for your business or a
competitor’s business that you might buy. You also want to
separate out expenses for interest, taxes, and depreciation. I
will show you how interest and taxes will drop as the inventory
investment goes down. I will also show you how depreciation
expenses may go up as you add new equipment to reduce
setup costs that drive inventory investment down, and how
depreciation expense goes down as you more effectively utilize
capital investment.

Truth #4: For a Continuous Improvement Program,

Only Four Asset Investments Need to Be Used in the
ROA Formula
The four asset investments project teams need to focus on to improve the
ROA percent are:
• Work-in-process inventory investment, which is cut by reducing
manufacturing and paperwork lead time.
• Product and component inventory investment, which is cut by
reducing setup costs.
• Capital investment, which is minimized by increasing the
utilization rate of equipment and facilities.
82 Chapter Eight

• Accounts receivable investment, which is minimized by controlling

the number of days a customer takes to pay an invoice after the
customer order is shipped.

Truth #5: The 80/20 Rule Is a Good Tool to Use to

Analyze the Facts Related to Projects and to Decide
on Which to Concentrate
Some examples will explain how to use this tool:
• 80 percent of sales come from 20 percent of products or models.
• 80 percent of sales come from 20 percent of market segments.
• 80 percent of setup costs come from 20 percent of components.
• 80 percent of a manufacturer’s component inventory is made
up of 20 percent of the inventory items.

SEGREGATING BUDGET LINE ITEMS

Segregating sales and budget expenses into logical categories is a good tool
for getting at facts needed by project teams. This process is an expansion
of truths #3 and #5. In this section I will dramatize what a great source the
annual budget plan is for discovering numerical values for a massive num-
ber of projects that won’t be discovered by more traditional analysis tools.
Many projects will be concentrated on cost reductions that may also
result in investment reduction. That’s why, in truth #3, we structured a P&L
statement as a pattern to help you identify groups of expenses that will help
you discover projects or understand calculations I will show you in other
places in this book.
Identifying the 20 percent of production machines that account for 80
percent of depreciation cost will help you determine if the most expensive
equipment is being heavily utilized to maximize the ROA.
Segregate material and supplies costs to determine if a slight increase
in material or supplies costs, to utilize material with less variation, might
result in lower labor and reject costs.
Taxes and insurance for real estate, capital equipment, and inven-
tory need to be investigated and/or included in the cost analysis of some
projects.
These segregated groups are where the 80/20 rule should be used
aggressively to provide employee teams with facts that will take the guess-
work out of which projects are the best.
 Projects to Reduce Total Expense per Sales Dollar 83

The cost that is usually most dominant is the total cost of employee sal-
aries and wages. It is so important that I have suggested in truth #2 that a
performance measurement be tracked to compare the year-to-year trend of
total annual salary and wage costs divided by annual sales.
The segregation of salary and wage costs is also a powerful revealer of
project opportunities. Salary and wage expenses should be segregated by
departments or business functions, including use of the 80/20 rule, to ana-
lyze specific functions to discover projects.
Since at this point in the book I am leading you into improvement proj-
ect discovery that impacts the seven key financial areas, we will go through
the P&L statement in Figure 8.1 line by line to clarify the expense segre-
gation process.
Line 1. Segregate product lines or models to find the 20 percent of models
that make up 80 percent of your sales. This analysis coupled with line 6 will
likely trigger some ideas about which products you might consider elimi-
nating or which products you will take through a redesign project.
The marketing function might want to segregate sales by market seg-
ment or distribution channel to discover things to discontinue or places to
expand to increase sales by increasing the market coverage elements cov-
ered in Chapter 13.
These facts will cause you to see things you never saw before about
your business. Your goal is to determine the quickest and easiest way to
increase sales in one or more of the segregated groups and then estimate
the increase in ROA percent as a way to compare these potential projects
with others that may be focused on cost reduction or inventory reduction.
Line 2. A manufacturer can segregate raw materials to identify the 20
percent of raw material categories that account for 80 percent of the total
raw material requirements. You might consider doing this analysis within
different categories. For example, you might analyze castings as one cat-
egory and bar stock as another category. You might look for opportunities
to standardize on fewer materials or find ways to reduce your raw material
inventory by negotiating shorter lead times on your most frequently used
materials.
For distributors, the purchased products are the raw material and may
or may not require some labor or material to make them usable for individ-
ual customers. To counteract the additional freight expense and erratic lead
times resulting from offshore sourcing, you may want to segregate freight
from purchased product cost.
Line 3. Verify whether setup labor is treated as direct or indirect labor.
Manufacturers need to track what percent of total direct labor is setup
84 Chapter Eight

labor because reducing this overall percent is one of the primary reasons for
setup reduction and lean cell design.
Setup cost for each component can be an average of the setup cost from
several most recent shop orders.
Distributors should segregate costs related to purchase orders because
reducing these costs financially justifies smaller lot sizes and a lower inven-
tory investment.
Line 4. This is direct labor that manufacturers call “run time.” For distrib-
utors it is usually the cost for components or products sold. This part of the
cost is normally treated as a constant no matter what the lot size. In prac-
tice, the average unit run time or purchased item cost usually becomes less
as lot sizes are increased. The total cost of each manufactured component is
the average setup cost divided by the lot size plus the run cost.
Line 5. For manufacturers, this is usually the overhead that is only related
to the direct labor departments, depending on how your annual budget is
formatted. If direct labor departments have their own budgets, this budget
will likely include salaries and wages for personnel who directly support
the processing of material, supplies used within the department, plus depre-
ciation on the capital assets used to manufacture the components. Many of
these costs will decrease as you define projects to reduce setup time and
lead time.
For distribution and service businesses, this could include the over-
head expense for receiving incoming shipments and receiving inspection
functions.
Line 6. Gross profit may not normally appear on your P&L. It’s included in
this pattern because I suggest that you rank the product line and models you
segregate in line 1 so you can discover the products or models you might
consider eliminating. Alternatively, you might consider raising their prices,
even if that would make them less competitive for some customers.
Line 7. For manufacturers, indirect labor should be significantly reduced
as you define projects to shorten lead time, move toward arranging for pur-
chased components to be inspected at the source, minimize in-process
inspection, reduce the number of components for which you need to main-
tain inventory, eliminate expediting, and many other improvements discov-
ered in the verb/noun project discovery process.
Distribution and service businesses can use this line to segregate
department-by-department payroll.
Line 8. You should segregate all other manufacturing salaries. As you
empower employees and minimize expediting, you will need fewer
 Projects to Reduce Total Expense per Sales Dollar 85

supervisors and support personnel. These supervisory and support employ-

ees can be much more valuable by investing their time in project discovery
and implementation.
For distribution and service business, this line can be used to segregate
payroll costs in line 7 from payroll taxes and fringes.
Line 9. For manufacturers this line is similar to line 5. It includes every-
thing left over from the manufacturing budget that isn’t included above. As
you check through these leftovers, consider whether something is left over
that should have been included in one of the previous lines. You might add
lines to your customized P&L pattern if it will aid project discovery or proj-
ect evaluation.
Distribution and service businesses can use this line for other major
cost categories such as auto and travel expenses. Even these expenses can
be broken down and grouped into other categories such as foreign travel by
sales and purchasing personnel.
Line 10. This is the total of lines 2 through 9 for a manufacturing business.
For a distribution or service business, it can serve as another category that
might be significant in an individual business.
Line 11. You may want to expand this line to separate field or branch sales
personnel from those who process sales orders in the home or branch office.
If you maintain a customer service, product repair, or spare parts service,
you will also likely want to segregate it out. If you have field sales offices, you
may want to show their salaries and overhead on separate lines.
Line 12. Manufacturers can segregate engineering salaries by new product
design, processing engineering changes, customer service, or product test-
ing. As project teams in these functions segregate their expenses, they will
discover many ways to do the routine things with less time and expense
so they can focus more time on projects that will reduce product process-
ing costs, setup costs, and lead time. Shortening paperwork and informa-
tion processing lead time in these areas should be a major contributor to
increased sales and reduced inventory investment.
A distribution or service business may have functions that don’t fit any
of the preceding categories.
Line 13. Break out these salaries into additional lines, depending on how
your annual budget is broken down. Be sure personnel in these departments
are generating projects that will increase the ROA and provide shorter lead
times for internal customers.
Line 14. Study these budget line items to identify the 20 percent of expenses
that make up 80 percent of the total expense so you can discover ways to
86 Chapter Eight

reduce them. For example, one of the reasons you lower your inventory car-
rying costs and lower your purchase order setup costs is to have smaller lot
sizes so that you can lower local or state taxes on your inventory assets.
Line 15. This line applies if your stockholders want to place a value on
your business or another business they want to buy.
Line 16. You will generate considerable cash as you increase your ROA.
Interest costs will just disappear as your need to borrow money becomes
less.
Line 17. Tax included on this line is the tax your accountant will include to
establish after-tax net profit.
Line 18. The only time project teams are going to have a chance to impact
depreciation expense is when a project recommends disposing of underuti-
lized equipment and facilities or when a project can justify the investment
in additional capital assets.
Line 19. Amortization expense will be of minimal interest to most proj-
ect teams. It is an annual expense shown on the P&L statement and bal-
ance sheet for such things as setting aside funds in advance to pay off a debt
before maturity or writing off obsolete inventory over a period of more than
one year. It will have minimal impact on the average ROA over a three- to
five-year business cycle.
Line 20. This line represents the annual cash generated after all expenses,
including all taxes.
Note: The primary mission of the accounting function is to provide accu-
rate information for the company employees, knowledge workers, and man-
agers, so that they can keep the profit and loss statement and the balance
sheet in financial balance.

LEAN WASTE DISCOVERY

Lean manufacturing is part of lean enterprise, a product of the Manufactur-
ing Extension Partnership (MEP). MEP is part of the National Institute of
Standards and Technology, an agency of the U.S. Commerce Department.
If you go to its Web site, [Link], you will find that MEP pro-
motes strategic business planning, quality systems, marketing, and human
resources to increase profitability.
The verb/noun process to discover projects in the seven key business
areas was not designed to match what MEP does as a government agency.
 Projects to Reduce Total Expense per Sales Dollar 87

The mission of this book is to look at every function of a business through

a financial lens. Where appropriate, I encourage you to focus on the lean
concepts that aren’t traditionally incorporated into the culture of your
business.

Advice from some Authors of Lean Thinking

The authors of MEP’s value stream mapping resources warn against plung-
ing into waste reduction projects without first converting your manufactur-
ing process from mass production to continuous flow. They say, “To reduce
the lead time from raw material to finished goods, you need to do more than
try to eliminate obvious waste. Too many lean implementation efforts have
been waste scavenger hunts. While it is good to be aware of waste, future
continuous flow process designs need to eliminate the sources or causes of
waste in the old value stream. Once the problem of mass production can be
seen in a way that reveals these root causes, your company can work at find-
ing original solutions.”

Wastes and Their Root Causes

This step helps identify the various categories of non-value-added wastes
that are present in your company. It will give you checklists of potential
causes from which you can create verb/noun combinations to name proj-
ects. Every observed cause of waste in your company should signal the need
to name and define a project.

General Causes of Waste

Overproduction is to produce more of something earlier than is required by
the next process. It applies to the purchase or manufacture of components
you are forced to make ahead of the receipt of a customer order because of
lead times and setup cost issues.
That’s why a material control system similar to the one described in
Chapter 11 is critical to maximize ROA. Material control, coupled with
lead time and setup cost reduction, can control causes of overproduction.
There should be no overproduction in the component manufacturing
area if you do everything you can to reduce setup costs, have a formula
to calculate financially sound lot sizes, and reorder components no earlier
than required.
Even though the causes of overproduction described in lean courses are
primarily discussed in terms of mass production and continuous-flow oper-
ations, you should look at them for potential projects and in instances when
you may be forced to use one of them in your job shop operations.
88 Chapter Eight

Just-in-case logic implies that your system doesn’t provide acceptable

controls. When this logic is used frequently, you’ve identified an important
project. There may be occasions, such as a potential strike at a supplier’s
plant or the installation of equipment in your plant, when temporary early
production of the related components might be a sound business decision.
Misuse of automation refers to overproduction waste that occurs when
large setup costs force large lot sizes.
Long process setup implies large lot sizes. The resulting inventory will
cause financial wastes.
Un-level scheduling implies that, over the whole mass production pro-
cess flow, more is made sooner than required at one of the process islands.
This cause of waste will disappear when a well balanced continuous-flow
process is implemented. It also hints at poor utilization of capital assets.
Unbalanced workload is a cause that can exist in a mass production
island that causes un-level scheduling. It can exist in a continuous-flow pro-
cess if each process that makes one and passes one to the next step isn’t
properly designed.
Overengineering can exist in the product design and process design
phases, depending on your definition of overengineering and whether it
causes overproduction.
Redundant inspections may cause overproduction because this activ-
ity must have its own wasteful inventory in order for the work to be done. If
you eliminate unnecessary non-value-added inspections, a probable waste
in itself, you also eliminate the wasted inventory investment and the costs
resulting from carrying the inventory. How many other redundant activities
might you discover that are adding non-value-added cost and investment?

Waiting Waste
Waiting waste is relatively easy to discover and quantify. At various times
you just take a mental photo of your assembly area, paperwork flow, or
inactive shop and office people. Another example is customers standing
in queue at a service counter. You count the number of people who aren’t
doing productive, value-adding work. It’s easy to detect when an assembly
line isn’t flowing smoothly due to the following root causes. These same
causes for waiting waste can occur in your component manufacturing area
but have a different impact and need a different kind of project to eliminate
them. When you look at the causes, compose a verb/noun combination to
name a project. Then, when you evaluate the project for its ROA impact,
you will be more likely to assign knowledgeable team members to it for
implementation. Look for both people and equipment waiting.
Unbalanced workload, anywhere in the business, is an indication
of poor planning on the part of all people in the company, at every level,
 Projects to Reduce Total Expense per Sales Dollar 89

particularly the people who are doing the waiting. If you empower your
employees to recommend project ideas to eliminate the causes of waiting
waste, it will be like discovering a new vein of ore in a gold mine. If you
pay them an incentive bonus, as described in Chapter 6, much of the waiting
waste will disappear without projects being formalized. Remember, plan-
ning is the least expensive form of control.
Unplanned maintenance is a financial crime committed against
your stockholders, customers, and product quality. Your stockholders are
robbed because preventive maintenance is the lowest-cost method to main-
tain equipment. Customers lose because unplanned maintenance results in
missed delivery dates. Product and process quality lose because dimen-
sional variation isn’t held to a minimum, as you use preventive maintenance
to control process capability.
Long process setup times are a cause of waiting waste. Expensive cap-
ital equipment must wait longer than necessary to get back into produc-
tion. Long setup times also force people to wait, and force you to have
more funds invested in capital equipment than will be necessary when you
reduce your setup times.
Upstream quality problems result in waiting in both production and
paperwork processes. This can result in unnecessary waiting by a customer
needing service. In the component manufacturing area, it may cause missed
delivery dates.
Un-level and unplanned scheduling can be a cause of waiting in a pro-
duction or paperwork process. It is less likely when processes are designed
around continuous-flow concepts. In the manufacturing area, look for poor
schedule planning or poor management of a good scheduling system.
Failure to provide instructions should never be a cause for waiting.
Think about the many times a supervisor, manager, or other decision maker
has been tied up in a meeting, or is traveling, and you are waiting for a deci-
sion. This cause disappears as your employees are empowered to make more
decisions at the lowest level. Let them make a few mistakes and learn from
them. That’s how each of us learned to make decisions more confidently.
Large staging areas are obvious clues that too much waiting has been
designed into the process. Look for these staging areas and formalize a
project to eliminate them. Think about how impressed you would be to go
to a very busy doctor’s office where there was very little waiting time after
signing in. This also applies to unnecessary inventory, patiently waiting to
be consumed, or material waiting in queue to be processed.

Transportation Waste
Transportation waste applies to production and office paperwork processes
or a service business where customers are the product in the process. This
90 Chapter Eight

waste and its causes relate to material handling activities as you move prod-
uct and information within the lead time stream. Value stream mapping is
described in Chapter 9. Product transportation is limited by speed limits to
physically move materials, particularly by human operated wheeled equip-
ment. Some of these limits can be overcome with automated equipment and
conveyors and by reducing the total distance people and transport equip-
ment travel each day. Fortunately, much of your information can travel by
computer, at the speed of light, making distance a nonissue.
Poor plant and office layout and poor understanding of continuous
process flow are causes of transportation waste. You have many crisscross-
ing travel lines and distances that are excessive. In office and paperwork
layouts, a continuous-flow design will be an excellent tool to minimize
this waste. Using the flowchart depicted in Figures 9.2 through 9.5, pages
106–16, you might want to look at your product flow from receiving dock
to shipping dock and paperwork process flow from customer order receipt to
invoice as areas in which to design two continuous-flow projects to see
how transportation waste can be eliminated. Apply what you learn from the
value stream mapping in Chapter 9.
Staging and holding areas and large lot sizes are a part of your
product and paperwork transportation value stream. They require handling
when material is moved in, plus handling as it is moved out. To eliminate
transportation wastes, drastically reduce lot sizes and lead times so fewer
and fewer components are required to be manufactured or purchased prior
to the receipt of a customer order. This is an even more serious issue in your
assembly area. Any time you see material being staged in your assembly
area for long periods of time, it’s a project crying out to be noticed. You
will probably find it is an upstream material control problem caused by an
inadequate material control system or a good control system being poorly
executed.

Processing Wastes
Processing wastes are those activities that add no value to the product or
service from the customer’s point of view. These wastes occur in both man-
ufacturing and office processes.
Failure to define true customer requirements is a cause of process and
material waste. Defining exactly what the customer wants is the starting
place in eliminating this waste and its causes. Be aware that you have both
external and internal customers. Each group has high expectations so you
must learn what it takes to satisfy each. Your external customers think it’s a
waste for you to provide product features they aren’t willing to pay for, even
if your engineers and sales people feel they need them. Your external cus-
tomers want the lowest price, the required quality and dependability, and
 Projects to Reduce Total Expense per Sales Dollar 91

on-time delivery. That’s also pretty much what your internal customers
want, and have a right to expect. Anything less makes their job more diffi-
cult and less enjoyable.
Failure to coordinate product and process design is a waste you can
eliminate at the product design stage. Coordinate the design of components
with the appropriate manufacturing equipment that is capable of consis-
tently holding the design tolerance. One major potential waste is then con-
trolled. Six Sigma processes are good tools to use here.
Product changes without process changes is like the preceding cause
of process waste. Obviously, a design change that doesn’t get implemented
by the appropriate process change isn’t really a change.
Lack of communication or excessive communication are causes for
processing waste as well as many other wastes such as waiting, excess
inventory, defects, and underutilized people. If you distribute too many
copies of a communication, someone has to read them and often get unnec-
essarily involved.
Redundant approvals are less likely to exist when your employees are
empowered and adequately trained. Approval at the lowest level is the least
expensive policy.
Redundant databases and related reentering of data are usually a
result of a poorly designed data processing system, incomplete networking,
or procedures that are poorly composed.

Inventory Waste
Inventory waste is defined in lean as, “Any quantity in excess of a one piece
flow through your manufacturing process.” This is a good definition if you
implement lean to replace mass production with continuous flow. It is also
a reasonable definition if all your processes, including component purchas-
ing, require almost zero setup cost. The lean definition is very confusing
to small or medium-sized manufacturers who are forced to release pur-
chase orders and shop orders for components because their product cycle
time (see Chapter 9) is longer than the lead time promised for new customer
orders. Inventory can’t correctly be termed a waste when it is required,
under current lead time and lot size restrictions, to meet customer order
delivery requirements. It would be more precise to identify setup costs as a
primary waste that needs to be minimized so that less inventory investment
will be required to meet customer delivery promises.
The misconception that inventory protects the company from inef-
ficiencies and unexpected problems is a result of your personnel having
inadequate knowledge about the reasons why you are forced to make an
inventory investment and the kind of material control system you must use
until you have dramatically reduced your lead times and setup costs.
92 Chapter Eight

Product complexity must be tempered by how accurately you define

and design the products your customer wants. If the customer wants and
is willing to pay for a complex product, and this forces you to maintain
inventory to provide it, you’re doing what is expected. You might be able to
relieve product complexity issues by reconfiguring product bills of material
to shorten the product’s cycle time, as described in Chapter 9.
Un-leveled scheduling and unbalanced workload in mass produc-
tion operations can be cured by converting to a continuous process flow.
In component manufacturing operations, the best control is manufactur-
ing capacity planning, described in Chapter 11 (blocks 7 and 12, page 169)
about your material control system.
Poor market forecasting is a cause of excess inventory if you rely on
forecasting as your method to determine future demand. I don’t recommend
that you place too much reliance on sales forecasts to forecast future prod-
uct demand. If you have an aggressive sales force, you should expect their
forecast plan to be greater than actual customer orders. Instead, you will be
most accurate in your estimating of future demand if you rely on your usage
rate from the most recent past (see Chapter 11).
Unreliable supplier shipments cause excess inventory. Unreliable on-
time delivery is a symptom that a material control system isn’t taking steps
to control supplier lead time, including replacing suppliers who don’t have
short, predictable lead times.

Defect Waste
Defect waste can have many definitions. In a service business, it could be
any service provided that doesn’t meet customers’ requirements. For com-
ponents, it would be any design feature that falls outside the dimensional
or specification tolerances. For paperwork and information processes, it is
incorrect information or instructions, or incorrectly following documented
procedures. The causes for defects are as varied as the places within a busi-
ness where they occur too frequently.
Customer needs not matching product and process design is the birth-
place for most defects and other wastes. It takes a project team made up of
customers, product designers, process designers, suppliers, and sales per-
sonnel to implement a proper design process. When this cause for defects is
eliminated, many of the other causes will disappear along with it.
Inadequate equipment and poor preventive maintenance are causes
of defects related to product dimensions and specifications. Not only must
customer requirements match with product and process design, but prod-
uct design must match with the tolerance-holding capability of your equip-
ment. In addition to minimizing downtime, the most important purpose of
 Projects to Reduce Total Expense per Sales Dollar 93

preventive maintenance is to maintain the dimension-holding capability of

your equipment.
Eliminating poor quality, such as through implementing ISO 9000
specifications, is an activity that eliminates many other causes for defects,
such as inadequate work instructions.
Inadequate education and training is a cause that can be eliminated by
following my suggestions in Chapter 6 about getting the most out of your
employee assets.

Motion Waste
Motion waste is any movement of people, product, paperwork, or machines
that doesn’t add value to your product or service. It can relate to the dis-
tance traveled by a person’s hands, feet, or mind. This waste is related to
waiting waste and transportation waste. Visually observe the layout of the
entire facility, manufacturing and paperwork processing areas, or indi-
vidual workstations in the shop or offices. Look for poor housekeeping or
poor workplace organization in individual employees or groups of employ-
ees. It’s very likely you will discover activities that, when eliminated, will
reduce hidden setup costs or lead time. Motion, transportation, or waiting
wastes, and their causes, such as the following, are things you might not
think about if lean didn’t suggest them:
• Poor people/machine interfaces
• Inconsistent work methods or inconsistently followed procedures
• Unfavorable facility or cell layout
• Poor workplace organization and housekeeping
• Extra “busy” movements while waiting

People Waste
People waste, particularly of their minds, is a big sin managers and
stockholders commit. When corrected, it will provide a greater and faster
ROA increase than increased sales, reduced inventory, or reduced lead
time. Fortunately, there are ways to be forgiven for this sin. Just eliminate
the causes.
Failure to empower employees is a mind-set that may exist within
many of your company’s key decision makers. It is safe to say that with-
out empowered project teams you won’t get the maximum results from
your efforts to implement lean or continuous improvement. Put another
way, without empowered project teams, the odds that you will double or
94 Chapter Eight

triple your ROA aren’t in your favor. Without empowered teams, you will
never discover nor implement the massive gold mine of projects contained
in these chapters. See employee empowerment in Chapter 6.
Poor hiring practices need to be replaced by good hiring practices.
I suggest that you focus on hiring the best knowledge resources available
that match your business plan. One major part of a business plan should
include project priorities rated by the project evaluation process found in
Chapters 5 and 7. Don’t just hire the very best people available. Hire the
specific knowledge resources you need to implement future projects.
Perform a knowledge inventory, using the verb/phrase combinations found
in Chapter 3, to discover and fill knowledge gaps. It’s a waste to hire knowl-
edge you now possess in ample supply. Look at these verb/noun combina-
tions and at your highest-priority future projects. You then have a precise
target for your knowledge search. If you don’t have a change agent who can
act as the champion to guide the project teams to implement the many proj-
ects discovered in each chapter, that person may be your most critical initial
investment. Sometimes it might be more economical to hire temporary con-
sultants to fill knowledge gaps that aren’t needed long-term.
Low investment in training is a cause for the wasting of employee
knowledge and creativity. The important point here is to invest only in the
most urgent knowledge and training needed to complete high-priority proj-
ects. Adults learn best when they learn something today that they can apply
tomorrow. Match training with simple projects so that each training session
completes a project.
High turnover resulting from low pay is a cause that can be easy to
resolve when you realize that it’s less expensive to pay above-average wages
than to continuously be searching to replace key knowledge resources.
Just think about a statistical normal distribution bell curve. There aren’t
many really poor employees on one end of the bell curve, just as there
aren’t many stars at the other end of the bell curve. You will have more than
your share of stars if you train them well, coach them well, and pay them
well. There’s another point to consider. Most employees will put a monetary
value on empowerment when they decide to seek their fortunes elsewhere.
If they decide to leave, many of them will want to come back very soon.
Be sure to let them know they are welcome to return. Job enjoyment from
job empowerment and recognition is a priceless fringe benefit employees
seldom are willing to give up. It buys a lot of loyalty.
Failure to provide financial incentives is why most businesses never
maximize their ROA. Properly designed and executed financial incentives
increase ROA more quickly because employees have a bigger incentive to
lower the costs in the profit and loss statement and minimize the investment
 Projects to Reduce Total Expense per Sales Dollar 95

in the balance sheet. It’s a financial decision that no knowledgeable stock-

holder will pass up. It lowers wage and salary expenses per sales dollar
more quickly because one measure of the incentive should be the improve-
ment in the percent of total salary and wage dollars divided by sales dollars.
The net profit increases because the new total for wages plus incentive pay
is less than the old total wages. The investment is lower because capital
buildings and equipment are utilized much more effectively, essentially
giving the stockholder more equipment at no additional investment. Higher
net profit divided by a lower investment results in a higher ROA. There are
few, if any, projects to increase sales, lower costs, lower inventory invest-
ment, or reduce lead times that can compete with a project to implement a
companywide incentive system as described in Chapter 6.

LEAN IMPROVEMENT
BUILDING BLOCKS
This section summarizes the building blocks used to implement lean man-
ufacturing concepts. This is not a lean course. But these lean features will
help you to discover more verb/noun projects.
Standardized work eliminates waste caused by various personnel
having their own individual procedures and methods for manufacturing or
paperwork. When you have empowered teams, these knowledge resources
will put their heads together and document the process that produces the
most value with the least waste. The standardization goal should be to doc-
ument each process or operation with all the operations or steps performed
in the best sequence with the best combination of people, raw materials,
methods, tools, and equipment.
An organized workplace is another way to reduce waste. We are
impressed when we see an office, desk, or workplace that is clean and
orderly. You’re probably thinking, “This sounds like something my parents
said to me over and over to get me to clean and straighten up my room.” Most
of us wish we had the discipline to keep our workplace neat and orderly.
Wouldn’t it be satisfying if you never again needed to do special cleanup
when some big-wheel manager or customer comes to visit your facility?
Lean has developed a system, called the 5S program, to help eliminate
waste that results from being disorganized:
• Sort through workplace items and move seldom used items to a
temporary holding area. If after a period of time you don’t need
any of these items, dispose of them in the most economical way.
96 Chapter Eight

• Set in order all remaining items, identify the best location for
them, and devise a visual indicator so you and your coworkers
will know where each item is to be returned after being used.
• Shine every item by inspecting it each time it is cleaned and
returned to its prescribed place.
• Standardize the rules and visual controls to make the first three
S’s work for you as you discover other items you decide to use in
place of existing items.
• Sustain the 5S program through good communications with
coworkers who utilize the same items. Train new coworkers to
stick with the standard until consensus is reached about a change.
Practice self-discipline by inviting your parents to come and
inspect your workplace.
Visual controls are signals to visually communicate some action for those
mutually involved in a process. The signal can be a card, flag, light, or
lines on the floor to identify storage areas, walkways, or work areas. It’s
what you do at a family dinner when, during the conversational noise, you
motion to someone that you want some more of something. At all-you-can-
eat restaurants, you might be provided with a little flag to signal a waiter
that you want more of a food item. The value of visual signals is that they are
inexpensive, self-regulating, and are managed by value-adding workers:
• Lean suggests kanban cards, a signal a coworker displays at
their workstation when their current supply of parts needs to
be replenished.
• In Chapter 11, I suggest bin reserve cards for your branch
inventory control or to control the reorder of some of the 80
percent of your components that make up less than 20 percent
of your inventory investment.
• Also in Chapter 11 (block 55, page 184), I suggest using shop
routers to signal materials personnel to deliver raw materials for
shop orders and to signal supervisors when a shop order start date
has been missed so that overtime, paralleling, or overlapping can
be used as expediting methods.
• Similar signals are color coded fixtures, tools, pallets, paperwork
forms, and paperwork folders.
Point-of-use storage is defined as locating materials and information
resources as close to the user as possible as a way to eliminate waste:
 Projects to Reduce Total Expense per Sales Dollar 97

• For some pieces of equipment, it may be possible to arrange for

raw material to be delivered directly from receiving and stored
near the machine.
• For some purchased components, such as nuts, bolts, screws, and
fittings, it can be arranged for vendors to bypass receiving and
deliver items directly to assembly stations, eliminating inventory
tracking, storage, and handling.
• Supplies used by a limited number of users can be delivered
directly to their workstation.
Quality at the source can be applied to purchased components, manufac-
tured parts with several operations, assembly line operations, or paperwork
operations. The idea is to eliminate inspection waste and the inventory and
lead time required for it. The concept is to make the person responsible for
the work also responsible for the inspection approval before moving the
work on to the next operation:
• For outside sources of supply, critical dimensions, or specifications,
you can document the criteria required by your inspector.
Surely you can provide the same documentation to your supplier
and require certification that they have done the inspections.
Random sampling by your inspector should be the maximum
amount of duplicated inspection you should require.
• For your own manufacturing operations, one of the best ways
to be able to eliminate inspection of critical features and
dimensions is to utilize preventive maintenance to document
process capability as you periodically perform planned and
scheduled preventive maintenance.
 9
Projects to Reduce Lead
Time and Inventory

T
his chapter provides added detail to help you reduce both work-in-
process inventory and component inventory by reducing paperwork
and processing lead times.

DOCUMENT CUSTOMER
AND MANUFACTURING LEAD
TIME MISMATCHES
An ideal goal is to shorten manufacturing lead time so it’s less than the
lead time you promise for shipment of customer orders. The goal is to do
your material control scheduling from customer orders rather than from fore-
casts. For most businesses there is usually a measurable mismatch between
how quickly a customer wants their order filled and the lead time you
require to process components and assemble a product. In these cases
you carry an inventory on certain manufactured or purchased components to
fill the gap in the mismatch. A pattern chart is provided in this section
so that you can learn how to document your own mismatches and initiate
appropriate projects to minimize the mismatch problem.
Document your company’s product cycle time so everyone in the com-
pany can see why you must maintain inventory on some components. This
condition will exist until you reduce your manufacturing lead times to less
than the lead time customers give you to deliver their purchases, and until
you reduce your setup costs so that you can economically produce in quan-
tities as small as those shown on customers’ purchase orders.

99
100 Chapter Nine

How to Graphically Illustrate the Lead

Time Mismatch
We will use the chart in Figure 9.1 to show you the mechanics of using mate-
rial lists (indented exploded bills of material) to make cycle time charts for
your various product lines. This pattern will help personnel visualize the
problem. Study this pattern and customize it to make your own cycle time
chart for each unique product line.

Cycle time chart Each column equals one week

Spec. Info Cust.
Part Item eng. lead order
no. name dwg. time rec.

1 End-item assembly
2 Subassembly
3 Purchased part
4 Manufactured component
5 Bar stock material
6 Manufactured component
7 Casting material
8 Special subassembly
9 Special manufactured part
10 Tubing material
11 Purchased part
12 Customer part
13 Manufactured component
14 Bar stock material
15 Purchased part
16 Purchased part
17 Manufactured component
18 Casting material
19 Grinding operation
20 Heat treat operation
21 Machining operation
22 Bar stock material
23 All hardware

Figure 9.1 Cycle time chart.

 Projects to Reduce Lead Time and Inventory 101

We suggest making a separate cycle time chart for each product line
that requires significantly different processing operations and equipment.
For example, you might have different product lines because you use two
different types of mechanisms or different mountings for different market
segments.
The chart in Figure 9.1 is a pattern you can customize to show
your own product cycle time charts. It represents a company product whose
customers are happy with a delivery lead time of six weeks (the calendar
time between the day their purchase order is received by the company’s sales
staff and the day their order is shipped and invoiced). This is an indented
material list for this product line, showing the average lead time for end-
item assembly, subassemblies, components, and raw materials.
Information Lead Time. This is the column to the left of the customer
order receipt column. This sample company takes a week to process the
customer’s order in the sales office, obtain credit approval, and get the
paperwork processed through inventory control so purchase orders and
shop orders can be released to suppliers and the shop. This week is no lon-
ger available for purchasing to use as supplier lead time or for the shop to
use as manufacturing lead time. This week to process the customer order
also forces the company’s stockholders to invest in another week of inven-
tory for each component whose lead time extends to the right of the cus-
tomer order receipt column.
For this sample company, if the customer order requires a special com-
ponent or a customer-supplied component, another week of lead time is
required to coordinate with the customer for design specifications, draw-
ings, and process routers (assuming no special tooling will be required). In
these cases, another week is consumed from what could have been allowed
for supplier and shop lead time. A third column, special engineering draw-
ing, must be added to the cycle time chart so you can visualize the impact
of these requirements. Only the lead times for the special subassembly and
its special components are actually impacted by this extra one week infor-
mation delay.

The Analysis to Recognize Which Components

Must Be Carried in Inventory in Advance of
the Customer Order

Now you can look at the cycle time pattern to see how you, if you worked
for this company, would decide which components must be kept in stock
to assure that you can meet the six-week customer lead time you nor-
mally promise. You might also recognize why this sample company may
102 Chapter Nine

consistently miss delivery dates for this product line, even though the com-
pany may do a considerable amount of expediting. Study the cycle time
chart, one line at a time, and see if you draw the same conclusions I do. Any
lead time to the right of the heavier vertical line must be stocked ahead of
customer orders.
Line 1. One week is required for the assembly operation. All subassemblies
and components that go directly into the end item will start their lead time
at the beginning of the second week of the time cycle. Obviously, you will
initiate a project to reduce the assembly lead time.
Line 2. This component is a subassembly that is common to this product
line. With only one week lead time required, it doesn’t need to be stocked. Its
assembly shop order can be issued after the customer order is received. If
this lead time can be reduced, you will reduce your assembly in-process
inventory investment by a few days.
Line 3. This purchased component goes into the common subassembly. Its
three-week lead time falls into the information lead time column. It might
be wise for you to control this component with a reorder quantity, including
a safety allowance, until you implement a project to reduce the order pro-
cessing time to one day or get the supplier to reduce its average lead time.
Then you wouldn’t need to issue a purchase order until the customer order
is received. These are places to discover projects to reduce supplier lead
times, such as through just-in-time delivery, as a way to eliminate the need
to carry component inventory on some items in your stock.
Line 4. You can wait until the customer order is received before you issue a
shop order for this manufactured component, since its lead time lies within
the safe area.
Line 5. However, the raw material for line 4 butts up next to the customer
order receipt column and you probably should have material on hand before
the customer order is received. However, that wouldn’t be necessary if the
manufacturing lead time were reduced for line 4. This is an example of
how inventory investment and its related costs magically disappear as you
reduce manufacturing, supplier, and paperwork lead times.
Lines 6 and 7. This is a manufactured component made from a casting. A
shop order won’t need to be issued until a customer order is received if the
casting is kept in stock in quantities that match line 6 lot sizes.
Lines 8, 9, and 10. Only four weeks lead time is allowed for this special
subassembly, its special component, and raw material. Its assembly shop
order must be completed by the start date for the end-item assembly. Its
raw material can’t be ordered until engineering drawings are released. This
company has a material control problem here that will surely result in a
 Projects to Reduce Lead Time and Inventory 103

late customer order delivery. There is no problem with the subassembly or

component manufacturing lead time after receipt of the customer order.
The problem is with the raw material lead time. You must initiate a proj-
ect to resolve this problem, with your customer being one of your project
team participants. It may be a simple solution if the material is a common
material for which the quantity required for the customer special compo-
nent is insignificant. The customer may be required to keep the special part
in stock if there isn’t any way to anticipate its future need. Perhaps a design
change for an alternative material is called for. Either the lead time prob-
lem needs to be solved or the customer needs to agree to a longer lead time
when they need this product.
Line 11. Even if the lead time issue for the line 9 component can be resolved,
you still have a control issue with this purchased component. These exam-
ples of the lead time mismatch between your customer order lead time and
your cycle time lead time are included in this chapter not only to reinforce
the goal to reduce lead times, but also to reinforce the reality that you must
have a reliable and rational tool like a cycle time chart to identify the items
that must be reordered in anticipation of the receipt of a customer order.
Line 12. If you use customer-supplied components, the chances are that
your customer may have some of the same cycle time mismatch problems
you have. You can’t expect their material control system to be so orga-
nized that they will check the lead time of the component they are to supply
before they ask you how much lead time you actually need. And if you
haven’t made your cycle time chart, you may make some promises you can’t
keep. In this specific example, the customer must do the expediting and
reschedule their shipping date to one week after you receive their material
or they must maintain an inventory of their part.
Lines 13 and 14. This is another example of a component that won’t
require inventory or a safety allowance if the raw material is kept on hand.
However, you should learn to look at these situations as one because if you
reduce the average processing lead time by one week, you won’t need to
stock the raw material.
Lines 15 and 16. These purchased component examples should be looked
on as opportunities. As they stand now, you must reorder with a safety
allowance in lot sizes appropriate to their setup costs. Line 15 might be
improved by putting your suppliers on your project teams and getting them
to commit to a shorter maximum lead time or a shorter average lead time.
Line 15 lead time might be cut to one week by buying from a distributor
rather than directly from a manufacturer and by deciding to tolerate an
increased unit cost for that part. If your purchasing function is given perfor-
mance goals that focus only on unit cost, rather than also considering lead
104 Chapter Nine

times, ask them to read this chapter and estimate how much they might be
able to reduce the company’s investment in purchased component inventory
if they were to focus attention on both unit cost and lead time reduction that
will get more purchased items under the customer order lead time wire.
Line 17. Here is another component that is ordered after the customer order
is received. However, don’t jump to the conclusion that you can order enough
only for this one customer order. You can order only the quantity the cus-
tomer order requires if setup cost for the component is very low in compari-
son to its unit cost. If your calculated method for setting lot sizes requires it,
you may have to order more than a given customer order requires.
Line 18. Castings will almost always have a lead time that exceeds the lead
time you promise to customers. You will likely have to order castings ahead
of receiving customer orders. A given casting may be used as material for
only one machined component or one casting may be used to make several
similar-looking components. Since this casting is used to make the line 17
component, your material control system must also be tuned with the lot
sizes for the one or more components the casting is used to make. Your
casting quantity on hand will need to be equal to or greater than the specific
component that will be reordered next. Remember, if your casting supplier
agrees to maintain an inventory of castings for you, they must add enough
cost to pay themselves for their increased investment in your inventory.
Lines 19 through 22. This component’s lead time problem might be
improved by maintaining stock on a semi-finished part that could go
through the heat treat and grinding processes after the customer order is
received.
Line 23. Most hardware items have a short lead time. They can be kept in
inventory because of the low inventory investment they create.

Summary
This sample company is allowed a customer order lead time of six weeks. If
its customers only allowed one week lead time, you can see why it would be
forced to carry inventory for most of the components or end items.

REDUCE MANUFACTURING
LEAD TIME
As a manufacturer, you must drastically reduce total lead time if you are
going to eliminate the mismatch between customer order lead time and pro-
 Projects to Reduce Lead Time and Inventory 105

cessing lead time. Any manufacturing, purchasing, or paperwork lead time

reduction will reduce your in-process inventory and, most importantly, will
increase sales because of on-time delivery. Any reduction in customer order
processing lead time will also reduce component inventory investment.
Most companywide process flowcharts begin with a customer order
and end with the invoicing of customer shipments. Ideally, the lead time
requested by the customer is equal to or more than the time required to pro-
cess a given customer order between these two points.
Imagine what your increased sales and ROA would be if you could take
sales away from your competitors and if you could, year to year, shorten
your customer order lead time. Or imagine your ROA increase if, because
of shorter component and paperwork processing lead times, you reduce
your inventory investment. The financial rewards for reduced office, ware-
house, or shop lead times will greatly contribute to the probability that you
can double or triple your ROA.
To discover projects to implement shorter lead times, you can custom-
ize the flowcharts in Figures 9.2 and 9.3 to define the variety of office and
shop processes you currently have that directly apply to processing customer
orders between customer order receipt and customer order invoicing.
Figures 9.2 and 9.3 relate to manufacturing businesses. They could also
relate to distribution businesses or service businesses that manufacture or
assemble some of their products. They are longer than Figures 9.4 and 9.5
(pages 115–116) because they include the extra lead time elements required
to manufacture and assemble products sold to customers.
The first block in Figure 9.2 is titled “Customer order receipt.” It needs
no explanation.

Lead Times from A to Z for Manufacturers

Block A—Product Line Cycle Times Charts. Figure 9.1 shows a cycle
time chart for one product line. Make one for each product line if there is a
significant difference in the equipment, materials, or processes used.
Block B—Master Plan and Forecast Schedule. Chapter 11, blocks 12
through 16 (pages 170–71) show how to match customer demand with cur-
rent shop capacity plans so that the components requiring reordering before
customer orders are received can be reordered early enough to avoid miss-
ing customer order delivery dates. As projects are implemented to shorten
lead times, fewer components will need to be ordered in advance of receiv-
ing customer orders.
Block C—Customer Order Processing Lead Time. This is a place to
apply lean value stream mapping. If only one person processes these orders,
106 Chapter Nine

Customer
order receipt

A. Product line C. Customer order

cycle times charts processing lead time

B. Master plan and D. Drawings and

forecast schedule router lead time

S. Assembly: E. Customer order

proceed to acknowledgment
Figure 9.3 and credit review

F. Material control
process lead time

I. Shop order start H. Shop order G. Purchase order

date lead time process lead time process lead time

M. Raw material K. Raw material J. Component

issue lead time receipt lead time receipt lead time

N. Component L. Receiving
preparation and inspection lead time
processing lead time
P. Assembly and
O. Component warehouse storage
family cell A
Q. Material handling
O. Component lead time
family cell B
R. Spare parts
O. All non-cell ship or storage
manufacturing
processes

Figure 9.2 Lead times from A to Z for manufacturers.

eliminate or shorten the steps in order processing to free that person up for
other duties.
You might eliminate this whole block, and block E, if you allow major
customers who order most frequently to have computer access to your
master plan. One of their personnel could be trained to acknowledge their
own orders.
If you have several employees doing this function, you should consider
implementing an order processing cell and other elements from the lean
value stream method.
 Projects to Reduce Lead Time and Inventory 107

S. Assembly shop
order processing
lead time

T. Product assembly
processing
lead time

U. In-plant V. Packaging
end item storage lead time
and inventory

W. Shipping X. Invoicing
lead time lead time

Y. Transportation
lead time

Z. Branch
inventory

Z. Distributor
inventory

Z. OEM customer
inventory

Z. Dealer
inventory

Figure 9.3 Lead times from A to Z for manufacturers.

Also consider the differences in flow for spare-parts-only components,

standard products, or special products that require special drawings or
special processing operations and tooling.
For every day you shorten the customer order processing time, you
remove one day of component inventory investment.
Block D—Drawings and Router Lead Time. Any time new draw-
ings or new material lists are required, you need dedicated personnel, and
cells if possible, to process the work quickly. You can consider immediately
releasing the standard part of the material list. Special components, as a
subgroup, can be released later after drawings and routings have been com-
pleted. The special components must have a lead time short enough to not
delay the customer order before the customer order and its delivery date are
acknowledged. Be sure you have a special short lead time process to release
108 Chapter Nine

drawings for special components. Be sure your engineering personnel are

trained to understand that a short lead time for their part of the paperwork
process can result in a lower inventory investment for many other compo-
nents on the cycle time material list.

Block E—Customer Order Acknowledgment and Credit Review.

Consider combining the process for blocks C and E into one person if you
are a small company or into your block C cell if several people process
sales orders. If you require a credit review, do it in advance of customer
acknowledgment so it doesn’t add to processing lead time. Your alternative
is to require a longer customer order lead time for customer orders that don’t
have documented credit arrangements agreed to in advance.

Block F—Material Control Process Lead Time. This is another log-

ical place to apply lean value stream mapping. If you think in terms of
work cells rather than departments, normal paperwork and data entry might
include block F in the blocks C and E cell. For manufacturers, any shop
orders with a start date of the current date or sooner (see block H) should be
immediately given to production control to start shop order processing.

Block G—Purchase Order Process Lead Time. What you do in this

area to shorten lead time depends on your company’s size. If you have
several people involved in blocks F, G, and H, you have an opportunity
to look at work cells that combine blocks F and G, blocks F and H, or
blocks F, G, and H. Some purchasing functions are organized around vari-
ous commodities or suppliers rather than using a cell approach. It could be
that block G release of purchase orders can be automatically triggered by
block F if all quotes and negotiations are completed in advance of the next
reorder. It wouldn’t be impossible to find a way for blocks C through H to
require only one day or one hour lead time.

Block H—Shop Order Process Lead Time. If you are using start dates
on your shop orders, as I suggest in Chapter 11, blocks 54, 55, and 56 (pages
185–87), they will provide you with lead time control. All production con-
trol needs to do with a new shop order, or a batch of shop orders, is place
them in start date sequence with other shop orders. This applies to both
component and assembly shop orders. Any shop orders with a start date of
the current date or sooner should be delivered immediately as the paper-
work is being processed so that shop orders can be issued within an hour.

Block I—Shop Order Start Date Lead Time. This is the lead time that
determines in-process inventory investment for components and assembled
end items. This is when a shop supervisor and production control personnel
 Projects to Reduce Lead Time and Inventory 109

concentrate on shortening lead time to reduce the company’s in-process

inventory investment.
The first requirement is, don’t start shop orders early. That puts inven-
tory dollars into work-in-process too early.
The second requirement is, once a shop order is started, move the shop
order from operation to operation with a minimum of queue time between
operations. This is what happens when you have a cell for a family of simi-
lar components.
To make your noncellular operations act like a cell, you can paral-
lel and overlap operations (Chapter 11, blocks 59 and 60 [page 189]) par-
ticularly for components that have a high unit cost (material, labor, and
overhead, Chapter 11, block 26 [page 174]) or a high usage value (Chapter
11, block 31 [page 175]). In-process inventory investment is most greatly
reduced by moving these high-dollar-value components through your shop
in the fewest days possible. However, don’t arbitrarily cut lot sizes to do
this. Let your lot size calculation method, Chapter 11, block 30 (page 175),
do this for you if you want your ROA to reach its highest level.
Blocks J, K, and L—Receiving and Receiving Inspection Lead
Times. If you perform a receiving inspection process, perhaps you might
creatively consider a cell that combines receiving, receiving inspection,
purchasing, and material handling. Your goal is to have the shortest lead
time possible from the time the components or raw materials arrive at the
receiving dock until the purchase order is closed. This is another place
where your personnel must be taught to think like businesspeople or inves-
tors. The group of people in this cell can, by closing purchase orders more
quickly, shorten the purchasing lead times and cause more components to
have lead times shorter than the customer order lead time. If purchase order
setup costs are reduced, as a result of block G improvements, purchases can
be made in smaller lot sizes. The combined actions of blocks G, J, K, and L
will result in lower inventory investment.
Some companies only receive shipments during certain hours of
the day. This forces batching. The cell would rather have receipts flow
more smoothly. Even if deliveries can be made at any hour, there will be
some batching.
Receipts should be grouped by the due date, with the oldest due date
entering the cell first.
For manufacturers, if the due date is older than the current date, the
process waiting for this material needs to be informed about the receipt so
that plans can be made to start the process because its start date is already
behind schedule and expediting per Chapter 11, blocks 57 through 60 (pages
188–89) must be initiated.
110 Chapter Nine

The next step in the cell might be to count to verify the quantity. Con-
sider performing receiving inspection first. If the components or material
can’t be accepted, why count them? Better yet, initiate projects to eliminate
counting and receiving inspection. Eliminate counting by having a record
and sampling process by component or by supplier. Counting is a waste of
time if your suppliers can prove they do an accurate job. Receiving inspec-
tion is a waste of time if you tell your supplier which features on a compo-
nent you are most concerned about and ask them to provide documentation
that they have made these inspections.
By using a cell approach and eliminating the counting and receiving
inspection, you can reduce your receiving lead time from days to minutes
and significantly lower your component inventory investment. Both will
result in a higher ROA.

Block M—Raw Material Issue Lead Time. Be sure that an opera-

tion to issue raw material appears on routers with its own start date. If you
issue material too soon, it may trigger a reorder too soon. By material issue
having its own start date, there’s no need for its delivery to delay the com-
pletion date of the shop order or to allow the shop order to be started sooner
than it should.

Blocks N and O—Component Preparation and Processing Lead

Time. This chapter and Chapter 10 describe the preparation activities that
will reduce setup time and lead time. As with raw material issue, give prep-
aration activities their own operation on a router. You should give these
operations zero lead time because they should be performed in parallel with
the current processing operation.
These kinds of operations are where you should consider setting up
cells for families of similar components. There are some CNC machines,
with multiple pallets and permanently positioned cutting tools, that function
as a cell within themselves. The setup time is normally so short that deliv-
eries to assembly might be based on hourly or daily batches. In most cases,
because of small lot sizes, your investment in this type of CNC machine
will be less than the inventory investment you eliminate. In Chapter 11,
blocks 59 and 60 (page 189), I show how to parallel and overlap to experi-
ment with how a cell might function. Chapter 10 covers cellular manufac-
turing and component families in detail.

Block P—Assembly and Warehouse Storage. Ignore this block if

you don’t have assembly operations. Warehouse lead time is eliminated
when setup cost for components is so low that any small lot size can be
delivered directly to assembly.
 Projects to Reduce Lead Time and Inventory 111

However, even with a lead time on the cycle time chart that allows the
shop order to be scheduled after receipt of customer orders, calculated lot
sizes (Chapter 11, block 30 [page 175]) may force you to issue shop order
quantities that are larger than required by a customer order. In these cir-
cumstances some of the quantity can be delivered directly to assembly, with
the remainder being delivered to the warehouse.
Block Q—Material Handling Lead Time. Material handling contains
lead time. As seen in Figure 9.2, it starts at the receiving dock and stops at
the shipping dock. By documenting it, you will discover enough waste to
justify a project to eliminate some material handling waste.
To evaluate and prioritize a material handling project, go to budget line
items to total all your material handling expenses, including those that are
required to transport components for outside processing and those for trans-
porting inventory to your branches. Include your expenses for fuel, mainte-
nance of material handling equipment, and containers or pallets you use to
hold batches of material and components within your in-process areas.
Next, ask your accountant the current value of your company’s investment
for material handling equipment. As a starting place, with this informa-
tion, use the project evaluation form in Chapter 5 to determine how much
you can increase ROA for every 10 percent reduction in material handling
expense and investment. Create a project to justify investment to automate
portions of your material handling processes as a way to reduce lead time.
To find the material handling waste and lead time that can be elimi-
nated, look at it as the processes between other processes, starting at receiv-
ing and ending at shipping. Then imagine yourself as a tracking satellite
and see how many miles per day you can eliminate. Be sure to include in
your study expenses for people who transport shop or office paperwork or
who transport tools used in manufacturing processes. Excessive miles trav-
eled each day by personnel is a symptom of poor planning, uncontrolled
process flows, and excessive lead time.
Block R—Spare Parts Ship or Storage. If you maintain spare parts
close to the customer (with one-minute, one-hour, or one-day customer
order delivery lead time), monitor spare parts usage history. Some compo-
nents or subassemblies are sold only as spare parts. Other components or
subassemblies are used both for spare parts sales and as components used
to assemble end items. Chapter 11, block 35 (page 177), describes a visual
control system called bin reserve, which you can consider to be sure you
have components or subassemblies on hand to meet spare parts delivery
date requirements. The system you use for block C will likely work for pro-
cessing customer spare parts orders.
112 Chapter Nine

Block S—Assembly Shop Order Processing Lead Time. Ignore this

if your business doesn’t require you to assemble products for customers. As
with component shop orders, assembly shop orders should have a start date
that isn’t started early and is processed in the shortest lead time possible.
Assembly processes will likely be able to make use of the lean value stream
mapping method in a similar way to its use in processing customer orders
and issuing shop orders and purchase orders (blocks C, E, F, G, and H).
You should look for cell opportunities during the assembly process to pull
components directly from component shop orders without having to pass
through the warehouse. This would be for components whose processing
lead time is shorter than the customer order lead time shown on a product
line’s cycle time chart. Other manufactured and purchased components will
be pulled from the warehouse. Your assembly process doesn’t care from
where they are pulled. Look for opportunities for purchased components
with lead times shorter than the customer order lead time to be delivered
directly to assembly from receiving.

Block T—Product Assembly Processing Lead Time. Ignore this

block if you don’t assemble products. Figure 9.6, page 126, is a pattern for
a product family matrix. It provides steps for grouping each product line
or models within each product line. Look at the grouping of these various
steps to see which are the logical product families so you can determine
how to convert a current assembly process to a cell. If you’re already using
some form of a cell, the matrix might help you make improvements. Here is
another opportunity to reduce the assembly time shown on your cycle time
chart from weeks to days or hours.

Block U—In-Plant End Item Storage and Inventory. Ignore this

block if you don’t assemble products. In Chapter 11, block 18 (page 172), I
ask you to document how close to the customer you are required to main-
tain inventory. In this block, and in the blocks designated by block Z, cus-
tomize a product family matrix to what actually represents your company.
Block U simply indicates that your end-item inventory is sometimes your
internal customer.
Some companies eliminate this investment by providing a discount to
distributors, dealers, and OEM customers. If you are selling into a distribu-
tor network, let a marketing consultant show you how to design a discount
structure. This is a financial decision, or project, that can be evaluated using
the evaluation form in Chapter 5 to assure that it will increase your ROA.

Block V—Packaging Lead Time. Packaging is its own process and a

processing operation that requires lead time upstream of the customer order
shipping date. First, ask yourself if it requires significant setup time. If it
 Projects to Reduce Lead Time and Inventory 113

does, you will likely see batches accumulating ahead of it, creating queue
time that will need to be shown on your cycle time chart. If the packaging
equipment isn’t too expensive, consider adding a parallel station to shorten
the lead time. Or look for a minimal setup alternative process. Second,
ask if the packaging work schedule is based on shipping dates, and what
happens if the shipping date is equal to or earlier than the packaging date.
If batches accumulate and there are several people involved, consider a
cell. If one or two people are normally required, transfer in personnel to
reduce the lead time. Remember, your goal is to shorten lead time in every
process in the flow so that more components on the cycle time charts won’t
have to be ordered until a customer order is received.
Block W—Shipping Lead Time. Perhaps packaging and shipping are
one process. If not, try to make them into a cell so that individual shipments
move through much more quickly. Shipping is a good place to test your
overall system consistency. If the shipping rate isn’t about the same every
day (versus heavier on Friday than during the week or heavier at the end of
the month), you are probably doing considerable wasteful expediting. If you
have several major customers who want to give you due dates at the end of
each month or at the end of each week, you will want your cycle time charts
and master plan to be in daily increments.
You will be surprised how much this policy will satisfy your stockhold-
ers with a higher ROA and your customers with shorter customer order lead
times. Think about it. Your customers are looking for suppliers who will
quote them shorter lead times just like your purchasing function is doing
with your suppliers. Shorter lead times eventually translate into increased
sales. Personnel outside of the sales department need to realize that they
can sometimes do more to increase sales and market share than the sales
personnel.
Block X—Invoicing Lead Time. Accounts receivable is one of your
company’s seven critical business elements listed in Chapter 2. Compa-
nies should require customers to pay their invoice within a certain number
of calendar days after they ship it. For your financial and credit personnel,
this is called the accounts receivable collection period. If there are a batch
of invoices mailed once each day, you have an opportunity to make a lead
time improvement that would reduce this investment by two or three per-
cent. You might consider including an accounts receivable person in your
packaging/shipping cell, even in a remote location. The point I’m trying
to make is that the lead time between a shipment and the processing of an
invoice should be a matter of minutes, so that invoices can be batched and
mailed as many times each day as practical, or may be sent one at a time
electronically.
114 Chapter Nine

Block Y—Transportation Lead Time. Some customers may use their

own truck to deliver their order. That’s how important they consider lead
time to be. Transportation lead time will also be critical to you if you
operate branch warehouses because that transportation time increases the
number of days you maintain the shipment as an inventory investment.
Your customers are thinking in the same way. You’ve invoiced them for
the order but the product isn’t yet available to them when it is shipped
commercially.
Think carefully about it before you accumulate enough completed prod-
uct to make a truckload shipment. Think like a financial businessperson
and do the project evaluation that will give you the highest ROA and best
availability of your products to your customers.
Block Z—Customer Types. This block is included primarily to get you
to identify the types of customers your office and shop processes are serv-
ing and to get you to think about the kinds of processes going on in each of
these groups.
In your branches, you have a similar kind of reordering process as used
for blocks F, G, and W and, in some cases, block S. I encourage you to use
something like a bin reserve system (Chapter 11, block 35 [page 177]) at
branches, since little paperwork is required and much of the work can be
done within the cell by block F personnel.
The reason you provide a discount to distributors is to get them to carry
inventory close to the customer and to process the many small customer
orders you would have to process if you carried inventory at the factory
facility for fast delivery (very short customer order lead time). You are also
paying them for maintaining a reordering process for the end items or com-
ponents they order from you.
A dealer may act very much like a distributor but may also install and
service your product when it is utilized on their customers’ equipment.
They will usually receive the same discount as distributors because you are
paying them for essentially the same services.
OEM customers probably have a factory flow similar to yours, with
even more opportunities to apply the lean value stream mapping method to
shorten lead times and reduce lot sizes. They are usually very fickle, just
as you are with your suppliers. They will buy from your competitors if they
have the shortest lead time, lowest cost, highest quality, and most reliable
delivery promises.
You should bring your major customers and major suppliers into your
project teams. Your customers, particularly OEMs, can provide valuable
knowledge resources if they are farther along on their mission for “better
customer services at a lower cost” than you are.
 Projects to Reduce Lead Time and Inventory 115

Including your suppliers on project teams is critical because, at some

time or another, you are going to need to get the message across to them
that shorter lead times, lower cost, higher quality, and more reliable deliv-
ery promises are part of your supplier selection process.

REDUCING DISTRIBUTION AND

SERVICE BUSINESS LEAD TIME
The chart in Figures 9.4 and 9.5 is for distribution or service businesses
that carry large inventories to meet short customer delivery lead times. As
a distribution or service business, if you manufacture some components or
products, use the flowchart in Figures 9.2 and 9.3 (pages 106–7) for those
items. In this section we are assuming that a distribution or service business
purchases all the components it sells.
Reduced office or warehouse lead times help you double or triple your
ROA. To implement shorter lead times, customize Figures 9.4 and 9.5.

Customer order
receipt

C. Customer order
process lead time

D. Drawings and
design lead time

E. Customer order
credit review

F. Material control
process lead time

G. Purchase order
release process
lead time

L. Receiving J. Component
inspection lead time receipt lead time

P. Assembly and
warehouse storage

Figure 9.4 Flowchart for distribution and service businesses.

116 Chapter Nine

S. Assembly shop
order processing
lead time

Q. Material handling
lead time

T. Product assembly
processing
lead time

V. Packaging
lead time

W. Shipping X. Invoicing
lead time lead time

Y. Transportation
lead time

Z. Branch
inventory

Figure 9.5 Flowchart for distribution and service businesses.

Define office and warehouse processes that apply to processing customer

orders between customer order receipt and customer order invoicing.
Blocks C, D, and E. See Reduce Manufacturing Lead Time, page 104.
Block F—Material Control Process Lead Time. In terms of work
cells, normal paperwork and data entry can include block F in the blocks
C and E cell.
Block G—Purchase Order Release Process Lead Time. If several
people work in blocks F and G, consider cells that combine blocks F and
G. Some purchasing functions are organized by commodities or suppliers
rather than using a cell approach. It could be that block G can be automati-
cally triggered by block F if all quotes and negotiations are completed in
advance of the next reorder.
Blocks J and L—Component Receipt and Receiving Inspection
Lead Time. If you perform a receiving inspection, consider a cell that
combines purchasing, receiving, receiving inspection, and material
handling. The goal is to have the shortest lead time possible from the time
components or products arrive at the receiving dock until the purchase order
is closed.
 Projects to Reduce Lead Time and Inventory 117

If purchase order setup costs are reduced as a result of block G improve-

ments, purchases can be made in smaller lot sizes. The combined actions of
blocks G, J, and L will result in lower inventory investment.
Some companies only receive shipments during certain hours of the
day. This forces batching. The cell wants receipts to flow more smoothly.
Even if deliveries can be made any time, there will be some batching.
Receipts should be grouped by the oldest due date.
Initiate projects that eliminate counting and receiving inspection. Per-
form inspection first. If material can’t be accepted, why count it? Eliminate
counting with sampling processes by supplier and component. Counting
is a waste of time if your suppliers can prove they are doing an accurate
job. Receiving inspection is a waste of time if you tell your supplier which
features on a component concern you most, then require them to provide
documentation that they have made these inspections. You should be able
to reduce receiving lead time from days to minutes and significantly lower
your component inventory investment.
Block P—Assembly and Warehouse Storage. Ignore this block if
you don’t have assembly operations in your business. The lean value stream
mapping method functions best when the setup cost for components is so
low that any reasonable lot size can be delivered to assembly as required by
a downstream pull scheduling process. If the component lead time is short
enough, pull scheduling can be considered.
Block Q—Material Handling Lead Time. Material handling contains
lead time. Your material handling starts at the receiving dock and stops at
the shipping dock. You should discover and justify projects to eliminate
material handling waste.
To evaluate and prioritize a material handling project, go to your budget
line items to total all material handling expenses. Include your expenses
for fuel, maintenance of material handling equipment, and containers or
pallets you use to hold batches of material and components within your
in-process areas. Next, ask your accountant to tell you the current value of
your company’s investment for material handling equipment. As a start-
ing place, with this information, you can use the project evaluation form in
Chapter 5 to determine how much you can increase your ROA for every 10
percent reduction in material handling expense and investment. You might
even create a project to justify an investment to automate portions of your
material handling processes as a way to reduce lead time.
To actually find the material handling waste and lead time that can
be eliminated, look at it as the processes between other processes, start-
ing at receiving and ending at shipping. Then imagine yourself as a track-
ing satellite and see how many miles per day you can eliminate. Be sure to
118 Chapter Nine

include in your study expenses for people who transport paperwork. Exces-
sive miles traveled each day by personnel is a symptom of poor planning,
uncontrolled process flows, and excessive lead time.
Block S—Assembly Shop Order Processing Lead Time. Ignore this
block if your business doesn’t require you to assemble products for your
customers. Look for opportunities for purchased components to be deliv-
ered directly to the assembly area from receiving.
Block T—Product Assembly Processing Lead Time. Ignore this
block if you don’t assemble products. Figure 9.6, page 126, is a pattern for a
product family matrix. It is provided so you can look at the steps for group-
ing each product line. By looking at the grouping, you can see which are the
most logical product families and determine if you can convert your current
assembly process to a cell. If you’re already using cells, the matrix might
help you make some improvements.
Block V—Packaging Lead Time. Packaging is a process requiring lead
time upstream of the customer order shipping date. If the packaging equip-
ment isn’t too expensive, consider adding a parallel station to shorten the
lead time. If batches accumulate and there are several people involved, con-
sider a cell. If only one or two people are required, transfer in personnel to
shorten lead time.
Block W—Shipping Lead Time. Perhaps packaging and shipping are
one process. If not, try to make them into a cell so that individual ship-
ments move through more quickly. Shipping is a good place to test your
overall system consistency. If the shipping rate isn’t about the same every
day or every hour, you are probably experiencing considerable wasted wait-
ing time somewhere.
Think about it. Your customers want suppliers with short lead times
just as your purchasing function desires from your suppliers. Personnel out-
side of the sales department need to realize that they can sometimes do
more to increase sales and market share than the sales personnel.
Block X—Invoicing Lead Time. Accounts receivable is one of the seven
critical business elements listed in Chapter 2. Companies should require
customers to pay invoices within a certain number of calendar days after they
send them. For your financial and credit personnel, this is called the accounts
receivable collection period. If there are a batch of invoices mailed once
each day, you can make a lead time improvement that would reduce this
investment by two or three percent. Consider including an accounts receiv-
able person in your packaging/shipping cell, even in a remote location.
The point I’m trying to make is that the lead time between a shipment and
 Projects to Reduce Lead Time and Inventory 119

the processing of an invoice should be a matter of minutes, so that invoices

can be batched and mailed as many times each day as practical, or may be
sent one at a time electronically.
Block Y—Transportation Lead Time. Transportation lead time is
critical if you operate branch warehouses because that transportation time
increases the number of days you carry the shipment as an inventory invest-
ment. Your customers are thinking in the same way. You’ve invoiced them
for the order but the product isn’t yet available to them.
Think like a financial businessperson and do the project evaluation
that will give you the highest ROA and best availability of your products to
your customers.
Block Z—Customer Types. Identify the types of customers you are
serving. Think about the kinds of processes going on within each of these
groups. Branches have a similar kind of reordering process as used for
blocks F, G, and W. Don’t leave them out of the analysis to eliminate small
pieces of lead time.
Bring major customers and major suppliers into your project teams.
They can provide valuable knowledge. Suppliers are critical because you
are going to need to get the message across to them that shorter lead times,
lower cost, higher quality, and more reliable delivery are part of your sup-
plier selection process.

APPLY LEAN VALUE

STREAM MAPPING
This chapter focuses on lead time reduction and its resulting benefit of
reduced in-process inventory investment.
I applaud lean manufacturing for its methods to reduce lead times for
your information and manufacturing processes. Value stream mapping pro-
vides you with methods that help you reconfigure your information and
manufacturing layout to facilitate shorter times to move a product through
your facility. To apply lean you need to contact a lean trainer or consultant. I
am only showing you how to use lean to discover more verb/noun combina-
tion projects. However, lean concepts should be applied only when you can
prove to yourself that they will yield the greatest ROA increase.

Minimize Manufacturing Work-in-Process Inventory

Since work-in-process inventory is an investment or asset on the balance
sheet, it’s natural to look for a verb/noun combination that provides a
120 Chapter Nine

financial phrase to answer how to minimize it. The only way to reduce
work-in-process inventory is to reduce manufacturing lead time between
the time material is assigned to a shop work order and the time the shop
work order is closed and the component is moved to stock, assembly,
or shipping.
Chapter 11, block 74 (page 196), shows a formula for calculating how
each manufactured item contributes to your investment in work-in-process
inventory. You will notice that the quantity you process—the lot size—
doesn’t affect your lead time or in-process inventory. Lot size does affect
finished component inventory. The quantity that affects the in-process
inventory formula is the usage, expressed in the same time period as the
lead time (days, weeks, months). You can use this formula to estimate an
in-process inventory budget or to understand why the company’s invest-
ment in this asset is as big as it is.
For project teams, the focus must be on reducing work-in-process lead
time as the primary way to minimize work-in-process inventory.
You can prove to yourself how important projects will be to reduce
your investment in in-process inventory. On any given day, take an in-
process inventory audit and estimate its dollar value. Then, assume you can
find ways to cut the average lead time in half. You can reasonably estimate
that you will have half as many dollars invested in in-process inventory.

Reduce Manufacturing Work-in-Process Lead Time

You’re probably already doing some things to reduce in-process lead
time. You and your fellow employees could, in less than one hour’s time,
come up with a multitude of projects to reduce in-process lead time.
Finding creative projects isn’t a company problem. The problem is
often one of investing in enough personnel to plan and implement projects.
Lead time reduction for cellular manufacturing, covered in Chapter
10, can be a powerful tool. If you have paperwork or manufacturing pro-
cessing operations located within a cell, and the cell operating times are
well balanced, you’ve greatly minimized the lead time between process-
ing operations, the total time to complete a work order, and the in-process
inventory.
Two principles are utilized by cells to reduce lead time that can also be
applied to noncellular arrangement of various pieces of equipment in a pro-
cess flow. Experiment with these two principles in a noncellular environ-
ment to test new cell designs.
The first principle is called paralleling. In a cell, if you have an opera-
tion that takes twice as much time as all other operations within the cell,
you simply place two of these machines in parallel within the cell to
 Projects to Reduce Lead Time and Inventory 121

minimize the time for each part to pass through the cell. For a noncellular
process flow, you can do the same if you have the appropriate equipment
available and if the setup time required to set up the parallel machine is
relatively low.
The second principle is called overlapping. This happens naturally in a
cell because each part in the process moves from one operation in the cell to
the next until all cell operations are completed. If an item or paperwork pro-
cess is done completely within the cell, the lead time will be about as short
as you can hope to get it. For a noncellular process flow, the total quantity
of parts on the work order or the total quantity of paperwork forms to be
processed can be broken into smaller batches so each operation is over-
lapped with the next. This means the order is completed in much less time.
Overlapping should be considered for long-lead-time processes.
Lean concepts can be applied to office processes to drastically reduce
paperwork or information lead times by using value stream mapping to
reduce these lead times.

When Can You Best Apply Lean Value

Stream Mapping?
Figures 9.2 through 9.5 provide charts you can customize to show the flow
of information and products inside your facilities. I suggest places in the
flow where value stream mapping is the best tool to reduce lead time. I also
show places in the product flow where its concepts don’t directly apply to
manufacturers and distributors that are forced to carry inventory for fast
delivery to customers.
An overly simplified description of lean value stream mapping is that
it is a method that causes each process to make only what the next process
needs, when it needs it, in a continuous flow, using cells, without detours,
and with the finished products and components being pulled through all
the processes without batches of inventory or paperwork waiting to be pro-
cessed. The customer order is sent to only one place in the flow, usually
near the end of the assembly process, to control the pull-through of compo-
nents, all of which are made in daily or hourly lot sizes.
You need to understand that lean manufacturing and value stream
mapping concepts are primarily directed at manufacturers that utilize mass
production. Our goal in this section is to help smaller-sized businesses that
don’t use mass production to pick out the lean concepts and ideas that will
identify additional profit-producing projects.
There are places in almost every business, particularly in the area of
information and paperwork flow, where the value stream mapping method
will result in shorter lead times.
122 Chapter Nine

Components and raw materials that will not easily fit the lean value
stream mapping conditions include purchased or manufactured compo-
nents whose lead times are longer than the customer order lead time as
described in the cycle time chart in Figure 9.1. These need to be controlled
by a material control system like the one detailed in Chapter 11. Short cus-
tomer order lead time requires more components to be carried in inventory
in anticipation of future customer orders.
Lean value stream mapping doesn’t care whether the process is for
a service business, an office or information process, or a manufacturing
process. Each of these businesses either has paperwork and information pro-
cesses, purchased products, or manufactured products. Also, each process
has either internal or external customers who want the processing time to
be as short as economically possible. The same mapping steps are used for
all processes.

Before You Start Lean Value Stream Mapping

Since my audience is distributors, service businesses, and manufacturing
job shop operations, not mass production operations, I have arranged my
interpretation of lean concepts in a framework that can most directly be
applied to operations currently forced to maintain inventory to meet cus-
tomer delivery lead time requirements.
I treat lean value stream mapping as just another logical tool to iden-
tify a large number of projects to reduce lead times. However, most of your
paperwork processing can best be improved by seeing paperwork as a mass
production operation.
If you are already experienced in lean concepts, I hope this book will
give you knowledge that will help you implement lean concepts more prof-
itably, particularly as they relate to component lot sizing, lead times, and
the seven critical financial elements in a business.
If you plan to apply lean concepts, I want to encourage you to get
started by supplementing lean with the cautions I mention at various places
in this book.
Right or wrong, my personal conclusion is, lean concepts work best
for small- to medium-sized manufacturers in their efforts to streamline
assembly and office flow. They fit best for manufacturers who have pre-
cisely known future demand, usually because there is a customer contract
for a given quantity to be delivered every day over a long period of time.
They don’t fit as well with manufacturers who have a broad product line
for which the receipt of customer orders is relatively unpredictable and for
which the customer order lead time is very short in comparison to compo-
nent purchasing and manufacturing lead times.
 Projects to Reduce Lead Time and Inventory 123

None of these comments about the limitations of lean should deter you
from utilizing lean concepts that fit your particular business.
While most of my manufacturing audience will be primarily oriented
to job shop lot sizes, manufacturers and distributors will want to use lean
concepts to identify projects that won’t be discovered without them.

Advice from Some Authors of Lean Thinking

The authors of MEP’s value stream mapping resources warn against plung-
ing into waste reduction projects without first doing work on manufacturing
and paperwork flow. They say, “To reduce the lead time from raw material
to finished goods, you need to do more than eliminate obvious waste. Too
many lean implementation efforts have been waste scavenger hunts. While
it is good to be aware of waste, your future continuous flow designs need to
eliminate the causes of waste in the old flow stream. Once process flow can
be seen in a way that reveals these root causes, your company can work at
finding original solutions.”
These authors of lean thinking offer a five-step process to improve
both information and product flow.
First, “Find a change agent.” This is a person who can constructively
create an atmosphere of dissatisfaction with the existing scheduling and
processing practices and then create excitement and inspiration to con-
vert to new practices, such as continuous-flow processing of products and
information.
Second, “Find a teacher whose learning curve you can borrow.” Invest
in training and hiring to get the precise knowledge resources required to
implement, year after year, continuous process improvement to reduce
product and information lead time and changeover time.
Third, “Seize or create a crisis to motivate action across your firm.”
Henry Kissinger said, “Policy emerges when concept meets opportunity.”
A crisis, or opportunity, will often occur when your company is facing a
financial crisis or missing sales because your lead times and costs are too
high. You and your stockholders should recognize this as a crisis when you
have made yourself aware that you can double or triple your ROA and aren’t
investing in projects and knowledge resources to make it happen.
Fourth, “Map the value stream for all your product families.” You map
your manufacturing and paperwork flow as they are now, perhaps using
the flowcharts from Figures 9.2 through 9.5, and as they will be after the
wastes are removed.
Fifth, “Pick something important and get started removing waste
quickly, to surprise yourself how much you can do in a very short period.”
124 Chapter Nine

Use verb/noun combinations to name, evaluate, and prioritize projects that

will reduce lead time, changeover time, and their waste costs.
The authors of lean thinking continue, “Unfortunately, we have found
that very few of our readers have followed our advice to conduct value
stream mapping before diving into the task of waste elimination. Instead,
in too many cases we find companies rushing into big waste elimina-
tion activities. These well intentioned exercises fix one small part of the
value stream. The net result is no cost savings reaching the bottom line, no
service and quality improvement for the customer, and another abandoned
program.”

After You Decide to Do Lean Value Stream Mapping

Most lean courses picture mass production as a chain of islands with product
batches (or stacks of paperwork) delivered from the preceding island in the
process flow. The people on each island perform their work and when they
complete a batch, deliver the batch across the water to the next island. Each
island may require its own “push” scheduling system to attempt to get opera-
tions completed soon enough that the remaining processing operations will
be completed in time to meet the delivery promise made to the customer.
To convert to continuous flow and greatly reduce the lead time and
batch inventory on each island, islands are all pulled next to each other so
that the batches can be eliminated and operations performed on each island
can be moved from one island to the next, one part or operation at a time.
Now, only the last island in the process needs to be scheduled since it is
“pulling” the process, one part or operation at a time, through the complete
process.
For the flow to be smooth and without wasted time, each step in the
process is designed to use about the same amount of time so the “make one,
move one” concept works as planned. This flow requires less lead time
and inventory. Lead time is reduced further by placing appropriate opera-
tions of the flow in parallel. Cost and lead time may be further reduced by
designing cells that will reduce both lead time and personnel costs.
I suggest you use your paperwork processes to more easily visualize
the application of value stream mapping. Look for places where the con-
cepts can be applied to your assembly and component manufacturing areas.
You will see how easily value stream mapping can be applied to a service
business or distribution business.
Consider paperwork flow when you receive a customer purchase order.
Information is flowed through the company, often in batches, from one
department or island to another. Some information may flow for credit
 Projects to Reduce Lead Time and Inventory 125

review, engineering actions, inventory control, purchasing, shop orders,

assembly scheduling, invoicing, and accounts receivable. Then imagine
how you can reduce paperwork lead time by converting to continuous flow,
with appropriate cells to reduce both processing cost and time.
Value stream mapping should be done for each product family. A
product family could be physical products made from similar components
assembled in the same sequence using the same equipment or assembly
station. A product family could be paperwork from a customer order used
to generate paperwork for the purchase and manufacture of components
that will be assembled into a product. Or a product family could be a cus-
tomer who walks into the door of a service business, or your branch office,
and expects to be quickly greeted so that their request for service can be
processed in a shorter amount of time than your competitors are able to
consistently achieve.
Once you have identified the product family, the mapping process is
very simple:
• Prepare a flowchart that shows the current steps required to
process the product. Lead time, processing time, queue time
(in minutes, hours, or days), and batching are documented for
each step of the process, including any of the other wastes
and their causes that were covered in Chapter 8. I’ve given
you my imagination of your process flow in Figures 9.2
through 9.5.
• Prepare a flowchart that shows the future continuous-flow
process, with wastes eliminated and appropriate cells added.
Estimate the new shorter lead times and processing times for
each step in the process. For paperwork, you should expect
times to be reduced from days to hours and from hours to
minutes or seconds.
• Evaluate, using the form in Chapter 5, the expected ROA increase
for each improvement in the new flow diagram so you can
determine the part of the process to change first. Remember,
mapping is a continuous improvement exercise. You should never
be satisfied as long as you can creatively find ways to reduce lead
time, reduce setup or changeover time, or do all your scheduling
based on the customer order.
• Get started on the most profitable project without delay, hiring
and investing in additional people resources as required to
implement projects in the shortest time possible.
126 Chapter Nine

More About Product Families for

Assembled Products
Figure 9.6 shows how to use a grid to group product or paperwork families.
In an assembly line, it’s often obvious how to separate your products into
families. You may already have separate assembly stations for each of them,
depending on the difference in the components that go into each of them.
Start by randomly entering products on the grid and rearrange them so
they are more logically grouped, based on the process steps and equipment.
If you feel a grid will be helpful to rationalize your products or paperwork,
this pattern may give you an idea of how to construct your own. You might
have an interesting opportunity if column 3 represents a very expensive
piece of equipment since it can be used on all of the product families.
You can easily agree to a goal to dramatically shorten the paperwork
processing lead time from the time a customer purchase order is received
until purchase orders and shop orders are released. Maybe this paperwork
currently must pass from sales to credit to engineering and then to inven-
tory control and purchasing, in batches, before the process is complete. You
can make a dramatic impact if you redesign your information system to
automatically trigger purchase orders and shop orders instantly when cus-
tomer orders are input upon receipt by a salesperson, or by a sales order/
material control cell.
In a service business, where information or paperwork is the product,
the transactions and transacting personnel may be configured in a grid, like
Figure 9.6, to discover transaction families.

Products or Process steps and equipment

paperwork
processes 1 2 3 4 5 6 7 8 9
A X X X X X
Product
B X X X X X X family
ABC
C X X X X X X
D X X X X X Product
family
E X X X X X DE
F X X X X X Product
family
G X X X X X FG

Figure 9.6 Product family discovery.

 Projects to Reduce Lead Time and Inventory 127

More About Your Current Flowchart

In an assembly function, a manufacturer may have one workstation where
one or more assemblers build a large number of components into a rela-
tively large end-item product. Or you may have low-volume, smaller prod-
ucts that can be assembled at a workstation by one person. These operations
don’t particularly lend themselves to lean value stream mapping and its goal
of continuous process flow in which you “make one and move one” in lot
sizes of one. However, even in these assembly operations, you can identify
projects that will eliminate waste.
For paperwork functions, in your current flowchart, look for flow that
looks like mass production with its islands or batches of paperwork. When
you see this in your current flow, you have a probable opportunity to make
significant continuous-flow lead time improvements.

More About Your Future Flowchart

Your future continuous-flow chart can be viewed in two stages. Ideally, you
are going to attempt to pull all the islands together and eliminate all the
inventory batches staged between each island. Also, you are going to look
for opportunities to place some of the islands in parallel as if they were now
only one island.
Another key element of your future continuous-flow chart is to iden-
tify one of the islands, usually near the end of the island chain, to use as the
only island for which you provide a customer delivery schedule. This island
sets the pace for all the other islands and allows all the preceding worksta-
tions to “pull” their needed components by using visual controls such as
cards, flags, or lights.
My interpretation of lean value stream mapping is purposely not as
detailed as an MEP course would normally be. The reason is I am pri-
marily trying to trigger more verb/noun or verb/phrase combinations to
discover more projects for paperwork and product cells and other lead time
reduction.
You can locate many books and consultants to teach you more detail
about lean concepts. Just use this book and its interpretation of lean to make
their approach financially sound.
 10
Projects to Reduce Setup
Cost and Inventory

I
n each section of this chapter we will focus on lot sizing principles that
will help maximize your ROA. I will encourage you to decide on a lot
sizing formula for those components that require forecasting or those
components that, by formula, require a lot size greater than is specified on
an individual customer order.
Even if the lead time for a standard component is less than the cus-
tomer order lead time, a financially sound lot sizing formula may require
the purchase or manufacture of a quantity greater than required by an indi-
vidual customer order. The reason for this is that lead time is purely a time
decision and lot sizing is purely a financial decision requiring a financially
sound formula.
This chapter provides detailed information for you to reduce compo-
nent inventory by reducing setup costs.

SETUP COST AND

COMMONSENSE LOT SIZING
This chapter and its seven sections are most valuable to manufacturing
businesses that have both purchase order and shop order setup costs. For
distribution and service businesses its value will depend on the setup costs
related to purchased components sold to customers.
Lean manufacturing enthusiasts might be tempted to arbitrarily reduce
lot sizes before making the appropriate reductions in setup and changeover
costs. This arbitrary action usually results in a lower ROA because costs go
up faster than inventory investment goes down.
In this chapter I show project teams how to avoid this mistake. By
linking setup cost reduction with lead time reduction, you can move closer
to the goal of scheduling work orders and purchase orders from customer

129
130 Chapter Ten

orders. The goal for purchase order and shop order setup cost reduction is
to dramatically reduce component inventory investment.

Commonsense Item-by-Item Lot Size Decisions

Many lean manufacturing practitioners will promote the concept that, as an
ideal goal, the only reasonable lot size is a quantity of one. I don’t have any
argument with that conclusion, as long as setup cost for every component is
very small in comparison to unit cost. For manufacturers, this will mostly
occur in assembly operations, where the setup cost is usually less than 10
percent of the cost of all the assembled components for one end item or fin-
ished product.
The goal I encourage you to embrace is to reduce your component setup
costs, item by item, until the setup cost for each purchased or manufactured
component is less than 10 percent of the component’s unit cost. This will be
a very challenging but financially rewarding goal.
Because of variables such as unit cost, setup cost, usage rate, and the
various costs to carry components or end items in inventory, common sense
tells you that every purchased and manufactured component must have its
own individual lot size. I will prove to you that unless the setup cost for any
component is less than 10 percent of that component’s unit cost, manage-
ment needs to approve a method to calculate a financially sound lot size.
This 10 percent rule of thumb is the reason you can financially justify
very small quantities for assembly shop orders. The setup cost to assem-
ble a product or end item is usually much less than the total cost for all the
components that go into one assembly. However, for most components, par-
ticularly those made from castings, it is unusual that the combined paper-
work and machine setup cost will be less than the component’s unit cost
unless you can financially justify a dedicated machine or CNC machine
that requires minimal setup/changeover time.
For example, it is common sense you wouldn’t decide on a compo-
nent lot size of one or two parts when the setup cost is ten times the unit
cost. Common sense tells you that if you persist in arbitrarily setting very
small lot sizes for components that require considerable setup time, your
unit costs and selling prices will be too high to be competitive. Your inven-
tory investment would be very low but it wouldn’t offset the excessively
high unit costs.
Common sense also tells you that your unit cost will be lowest if you
arbitrarily run large lot sizes. Your unit costs would be very low but won’t
offset the excessively high inventory investment.
In between these two extremes is an optimum quantity that will give
you the lowest total component cost. Therefore, common sense tells you
 Projects to Reduce Setup Cost and Inventory 131

it will be financially dangerous to arbitrarily guess at a lot size. Common

sense demands a rational calculation method that is financially sound. The
lot sizing method you use must either show you how to identify the quantity
that will give the lowest total cost (unit cost plus inventory carrying cost)
and the highest ROA.
In other words, your lot sizing decision is a financial decision and must
be guided by your company personnel who are most directly charged with
financial results. These personnel must provide or approve a formula and
material control procedures that will allow material control personnel to
quickly and automatically make these financial decisions about lot sizing.
I encourage your material control personnel and your finance personnel to
reach a consensus that lot sizing is a joint decision between these two com-
pany functions.

FINANCIALLY SOUND LOT SIZING

This is a vitally important section if you are serious about selecting the
most financially sound lot size. This isn’t a quantity that can arbitrarily be
pulled out of the air to satisfy concepts of lean manufacturing courses. If
your lot sizing method doesn’t do something to bring a financial balance
between inventory carrying cost and setup cost, I can assure you, and will
prove to you, that you are not maximizing your ROA.

EOQ, the Traditional Lot Sizing Formula

We will use the traditional economic order quantity (EOQ) lot sizing for-
mula as an example of a formula that will calculate a quantity that will give
you the lowest total cost (unit cost plus inventory carrying cost) and the max-
imum net profit for every single manufactured or purchased component.
I like this formula because it includes all the elements required to find
the lowest total component cost, setup cost, usage rate, inventory carrying
percent, and unit cost. The traditional EOQ formula is as follows:

2 × Setup cost × Annual usage rate

EOQ =
Inventory carrying percent × Unit cost

24 × Setup cost × Monthly usage rate

or EOQ =
Inventory carrying percent × Unit cost

104 × Setup cost × We e kly usage rate

or EOQ =
Inventory carrying percent × Unit cost
132 Chapter Ten

I present the EOQ formula as an option your company can use to deter-
mine lot size, or as a pattern by which your material control and finance
personnel can design their own method to authorize financially sound lot
sizes. It just happens that this is the formula I would use if I were a stock-
holder in a manufacturing business that had a goal to maximize ROA.
The formula was derived by putting the elements that determine inven-
tory carrying costs on one side of an equation (like putting them on one end
of a teeter-totter) and by putting elements that determine setup costs on the
other side (or the other end of the teeter-totter). The idea is to make both
sides of the formula equal (or to put the teeter-totter into balance).
When the setup cost and inventory carrying cost are equal, you end up
with the lowest total cost for that particular component shop order quantity
or purchase order quantity.
In the mathematical derivation of a formula, we put everything but
the EOQ on one side of the equals sign. As we do this we get EOQ times
EOQ (or EOQ squared) on one side of the equals sign. Therefore, we take
the square root of both sides of the equation so that we have just the EOQ
on one side of the equation. The square root sign covers everything else on
the other side.
If you don’t like arithmetic just take my word for it. I didn’t invent
the EOQ. It’s a formula that has served many manufacturers well since the
early 1900s. The importance of this formula is that it provides a way to get
the lowest cost in your profit and loss statement and annual budget for inven-
tory carrying costs and setup costs in total. It helps see the four elements or
facts you need to know to determine a lot size for every component.
Setup Cost. For manufactured components this is the total accumulated
shop order paperwork cost, plus the setup time for all operations for a given
component, multiplied by the appropriate hourly shop rate, including over-
head. For purchased parts, setup cost is the paperwork cost for processing
purchase orders. Calculating setup costs for purchased and manufactured
components is detailed later in this section.
Usage Rate. This is the best estimate of future annual, monthly, or weekly
usage. For a usage rate I prefer to use the quantity of the last one or two
lots and the time period it took to consume this quantity to get a monthly
or weekly usage rate. This method is described in greater detail in Chapter
11. If you want to use an annual forecast, you may have to use the past 12
months’ usage multiplied by a trend for the future. The most recent past is
usually the most reliable estimate of the short-range future usage. I don’t
like to use annual sales forecasts.
 Projects to Reduce Setup Cost and Inventory 133

The 2 in the EOQ Formula. The 2 is there because your average quan-
tity in inventory at any given time is one-half of the most recent lot size. If
you use a monthly usage value, the 2 in the formula is multiplied by 12 and
becomes 24. If you use a weekly usage value, the 2 is multiplied by 52
and becomes 104. In other words, the formula treats usage rate and inven-
tory carrying costs in annual terms.
Unit Cost. This is the cost of each individual component, including mate-
rial, direct labor, and overhead, including setup cost. Actually, purchased
components should absorb some of the shop overhead but most manufac-
turing businesses absorb all the overhead into shop orders. Our definition
of unit cost is the cost of each component, including setup cost, as the com-
ponents go into stock or into assembly.
The Inventory Carrying Cost Percent. This is a value that represents
the total of the many costs for carrying inventory, divided by the annual
average total inventory investment. Normally it is about 25 percent, which
is another way of saying that an item held in inventory will eat up its own
value within four years (100 percent divided by 25 percent). This percent is
seldom less than 15 percent in most manufacturing companies. Details for
calculating the inventory carrying cost are shown later in this section.
As you implement each project to reduce lot sizes, the inventory carry-
ing costs automatically disappear from operating budgets at the same time
your inventory investment reduces. Net profit increases as your inventory
investment goes down and, as a result, your ROA increases. That’s why you
should continuously have many projects to reduce setup cost and lead time
on individual components (or groups of very similar components). The goal
is to continuously have more components that can be ordered after you
receive customer orders because their setup cost is less than 10 percent of
the part’s unit cost.
Note: Normally you also invest in capital equipment or tooling expense
to obtain an inventory investment reduction as you implement projects to
reduce setup time and lot size on various components. When evaluating a
project (with the forms in Chapter 5) to reduce setup cost and the inventory
investment on a component, or a family of similar components, be sure to
include the investment for the required capital equipment or the expense for
tooling that won’t be capitalized. The equipment or tooling cost is usually
less than the reduced average inventory value.
134 Chapter Ten

Inventory Carrying Cost Expenses

The lines in the list in Figure 10.1 are the expenses needed to estimate the
inventory carrying cost percent. You need to have an idea about how many
cents in expense you have buried within other expenses just to maintain
each dollar of inventory investment for components and finished products.
This means that when you reduce setup cost so that you can reduce inven-
tory investment, you also receive an expense reduction bonus of 15 to 25
cents for each dollar you reduce inventory.
Just go to your annual budget and gather all the costs that relate to
each of the lines in the list. Next, total lines 1 through 12 and enter this
total on line 13. Line 13 is the total annual cost to maintain your current
level of inventory for components and finished assembled products. On line
14, enter the total asset investment for all component and finished product
inventory. Then divide line 13 by line 14 to get a percent, which you enter
on line 15, as a factor to represent the cost to maintain each dollar of your

Line Inventory carrying cost

1 Rework or scrap because of design changes

2 Change of inventory value from reevaluation
3 Rework or scrap from deterioration or damage
4 The current interest percent even if you’re not currently borrowing
5 Warehouse labor, including supervision.
6 Receiving and shipping labor, including supervision
7 Depreciation or rental cost for warehouse, shipping, and receiving
floor space, storage racks, and material handling equipment
8 Property taxes related to the inventory value
9 Real estate tax for warehouse, shipping, and receiving areas
10 Insurance premiums for inventory
11 Insurance premiums for warehouse, shipping, and receiving areas
12 Workmens compensation insurance for warehouse, shipping, and
receiving personnel
13 Total inventory carrying expense
14 Total component and assembled end-item inventory investment
15 Percent for line 13 divided by line 14

Figure 10.1 Expenses needed to estimate inventory carrying cost percent.

 Projects to Reduce Setup Cost and Inventory 135

inventory investment. For most businesses, this percent factor will be 15 to

25 percent.
This calculation should give you clear insight into the expenses that
will systematically evaporate as setup costs and lead times are reduced,
resulting in even smaller lot sizes and a lower inventory investment.
The EOQ formula is a result of placing the inventory carrying costs
on one end of a teeter-totter with setup cost on the other end of the teeter-
totter to see what lot size quantity will bring the teeter-totter into horizon-
tal balance.
Each line is self-explanatory. You will need to ask your accountant to
help you use the budget to estimate these values. This carrying cost percent
will apply to both purchased and manufactured components.

Setup Costs for Purchase Orders and Shop Orders

The next list of expenses (Figure 10.2) are those needed to cover paperwork
setup costs related to processing purchase orders, receiving costs for pur-
chased items and outside processing, or shop order paperwork processing,

Line Setup cost expenses

1 Inventory control salaries

2 Portion of purchasing salaries related to product sales
3 Receiving salaries related to counting and paperwork, excluding
material handling
4 Receiving inspection salaries
5 Production control salaries
6 Physical inventory and/or inventory cycle counting
7 Data processing allocated to the above functions
8 Total dollars allocated to purchase orders
9 Total number of purchase order line items plus blanket order releases
10 Paperwork setup cost for each purchased component ordered
11 Total dollars allocated to shop orders
12 Total number of shop orders
13 Paperwork setup cost for each manufactured component ordered.
14 Machine setup cost or process changeover cost

Figure 10.2 Expenses needed to cover paperwork setup costs.

136 Chapter Ten

shop scheduling paperwork costs, and machine setup or changeover costs

for manufactured items.
For this list of expenses, look at your annual budget and identify the
departments that perform duties related to inventory control, purchasing,
receiving, receiving inspection, production control, data processing costs
allocated to these functions, and physical inventory or inventory cycle
counting.
Purchased items have paperwork setup costs that must be considered to
decide ordering quantities, and manufactured items have shop order paper-
work costs and machine setup costs to decide lot or batch sizes.
The values in this list should be the amounts shown in the current
annual budget or the actual annual values from the preceding year.
Again, I encourage you to utilize the facts gathered and recorded by
accounting personnel for other business purposes to support project teams
as they look for facts to improve the ROA.
Use the list in Figure 10.2 to make a list that relates to the way your
company is organized and/or the way your budget is formatted. If you are
a small company, you may have one person who performs several of these
functions. Study the following instructions for each line and, with the help
of your accountant, make the best estimate you can for each line.
Accumulate the values for these lines to design a financially sound lot
sizing formula. If your estimate is too low, order quantities and inventory
will be smaller than a formula would recommend. If your estimate is too
high, order quantities and inventory will be larger than a formula would
recommend.
Line 1. This line is for salary expenses of the inventory control func-
tion. This is the function through which sales order quantities, or forecast
quantities, are translated and communicated to the purchasing and shop
scheduling functions. Then, after purchased and manufactured items are
received into stock, this function may be responsible for maintaining accu-
rate records of quantities on hand until issued for assembly shop orders
or shipping orders. For manufacturers, part of this dollar amount will be
allocated to purchase orders, and the remainder will be allocated to shop
orders. For distributors or service businesses, all of these costs will usually
be allocated to purchase orders for products inventoried and sold to custom-
ers. To make the allocation, you can count the number of inventory items
that are purchased and the number that are manufactured, total them, and
use the two totals as the divisor to get the percent of salary costs that should
be allocated to each group. You can save time by counting every tenth com-
ponent and then multiply by 10.
 Projects to Reduce Setup Cost and Inventory 137

Line 2. Salary dollars for this line will be allocated only to purchase order
setup cost. Look in your budget at the salaries for your personnel who pro-
cess quotations, place purchase orders, and follow up on open purchase
orders for product components. You might include some or all of a depart-
ment manager’s salary. Don’t include any salary expense for processing
purchase orders for plant and office supplies. Do include purchase orders to
process manufactured components outside.
Line 3. The salary dollars for this line will be allocated only to purchase
orders. Include salaries and wages for receiving used for counting and
processing paperwork. Don’t include material handling into or out of the
receiving area.
Line 4. Include inspector expenses to accept or reject incoming compo-
nents or incoming outside processing.
Line 5. For manufacturers, production control activities control shop
orders, after being triggered by inventory control, until parts are delivered
to assembly, stock, or shipping. This function does shop order planning,
scheduling, and expediting. In some shops, much of a supervisor’s time
may be used to schedule and expedite orders. This salary can be rightfully
included. These activities relate to in-process inventory investment.
Distributors and service businesses may have a schedule control system
incorporated into the costs for purchase orders.
Line 6. If you must maintain inventory for some items, you must keep an
accurate quantity count for both accounting purposes and reordering pur-
poses. If you perform an annual physical inventory, or rely on ongoing ran-
dom cycle counting, you should include salaries and wages used to do both.
Manufacturers will need to allocate the cost from this line for purchase
orders and shop orders in the same percentages as used for line 1. I rec-
ommend eliminating annual physical inventory in favor of random cycle
counts, because random cycle counts are much more accurate. In Chapter
11, I will suggest to you the best time to take a physical inventory count.
Line 7. It may be difficult to accurately define a percent of total data pro-
cessing costs for inventory, purchasing, and production control activities.
Personnel in data processing can make the best guess possible about what
percent of their total budget could be charged to these functions. Allocate
the total cost between purchase orders and shop orders the same as you did
for lines 1 and 6.
Line 8. The sum of lines 1, 6, and 7, times the percent from line 1 allocated
to purchase orders, plus lines 2, 3, and 4.
138 Chapter Ten

Line 9. For the same period of time you estimate the dollar values, you
can take every tenth purchase order for purchased components, count the
number of line items found plus the number of blanket order releases, and
multiply by 10.
Line 10. Divide line 8 by line 9. This will be the purchase order setup cost
you will use if you decide to use a financially sound lot sizing formula for
purchased items.
Line 11. This is the sum of lines 1, 6, and 7, times the percent from line 1
allocated to shop orders, plus line 5.
Line 12. Manufacturers should count the number of released shop orders
for the same period of time used to estimate dollar values.
Line 13. Divide line 11 by line 12. This is the shop order paperwork setup
cost in the lot sizing formula for manufactured items.
Line 14. For manufacturers, machine setup cost for each manufactured
component should be the historical average time it takes to set up or change
over a machine or process, times the hourly shop rate. Hourly shop rates
can run as much as $40 to $75 per hour, or more. If you don’t have a logical
setup cost calculated for each component in your cost accounting system,
you may have to rely on shop or accounting historical averages or on pro-
cess engineering or supervisor estimates for setup hours.
Often, shop hourly rates include overhead for receiving costs for mate-
rial. Consider only including overhead related to the processing depart-
ments to set the hourly shop rate for setup cost.
The EOQ formula doesn’t do anything to lower your inventory invest-
ment. It only gives you the lowest-cost inventory level. You only lower
your component inventory investment by lowering your setup cost, com-
ponent by component. It may take several years to complete all the poten-
tial projects.

Experimenting with the EOQ Formula

Here’s a simple way to experiment with the EOQ formula to determine the
weeks’ or months’ supply you will make, based on your own setup costs,
unit cost, and usage rate.
You can increase your ROA by increasing your inventory invest-
ment if your lot sizing formula tells you to begin making components less
frequently than you do with your current lot sizing method.
 Projects to Reduce Setup Cost and Inventory 139

Let’s use the EOQ formula based on monthly usage and simplify it
slightly by pretending that your inventory carrying cost percentage is 24
percent. The formula becomes, after dividing 24 percent into the 24 in the
numerator:

24 × Setup cost × Usage

= Lot size
24% × Unit cost

or, by dividing 24 by 24 percent,

100 × Setup cost × Usage

= Lot size
Unit cost

Do your experimenting by using round numbers such as 10, 100, or 1000.

100 × $100 × 100 quantity

= 316 = Lot size
$10 Unit cost
316
Inventory investment = × $ 10 = $ 1580
2
100 Usage per month × 12
Set u ps/year = = 3 . 79
316
Set u p cost/year = 3 . 79 × $ 100 per setup = $ 379
Inven t ory carrying costs/year = $ 1580 × 24 % = $ 379

These calculations should prove to you that the formula does balance setup
costs with inventory carrying costs. The EOQ formula gives the lowest
total cost for carrying inventory and making setups. Then, as you reduce
setup costs, both your expenses and your inventory investment go down at
the same time, giving you a double kick to your ROA.
For example, in the above exercise, if you reduced the setup cost to
$50, the EOQ would be 223. Every time you can cut a setup cost in half, the
lot size and inventory investment is 70.6 percent, or (223 ÷ 316 = .706) of
what it was previously for that component.
Stockholders in your company should insist that the EOQ formula be
used to communicate to material control personnel how to make the lot
sizing financial decision to govern component inventory levels.
If you’re able to get all your setup costs down to 10 percent of each
component’s unit cost, no lot sizing formula will be needed. You can
140 Chapter Ten

experiment with the formula and prove to yourself that this 10 percent rule
of thumb would be financially acceptable.

PRODUCT AND PROCESS DESIGN

TO REDUCE LOT SIZES

Calculating Lot Sizes for Families of Components

Whether you use cells to reduce setup costs, or whether you decide to group
similar components until you can justify cells, you still have a financial
decision to make each time a quantity of individual parts is processed.
Be sure the lot sizing formula you decide to use can be utilized when
you decide to run a group of similar components, one behind the other. The
EOQ formula can easily be used to calculate the lot sizes for a group of
components using almost the same setup. The easiest way to explain this is
with an example.
Let’s say you have a group of six components whose tooling and
sequence of four operations are almost the same. They are made from the
same or similar castings and are processed on the same holding fixtures.
Each component has some unique dimensional feature that makes its setup
slightly different from the others. When run individually, the setup time for
the four operations is eight hours each. When two or more components can
be run on a common setup, the changeover from one part to another totals
three hours.
• For two parts, the average setup will be (8 + 3) ÷ 2 = 5.5,
a 31 percent setup time reduction.
• For three parts, the average setup will be (8 + 3 + 3) ÷ 3 = 4.7,
a 41 percent setup time reduction.
• For four parts, (8 + 3 + 3 + 3) ÷ 4 = 4.3, a 46 percent reduction.
• For five parts, (8 + 3 + 3 + 3 + 3) ÷ 5 = 4.0, a 50 percent reduction.
The process begins each time one of these six parts is reordered. At that
time, the material control system predicts which of the other five compo-
nents will be reordered within the next two weeks (or another short time
period). Assume that three components can run together as a group. One
full setup and two partial setups will be made. From the preceding para-
graph, you use the setup cost of 4.7 hours for each of the three components,
rather than 8.0 hours for a full setup for each. The inventory investment
 Projects to Reduce Setup Cost and Inventory 141

for this combination of three parts would be 77% ( 4 . 7 ÷ 8 = . 77 ) of the

investment if all three components were processed on separate setups.
A more detailed proof of this simple calculation is as follows, using the
preceding example on page 139:

100 × Setup cost × Usage

Unit cost
100 × $ 100 Setup cost × 100
= 316 Lot size
$10

The average setup time for parts run separately is eight hours each. When
three are run together the setup time is 4.7 hours each. Therefore, in the
above example, the setup cost for 4.7 hours would be 58.75 percent of
the setup cost for eight hours (4.7 ÷ 8 = .5875 or 58.75%).
The above lot size calculation would become

100 × $ 58 . 75 Setup cost × 100

= 242 Lot size
$10

For a 4.7-hour average setup time, the inventory investment would be 77

percent of what it would be for an eight-hour setup for each part (242 lot
size ÷ 316 lot size = .766 or 77%). Thus

4 . 7 ÷ 8 = . 5875 = . 766 or 77%

This example illustrates how to reduce setup costs and inventory invest-
ment without making improvements in the setup itself. It also illustrates
how much lot sizes can be reduced by manufacturing cells or by experimen-
tal cells using paralleling and overlapping techniques explained in blocks
59 and 60 of Chapter 11.

Reducing Changeover Time by Shortening

Pit Stop Time
Later in this chapter lean quick changeover and cellular manufacturing are
covered. In this section we cover setup and lot size reduction in a general
way to discover project opportunities.
Focus some setup cost reduction on reducing your operator’s time “in
the pits.” Observe the operator between shop orders to see how you can have
other personnel prepare replacement tools ahead of the pit stop (changeover)
142 Chapter Ten

and then gang up on the processing equipment to get it back into production
in the shortest time, hopefully in minutes. This doesn’t always mean that
the total personnel direct hours won’t be the same as before. However, the
cost per machine hour will go down dramatically and machine utilization
percentages will increase.
Can you imagine a NASCAR race where at a pit stop the driver gets
out of a car to change the tires and fill the fuel tank? Yet the same thing
probably happens every day in your shop. Every setup should be treated
as a portion of a race, with ROA points that count toward the champion-
ship. Every setup should have a “pit crew” to plan and prepare for the next
time the machine operator finishes one shop order and comes into the pit to
start the next. A racing team knows that the race car needs to get back out
on the track quickly or it will get behind and not place well in the race or
the point standings. The same applies to expensive shop equipment. The
longer a machine stays in the pits between shop orders, the less chance it
has to maximize the quantity of product it can produce per hour and per
year, increasing its utilization rate and eventually reducing the investment
required for capital equipment.
Race teams invest much money in equipment and people to win races
and gain customers for their sponsors. They know that many races are won
in the pits. The same goes for your shop. Your company’s ability to stay in
the race against competitors for the championship may depend on how
much you invest to reduce setup pit time. Your sponsors, customers and
stockholders, will insist on it.
The goal of a setup reduction strategy is that while an expensive piece
of capital equipment is completing its last few parts, a setup team is gather-
ing raw material and tooling to be ready to come over the pit wall so they
can get the equipment back into the race in the shortest possible time.

Reducing Manufacturing Lot Sizes by Investing in

Tooling and Equipment
Many setup cost reduction projects can be initiated with little investment.
You will have projects for which your accountant will write off tools as an
expense. You will have others that will require major capital investment.
When you discover a project that requires an investment, before com-
pleting the Project Evaluation Form from Chapter 5, ask your accountant
whether the investment will be treated as an expense in the profit and loss
statement or whether it will be capitalized as an asset in the balance sheet.
If it will be an expense, include it on line 7 of the form. If it will be treated
as a capital asset, include it on line 16 of the form, and on line 7 include its
annual depreciation expense.
 Projects to Reduce Setup Cost and Inventory 143

What you are really doing in setup cost reduction is implementing proj-
ects that reduce your inventory investment more than you increase your
capital investment. As you reduce your lot sizes by reducing setup time and
costs, your inventory investment will go down. To reduce the setup time
will usually require an expense or capital investment. This will always be a
good investment if you evaluate each project as I have suggested in Chapter
5 and prove that the project will increase rather than decrease the ROA.

Design Setup out of Your Components

In case it isn’t part of your product and process design culture, I suggest you
establish a design philosophy that focuses on product designs with fewer
components and fewer setups on individual components.
Most products made of assembled components contain two or more
components that can be redesigned into one. For example, in the original
design two different parts may have been designed to be bolted together.
As time has passed, casting and machining equipment may have improved
to the point where the two parts can now be machined from one casting.
Or, it’s possible that you can now financially justify a new piece of capital
equipment that can machine more surfaces with a single holding fixture.
As a result, two or more machining operations and their setups can be
designed out of the original two components. Obviously, if products can
be economically redesigned to reduce the number of components or number
of setups, this approach can become part of your design philosophy for all
future new product designs.
Included in this design philosophy is the approach that new prod-
uct design becomes a joint venture between personnel who design the
product and personnel who design the processes, including the operators
who set up and run the process. The processing personnel must be brought
in at the initial product design phase to get the best results. Help the design
personnel to make it a normal part of their design culture that your stock-
holders, with their desire to minimize inventory investment, are one of the
customers that need to be satisfied with a final product and process design
that reduces the investment in inventory. This kind of action is incorporated
in Six Sigma improvement programs.
The next piece of this design philosophy is to design components
in such a way that they can be processed in the least number of operations
and with the fewest number of setups. For example, you might add chuck-
ing lugs to a casting so that two lathe operations can be performed on a
single setup.
Another example is to design a component so all machining operations
can be performed on one setup on a CNC machining center. Or, you might
144 Chapter Ten

be able to financially justify a machining center that has multiple indexing

tables built in so you can run very small lot sizes to feed to assembly opera-
tions on a daily or hourly basis.
A bonus from this product and process design culture is the improve-
ment in product quality. If you can do all processing operations with one
setup, all dimensional controls are dependent on the repetitive capabil-
ity of the processing equipment. Each time a component is moved from
one operation to the next, dimensional features that depend on each other
will often require additional inspection. If all dimensions are obtained in
one holding, inspections are minimized or eliminated, particularly if you
use preventive maintenance as a tool to maintain the dimensional capability
of your equipment. This is another element included in Six Sigma improve-
ment programs.
Another bonus from this design approach is that as you reduce the
number of setups for current processing operations, you also reduce
the number of stations needed when you design a manufacturing cell.
If you make the investment to send your product and process design-
ers to trade shows, or schedule periodic meetings with equipment sales
representatives, you will make it easier for them to discover appropriate
equipment to process components with minimal setup. Equipment such as
machining centers with multiple pallets to hold fixtures and with multi-
ple cutting tool holders appears to be a very expensive investment until
you calculate the reduction in your inventory investment that will result
from shorter setup times and smaller lot sizes. Look for these opportunities
where the equipment investment plus the smaller inventory investment will
be a fraction of your current inventory investment for the components plus
your current capital equipment investment.
As you modernize your processing equipment, look for opportunities
to dedicate a piece of fully depreciated equipment to a few components that
require significant setup time. If you have the floor space available, you
may be able to keep the equipment set up for a few appropriate components
so you can make them in very small lot sizes, hopefully only when required
by a customer order or an assembly shop order.

LEAN QUICK CHANGEOVER

CONCEPTS
In this section I refer to lean concepts that relate to setup and changeover
reduction. In most lean manufacturing courses, setup reduction is related
 Projects to Reduce Setup Cost and Inventory 145

to changeover that occurs when a mass production line or continuous-flow

process is changed over to a different product line.
In continuous-flow processes the products will be grouped in families
that use the same equipment in the same sequence. Many of the same con-
cepts can be applied to job shop assembly, component manufacturing, and
paperwork or information processing. This section and the next are closely
related to the previous material in this chapter that focused on setup cost
reduction for manufactured and purchased components.

Components That Don’t Mesh with Lean

If you’ve studied lean manufacturing or attended lean seminars, you may
wonder how you can apply lean concepts to your particular business, espe-
cially if your customers give you a very short lead time between your receipt
of their purchase order and their expected delivery date.
For example, [Link], the lean Web site, encourages you to,
“avoid batches and move toward continuous flow in batches of one.” A lean
workbook states, “Any supply in excess of a one-piece flow through a man-
ufacturing process” represents inventory waste. This has caused many lean
practitioners to arbitrarily reduce lot sizes before they design a lot sizing
formula or sufficiently reduce setup cost.
The above quotations relate to manufacturers who are currently uti-
lizing mass production and desire to apply lean concepts to convert to a
continuous-flow process. I will clarify this confusion as I show you how to
apply lean concepts to businesses like yours, which are forced to manufac-
ture components and assemble products in job shop lots ahead of the receipt
of a specific customer order.
Another quote from the lean Web site states, “Pull systems are cus-
tomer order driven production schedules based on actual demand and con-
sumption rather than forecasting.” This has caused some lean practitioners
to decide that material requirements planning or other push systems should
be eliminated for all components.
The fact is, if a component has a longer purchasing or manufacturing
lead time than the customer order lead time you promise to customers, that
component requires some method to predict its future usage so it can be
ordered before the customer order is received.
Reducing lot sizes and lead time, and using pull systems based on
actual customer orders are very good lean concepts and should be applied
to as many purchase orders and shop orders as possible, particularly in
assembly operations.
146 Chapter Ten

Lean Quick Changeover

Quick changeover as presented in traditional lean courses is primarily
focused on changing a mass production line or continuous-flow line from
one product to another. Since my audience here is small- to medium-sized
manufacturers who aren’t currently using mass production, my description
of lean quick changeover for setup time reduction will focus on applying
lean methods to your setup cost (and time) reduction projects. Remember
to link the methods described in this section with the principles presented
in the previous sections of this chapter, which speak to setup reduction for
component manufacturing operations.
The changeover improvement process is an organized sequence of
activities that seeks to eliminate the wastes that contribute to excessive
setup time and costs:
• Document all actions* performed during a changeover, including
the teardown of the existing setup and actions required after the
new setup is complete and until the processing dimensions and
specifications are acceptable. Look for other kinds of waste.
• Analyze the detailed information, looking for wastes and their
causes (see Chapter 9). Think about actions that can be done by
people other than the machine operator before, during, and after
the machine setup and changeover activities are completed.
• Implement and experiment with various changes and numbers of
people involved as if they are a NASCAR auto racing team’s pit
crew members.
• Standardize the changes, much as you would in the 5S program for
workplace organization described in Chapter 9.
There are quick changeover financial rewards to be gained as you apply
lean quick changeover concepts.
Increased accuracy and improved quality become more important as
you reduce your setup costs. The reason is because as you reduce setup
costs you are financially justified to reduce your lot sizes. When you reduce
lot sizes, you make more frequent setups (more setups per year). Those of
you who have performed machine setups from bar stock or castings can tes-
tify how difficult it is to complete a setup without having to scrap material

* Italics in this section signify verb/noun combinations that discover additional

team projects.
 Projects to Reduce Setup Cost and Inventory 147

before making the first acceptable part. This is a waste your setup reduction
projects can and must solve.
Decreased costs and increased capacity are issues that relate to setup.
The primary cost you will want to reduce is the total cost for shop order cost
and machine setup cost. You will want to reduce total setup cost (and time)
because that is what financially justifies smaller lot sizes. You also want to
get your capital equipment back into the race as soon as possible at each
setup pit stop because this results in increased manufacturing capacity for
each individual piece of equipment. This is like getting additional capital
equipment and manufacturing capacity without making additional invest-
ment. Financially speaking, net profit increases (from reduced setup, scrap,
depreciation, and inventory carrying costs) and asset investment decreases
(lower inventory and capital investment) resulting in a bigger ROA.
Reduced lead time is a reward for both customer and stockholder. As
you shorten a component’s setup time on one or more operations, you reduce
shop order lead time and decrease stockholder work-in-process inventory
investment. There are other things that reduce lead time much more than
reducing setup time. However, lean quick changeover needs to be given its
share of the financial reward.
More flexible response to customer needs from quick changeover may
have a dramatic impact on helping you respond to your customers’ need for
shorter delivery lead time. Remember, if you have component lead times
that are less than your customer order lead time, and you have reduced
setup cost to less than 10 percent of the total component cost, you will be
more flexible in your response to customers because you will only need to
make components in the quantity shown on customer orders.
Improved on-time delivery, a major customer satisfaction issue, will be
improved by anything that shortens lead time. Though quick changeover
on individual components may have little impact on customer delivery, the
accumulated results from many components will have significant impact.
Since meeting customer delivery promises is so important, every little bit
helps. As we all know, often it is the delay of one component that keeps you
from meeting a delivery date.
Three stages for lean setup reduction are suggested as an organized
way to achieve quick changeover.

Stage #1: Separate Internal and External Setup

Internal setup is changeover that must be performed directly on the equip-
ment used for processing. External setup includes preparation activities that
can be performed for the next order while the equipment is processing a
current order. External setup also includes such things as returning tools
148 Chapter Ten

from the preceding order to their designated locations after the new order
begins being processed.
Develop and implement changeover checklists for every piece of
equipment and each component or component family. A component family
is a group of similar components, using the same or similar material, with
operations on the same piece of equipment, and with operations performed
in the same sequence. You might focus first on those components with the
largest setup cost.
Separate the checklist into actions that comprise internal setup and
those that comprise external setup. For each item on the two checklists, ask
questions such as, What needs to be done? When and where will it be done?
Who needs to do it? How much time will it take? What are the correct pro-
cess settings and can they be partially or completely set externally? and
Have checklists been documented on appropriate paperwork or information
sources so they will be consistently communicated and used?
Document a checklist to clean and inspect tools and fixtures after
completion of each shop order. Have repairs made before the next sched-
uled requirement.

Stage #2: Convert Internal Setup into External Setup

Do this by standardizing the external activities on appropriate documents.
Show a preparation operation and scheduled date on shop order
routers to assure that the raw materials and external activities will be com-
pleted and delivered before the internal setup is scheduled to start. This is
simplified if dedicated tools, fixtures, and raw materials are stored near the
machine or workstation.
Include external process settings, such as dimensions, pressure set-
tings, or temperature settings, on your preparation checklist. Document on
your checklists what, when, and by whom something needs to be done,
including such things as presetting of cutting tools for length and diame-
ter. Many of these things are solved by making capital investments in CNC
machines that provide dedicated pallets with permanently mounted holding
fixtures and a large tool conveyor of permanently dedicated cutting tools
and holders.

Stage #3: Streamline Internal Setup Elements

Do this by paralleling checklist items.
Separate out internal elements to be performed by someone other than
the person who sets the equipment to specific dimensions. Using the time
allowance documented for each internal checklist item, you can determine
how much time the internal person (machine operator) and the external pit
crew will require during the setup pit stop. You can also determine how
 Projects to Reduce Setup Cost and Inventory 149

many internal pit crew members you should assign to complete the internal
setup in the least elapsed clock time.
Other ways to streamline internal changeover are to use visual indi-
cators, quick-set mechanisms, or fixed stops to eliminate the need for
adjustments.

LEAN CELL DESIGN AND

IMPLEMENTATION
Cells don’t care whether they are processing paperwork and information or
are being used to process components or assemble products. Cells should
be applied to paperwork processes as well as machining processes. Contact
a lean trainer to learn more. This section is only an overview of what you
can learn from lean.

Cells for Manufacturing or Paperwork Processing

Traditional lean manufacturing is primarily about converting mass pro-
duction processing islands to a continuous-flow process. The islands have
batches of inventory or batches of paperwork between each island. In a
continuous-flow process, the batch sizes are minimized and the islands are
moved closer together so you can “make one and move one,” resulting in lot
sizes of one. Labor costs, lot sizes, and lead times are drastically reduced.
When the continuous-flow design is completed, there are opportuni-
ties to reduce the lead time and labor even further by designing U-shaped
cells in which two or more employees, as a team, operate several process-
ing steps or several machines.
U-shaped cells can also be applied to paperwork and processes in a
manufacturing, distribution, or service business.
Manufacturers who make components requiring several operations can
view each of the operations for each component as a mini mass production
operation that needs to be converted to continuous flow provided by a cell.
As the many components of a component family are added to the cell, it
can still be viewed as the same continuous-flow process that has many fre-
quent changeovers, as if changing from one product to another. The reason
a cell can be viewed as a continuous process is that after each changeover
all components use the same or similar material, use the same machines,
and perform operations in the same sequence. These same principles apply
to office processes.
I now show a lean five-step process for developing cells, particularly
as it applies to paperwork and information processes. Experiment with
150 Chapter Ten

machines in their current locations. Use paralleling and overlapping to get

an idea of which configuration is best before you actually relocate and
reconfigure your machines into a U-shaped cell. See Chapter 11 (blocks 59
and 60, page 189).

The Lean Five-Step Cell Design Process

This five-step design process provides a procedure to gather data about a
process and analyze it to discover the best cell layout.
In a continuous-flow process, there will be sections of the flow that
better utilize people by consolidating several individual operations into a
cell (a mini continuous-flow process) that allows them to flexibly work as
a team within the cell, sharing activities that make the whole cell more
productive than before.

Step #1: Group Products in a Grid or Spreadsheet

We’ve already discussed the requirements to identify component families
and product families (same or similar raw material, same processing equip-
ment, and same sequence of operations). A sample grid is shown in Figure
9.6, page 126.
• Customer order processing can be looked at as the raw material
for a continuous-flow process for a standard product. Every
operation, department, and piece of equipment within each
department, between customer order receipt and invoicing,
could be included in the total process. Certainly the scheduling
of component purchase orders, component shop orders, and
assembly orders would be important elements. Separate but
similar customer order processing flow could be customer orders
for special products made from standard products, customer
orders for a one-time contract for a unique product, or a
customer order for a product made to a customer’s drawings and
specifications. The paperwork flow for these four possibilities
will likely be so similar that when shown on a grid it will be
clear whether they can be treated as a family. The four possibilities
would be listed on four rows in the first column of the grid. The
departments or equipment or operations, in their flow sequence,
would be the headings for the other columns. By placing an “X”
under each of the columns that matches with the appropriate
row, you can begin to get a picture of how many rows can be
brought into one cell. In addition to deciding which rows can
be in the same family, you are also looking for columns that
might be pulled together into a U-shaped cell.
 Projects to Reduce Setup Cost and Inventory 151

• A service business or a manufacturer’s branch office can use

the same grid process for the various kinds of customers who
phone, e-mail, or walk in the door for service.
• Component manufacturing areas can use a grid with many rows
to list component names and part numbers. The columns would be
used to list equipment names, types, or machine numbers for the
various operations.

Step #2: Do the Arithmetic

For each row and product family you need to know how much is coming
into each row (quantity of customer orders for a given time period, rate at
which customers come in the door, quantity of components or machine-
hours for a given time period) so you can compare it to the daily, weekly, or
monthly availability of time from each column or the columns in total:
• Customer orders, as an example, might flow into your business
at a rate of 50 orders per day. To convert the customer orders
into component purchase orders and shop orders may require
25 hours per day total by personnel in various departments.
Therefore, the unit processing rate (lean uses the phrase takt
time) is .5 hours per customer order (25 orders per day ÷ 50 hours
per day = .5 hours per customer order). This departmentalized
approach may use up three to five calendar days before purchase
orders and shop orders are released. However, if you have a
cell composed of a maximum of three people, you could easily
reduce the calendar time to one day maximum. And, depending
on the minimum batch sizes you can arrange for your cell to
receive, your order processing time should range between 30
minutes and a few hours. With creativity and automation, the
30 minutes should be further reduced as a cost reduction to
require fewer people in the cell.
• Service businesses or branch offices, where the customer is
involved in processing time, can make the same calculation to
shrink the processing time and batch sizes. When customers are
involved, by phone or walking in the door, you are interested in
the average rate at which customers make contact, such as one
every 10 minutes or six per hour. If it takes an average of five
minutes to process each customer, there is a low probability that
the waiting time will be significant. However, if the average
processing time is eight minutes, or a range of five to 11 minutes,
there is a higher probability that one or two people will sometimes
be waiting to be served.
152 Chapter Ten

• Component manufacturing opportunities to rationalize the

possibility of a cell require a similar calculation approach. You
will first decide how many shifts or how many hours per day you
must operate the cell for it to pay out financially. A cell will
normally be a multi-shift operation. Since each component in the
cell or component family won’t have exactly the same processing
time for each operation, you may find it easier to simply use your
grid from step #1 and enter the daily, weekly, or annual hours
needed from the cell for each component. This time requirement
is the result of multiplying the run time for each operation for each
component by the component’s usage rate. This will give you the
weekly, monthly, or annual hours needed from the cell for each
component. Then, as you accumulate the cell time, component
by component, you will determine whether you have enough hours
to justify at least one cell.

Step #3: Review the Processing Sequence

You broadly described the process operations by name or equipment in
the step #1 grid. In this step you are breaking each operation down into
its smaller elements to eliminate waste that adds no value to support cus-
tomer satisfaction. Use the same analysis for paperwork and information
processes such as customer orders, service business processes, or compo-
nent manufacturing cells:
• Document and study the sequence of each task the person or
machine performs in each separate operation. Analyze the cell
and the sequence you recorded on your grid. By moving some
operations to a different place in the sequence, you may be able to
combine two or more component families into one.
• Break each operational task down into the smallest observable
elements. For manufacturing parts, challenge the necessity of
design features or close tolerances that add no value. For paperwork
processes, ask whether some actions, such as redundant approvals,
are really required.
• Minimize the non-value-added elements. Identify which of
the elements are non-value-added elements. Eliminate those
wastes on which your project team can reach consensus.
• Refine the cell’s capacity by reducing the times recorded on the
grid for non-value-added elements that have been eliminated.
Also be sure that every line has an estimate for the number of
changeovers each year based on the best estimate of lot sizes
 Projects to Reduce Setup Cost and Inventory 153

calculated by a financially sound lot sizing formula. Also,

estimate a time period for scheduling preventive maintenance
for the cell equipment.

Step #4: Combine Operations to Balance a Process

In step #2, you looked at ways to arithmetically relate the work flowing into
each paperwork or manufacturing process (such as 50 customer orders per
day) with the work time available (such as 25 hours per week) to determine
the processing rate (such as .5 hours per customer order).
The total processing time is made up of highly variable times for each
operation in the total process. The longest operation may take five times as
many minutes as the shortest operation. This variation isn’t a big problem in
a cell where the operations are done by hand by people. However, in man-
ufacturing cells where operations are performed by machines, it requires
more thought and creativity to decide how to combine operations to bal-
ance the process with the number of people required in the cell. For paper-
work or service business cells, your goal is to share the work equally among
the personnel in the cell. For component cells, your goal will be to mini-
mize the work done in the cell with the longest time requirement by mov-
ing the work to a different machine in the cell, and attempt to sequence the
machines next to each other that have the shortest time requirements.
• Customer order processing in many companies is done by
several departments such as sales, inventory control, purchasing,
and production control. Together they consume excessive lead
time. However, if converted into a cell that flexibly combines the
tasks of several departments, and by reducing the batch sizes,
the cycle time for each customer order can be reduced from days
to minutes. It’s only necessary to train the few people in the cell to
do most or all of the tasks so the task times can be broken into
equal parts for the number of people required.
• Service businesses or branch offices include customers as one
of the participants in the process. One goal is to reduce the batch
size of customers waiting in queue to be serviced. The other goal
is to reduce the processing time previously required to process
each customer, or reduce the lead time to do the work performed
for them.
• Component manufacturing families shown on your grid may
have enough operations to require six or seven machines that will
require only two or three people when combined in a U-shaped
cell. If the cell is designed to reduce setup or changeover time,
154 Chapter Ten

batch sizes will be much smaller than before and, internally

within the cell, you will be able to “make one and move one.”
As a result, the cycle time for individual components can be
reduced from days to hours or minutes to help shorten the
lead time and get components to assembly or the shipping dock
daily or hourly.

Step #5: Design and Implement the Cell

Using the facts documented and analyzed in the first four steps, your
project team is ready to bring their knowledge together to implement
the cell. If you want to, your team can cut the lead time it takes to com-
plete the first four steps by dividing the team into three or four leaders of
three or four other project teams to get the first four steps done in weeks
rather than months.
If a cellular project is prioritized by a high ROA when evaluated by the
form in Chapter 5, your company will be ahead of the game if you allow
the teams to concentrate full time to complete these steps in the shortest
lead time. That’s why I suggest you invest in additional personnel if you
expect to quickly double or triple your ROA using lean and the verb/noun
project discovery process.
In this step you want to go back to Chapter 8 to look again at the vari-
ous wastes and their causes to identify wastes you can eliminate. Also, you
will want to review the lean building blocks, also in Chapter 8, for such sub-
jects as point-of-use storage and visual controls.
• Agree about design goals as a team. Use the facts you’ve
gathered to establish cell design goals. This activity will reveal
whether you need to gather additional facts when the team is
having trouble reaching consensus. Test goals as you would test
a new product prototype. Make several U-shaped layouts to see
whether adding one or two extra machines would allow you to
draw additional component families into the cell.
• Simplify the flow using concepts from Chapter 9 under Apply
Value Stream Mapping. Minimize the need for operations that
interrupt one-way flow. Don’t avoid minor interruptions in the
flow if that maximizes the number of hours the cell is used or
allows you to bring additional component families into the cell.
Integrate process operations so that the cell is seen as a single
piece of equipment. For paperwork processes where several
people are operating the cell, your goal should be to make it
appear as if the cell were one person.
 Projects to Reduce Setup Cost and Inventory 155

• Design-in preventive maintenance procedures. Include a

maintenance person on the team during changeover activities.
Train maintenance personnel to assist with preventive maintenance
during changeover pit stops between component shop orders.

SUPPLIER SETUP COST CONTROL AND

REACTING TO PRICE BREAKS
When you get supplier quotes with quantity price breaks, in most cases they
are telling you that they have significant setup cost for that particular com-
ponent. Your first reaction to this information should be to work with that
supplier and insist that they allow you to help them reduce their setup cost.
Your other option is to get quotes from alternative suppliers who will work
with you to reduce setup costs so you and they can reduce lot sizes.
Your obvious reason for building this kind of relationship with your
suppliers is for both of you to understand that they have great control over
your component inventory investment and, therefore, must work with you
to reduce their setup costs and lot sizes. This simply means that with a little
investment in setup cost reduction by you or your supplier, unit prices for
the affected components will also be reduced as soon as the investment is
paid off. This is a place where you will use the project evaluation form in
Chapter 5 to determine whether the investment will increase the ROA.
Put another way, you won’t maximize your ROA if the 20 percent of
your suppliers that supply 80 percent of your components with price breaks
don’t implement projects to reduce their paperwork and manufacturing
lead time and projects to reduce setup costs. They must be required to do
this so they can minimize their in-process inventory investment and your
component inventory investment and pass less than the cost of inflation
on to you.
You must work with suppliers to reduce setup costs, even if you must
invest in tooling to force down their setup costs so lot sizes can be mini-
mized. The results will be a lower unit cost and a lower inventory invest-
ment. Keep this fact in mind as you look for projects to increase your ROA,
because some of your best projects are hidden from your view in your sup-
pliers’ processes.
Here’s a checklist of things you should expect from all your suppliers:
• Increase their prices at a rate lower than inflation
• Follow continuous improvement principles so they can also
increase their ROA year after year
156 Chapter Ten

• Reduce their setup costs so your unit costs will be lower and,
by running smaller lot sizes, your inventory investment will be
much lower
• Have minimum variation in the lead time of each given
component they supply so you won’t have to invest in as much
inventory for safety allowance
• Deliver the full quantity ordered on the day promised
• Follow a documented quality system so they can minimize
dimensional variation and perform inspection and part counts
at their location so that you can eliminate these activities at
your location
• Reduce their ratio of salary and wage costs and overhead costs
divided by sales so they can pass some of the savings on to you

Quantity Price Break Financial Evaluation

Until you and your supplier achieve a significant reduction in their setup
costs, you need a way to separate their setup cost from the price they give
you for each quantity.
You can always justify an EOQ quantity or the quantity from your own
financially sound lot sizing formula.
Remember, a financially sound lot sizing formula, such as the EOQ
formula, is your tool to prove that you have the lowest possible cost for
inventory carrying costs and setup costs in your annual budget and profit
and loss statement. This also means the formula will cause you to maxi-
mize your net profit.
Therefore, when a supplier gives you a quantity price break, your first
action should be to determine the dollar value of the setup cost in each of
the price breaks. If you have a good working relationship with the supplier,
you can ask them to tell you the dollar value of the setup cost in each quan-
tity. The reason you need the setup cost on each individual component with
a price break is so you can compare it with other projects to reduce setup
cost on other specific components and decide which project will improve
the ROA most, using the project evaluation form in Chapter 5.
This is going to look like a lot of work. However, the math is simple
and a computer can make these calculations on a moment’s notice and store
them until one of the values changes. If you’re serious about selecting the
right lot sizes so that you will maximize net profit and ROA, you just have
to accept that this is a necessary process.
 Projects to Reduce Setup Cost and Inventory 157

Let’s assume a supplier provides you with the following price break
schedule for a particular component:

Quantity Price
10 $150
20 $100
25 $90
50 $70
100 $60
200 $55
250 $54

You are always financially justified to buy an EOQ if you have all the
required values to insert into the formula. For annual usage the EOQ
formula is:
2 × Setup cost × Annual usage rate
EOQ =
Inventory carrying percent × Unit cost

For this particular part, assume that the annual usage rate is 200 per year
and that you have calculated your inventory carrying cost and found it to
be 20 percent. However, you can’t calculate the correct lot size because you
don’t know which quantity and price to pick. Therefore, if your suppliers
won’t or can’t tell you the setup cost, you must calculate it for them. To cal-
culate the setup and run costs requires you to solve a simultaneous equation
like the ones you should have learned in math or algebra classes.
The equation you will use is:
Setup $ + Price break quantity × Run $ = Total lot $
For this simultaneous equation solution, use the values from the price break
schedule for quantities of 20 and 25.
In case you don’t remember how to solve a simultaneous equation, here
are the detailed steps you could design into a spreadsheet and let it do the
calculations for every price break quote you receive.
Step 1: Revise the preceding formula to say: Setup $ + Price break quantity
× Run $ = That quantity × Its price.
Step 2: Pick any two price breaks.
Step 3: Enter the values into the step 1 formula for the smaller quantity.
158 Chapter Ten

Setup $ + 20 × Run $ = 20 × $100 Total lot $

or Setup $ + 20 × Run $ = $2000 Total lot $
Step 4: Enter the values into the step 1 formula for the larger quantity.
Setup $ + 25 × Run $ = 25 × 90 Total lot $
or Setup $ + 25 × Run $ = $2250 Total lot $
Step 5: Set up and solve the simultaneous equation by changing the step 3
equation positive values to negative values and placing it beneath the step
4 equation:
Setup $ + 25 × Run $ = $2250 Total lot $
– Setup $ – 20 × Run $ = –$2000 Total lot $
0 5 × Run $ = $250 Difference
The setup dollars become zero, 25 – 20 × Run $ becomes 5 × Run $, and
$2250 – $2000 becomes $250.
Step 6: Move the 5 difference between the two quantities to the other side
of the equals sign.
Run $ = $250 ÷ 5 = $50 Run price
Step 7: Insert the $50 Run price into the step 3 equation and it becomes:
Setup $ + 20 × $50 Run = $2000 Total lot $
Step 8: Reconfigure the step 7 equation so only setup $ is on one side of
the equals sign.
Setup $ = $2000 – 20 × $50
or Setup $ = $2000 – $1000 = $1000
Now we have setup and run values we can insert into the EOQ formula to
make a good judgment about lot size. If the supplier knows what they’re
doing, any pair of the price breaks will give the same answer. If various
pairs don’t give the same answer, that supplier may be just guessing or may
be arbitrarily increasing some of the price breaks so they can make a higher
profit if you happen to select the one that favors them. Start with the price
break that approximates a one-month supply:

2 × $ 1000 × 200
EOQ = = 149
20 % × 90

Next, contact the supplier to get a price break for 150 parts or just calculate
it for yourself:
 Projects to Reduce Setup Cost and Inventory 159

$1000 Setup ÷ 150 = $6.67 + $50 = $56.67

Finally, get with this supplier and decide what you are going to do together
to reduce the lot size and inventory dollars.
Inventory investment $ = 150 ÷ 2 × $56.67 = $4,250.25
The whole reason for taking the time to perform this calculation on each
component that your supplier prices with a price break is to find the lowest
total cost for a component so that you will make the best decision about the
right lot size. It’s just another tool to be sure you know you will make
the highest ROA on each individual component.

DISPOSE OF SURPLUS INVENTORY

Almost every business has money invested in inventory that it will never sell.
Many managers are reluctant to dispose of surplus and obsolete inventory
because in the year it is written off as an expense the net profit for that year
will be lower than desired. However, managers must think of the two other
offsetting financial issues that temper the lower net profit for that year:
• First, the inventory asset investment is lowered by the same
amount as the expense that is written off, tempering the impact
on the ROA.
• Second, all the expenses for the inventory carrying costs listed
in this chapter will be reduced to offset the write-off. If your
inventory carrying percent is 25 percent, for every surplus or
obsolete dollar of inventory you keep you are paying 25 cents
each year just to hold on to it. That means in four years you will
have had expenses equal to the value of that inventory item.
Consider disposing of surplus and obsolete inventory every year, as soon as
it’s obvious that you will not sell it within the next year or two. For some
spare parts components you might be able to justify keeping a seven-year
supply when you make this decision.
It will be almost impossible to avoid having some surplus or obsolete
raw material or finished components.
Surplus usually results from inflated inventories near the end of a com-
pany’s business cycle. You may have been operating for several months at
nearly full capacity when your customers’ sales begin to fall off and they
begin to shut off their orders to you. Meanwhile, the same thing is going
on between them and their customers. You don’t recognize soon enough
that your company business cycle is turning down. Therefore, you don’t
160 Chapter Ten

shut off your shop orders and purchase orders soon enough to avoid an
inventory surplus.
At this point I hope you will ask yourself why you haven’t been moni-
toring your company business cycle, as will be described in Chapter 14.
Surplus inventory implies that the inventory will eventually be con-
sumed when you start getting new customer orders. However, it’s not impos-
sible that you will have several years’ supply on some components or raw
material. If your inventory carrying cost percent is 25 percent, you should
retain less than a four-year supply (100% ÷ 25% = 4). If it is 20 percent,
your retention time would be less than five years.
Obsolete inventory is often a result of product design changes or as a
result of a product being discontinued by you or your customers. You need
an ongoing project that monitors your surplus and obsolete inventory. You
can use the evaluation form in Chapter 5 to calculate the additional expense
and reduced net profit to write off the unnecessary inventory. The proj-
ect evaluation may show, even with the reduced inventory investment, that
this action will negatively impact your ROA for that year. However, it will
certainly increase the ROA for all future years or future business cycles.
The only solution for obsolete inventory is to dispose of it as soon as
possible at the best price you can get for it.
If you have a sizable amount of sales of spare parts, there will be per-
sonnel in your sales or service department who will want to keep several
years’ supply of spare parts items declared to be surplus, particularly if they
are no longer being manufactured. As a rule of thumb, once you have mate-
rial or components in your inventory to service anticipated future customer
demand for spare parts, you should avoid keeping more than a four-year
supply. The reason for this is that it costs about 25 percent of the value of a
part just to hold it in inventory for a year. Therefore, if a quantity of a part
is likely to be in stock more than four years, it would probably be a good
financial decision to dispose of the excess as soon as possible, or sell it at a
very low price to a customer who might be able to use it.
 11
Rationalizing a Material
Control System

I
’ve done two things to make reading this chapter easier for those who
only need an overview of what material control must do to consolidate
the basic elements of shipping customer orders on time, controlling lead
times, controlling lot sizes, and doing all of this at the lowest possible cost.
First, I have summarized several very detailed flowcharts into one flow-
chart that contains the bare essentials about what a material control system
must contain. Second, in the detailed explanations about each block in the
flowcharts, I’ve italicized the few sentences that give a short description of
each block. The fully detailed description is for those material control pro-
fessionals who must make decisions about all the various things a material
control system could and should do.

RATIONALIZING A MATERIAL
CONTROL SYSTEM
Material control and scheduling systems will be most complicated for a
manufacturing business and most simple for a service business. Systems for
distributors fall somewhere in between these extremes. Detailed charts and
formulas are provided to help employees discover whether there are critical
gaps in your material control system that need to be corrected before proj-
ects to reduce lead times and setup costs can be effectively implemented.
The cause of these gaps may be disconnects between the material con-
trol system and accounting or data processing systems. Other gaps may
exist because employees don’t embrace or haven’t been trained in the most
basic inventory and production control principles and formulas.
I will explain the basic material control principles by which you can
plan and schedule for the shortest lead times and determine the most

161
162 Chapter Eleven

profitable lot sizes. All the major ways to double or triple your ROA will
be significantly limited by an incomplete or poorly managed material con-
trol system.
If you are a manufacturer, you need to study this section very thor-
oughly as summarized on the flowchart in Figure 11.1. If you are a distrib-
utor, you will want to look at all of the chart except the part that has to do
with the scheduling and control of manufacturing shop orders. As a service
business, how much of the chart you will need to consider will depend on
those elements that have to do with delivering product or services on time,
how large a purchasing function you require to deliver product to your cus-
tomers, and how much manufacturing you do.
If you have a significant number of weaknesses in your material control
system, you won’t get the maximum ROA improvement from implement-
ing projects generated by any kind of continuous improvement process,
whether you use my approach, the lean manufacturing approach, the Six
Sigma approach, or implementation of a quality system such as ISO 9000.
Before I cover Figure 11.1 in detail, I will cover some basic principles
of material control systems to help you decide how important this chart is
to your business.
Material control financial arithmetic is very important and very simple.
If I hadn’t provided the financial formulas and financial mathematics, you
would have said my claim that you can double or triple your ROA is just
bold bragging. The same applies to my claim that lead time and setup cost
reduction projects can’t be successful with a poor material control system.
The mathematics of material control is just as important as account-
ing and financial mathematics. Many material control professionals don’t
know how to effectively apply financial and material control formulas
to their daily decision making. Even fewer top management or financial
people realize that setting policies about manufacturing and purchasing lot
sizes is a financial decision rather than a material control or manufactur-
ing decision.
My point is, every time you make a decision about a purchase order or
shop order quantity, you are making a high-level financial investment deci-
sion about the size of your component and product inventory investment.
Therefore, this chapter and its four sections are organized around a
small number of material control formulas, the names of the values that go
into them, and an explanation of the principles behind them. Don’t reject
these formulas because they appear to be old-fashioned. I simply use them
to prove that any material control system, no matter how sophisticated,
requires this arithmetic to make financially sound decisions.
 Rationalizing a Material Control System 163

1. Agree on
your material
control goal

2. Customer 4. Cycle 3. Component

order times by processing
lead time product line lead time

6. Items 12. Capacity 23. Calculate 17. Accept

requiring available for component new customer
inventory customer item-by-item orders to fill
orders usage rate remaining
capacity

26. Calculate 37. Calculate 45. Issue 49. Issue

unit cost safety purchase shop order
allowance orders quantity and
due date

30. Determine 38. Determine 48. Expedite 55. Sequence

item-by-item item-by-item item-by-item and schedule
lot sizing reorder timing by safety shop orders
calculation calculation allowance by start date
exceptions
57. Expedite
shop orders
by start date

64. Move
completed
components
and assemblies
to assembly,
warehouse,
or shipping

66. Ship
customer order
on time

68. Evaluate
calculated
controls

73. Calculate
inventory
budget

Figure 11.1 Necessary elements of a material control system.

164 Chapter Eleven

The Ideal Material Control System

The ideal material control system defends against imperfections in sys-
tems used by customers, suppliers, and yourselves. For example, most
small- or medium-sized manufacturers have few processes with negligible
setup or changeover time and few have situations where all components of
an assembly have combined customer order processing, purchasing, and
manufacturing lead times shorter than the delivery lead time customers
will accept.
I provide you with material control arithmetic, formulas, elements of
the formulas, and explanations about control of elements for businesses that
currently have purchasing and manufacturing lead times that are too long,
setup costs that are too high, and customer orders that are shipping too
late. I will show you what I consider to be requirements of an ideal produc-
tion and inventory control system and how to implement projects that make
adjustments to your current system.
Elements of your existing material control system may be working well
to help you minimize stock-outs at low material control costs and at the
lowest possible inventory investment. Use this chapter as a checklist to dis-
cover projects that will help you evaluate your current system. I promise
that you will discover improvements that will increase your ROA.
Much of what I present in this chapter, and presented in Chapters 9
and 10, was gleaned from books written by Robert L. VanDeMark, titled
New Ideas in Materials Management, Inventory Control Techniques, and
Production Control Techniques.
The numbered blocks in the flowcharts in the remaining three sections
of this chapter can be basically divided into three main groups. Descrip-
tions for each block in the chart in Figure 11.1 begin in the next section.
• Blocks 1 through 44 represent an inventory control system
that begins when a customer purchase order is received
and ends when it’s time to issue purchase orders and
shop orders.
• Blocks 45 through 66 represent a production control system
that begins when it’s time for your purchasing function to
release purchase orders for material and purchased components
and when shop orders are released to the production control
function. The production control system ends when a customer
order is shipped.
• Blocks 67 through 76 represent a system to check and evaluate
how well the overall system controls lead times, lot sizes, and
on-time shipment of customer orders.
 Rationalizing a Material Control System 165

IMPROVING INVENTORY CONTROL

The chart in Figure 11.1 is a summary of the other charts in this chapter.
There is much detail in this chapter because material control is a com-
plex practice for businesses that must carry inventory because customers
demand on-time delivery. Keep your system as simple as required to con-
sistently make on-time shipments at the lowest possible cost.
This chapter is primarily designed for sales order processing, inven-
tory control, purchasing, and production control personnel. However, we
will point out places where personnel in other departments impact your
company’s ability to make on-time deliveries at the lowest possible mate-
rial control costs.
Look at Figure 11.1 to see the benchmarks for a complete material con-
trol system. When you recognize that you have a material control problem,
go to the more detailed charts in the remaining sections for answers.
Use the detailed charts as checklists to document the current material
control system. Rationalize the things that interest you and identify projects
that will result in cost reduction or better customer on-time delivery. Decide
what changes can be made, what benefits would result, and what investment
would be required so you can rank your material control project ideas with
other projects.
Don’t worry about a major improvement program as much as improv-
ing the bits and pieces. Likely your current system is serving well. Don’t
destroy the methods you now use. Let your improvements be an evolution
process by considering suggestions I will make as you read the explanation
for each block. We’ll begin with the flowchart in Figure 11.2.

Block 1—Agree on Your Material Control Goal

Customers expect you to provide delivery within a competitive time frame.
Their suppliers, such as your company, with the shortest lead times often
get the sale. Your stockholders realize this fact and expect you to increase
sales levels by providing better lead times than your competition, at a cost
lower than your current cost. A good starting place to improve material
control will be for your company management to agree about your mission.
A short, simple goal might be, “Better customer service at lower cost.”

Block 2—Document Your Customer Order Lead

Time Policy
If your customer expects product delivery the same day as ordered, you
know you must carry inventory at your plant, a branch warehouse, or with
166 Chapter Eleven

1. Agree on your
material control goal

2. Document your customer 3. Calculate item-by-item

order lead time policy and paperwork lead times

4. Document cycle times

by product line

5. Compare cycle times

with customer delivery
lead time policy

6. Determine which
components will require
inventory investment

Figure 11.2 Inventory control system.

a distributor. If you were given six months lead time for standard products,
you would need minimal inventory and could do almost all your purchase
order and shop order scheduling based on customer orders only. Your situ-
ation may be somewhere between these two extremes.
Be sure your personnel who influence paperwork and information lead
time as well as purchased item and shop order lead time know the customer
lead time restrictions under which you must operate. They need to know
the customer lead time restrictions to limit the number of components and
end items for which inventory must be maintained. Your particular mar-
ket has likely determined the maximum customer order delivery time it will
allow and, therefore, forces you to carry some components in inventory. To
get an advantage over your competitors, you must implement projects that
will minimize lead time before your competitor beats you to it.

Block 3—Calculate Item-by-Item and

Paperwork Lead Times
When you receive a customer order, your personnel must get information
about the customer order to the shop and purchasing functions in the short-
est time practical. Therefore, you must document the lead time required for
the flow of information so the required actions are quickly handed off to
purchasing and manufacturing. Then, you need to know the historical lead
time required for purchased and manufactured components on an item-by-
item basis. The most reliable way to get an idea about the lead time for these
 Rationalizing a Material Control System 167

various activities is to measure the time each has been taking in the most
recent past. You’re going to discover that most of the functions are actu-
ally taking more time than is required. Eliminating the difference between
“taking” and “required” for information flow is your first group of mate-
rial control improvement projects.
For the information flow lead time facts, take a sampling of the most
recent customer orders and subtract the order receipt date from the date the
information was received by your inventory control function. If this isn’t
less than one calendar day, break this part of the lead time into controllable
pieces. Next, sample information flow from the inventory control function
to the issuing of all the purchase orders and shop orders triggered by cus-
tomer orders. If these lead times aren’t reasonably short, you have found
some more improvement projects.
For component lead times, make the calculation item-by-item for every
component. To complete blocks 4, 5, and 6, sampling will be adequate.
However, when your system analysis gets to blocks 24 and 49, you will need
to calculate the lead time for every component you buy or make. Your most
reliable way to keep item-by-item lead times up to date is to maintain a
record of the last three receipts for all purchase orders and shop orders. For
most inventory control purposes, the recent past is the best predictor of the
future. This calculation will gradually adjust lead times downward as you
implement projects to reduce purchasing and manufacturing lead times.

Block 4—Document Cycle Times by Product Line

Figure 9.1, page 100 shows you a pattern you can use to create a cycle time
chart so you can graphically illustrate the mismatch between your cus-
tomer and manufacturing lead times. This is a necessary step in identifying
specifically which end items and components you must maintain in inven-
tory to consistently meet customer delivery date promises.
A cycle time chart shows the accumulated paperwork, purchasing,
and manufacturing lead times drawn on an exploded material list. The
list shows each component in an assembled end item along with the raw
materials and/or subassemblies. A cycle time chart should be made for a
typical model in each product line. In some cases, there are some common
components in each product line.

Block 5—Compare Cycle Time with Customer

Delivery Lead Time Policy
After the lead times are drawn horizontally on the charts in the appropri-
ate sequence, the lead time that must be promised to customers is drawn as
168 Chapter Eleven

a vertical line. Any assembly, subassembly, raw material, or component

whose lead time is to the right of the vertical customer lead time line will
require an investment in inventory if you expect to consistently make
on-time customer deliveries.

Block 6—Determine Which Components Will

Require Inventory Investment
A cycle time chart will serve as a powerful motivator for personnel in charge
of information regarding purchase order and shop order flow to implement
projects that will dramatically reduce the accumulated lead times for all
of the items shown on the chart list. Then, coupled with reduced setup cost
for purchased and manufactured items, you will start seeing a significant
reduction in your inventory investment.
Update the chart every year to dramatize the “before and after” prog-
ress your project teams are making.

Block 7—Calculate End Item Usage Rate

by Product Line
In block 3, to predict future lead time, I said the most reliable information
is found in the most recent lead time history. I say the same for predict-
ing future usage for end items. By knowing your end item usage, you can
do a better job of deciding on your manufacturing capacity for accepting
new customer orders in blocks 8 and 12, for component reorder timing, and
for calculating lot sizes (see Figure 11.3). If most customer orders are for
customized products, you may have to use man-hours or machine-hours to
decide when you exceed your capacity for a future time period.
Most sales forecasts show a smooth month-to-month demand on an
annual basis and may even predict seasonal demand if that is normal for
your business. Sales forecasts are usually more optimistic than your most
recent history. They should only be looked at as a guide.
Since actual demand for each end item tends to be erratic, monitor your
end item usage each month, based on the most recent time period. This is
a good starting place and will help material control see trends or normal
seasonal expectations.
If you have accurate data about equipment-hours for each product, you
may have a starting place to get a feel for when in any given week or month
you should not schedule any additional orders. You may also look at your
most recent peak business cycle to get a feel for maximum capacity levels
that might be achieved again by adding man-hours to existing equipment.
 Rationalizing a Material Control System 169

7. Calculate end item

usage rate by product line

8. Calculate manufacturing 9. Classify equipment

capacity by utilization rate

10. Estimate percent

allowance for preventive
maintenance

11. Consider capacity

allowance for rush orders
and specials

12. Calculate capacity

available for normal
customer orders

Figure 11.3 Inventory control system.

Block 8—Calculate Manufacturing Capacity

Manufacturing capacity is defined by processing bottlenecks. Capacity is
a pipeline with departments or machines that have various diameters. The
smallest diameter determines your capacity to accept customer orders. To
improve the odds that you won’t accept more customer orders than you
have machine-hours, consider relating machine-hour requirements for each
end item to the usage of each end item from block 7. You divide the annual
usage for each component by the number of shop orders for each compo-
nent to estimate machine setup hours. With this data, you can get a feel in
advance for when to expand bottlenecks to help make on-time delivery.

Block 9—Classify Equipment by Utilization Rate

By using the facts from block 8, or a sampling method as in blocks 61 and
62, identify existing and potential bottlenecks by monitoring the increase in
the utilization percent for each machine. It will be obvious which machines
have low utilization rates and are candidates to be sold to reduce capital
investment.
170 Chapter Eleven

Block 10—Estimate Percent Allowance for

Preventive Maintenance
Preventive maintenance to control process capability is important to connect
product design with process design. Product designers must not design-in
tolerances that exceed the capability of the machine or process. Preven-
tive maintenance is the function that maintains or improves the capability
of the machine to hold design tolerances consistently. You will be wise to
rationally set aside a certain percent of a machine’s capacity for preven-
tive maintenance.

Block 11—Consider Capacity Allowance for Rush

Orders and Specials
I include this as a consideration if your real world has customers or sales
staff who thrive on this kind of excitement. It’s not fair to your customers
who plan well enough to avoid it. Set a little time aside so you don’t add to
the problem by delaying other customer orders when you have to run in a
rush order.

Block 12—Calculate Capacity Available for Normal

Customer Orders
You may already be doing blocks 7 through 11, or something like them.
Keep blocks 7 through 11 in mind if your customer order scheduling or
your product lines get more complicated.

12. Calculate capacity

available for normal
customer orders

13. Maintain a master 14. Adjust master 15. Review the

plan for scheduling plan with sales master plan
customer orders forecast monthly

16. Document
customer orders
on hand

17. Accept new

customer orders to fill
remaining capacity

Figure 11.4 Inventory control system.

 Rationalizing a Material Control System 171

Block 13—Maintain a Master Plan for Scheduling

Customer Orders

Planning is the least expensive form of control. Your master plan is the
time and quantity coordinator for all company operations. I recommend
some form of master planning that will accurately connect your accep-
tance of future customer orders with your current manufacturing capacity
plan. Review the plan monthly with key sales and management personnel
to make adjustment up or down based on the most recent usage or known
future demand. The time period covered by the master plan should be
slightly longer than the cycle time from block 4 for each of your product
lines. The individual time periods shown on your master plan should be in
the days, weeks, or months you use to make delivery promises.
The quantities should be broken down by product line or models within
each product line. A master plan should be a communications and disci-
pline tool between sales and manufacturing. Much expediting expense will
be eliminated by this tool and blocks 48 and 57.

Block 14—Adjust Master Plan with Sales Forecast

As mentioned in block 7, use sales forecasts as guides to make adjustments

to the master plan. Use the most recent usage over a cycle time period to
make initial estimates for future usage. Make adjustments in consultation
with a key sales person.

Block 15—Review the Master Plan Monthly

A master plan establishes customer delivery promises for future time peri-
ods for each product line. It isn’t only a guide for customer shipping prom-
ises. It also serves as the guide for capacity improvement as sales trend
upward. Since business conditions often change quickly, the master plan
must be reviewed monthly by key planning personnel. The monthly review
also forces planners to evaluate material control system performance each
month by counting the number of past due orders so additional capacity can
be added as required.

Block 16—Document Customer Orders on Hand

If the master plan covers a complete cycle time for each product line, on any
given day you will have some accepted customer orders scheduled for some
or all of the future time periods.
172 Chapter Eleven

Block 17—Accept New Customer Orders to Fill

Remaining Capacity
You’re now ready to start filling your planned capacity by making
delivery date promises for customer orders based on the remaining avail-
able capacity.

Block 18—Maintain Inventory Close to Customers

Proximity to customers is measured in minutes, hours, days, or weeks (see
Figure 11.5). It can also be measured by shipping time from the plant to the
customer. If competition requires it, or you desire to increase sales, you may
move it closer by setting up branch warehouses or get distributors to carry
an inventory. If you must maintain branch inventories, I will suggest, in
block 35, a visual reorder method you can utilize to know when to reorder.

Block 19—Decide on End Item Reorder Method

This block primarily relates to blocks 20 through 22. You won’t need blocks
20 and 21 unless forced by customers to deliver assembled end items from
the plant on short notice. If components are carried in inventory, stock-
ing for quick delivery will depend on assembly lead time and daily usage

6. Determine which
components will require
inventory investment

18. Maintain inventory 19. Decide on end item

close to customers reorder method

20. Process new

plant stock orders

21. Process new

branch orders

22. Process new

customer orders

17. Accept new

customer orders to fill
remaining capacity

Figure 11.5 Inventory control system.

 Rationalizing a Material Control System 173

demand. Visual bin reserve methods can be used, or detailed perpetual

inventory records may be required to cover for components requiring long
lead times.
These blocks dramatize the conflict between pull material control
systems, preferred by lean, and the MRP push methods you may be using.

Blocks 20, 21, and 22—Process New Plant

Stock Orders, New Branch Orders, and New
Customer Orders
All new customer orders, branch orders, or plant stock orders should be
given equal priority because each is intended to get your product as close to
the customer as you decided was necessary in block 18.

Block 23—Calculate Component Item-by-Item

Usage Rate
By dividing the most recent one or two lot sizes of each component (block
24) by the period of time it took to consume it (block 25), you will have
a weekly or monthly usage rate that you will use to determine lot sizes in
block 30 and reorder timing in block 38. See Figure 11.6.

23. Calculate
component item-by-
item usage rate

24. Select the most 25. Select the lot

recent lot size size time period

26. Calculate 30. Determine

component unit cost item-by-item lot
sizing calculation
27. Calculate inventory
carrying cost percent

28. Calculate
setup cost

29. Consider
component family
setup costs

Figure 11.6 Inventory control system.

174 Chapter Eleven

Blocks 24 and 25—Select the Most Recent Lot

Size and Lot Size Time Period
You’re now ready to explode the master plan and firm customer orders
into the components required for product assembly. Item-by-item usage is
needed to determine quantities and timing for purchase orders and shop
orders released by blocks 45 and 49. Our suggestion for estimating future
usage requires the combination of blocks 23, 24, and 25.
In block 7, I told you that the most reliable way to predict future usage
is to start with history for the most recent past. You must decide how far
back into the recent past to look. You can get the best usage quantity by
going no further back into history than the period of time it took to con-
sume the last one or two lot sizes. The lot sizes will be good for determining
usage only if they are determined by some financially logical calculation
similar to block 30.

Block 26—Calculate Component Unit Cost

Unit cost for each component is required to calculate the lot sizing cost
in block 30 and to classify components in block 32. Our definition of unit
cost is the total material, direct labor, and manufacturing overhead cost
of components, including equipment setup or changeover, as the compo-
nents go into stock or assembly. It may be the same cost your accountant
uses for cost accounting.

Block 27—Calculate Inventory Carrying Cost Percent

Blocks 26 through 29 are the ingredients for the lot sizing formula in block
30. In Chapter 10, I showed the costs for carrying inventory and the inven-
tory carrying percent.
Inventory carrying costs are expenses that are hidden in a financial
budget and P&L statement. These are expenses that components accumu-
late when they are held in inventory. Expenses such as depreciation, obso-
lescence, borrowing cost, storage area costs, taxes and insurance for both
property and inventory, and a small amount of material handling attach
themselves to each inventory item waiting to go into an assembly or to be
shipped to a customer, branch, or distributor.
These costs will automatically drop from budget expenses as you
reduce component setup time and cost, and as you reduce lead times. This
should motivate you to aggressively initiate projects that will reduce setup
costs and lead times when you study Chapter 10.
 Rationalizing a Material Control System 175

Block 28—Calculate Setup Cost

Purchased component setup cost is the cost of processing and receiving
each purchase order. For shop orders, it is a combination of the cost to
process, schedule, and control each shop order plus the cost of the time
required to set up equipment between shop orders. The calculation of these
costs is covered in Chapter 10.

Block 29—Consider Component Family Setup Costs

If you have components that fit into families because they look alike and
have very similar processing operations, you can cut the lot sizes in half,
rather than processing them in separate setups. For cellular manufactur-
ing, see Chapter 10.

Block 30—Determine Item-by-Item Lot

Sizing Calculation
In Chapter 10, I proved that you need to calculate a lot size for all compo-
nents until their setup cost, from block 28, is less than 10 percent of the
component’s unit cost from block 26.
Common sense tells you not to make just one or two parts at a time if
your machine setup time is several hours and the current unit cost is only
a few dollars. The result of arbitrarily setting small lot sizes for compo-
nents that require considerable setup time is an excessively high unit cost.
Common sense and experience also tell you that your unit cost will be low-
est when you run larger lot sizes. In between these two extremes is an opti-
mum quantity that will give you the lowest total cost for setup cost and
inventory carrying cost.
Remember, lot sizing is a financial decision that must be governed
by a formula used by material control personnel and approved by top-
level financial managers. Setup costs should determine lot sizes because
lot sizes determine the investment for component inventory.

Block 31—Calculate Usage Value for

Each Component
Usage value is equal to a component’s unit cost times its usage rate per
month or annually. Usage value is only important when it is compared to
the usage value for all other components for which inventory is required.
See Figure 11.7. The combination of a high-cost component with a very
176 Chapter Eleven

23. Calculate
component item-by-
item usage rate

31. Calculate usage 32. Classify 33. Determine

value for each components by item-by-item
component usage value control option

34. Set up perpetual

inventory controls

35. Set up bin

reserve visual
inventory records

Figure 11.7 Inventory control system.

high usage rate will result in a high usage value. These are items you
will want to control very carefully because they represent the 20 percent
of the components that make up 80 percent of the inventory investment.
Conversely, your components with low usage values are the 80 percent that
represent 20 percent of your total inventory investment and can be con-
trolled by less expensive methods.

Block 32—Classify Components by Usage Value

Divide components into at least three (ABC classification) or four (ABCD
classification) categories, depending on the different levels of control you
believe will yield the lowest material control costs. If you calculate by
computer you can know the usage value for every component and arrange
them in order from the largest usage value to the smallest. With this data
you can classify components into ABC or ABCD groups. The percent of
components or the percent of total usage value in each group is arbitrary.
Experiment with various combinations until common sense makes the
decision for you.
For ABC classification, you might settle for combinations with “A”
classification to be 70 percent of the total usage value representing 15
percent of the components. For “B” classification it could be 20 percent of
usage value representing 30 percent of components. For “C” classification
it could 10 percent of usage value for the remaining 55 percent of compo-
nents. For ABCD classification, break the groups into smaller percents if
you want a greater variety of control options.
 Rationalizing a Material Control System 177

Block 33—Determine Item-by-Item Control Option

Inventory control is item-by-item control to assure that you will deliver cus-
tomer orders on the promised date. Let’s look at options by which you can
use item-by-item classification to lower your costs and investment.
The variables you can use to determine your ABC control options are
lot size (block 30), safety allowance (block 37), and record keeping method
(blocks 34 and 35).
Using a financially sound lot sizing formula, as proposed in block 30,
lot sizes will automatically tell you to look more frequently at the 20 percent
of your items that make up 80 percent of the inventory investment. View
lot sizes as the number of months’ supply rather than a specific quantity.
A good lot sizing formula will tell you to make your highest usage/highest
cost items more frequently.
For “A” class components, you automatically review the major part
of the inventory investment more frequently. Because of the short reorder
frequency, you might decide to minimize your safety allowance inventory
investment. On an exception basis, expedite when the on-hand quantity
reaches one-half the safety allowance. You should maintain control using
perpetual or computer records.
For “B” class components, the lot size will also control reorder fre-
quency. You can use the full calculated safety allowance to expedite by
reporting exceptions when the on-hand quantity reaches the safety allow-
ance. Maintain perpetual or computer records.
For “C” class items consider visual controls such as a manual bin
reserve system rather than computer records. In visual control systems you
relate the lot sizing calculation with usage values and arbitrarily assign lot
sizes as a number of months’ supply up to a maximum of 12 months’ supply
for very low usage value “D” class components. You can double the safety
allowance without greatly increasing the inventory investment. This can be
the 55 percent of your components that account for only 10 percent of your
component inventory investment.

Blocks 34 and 35—Perpetual Inventory Controls

versus Visual Inventory Controls
These blocks connect with block 33 because at this point you evaluate
whether you have the lowest-cost system to determine lot sizes and reorder-
ing of components that must be carried in inventory (blocks 30 and 38). Use
blocks 32 and 33 to make your item-by-item decisions for each component
in block 38. See Figure 11.8.
178 Chapter Eleven

3. Calculate item-by-
item and paperwork
lead times

36. Calculate erratic

lead time and
erratic usage percent

23. Calculate 37. Calculate safety

component item-by- allowance
item usage rate

38. Determine
item-by-item reorder
timing calculations

39. Set required

order due date

Figure 11.8 Inventory control system.

Block 36—Calculate Erratic Lead Time and

Erratic Usage Percent
If you must carry a component in inventory, you need a rational way to cal-
culate a safety allowance for it. Safety allowances are required because the
usage rate and lead time for a given component varies from one purchase
order or shop order to the next. With no safety allowance for components,
you will miss many customer delivery dates. Safety allowance becomes a
permanent investment that must be reduced by shorter and more consistent
lead times for both purchase orders and shop orders.
You need a percent by which to multiply a component’s usage rate to
obtain a reasonable quantity that will act as a cushion when the lead time is
longer than average and/or when the usage rate is significantly increased or
decreased by actual customer demand. A large percent will be your signal
to initiate projects to shorten lead times and make them more consistent
from order to order.
I recommend that you start with a percent based on the following for-
mula to cover both erratic lead time and erratic usage. You can adjust it up
or down based on your system evaluation as described in blocks 68 through
71. I recommend that you use as the lead time the three most recent lead
times from purchase orders or shop orders for each component.
 Rationalizing a Material Control System 179

Maximum lead time − Averag e lead time

Safety allowance % =
Average lead time

This percent will likely range between 15 percent and 50 percent.

Block 37—Calculate Safety Allowance

My suggested safety allowance formula is as follows and must be calcu-
lated item-by-item each time it is reordered:
Safety allowance quantity = Usage rate × Safety allowance %

Block 38—Determine Item-by-Item Reorder

Timing Calculations
Normally you will want to release a new purchase order or shop order for
a component when there is just enough material on hand to last until a new
customer order is received. The suggested formula below uses information
from blocks 23, 3, and 37.
Reorder quantity = (Usage rate × Lead time) + Safety allowance
If you didn’t have the cycle time problem described in block 4 and Chapter
9, you could wait to release new orders based on actual customer orders.
However, you have to face the reality of needing to issue these new orders
before you actually receive your customer purchase orders.
Neither your usage rate nor your lead times can be relied on to
be exactly right. That’s why I believe your most reliable estimate of the
future will come from the most recent past as described in blocks 3 and 23.
The better your estimates, the better you can gamble that you will minimize
your inventory investment and meet customer delivery dates. Then, since you
know that your estimates for usage rate and lead time for each component
are going to be wrong, you will want to add a safety allowance.
Gambling isn’t a consistently profitable activity in either a business or
the most colorful casino you can imagine.
Relatively small investments in safety allowance will create large
decreases in stock-out rates. As you keep increasing the safety allowance,
there is a point between five percent and one percent stock-out rate where
the safety allowance investment becomes prohibitive. I give you this warn-
ing so you won’t expect more from a material control system than it is statis-
tically able to deliver. Just evaluate your controls, using block 68, and make
logical changes in the formulas to improve future system performance.
180 Chapter Eleven

Block 39—Set Required Order Due Date

This is the simple calculation of adding lead time to the reorder date to
inform purchasing or production control when an order must be delivered
to the warehouse, assembly, or shipping to assure that customer delivery
promises will be met. Along with due date, the inventory control function
also communicates the order quantity authorized by block 30.

Block 40—Adjust Component Usage Exceptions

Upward Based on Actual Customer Orders
The only reason I include this block is to recognize the possibility that
actual customer orders might introduce an unusual demand pattern such
that, using our recommended method of calculating usage rate, you would
not reliably ship customer orders as promised. Just look for these exceptions
and make usage rate adjustments as appropriate. See Figure 11.9. Generally
speaking, you should trust the usage rate from block 23 to make lot size and
order timing decisions.

Blocks 41 and 42—Maintain On-Hand Quantity

Accuracy and Determine Auditing Method
Be sure on-hand quantities for components are correct. You must do an
annual physical inventory and/or systematic cycle counting. The point is, to
make on-time delivery, your on-hand quantity records must be accurate.
See Figure 11.10.

Blocks 43 and 44—Physical Inventory versus

Cycle Counts
From my experience, for both accounting and material control, physi-
cal inventorying creates as many on-hand quantity errors as it corrects. I
believe systematic cycle counting is more accurate for both functions.
Also, by doing cycle counting your manufacturing operations aren’t shut
down for the time required to do the annual physical count. Cycle counting
improves capital asset utilization and yields a small ROA increase.
The best time to take an inventory count is each time a component
reaches its reorder quantity (block 38). One reason this method is best is
because you have a chance to delay a new order if the actual quantity
is greater than the record. If the actual quantity is less than the record, it
gives you a chance to expedite the new order at the earliest possible moment.
Another reason is because the frequency of counting is automatically regu-
lated to count items based on their usage value calculated in block 31. This
 Rationalizing a Material Control System 181

17. Accept new

customer orders to fill
remaining capacity

40. Adjust component

usage exceptions
upward based on
actual customer orders

30. Determine 38. Determine

item-by-item lot item-by-item reorder
sizing calculation timing calculations

Figure 11.9 Inventory control system.

41. Maintain on-hand

quantity accuracy

42. Determine
auditing method

43. Utilize physical 44. Utilize cycle

inventory counts

Figure 11.10 Inventory control system.

means items that impact the inventory investment and customer service
the most are counted most often and those items with the least impact are
counted less often.
Be sure to consider paperwork cutoff times when you do cycle count-
ing. The best time to take your cycle counts is at the beginning or end of
each day, in concert with when computer transactions are made.
If the above method isn’t acceptable to you, you can count in blocks
of parts using the classification from block 32 to control frequency. Or you
can count the on-hand quantity each time a new order is received to stock.
This is the least expensive way to correct your records but it happens too
late to delay or expedite a new order.

PRODUCTION CONTROL
IMPROVEMENT
Use blocks 45 through 66 in these charts as a checklist to document your pro-
duction control system. Rationalize the things that interest you and identify
projects that will yield cost reductions or better customer on-time delivery.
182 Chapter Eleven

Block 45—Issue Purchase Order Quantity

and Due Date
Responsibility for purchased components is relayed from inventory con-
trol to purchasing. See Figure 11.11. If supplier lead times are greater than
calculated by block 3, buyers will need to start expediting the order imme-
diately. If a supplier isn’t able to meet the lead time requirement, communi-
cate this to customers if no other solution is available.

Block 46—Consider Price Break Quantities

Reorder requirements for a part for which a supplier offers price breaks
should trigger two actions. The reason these price breaks exist is because
suppliers have large setup costs for some components.
Trigger an improvement project to help a supplier lower setup costs so the
lot size can be smaller. Then, determine which price break will give you
the lowest total setup cost plus inventory carrying cost. See Chapter 10.
I suggest that your purchasing function list the purchased compo-
nents that offer price breaks and document what they do when they make a
reorder decision. If your buyers have been given goals to reduce unit cost,
you may be surprised that they are making decisions to exceed the autho-
rized lot size to the detriment of the lowest-cost buying decision. Selecting
lot sizes is a financial decision that must be governed by lot sizing calcula-
tions authorized by top-level managers.

Block 47—Authorize Blanket Order Releases

If you utilize blanket purchase orders, I recommend you have a clear policy
about the release of quantities. Your policy should dictate that blanket order
releases be in authorized lot size quantities.

45. Issue purchase

order quantity and
due date

46. Consider price 47. Authorize blanket

break quantities order releases

48. Expedite
item-by-item by safety
allowance exceptions

Figure 11.11 Production control system.

 Rationalizing a Material Control System 183

Block 48—Expedite Item-by-Item by Safety

Allowance Exceptions
When most material control and sales personnel talk about expediting,
they’re talking about activities performed when a customer delivery date is
going to be missed and purchase orders or shop orders for components have
missed a due date. Too often actions are taken to run a behind-schedule
order in ahead of another. This never solves the problem. It just causes other
customer delivery dates to be missed.
I want to help your company get out of the expediting business.
Expediting occurs because sales has promised a customer order in less
time than is allowed by your company policy and your master plan or
because your material control system hasn’t performed as I’ve laid out in
these flowcharts.
Most expediting is done too late to fix the problem that caused the
delay. Blocks 55 and 57 show how to expedite shop orders by start date.
For purchased parts, you must take action as soon as the on-hand quantity
reaches 50 percent to 100 percent of the safety allowance quantity.

Block 49—Issue Shop Order Quantity

and Due Date
This is when shop orders for manufactured components are relayed by
inventory control to production control. See Figure 11.12.

Blocks 50 and 51—Consider Seasonal Load Leveling

and Business Cycle Load Leveling
You may need to practice shop load leveling because you have seasonal
demand or because you want to purposely invest in inventory just ahead
of the business cycle, before you run out of capacity because of process-
ing bottlenecks. You may prove, by using the project evaluation form in
Chapter 5, that the annual ROA will be higher if some short-term inventory
investment, just ahead of the seasonal demand or just ahead of the business
cycle peak, will result in a higher ROA than the investment in capital equip-
ment to meet the peak seasonal capacity demand. To do this you simply add
quantities for the necessary components and/or end items to appropriate
time periods in your master plan for bottleneck processes.
At one point in each business cycle there’s an opportunity to get ahead
of competitors by adding some inventory investment in anticipation of sig-
nificant increases in sales demand. As with seasonal planning, you have
an opportunity to capture sales from your competitors if they’re not as
184 Chapter Eleven

49. Issue shop order

quantity and due date

50. Consider seasonal 51. Consider business

load leveling cycle load leveling

3. Calculate item-by-
item lead time

52. Calculate 53. Provide machine-

machine-by-machine by-machine routers
queue times for each component

54. Calculate start

dates for each
operation

55. Sequence and

schedule component
and assembly shop
orders by start date

Figure 11.12 Production control system.

well prepared as you are. And, you might meet demand with lower capital
investment during the peak of the business cycle from year to year.

Block 52—Calculate Machine-by-Machine

Queue Times
Inventory control is item-by-item control and production control is machine-
by-machine control. The best way to control shop orders is by start dates
for the most heavily loaded machines, as explained in blocks 54 and 55.
Continuous operations or manufacturing cells have no queue time between
processing operations. Queue time is the time a batch of components waits
between processing operations. More than one shop order waiting in queue
ahead of each machine is a signal that some blocks, up to block 64, are
missing or are not being executed properly. Keep queue times as short as
practical because excess queue time causes excess shop order lead time,
and excess lead time creates excess investment in in-process inventory.
Lead time = (Lot size × Run time) + Setup time + Queue time
You work back from the shop order due date to get the start date for each
operation.
 Rationalizing a Material Control System 185

Block 53—Provide Machine-by-Machine Routers for

Each Component
A document is needed to show each process operation in sequence, start-
ing with raw material issue and any setup preparation that can be done prior
to the beginning of the next operation. For each operation, the router must
show machine number, setup time and run time, operation instructions,
and special tooling. For production control scheduling purposes, you’re
primarily interested in operation sequence, machine number, and setup
and run time. For queue time, you’re interested in minimizing the time that
material stands in queue waiting for run time to be applied to the material.

Block 54—Calculate Start Dates for

Each Operation
Inventory control, in block 49, issues shop orders with a calculated lot size
and a required due date based on the queue time, setup time, and run time
for the lot size. The due date is secondary as far as scheduling of component
shop orders is concerned. If you don’t start each operation at the right time,
you know you have no chance of completing the last operation by the shop
order due date set by your inventory control system.
Each date set by a material control system serves a dual purpose. The
due date for raw material becomes the start date for first operation on shop
orders. The due date for a component shop order is the start date for an
assembly order. The assembly completion date becomes the customer ship-
ping date.
The simplest way to assign a start date to a shop order is to take the
historical lead time for that component from block 3 and subtract it from
the shop order due date. You must issue the material and start the first pro-
cessing operation on that date, no sooner and no later. Then, you move shop
orders through all operations with minimum queue time between opera-
tions, assuring that you complete all operations by or before the required
due date.
When you follow this scheduling method, block 3 lead times shrink and
in-process inventory investment will be the lowest it can be until you make
additional lead time reductions from projects generated by Chapter 9.
With this method you expedite machine by machine any day you are
unable to start initial operations on the required start date. Look for oper-
ations with too many shop orders in queue and follow blocks 57 through
60 to add machine-hours. Any other expediting method, such as shuffling
orders or splitting lot sizes, is much more expensive than a little overtime
to get back to start date.
186 Chapter Eleven

A slightly more expensive scheduling method may be required if you

have equipment that you know, from blocks 61 and 62, has high utilization
rates. Generally, these high utilization rates are desirable because it means
you are minimizing capital investment. The advantage to the start date
method is that by looking at the start date for every operation, you can
know on any day where the bottlenecks are forming and can take expedit-
ing action immediately to add hours where required.
If there is a significant difference between the total lead time for a shop
order and its lead time from block 3, you may have discovered a project
opportunity. It may tell you that your database for setup time, run time, or
queue time isn’t accurate. It may be an indicator of how well or how poorly
you are executing your overall scheduling. It might tell you that you’re still
allowing too much lead time and too much inventory investment between
operations.

Block 55(A) —Sequence and Schedule Component

and Assembly Shop Orders by Start Date
Each day, inventory control releases new shop orders to production control.
Supervisors’ jobs are much more pleasant if all they need to do is put the
new orders in start date sequence with the orders released on previous days.
All shop orders are visually displayed so responsible personnel can issue
raw material no sooner and no later than needed. If material isn’t avail-
able you can expedite it. Once material is issued, shop orders are arranged
in start date sequence for initial operations. If these same machines are
routed for secondary operations for other components, they are placed in
the appropriate start date sequence with other operations. This same visual
method can be used for all subsequent operations, particularly those that
require machines with high utilization rates.
This visual method creates an automatic expediting tool to tell you
when to add additional hours to secondary-operation machines. Machines
with utilization rates of 50 percent or less will almost never require expe-
diting because their hours can be easily increased simply by moving a
machine operator as required. With a few minutes each week, top manage-
ment personnel and sales staff can know whether a customer delivery prob-
lem is developing and whether it’s time to take action to expand capacity.
Expediters can be assigned to more productive activities such as continuous
improvement teams.
 Rationalizing a Material Control System 187

Block 55(B) —Sequence and Schedule Assembly Shop

Orders by Start Date
The due dates on component shop orders are the start date for an assembly
order or a shipping date for a customer order. The reason most assembly
orders can’t be started on time is because component shop orders or pur-
chase orders haven’t been received into stock or into assembly by their due
date. If you are managing your material control system well, less than five
percent of your assembly orders should be started later than their start date.
Any percent greater than this means you’ve got a system problem some-
where upstream in the flow.
Take my flowcharts, customize them to fit your company and custom-
ers, and use them as a problem-solving tool to implement projects that will
fix your problems. You don’t need to wait until you start missing customer
delivery dates to know you have a problem.

Block 56—Document Component and Assembly

Shop Order Schedules
You likely have a computer screen or computer report that lists the date and
quantity requirement and status for all purchase orders, shop orders, assembly
orders, and shipping orders. An ideal example would be an assembly sched-
ule that exactly duplicates the master schedule. Another example would be a
component schedule that matches with a cycle time chart. Almost everyone
likes lists and reports that give them status information. See Figure 11.13.
I suggest you evaluate these reports to see if their expense justifies their
existence or if they really tell whether your existing material control system
is performing well. I’ll speak more about system evaluation in blocks 68
through 76.

56. Document
component and
assembly shop
order schedules

57. Expedite shop

orders by start date

58. Schedule 59. Parallel 60. Overlap

overtime individual operations sequential operations

Figure 11.13 Production control system.

188 Chapter Eleven

Block 57—Expedite Shop Orders by Start Date

The way many companies do expediting it isn’t a rational activity, and
much unnecessary expense is expended on it. Expediting is a time issue,
not a quantity issue. You expedite because you’re trying to make up for
lost time.
The only effective way to expedite a shop order is to provide machine-
hours or worker hours equal to the calendar time you are behind in compo-
nent and assembly start dates or customer delivery due dates. Expediting
is a symptom of a scheduling problem. It’s not a cure when one shop
order is moved ahead of another that has also passed its start date. Any
time you have one work order starting later than its planned start date is a
signal that you need to make up schedule time as soon as possible. Either
your manufacturing lead times are longer than you planned, from block 3,
or you don’t have enough manufacturing capacity hours somewhere in the
process flow.
There is one way to correct this problem. Expedite by adding process-
ing hours equal to the number of days any process operation is behind its
scheduled start date.
For example, you can look at shop orders for any work center and add
up the number of processing hours that are behind the current date. That’s
the number of extra hours, for that work center, you must add to get that
work center back on start date schedule. Your basic choices are: work over-
time, add or transfer personnel to a parallel setup on similar equipment,
overlap operations, or farm out these operations.

Block 58—Schedule Overtime

When you have a behind-schedule condition, overtime is a less expensive
method than calling customers to tell them you must reschedule the delivery
date. Late deliveries are expensive for your customer and your customer’s
customers. If done too frequently it’s going to result in lost sales and lower
ROA. Quickly decide to use overtime when no other fast solution is avail-
able to meet a shipping due date.
Overtime is a budget expense you want to minimize. But material
control is a professional gambling business, and I’ve already assured you
that you’re probably going to lose one percent to five percent of the time
even if you execute your system perfectly.
Another alternative to overtime is inventory investment for safety
allowance. Just think of overtime as an alternative way to temporarily
increase capacity.
 Rationalizing a Material Control System 189

Block 59—Parallel Individual Operations

This is when you put more than one piece of equipment or more than
one person on a given operation to temporarily or permanently increase
capacity. Since assembly operations have very low setup costs, adding
people or setting up another line may be a good way to get back on schedule
or increase capacity. The same applies to component shop orders if
the added setup time is less than the overtime expense to get back on start
date schedule.

Block 60—Overlap Sequential Operations

When setup costs are high or there is no available equipment or tooling
for paralleling, consider overlapping to make up lost time or lead time. To
overlap, you start running the next operation before the current operation
is completed. It’s essentially what happens in a manufacturing cell. You
simply set up and start running a subsequent operation before the whole
lot size is completed on the preceding operation. If a component requires
several operations you might gain back one or more days of calendar time.
This method requires no additional setup costs. If setup costs are low, you
can utilize overlapping in conjunction with paralleling. For assembly opera-
tions you might temporarily add some additional subassembly steps.
Since setup plus total run time isn’t the same on each operation, you
need to do a little advance planning so heavily utilized equipment won’t be
sitting idle too long.
Planned overlapping is a good way to experiment with how a manufac-
turing cell (Chapter 10) might work on an individual shop order, or a family
of shop orders, for components that are similar and use the same process-
ing sequence.

Block 61—Calculate Machine Utilization Percent

Even if you have a large number of different machines, you should have a
good idea about the ones that are most heavily utilized and which ones are
usually scheduled for overtime. You may have particular machine numbers
that are on your routers with so many hours assigned to them that it’s impos-
sible to process all the parts routed to those particular machines during the
regular non-overtime hours and the number of shifts you have decided to
staff. See Figure 11.14.
Personnel who route and schedule shop orders can start a project to
analyze the components routed across the overloaded machines and reroute
190 Chapter Eleven

61. Calculate
machine utilization
percent

62. Classify
machine-by-machine
by utilization rate

62. Load more 62. Load and

than 100 percent unit dispatch
utilization 80 to 100 percent

62. Schedule and 62. Schedule and

unit dispatch group dispatch
50 to 80 percent 10 to 50 percent

63. Determine the

machine-by-machine
scheduling control
method

Figure 11.14 Production control system.

them to either get the lowest total setup hours or the lowest total unit cost,
or the optimum between the two. Remember, planning is the cheapest
kind of material control.
To calculate utilization percent, you total the number of hours each
machine is utilized or scheduled in either actual hours or theoretical hours
and divide these hours by the non-overtime hours and shifts available
to obtain a percent utilization rate. The actual hours will verify what you
already know or will reveal to you that your estimate wasn’t as good as
you thought it was. The calculation of the utilization percent will identify
the machines that are excessively overloaded.
To manually gather the actual utilization hours, you can take a
random sample of 10 percent of the closed component shop orders for the
most recent period of time approximately equal to your cycle time period.
Total the setup and run hours for each machine number and you will have
enough facts to draw some rational conclusions. If you have some documen-
tation of the actual machine-hours for each machine, this may give even
better results.
 Rationalizing a Material Control System 191

Blocks 62 and 63—Classify Machine by Machine

by Utilization Rate and Determine the Machine-by-
Machine Scheduling Control Method

In blocks 31 through 33, I showed you how to classify components that must
be kept in inventory so you can focus control on the small percent of them
that make up the largest percent of your inventory investment. I suggest
the same concept for controlling manufacturing equipment. From block 61,
arrange the machine numbers in groups by a percentage range and deter-
mine the level of control for each group.
For machines with a rate of 100 percent or more, monitor their load
daily and hour to hour. Consider more shifts, offload to another machine,
or schedule regular overtime.
You will have multiple shop orders competing for the same start date.
Have a specific plan or machine-loading method to resolve these start
date conflicts.
For machines with a utilization rate of 80 percent to 100 percent, you
can relax only slightly. For these machines, review the start dates each day
and increase machine loading control when you see many shop orders with
the same start date.
For machines with a rate of 50 percent to 80 percent, control them
simply by moving operators to them when the initial operation shows a start
date of the current date or when material is standing in queue for a second-
ary operation.
For machines with a rate of 10 percent to 50 percent, accumulate them
in start date groups so you can move an operator to those machines less
frequently.
Any time material is in queue for a secondary operation, process it as
soon as possible, even if it is sooner than the start date shown for that opera-
tion. Running secondary operations sooner than the schedule requires will
shorten the recorded lead time for block 3 and will begin shrinking your
cycle time and in-process inventory investment.
For machines with a rate of less than 10 percent, consider rerouting
to other machines for that operation so the machine can be sold and free
up floor space. Or, if this machine has low capital investment remaining
on your balance sheet, open a project to determine if it can be perma-
nently set up to eliminate setup time for a significant number of similar
components.
192 Chapter Eleven

If most of your machines, particularly those that are most expensive,

are being utilized more than 80 percent, this may be a clue that you may be
ready to use the overlapping method to test out the potential for manufac-
turing cells or order additional equipment.
Taking time to rationalize the material control system will generate
projects that decrease material control costs, reduce inventory investment,
and increase sales because of on-time customer shipments.

Block 64—Move Completed Components and

Assemblies to Assembly, Warehouse, or Shipping
Your goal is to make dramatic decreases in cycle time so more compo-
nents can be scheduled by customer orders. When you shrink the cycle time
period and reduce your setup costs enough, most shop order quantities can
bypass inventory storage and go directly to assembly. The exceptions will
be spare parts orders, which go to the warehouse or shipping. See Figure
11.15.
Be sure the assembly order completion date isn’t the same as the ship-
ping date you show for the customer order shipping date unless you consis-
tently do both on the same day. This is particularly important if your product
requires significant time for packaging between assembly and shipping.

Blocks 65 and 66—Package Shipments and Ship

Customer Orders on Time 95 Percent of the Time
I’ve included these blocks just to be sure you allow lead time for packag-
ing when you are mapping out your entire process flow. Another reason
for including these blocks is in case you use a machine to do packaging

64. Move completed components

and assemblies to assembly,
warehouse, or shipping

65. Package
shipments

66. Ship customer

order on time 95
percent of the time

Figure 11.15 Production control system.

 Rationalizing a Material Control System 193

that requires significant setup time. If you have this situation, you probably
have completed assembled product standing in queue. If assembly orders
are consistently completed on time but packaging and shipping opera-
tions are causing you to miss customer due date promises, you must con-
sider implementing some of the same scheduling practices you are applying
to schedule and expedite component shop orders.

CHARTING MATERIAL CONTROL

SYSTEM PERFORMANCE EVALUATION
I suggest that material control personnel use blocks 67 through 76 in Figure
11.16 as a checklist to evaluate the overall performance of the material
control system. Identify projects that will result in cost reductions, operate
the system more effectively, or improve customer on-time delivery.

67.
3. Calculate
Evaluate item-by-
material
item
control
andsystem
paperwork
goal
bylead
exceptions
times

1. Agree on your
material control goal

68. Evaluate 73. Calculate

calculated controls inventory budgets

69. Compare on-hand 74. Compare

quantity with component work-in-
safety allowance process budget

70. Compare the 75. Compare

received quantity with component inventory
original order quantity budget

71. Compare the 76. Compare

received order lead end item
time with the current inventory budget
maximum
and/or average

72. Calculate and

compare stock-out rates

Figure 11.16 System evaluation.

194 Chapter Eleven

Block 67—Evaluate Material Control System

Goal by Exceptions
In block 1, I encouraged you to set a material control goal or mission that
says something like, “Better customer service at lower cost.” Use the blocks
in Figure 11.16 to evaluate system performance so you can initiate projects
to make improvements and fine-tune your system where you have vari-
ables that can be adjusted. Don’t create a voluminous report. Report the
exceptions that are outside your calculated guidelines so you spend more
time solving the most serious problems.

Block 68—Evaluate Calculated Controls

Fortunately you have simple arithmetic and formulas to determine where in
the system problems exist. In blocks 67 through 72, I show you how you can
evaluate your calculated controls for items that the cycle time chart forces
you to keep in inventory before customer orders are received. You evalu-
ate the total system at two different places. One is at the receiving dock for
purchased components and the other is at the warehouse when shop orders
are completed. Evaluation of these calculated controls is based on actual
conditions that exist at the time material is received at the receiving dock
or into stock. The factual conditions you find when material is received tell
you how well your controls are working.
In blocks 73 through 76, I show how to estimate the minimum size of
your inventory investment as determined by your calculated controls. These
estimates give you an inventory budget you can use as a target to tell you
how well you are managing your inventory budget allowance.

Block 69—Compare On-Hand Quantity with

Safety Allowance
This block tells you whether the new material was received at the right
time and in the right quantity. To determine whether these two things have
happened, you need to make three different comparisons.
First, compare the on-hand quantity at the time of receipt with that
component’s safety allowance, calculated in block 37. What you’re actu-
ally evaluating is the formula you used in block 38 to decide at what on-
hand quantity to issue a new purchase order or shop order. If the on-hand
quantity is 50 percent to 150 percent of the safety allowance, your invest-
ment in safety allowance to protect your customer is about as high as it
needs to be to minimize the number of times you miss customer delivery
 Rationalizing a Material Control System 195

promises. Report an exception only when your percentage range is less than
50 percent or more than 150 percent. If you want to increase your risk, just
play around with the safety allowance percent you calculated in block 36.
Realize that as your lead times get more consistent and predictable, your
safety allowance percent will automatically get smaller and your safety
allowance investment will automatically get smaller.

Block 70—Compare the Received Quantity with

Original Order Quantity
If the quantity received is more than plus or minus 10 percent of the order
quantity, as calculated by the method you’ve chosen for block 30, you are
exceeding a rational total cost for that component. This excessive cost will
eventually show up as lower net profit and a lower ROA than necessary. Just
report the exceptions. As you get fewer and fewer exceptions, reduce your
evaluation percent so you can measure the average percent variation.

Block 71—Compare the Received Order Lead Time

with the Current Maximum and/or Average
In block 3, I recommended that you determine your lead time by averaging
the three most recent lead times for each component. If you compare the
lead time for the new receipt to the maximum from the three most recent
and find that the new lead time is longer than the current maximum, report
it as an exception. This may be a signal that your supplier’s system isn’t
providing acceptable control for purchased items or that your shop may
not be reducing lead times. If you have implemented projects with a sup-
plier specifically aimed at reducing purchase order lead times, make the
comparison with the current average to provide yourself with an ongoing
improvement target for you and that supplier. Using suppliers who continu-
ously shorten their lead time will increase your company’s ROA.

Block 72—Calculate and Compare Stock-Out Rates

You may not be able to maintain a material control system with a consis-
tent stock-out rate less than two percent to five percent unless you have an
excessive inventory investment as explained in block 43. Common sense
will tell you that many of your customers will be looking for other suppliers
if your stock-out rate exceeds 10 percent.
Compare the on-hand quantity with your safety allowance from block
69. Sometimes the quantity will be zero. Keep a separate tally of stock-outs
196 Chapter Eleven

for purchase orders and shop orders. Divide the number of stock-outs by the
number of opportunities to have a stock-out. The number of opportunities
for a stock-out equals the number of purchase order receipts and the number
of shop order completions during a specific time period, such as your cycle
time period or six months.
For purchase orders, look within the supplier group to discover projects
related to specific suppliers that need to improve. For shop orders, look at
your own material control system.
You don’t actually have a stock-out unless you have a back order for the
component that has a zero on-hand quantity. Therefore, if you don’t have
a good way to exclude these zero-on-hand situations, you can expect your
stock-out rate to be overstated.
As an alternative, you could monitor the number of times you ship a
customer order a certain number of days late as a system evaluation tool.

Block 73—Calculate Inventory Budgets

Perhaps you aren’t aware that there is a way to estimate what your inventory
investment should be. This is a critical issue because, for many manufactur-
ers, inventory investment is a significant percent of their total investment.
Your inventory investment hinges on lead time and lot size for each
assembled end item and each component or raw material that must be kept
in stock. Your inventory budgets, calculated periodically, will document
how much progress you are making with projects to reduce lead time and
setup cost.
The best way to bring your material control goal into financial focus
is through inventory budgeting. An accurately calculated inventory budget
will tell you how much inventory investment you should have based on the
effective control of each individual inventory item.
If your company financial personnel insist that you arbitrarily reduce
inventory levels, they must also tell you how many sales they are will-
ing to lose because of late delivery dates. Keep everyone focused on the
fact that reduced inventory only comes from shorter lead times and lower
setup costs.

Block 74—Compare Component

Work-in-Process Budget
In-process inventory includes component shop orders and assembly shop
orders. Lot size quantities only impact in-process inventory if you manu-
facture custom products. For each component, subassembly, and assembly
 Rationalizing a Material Control System 197

for which you issue shop orders, calculate a budget based on the following
formula and then add them all together to get the total. You can get a good
estimate by using a 10 percent sample.
In-process budget =
(Material cost/2 + Unit cost/2) Lead time × Usage
Material cost plus unit cost is divided by two because the component starts
as raw material but doesn’t reach its total unit cost until all of the labor and
overhead have been added. As you reduce setup cost, unit cost gets smaller
and your investment goes down a small amount.
The lead time should be the average lead time from block 3. As shop
order lead times, including queue times, become shorter, your investment
goes down some more. The lead time must be expressed in the same time
units as the usage rate. The usage rate is from blocks 23 through 25.
Multiple shifts will shorten the lead time in this formula and, at the
same time, more highly utilize your capital equipment investment, result-
ing in a higher ROA. Some managers who don’t like multiple shifts fail to
consider the reduced in-process inventory investment when evaluating the
costs related to an additional shift.
For subassemblies and assembled end items, material cost is the sum of
the unit costs that make up the material list.

Block 75—Compare Component Inventory Budget

A manufactured component, if your cycle time allows, goes directly to
assembly and continues to be an in-process inventory investment.
If a component must be held in stock to assure that you meet cus-
tomer delivery promises, or because the component’s setup costs are high,
financial personnel need a rational estimate for the component inventory
investment. The two quantities that determine the component inventory
investment are lot size and safety allowance. Using the following formula,
you can calculate the budget allowance for each component and add them
to get a total. Or, take a 10 percent sample, add these components together,
and multiply by 10 to get the total.
(Lot size/2 + Safety allowance) × Unit cost
The lot size comes from block 30. The safety allowance comes from block
37. The unit cost comes from block 26.
Lot size is divided by two to obtain the average quantity in inventory
as the lot size is being issued for assembly shop orders or for shipment to a
customer or branch.
198 Chapter Eleven

As you can see, when you reduce setup cost for each item, the lot size
decreases. Then when you make lead times shorter and more consistent, the
safety allowance becomes smaller. This formula mathematically demon-
strates why setup cost reduction and lead time consistency are so powerful
in minimizing investment and increasing ROA.

Block 76—Compare End Item Inventory Budget

The end item inventory budget is calculated using the same formula as in
block 75. Setup costs for assembled end items may be so small that you
make product only to customer or branch orders. However, shipping cost to
branches may be such that you can prove that your total costs are lowest if
you make larger lot sizes and ship in truckload shipments.
 12
Linking Continuous
Improvement with
ISO 9000

I
SO 9000 is another tool project teams can use to discover projects. ISO
9000 is in tune with this book’s approach to continuous improvement. I
will point out parts of ISO 9000 that provide opportunities to increase
your company’s ROA. I will name each section of the ISO 9000 standard
with a verb/noun or verb/phrase combination so you can name projects that
might be missed by other chapters.
I suggest you implement a quality standard, such as ISO 9000, if it is
done to increase your ROA. You may see some other suggestions that will
help with your quality audits or discover projects that relate to corrective
and preventive action projects that will increase your ROA.
For this chapter I use ANSI/ISO/ASQ Q9001-2000, which has been
approved as the American National Standard by the American Society for
Quality. Look it over for project ideas even if you’re registered to another
accepted quality standard.
Agree on the Quality Mission. Don’t implement a quality standard
because a key customer requires it. The best approach is to treat implemen-
tation of a quality standard as an investment that results in ROA improve-
ment. If your mission is a strategic decision to identify and prioritize projects
that increase sales, hold cost and price increases to a rate lower than infla-
tion, reduce product and process variation, and eliminate quality-related
wastes, this approach satisfies both customers and stockholders.
Increase customer satisfaction. Meet customer requirements. Develop,
implement, and improve quality management system effectiveness. Identify
and manage company activities linked to quality. Continuously improve
processes based on measurable objectives.
These are verb/noun combinations directly out of the ISO standard that
encourage a process approach to managing the quality system. ISO 9001
focuses on the effectiveness of the quality management system in meeting

199
200 Chapter Twelve

customer requirements. I will go one step further by using the quality man-
agement system to effectively meet stockholder requirements.
Define Quality Management System Requirements. As a manu-
facturer, you may think of processes as those activities that convert raw
material into a finished product. Or you may think of paperwork processes
used to control the flow of material through the manufacturing processes.
In a quality system, quality standards focus on procedural processes linked
in a quality system to meet customer requirements. Therefore, some of the
general requirements for your quality management system are:
• Identify processes and applications companywide
• Determine the sequence and interaction of processes
• Determine the criteria and methods necessary to prove they
are effective
• Provide resources and information to monitor the processes
• Monitor, measure, and analyze these processes
• Implement projects to continually improve quality processes
Document Your Quality Management System. Record the sys-
tem’s requirements to communicate the requirements to those who must
manage the system. The documentation will depend on company size,
complexity of the processes, process interactions with each other, and
the competence of the personnel who are performers within the documented
procedures or script. Some general documentation requirements are:
• Document quality mission, policy, or objectives
• Document a manual to organize procedures
• Document required procedures as a script for the performers
• Identify documents to plan, operate, and control the processes
• Document records required by the standard and for
internal auditing
Document the Quality Manual. Your quality manual is the primary
device used to communicate your quality system to employees, customers,
suppliers, and auditors. You list the top-level procedures that describe the
interactions of the quality system processes and how you will control them.
Control the Quality Manual and Procedures. One set of proce-
dures defines how you control copies of your quality manual and how you
 Linking Continuous Improvement with ISO 9000 201

control top-level procedures listed in the manual. Some of the issues to con-
sider are:
• Approving the manual and procedures
• Reviewing and updating the manual and procedures
• Providing easy access to the latest revisions
• Documenting control of customer drawings
Control the Quality Records. You will experience a quality audit
by some of your most important customers, by an internal audit performed by
one of your own employees, or by an official registrar to prove you are con-
forming to a quality standard. It is reasonable that records remain legible
and are readily identifiable and retrievable. For good control you must have
appropriate procedures to communicate these requirements to employees.
Document Management Commitment. Customers insist on three
things: control of prices, meeting the promised delivery date, and qual-
ity products. They know from their experience that if top-level managers
aren’t continuously monitoring the effectiveness of the quality system, they
will eventually not experience satisfaction in all three areas. One of your
procedures should communicate management’s responsibility to commu-
nicate to employees the importance of meeting customer and regulatory
requirements. To communicate this:
• Focus quality on the customer
• Establish a quality policy or mission
• Establish measurable quality objectives
• Conduct quality system reviews and audits
• Provide resources to keep the quality system effective
• Follow up corrective and preventive actions
Provide Knowledge and Skill Resources. A quality system is only as
effective as the performers who come on stage in each quality procedure or
script. In Chapter 6, I suggested that you take a knowledge inventory. Look
for knowledge and skills required by the quality you’ve designed for your
business. The requirements you place on yourself should include:
• Determine the necessary personnel competence
• Provide the appropriate training
• Evaluate the effectiveness of the training
202 Chapter Twelve

• Verify that personnel connect training and related activities to

the quality system and its objectives
• Maintain education, training, and skills records
Provide and Maintain the Quality Infrastructure and Work
Environment. Just as a nation needs an infrastructure for communication
of government processes and procedures, you must define the same kinds of
elements for the quality system infrastructure. Focus on the communication
of the most critical elements of your infrastructure to achieve conformity to
product requirements. Some examples are:
• Provide preventive maintenance to minimize equipment
dimensional variation
• Require design requirements to match equipment capability
• Provide process routers that match equipment capability with
product requirements
• Identify and control processes that are used even if the process
lacks the required process capability
• Maintain the health and safety of employee assets
Document Product Realization Procedures. This is used by the ISO
9000 quality standard to define the many procedures required to convert
a product from the customer’s imagination into a real product that realizes
the customer’s imagination. It’s the processes and procedures in the quality
system that make customers’ product dreams come true. It’s a very broad
spectrum and may represent the bulk of your quality procedures and train-
ing aids. Product realization requires you to:
• Define customer-related processes and procedures
• Define design and development processes
• Define purchasing processes
• Define production and manufacturing processes
• Define control of monitoring and measuring devices
Determine Initial Customer Product Requirements. When, as an
individual, you decide to buy a product, you start with a mental image of
its function, size, shape, features, and so forth. You hope an available prod-
uct won’t force you to pay for features you don’t need or don’t have value to
you. As you go through your process of selecting a product, you expect the
product supplier to have a user-friendly process to assure you that you are
 Linking Continuous Improvement with ISO 9000 203

going to get the exact product that meets your needs. Your company’s first
obligation is to provide each customer with an orderly two-way communi-
cation process that helps them articulate their requirements. Your processes
should help them:
• Document product requirements, including post-delivery acts
• Clarify requirements not stated by the customer but known by
the supplier to be required for intended use
• Communicate statutory and regulatory product requirements
• Recommend requirements that add value for the customer
• Cover prototype or field testing requirements up front
Review Initial Customer Product Requirements. The initial com-
munication with your customers about product requirements is usually
conducted by a limited number of people in the organization. If the cus-
tomer order is a repeat order for exactly the same product, a review process
may not be needed. The other extreme is a contract for a new product not
yet provided by any supplier. Between these two extremes, your personnel
should review the product specifications to minimize the chance that the
customer will be dissatisfied with your product. Your processes should help
personnel in your organization to:
• Verify that product requirements are completely defined
• Resolve contract or order requirements differing from the initial
product definition
• Verify that you have the ability to meet defined requirements
• Document communications with the customer related to the
review process
• Confirm customer consensus before accepting the order
or revisions
Communicate with Customers. Like any good marriage, marriage
to your customer to produce maximum sales should build a relationship
of common interests that make both better than you could be otherwise.
Advertising and providing catalogs about your products and services are
ways to convey the desire for a continuing relationship. Satisfying your cus-
tomer marriage partner might include:
• Communicating order acceptance and delivery date
• Answering product inquiries promptly
204 Chapter Twelve

• Communicating unexpected delivery delays

• Communicating quality or performance problems
• Resolving customer complaints to their satisfaction
• Communicating corrective or preventive actions taken in
response to complaints
Plan and Control Product Design and Development. Product
design and development may range from minor redesigns for an exist-
ing product to a contract for development of a major project. For each of
these extremes, consider design review checklists that can serve as project
plans, schedules, and documentation for record purposes. Consider includ-
ing customers and suppliers in the design process. A product development
plan includes:
• Defining the design and development stages
• Defining review, verification, and validation for each stage
• Defining responsibility and authority for each stage
• Managing the interfaces between different groups involved in
the design and approval process
Determine Design and Development Inputs Related to Product
Requirements. Design inputs relate to customer product requirements
discovered in the communications you had with the customer as you com-
municated back and forth about the product requirements. Inputs the ISO
9000 standard suggests are:
• Determining and recording functional and performance
requirements
• Documenting and communicating applicable statutory and
regulatory requirements
• Considering information from previous designs
Determine Design and Development Outputs Related to Product
Requirements. Outputs can be prototype testing of a design project or
could relate to the routine testing of assembled products shipped to a cus-
tomer. Outputs can be defined by drawings, bills of material, process rout-
ers, and end item test instructions. The ISO 9000 standard requires that the
design and development outputs shall:
• Meet input requirements for design and development
 Linking Continuous Improvement with ISO 9000 205

• Provide appropriate information for purchasing, manufacturing,

and service activities
• Contain or reference product acceptance criteria
• Specify the characteristics of the product that are essential for its
safe and proper use
Determine Design and Development Review Related to Product
Requirements. In the preceding section you have determined the design
stages appropriate for redesign and new design. To be sure product
design requirements are met at suitable stages, you perform systematic
reviews of the design according to planned arrangements, such as a check-
list. Design reviews at each stage will cause you to:
• Evaluate the ability of the design and development process to
meet requirements
• Identify problems and propose necessary actions
Determine Design and Development Verification Related to
Product Requirements. Perform verification to prove that the out-
put meets design and development inputs. Verification documents for the
customer that products meet their specified requirements. Just add this
stage to your checklist.
Determine Design and Development Validation Related to
Product Requirements. Hopefully, you discussed prototype or field test-
ing in your initial communications with your customer. This is the design
stage when you give the product the opportunity to prove it will meet the
customer’s requirements and your design requirements.
Control Design and Development Changes. After design verification
and validation, design or process changes may be needed. You might use an
engineering change notice procedure to communicate the recommended or
required changes to the product before the change is implemented.
Note: Quality standards related to product design are used to sat-
isfy your customers. There is no better time than the design and develop-
ment stages to build shorter lead time and lower setup into the product and
into the product and development lead time. Consider a parallel checklist,
not directly included in your quality system, that includes principles from
Chapters 9 and 10 to reduce processing lead time and setup time and cost.
Design reviews should look for ways to design for fewer parts and
for more operations to be performed with each holding of a component.
Consideration should be given to use of Six Sigma during design and
206 Chapter Twelve

development to limit dimensional variation and match drawing dimensional

requirements to capability of the processing equipment. Your quality stan-
dard is the minimum you commit to in order to satisfy your customers.
Ensure That Purchased Components and Processes Conform to
Design Specs and Purchase Order Requirements. Customers expect
both you and your suppliers to be committed to a quality system similar
to their own. They know that the product they buy from you is no better
than the purchased and manufactured components that go into it. They also
realize that you farm out some of your manufacturing processes and expect
you to verify that processes performed outside your direct control will meet
all product specifications. Therefore, you should:
• Establish selection and evaluation criteria for suppliers
• Maintain records of the results of evaluations and actual
performance
• Document corrective actions required for supplier approval
Establish Requirements for Information Communicated to
Suppliers About the Product or Process to Be Purchased. The
information you communicate to a supplier on a purchase order or other
document should:
• Include requirements for approval of product, processes,
equipment, and procedures
• Include requirements for personnel qualification
• Include quality system requirements
Verify That Purchased Product Meets Specified Purchase
Requirements. You may use inspection to perform product verification.
You are the only one who can decide how much inspection is required,
whether it will be performed at your facility or the supplier’s facility,
and which product characteristics are the most critical. State the verifica-
tion arrangements and method of product release in the purchasing infor-
mation you communicate. State how the inspection will be performed by
you at your facility. To avoid duplicate inspections, require inspection
certification to document inspection performed by the supplier.
Ensure That Manufactured Components and/or Services
Conform to Product Specifications. This and the next four sections
apply to a product manufacturer or a service business that derives its sales
from both products and services. What you require of yourself in your qual-
ity system for manufactured components is what you would look for in your
 Linking Continuous Improvement with ISO 9000 207

supplier’s facility when you perform supplier evaluation and selection. You
would look for how they control the conditions under which manufactur-
ing or service is carried out. Many of these conditions might be included in
your process routers, setup instructions, or operations procedures related to
equipment maintenance or maintaining the accuracy of measuring instru-
ments. For conformance evaluation or potential improvement projects, you
should look for:
• Information that describes characteristics of the product
• Availability of appropriate work instructions
• Use of suitable equipment
• Use of monitoring and measuring devices
• Release, delivery, and postdelivery activities

Validate Processes That Can’t Utilize Monitoring and Measuring.

Some products and processes are such that the processing output can’t be
verified by monitoring or measuring. This would include processes where
the deficiencies become apparent only after the product is in use or the
service has been delivered. Validation is how you demonstrate the ability of
these processes to achieve the required specifications. To assure that these
processes are under control, you should:
• Define criteria to review and approve the processes
• Approve equipment and qualification of personnel
• Use specific methods and procedures
• Define records requirements

Determine the Appropriate Degree of Identification and

Traceability. If your customer or industry doesn’t require it, ISO 9000
doesn’t require every item to be identified by a part number. During pro-
cessing and storage, paperwork included in the component container may
satisfy your needs. To satisfy the quality standard, you must define the
means you will use to identify each component and finished product as
well as the way you will provide reliable traceability when you need to
recall defective components or finished product. By not having specific
traceability by part number and work order number on each component,
you may find that you often need to recall more product than you would
with an expensive traceability system. Review the economics of what you
are now doing to find the least expensive way to satisfy your own and your
customers’ purchasing information requirements.
208 Chapter Twelve

Protect Customer-Supplied Property. If your product or service

includes customer-supplied materials, you must safeguard them from
damage or loss. If damage or loss does occur, you must report the damage
or loss to the customer and maintain transaction records. One simple way
to satisfy this quality system requirement is to assign one of your part num-
bers to customer material, treat the customer as a supplier for this material,
and allow your purchasing and material control systems and nonconfor-
mance systems to control customer material.
Preserve and Protect Components and Finished Product. Use
common sense to protect components and finished product during the man-
ufacturing process. For uncontrollable reasons, you may be forced to hold
parts and finished products in stock for long periods of time. Or there may
be components with sensitive surfaces or with short shelf life that need spe-
cific procedures to detail your method of protection or preservation. This
type of damage reveals itself in the nonconforming material area. If you
have a specific packaging method required by a customer, you may share
shipping preservation and protection duties.
Control the Accuracy of Monitoring and Measuring Devices. Your
quality system should be the vehicle you use to drive your quality costs
down by limiting the dimensional and specification variation in your prod-
ucts. Projects related to measuring instruments can be big profit producers
because a very few instruments can impact the dimensional and specifica-
tion integrity of your components and finished products. Maintenance pro-
grams for monitoring and measuring devices can include instruments for
measuring component dimensions, instruments for surface measurement,
temperature and pressure gages for processes such as heat treating, paint-
ing, or mixing, and gages and other devices that may be used in the testing
of an assembled product. For project discovery, consider the relationship
between measuring instruments and preventive maintenance of manufac-
turing or processing equipment. If you use preventive maintenance to main-
tain the capability of a machine to hold close tolerances, you can eliminate
inspection operations. To prove conformity of product to required dimen-
sions and specifications, the following quality system requirements should
be provided:
• Calibrate instruments at given intervals against measurement
standards traceable to national or international standards
• Provide a way to show calibration status
• Safeguard instruments from unauthorized adjustment
• Protect instruments from damage during use and storage
 Linking Continuous Improvement with ISO 9000 209

• Maintain records of calibration

• Provide procedures for potential product recall when incorrectly
calibrated instruments may cause product performance problems

Accumulate Facts, Analyze Them, and Improve the Quality

Management System. Remaining sections of the ISO 9001 standard
have improvement projects as their primary goal. The standard encourages
you to:
• Demonstrate conformity of your products to requirements
• Ensure conformity of the total quality system
• Continually improve the effectiveness of quality
management systems

Measure and Monitor Customer Satisfaction. Perception is almost

everything in all human relationships. The dictionary says it’s an impression
received by our mind through the senses. It’s like the different eyeglasses
our individual minds wear, resulting from past and current experiences.
Perception is seldom based on pure facts. Measuring customer satisfaction
isn’t a pure science because you’re measuring customers’ perceptions as
to whether your organization meets customer requirements. Monitor and
measure the perceptions of the 20 percent of your customers that make
up 80 percent of your sales to discover projects that help you maintain or
increase sales. Get feedback about improvements they suggest for your
quality system and analyze them for quality system improvements using a
customer survey.
Conduct Periodic Internal Audits of Your Quality System and
Monitor and Measure Procedures. An internal audit of the quality
system is performed by your personnel. Like a customer satisfaction survey,
your purpose is to gather facts and analyze them so you can discover proj-
ects that will make your quality system more effective and further improve
your ROA. One good way to perform an audit is similar to what an official
registrar would do. You go to each section of your quality manual and the
related procedures to determine if performers identified in the procedure
script are doing the actions described in the procedure and whether your
quality manual accomplishes what the quality standard requires. When
you find a nonconformance, either prompt the performers immediately to
follow the script, work with them to find a better way that still meets the
requirements of the standard, or initiate a formal corrective action project
to fix the problem. Corrective actions provide a good starting place for
future audits.
210 Chapter Twelve

Measure and Monitor Your Completed Product. If you produce

customized products, the contract may require that the product requires
acceptance at various stages by a relevant authority, by your customer, or
by a customer representative. At the other extreme, your product may be
such that you can monitor and measure the product at routine inspection
stages such as receiving inspection, component manufacturing, and final
end item testing. Every nonconformance, or the accumulation of data from
each nonconformance, provides the facts from which good analysis will
yield profit-improving improvement.
Control Nonconforming Product. Not only are you using noncon-
forming product to gather factual data, you should identify nonconform-
ing components and products to prevent their unintended use or shipment.
Nonconforming material must be reviewed by authorized personnel to
determine its appropriate disposition. You can deal with nonconforming
product in one or more of the following ways:
• Take action to eliminate the nonconformity
• Authorize its use by the appropriate authority
• Take action to prevent it being used
• Reevaluate it after being reworked
Analyze Accumulated Data from All Appropriate Sources. From
the five preceding sections you will have accumulated considerable factual
data that, when analyzed, can be used to demonstrate the suitability and
effectiveness of your quality management system and to evaluate where
continual improvement can be made. The analysis of the data should pro-
vide information to:
• Improve customer satisfaction
• Improve conformity to product requirements
• Improve characteristics and trends of processes and products
• Provide opportunities for preventive actions
• Improve the quality effectiveness of your suppliers
Document a Corrective Action Procedure. This is a way to generate
profit-producing projects. Corrective action projects should be focused on
eliminating the causes of nonconformities to prevent recurrence. Your
documented procedure should define requirements to:
• Review nonconformities and customer complaints
 Linking Continuous Improvement with ISO 9000 211

• Determine causes of nonconformities

• Evaluate actions to ensure that nonconformities don’t recur
• Determine and implement corrective action
• Record the results of action taken
• Review corrective action taken
Document a Preventive Action Procedure. This is a very important
source of projects to preserve the highest level of quality system effective-
ness. I want to emphasize, from a continuous improvement point of view,
that quality system and continuous improvement program effectiveness
must be evaluated and measured on a financial basis.
It’s bad business if you don’t prove that every quality system project
will increase the ROA level over a full business cycle.
As you analyze factual data, such as trends, from your quality system
or your company’s financial statements, you will see potential problems
present themselves for attention.
For example, as you perform preventive maintenance to maintain
dimensional integrity of a piece of equipment, it may become obvious that
the equipment is no longer capable of holding the dimensional tolerances
required by the original customer product design requirements.
Or, from a business point of view, you may see trends that sales of a
particular product or in a specific market segment are diminishing, warn-
ing you of a potential loss of sales that will negatively affect your ROA.
Improved quality is a financial decision.
 13
Projects to Increase
Market Share

I
n Chapters 1 through 4, I hammered away at the fact that “increase
market share” and “increase market coverage” are more critical than
“increase sales.” This chapter supports the fact that permanent sales
increases only result from increased market share and specific plans and
projects to increase market coverage.

COMPANYWIDE MARKETING
PLANNING
Many manufacturing, distribution, and service businesses market products
that are commodities in customers’ eyes. The importance of the eight sec-
tions of this chapter is that marketing plans are a companywide affair. The
reason is that plans to improve quality, reduce delivery time, and control
price increases can increase sales and market share as well as plans that
expand the product line, market segments, and marketing channels.
My approach to continuous improvement is to train all employees to
become businessmen and businesswomen so that as you expand products,
market segments, or distribution channels, you will have managers and
knowledge resources ready to meet the demands of increased sales.
I am greatly oversimplifying the subject of industrial marketing so
I can provide you with a checklist of verb/noun combinations to remind
you about projects that apply to increasing sales and market share with
market coverage.
I will show you some graphics you can use to quickly gather impor-
tant financial and marketing facts to help discover projects that increase the
company’s ROA by increasing market share. By using the project evalua-
tion form from Chapter 5, you can allow manufacturing projects to compete
head-on with projects to increase market share.

213
214 Chapter Thirteen

Market Share/Marketing Planning

Many products are commodities in the customer’s eyes, such as products in
the mature stage of their lifecycle. The importance of this section lies in the
fact that increased sales and market share must be achieved by plans and
projects that do such things as expand the product line, market segments,
and marketing channels, as well as projects found in previous chapters that
improve quality, reduce delivery lead time, and control pricing at a growth
rate less than inflation.
Your company may not be big enough to have a marketing function
separate from your office sales function and your field sales force. My
approach to marketing planning will treat marketing planning and the field
sales force as two separate functions. My reason for this approach is that
your marketing plan to increase market share is the mechanism that links
what management wants done within a given time frame with what the
sales force must do to increase the market share.
Just selling harder isn’t a viable marketing plan.
Your first step in marketing planning is to select the knowledge
resources from within your company and your customers’ businesses who
will, as a team, serve as your marketing function. As a group they will set
marketing objectives and design a marketing plan. This could include exter-
nal knowledge resources such as stockholders, retired personnel, exclu-
sive distributors, consultants, product designers, personnel and functions
that are required to demonstrate good customer service, personnel who get
customer orders shipped on time, and those charged to see that customer
invoices are paid within the contracted time allowed.

MARKET COVERAGE
The graphics in this section are borrowed from The Richmark Group,
[Link]. They provide a very comprehensive pattern to help a
company identify potential projects to expand market share by analyzing
market coverage.
These graphics utilize several verb/noun combinations to demonstrate
how a continuous improvement process can be applied to increasing sales
and ROA by increasing market share at all stages of each product’s lifecycle,
for each marketing segment you serve, and for each phase of a company’s
economic business cycle.
Notice that the first pair of graphics (Figures 13.1 and 13.2) and their
lists of verb/noun combinations are very similar to the second pair (Figures
 Projects to Increase Market Share 215

Analytical Assessment of Market Share

• When selling through indirect channels (who carry competing brands), there are
five coverage measurements
• When selling through indirect channels (who are exclusive), there are four
coverage aspects (that is, brand coverage becomes 100 percent)

Product management issues

Product
coverage
Distribution channel marketing factors
Portion not
covered Price
(wrong type,
size, design, coverage
materials, Distribution
and so on) channel
Portion for coverage
lower-priced
products
Portion Promotion
of the Portion not coverage
seen by your
market Portion channels
“covered” of the Brand
by your market Portion Portion they coverage
lose to
existing segment that your another
products that is distribution
premium channels Portion that
Portion your competitor
price, see your gets
Your quality, (that is, are distribution Portion of your
share or value aware of channels distributor’s Your
of the or bid on) win business that sales
you get
market
Total market $
(All products, all
types, all vendors)

Figure 13.1 Marketing strategy evaluation—selling through distributors

and dealers.
Source: The Richmark Group ([Link]). Used with permission.

13.3 and 13.4). The first pair is used when the marketplace requires you
to sell through distributors and dealers. The second pair applies when the
marketplace, or a group of very large customers, requires you to sell through
your direct sales force.
These four figures and verb/noun combinations will save you consid-
erable time when you decide to systematically increase sales by increasing
market share with increased market coverage. Following these figures, I
will provide you with an organized approach to formulating your market-
ing objectives, your marketing plan, and actions the sales force and man-
agement will take to increase market share.
I suggest that you use your estimate of your current and future cover-
age for each of the bars in the figures, along with other intelligence you can
216 Chapter Thirteen

Some of the Potential Approaches to Increasing Coverage

• Design new products
• Acquire another company

Product • Reengineer existing line

coverage • Acquisition
• Have a new line private-labeled

• Change channels
Price • Add distributors
coverage • Pull more through existing distributors
Distribution
channel • Improve delivery
coverage • Telemarket
• Change advertising
Promotion • Target industries
coverage • Improve training

• Increase
Brand sales force
coverage contact
• Change
discount
structure
• Reduce
conflicts

Total market $ $ $ $ $
(All products, all
types, all vendors)

Figure 13.2 Marketing strategy implementation—selling through

distributors and dealers.
Source: The Richmark Group ([Link]). Used with permission.

gather, to get a more realistic estimate of your market share before and after
you implement your next marketing plan.
Notice: The market share for a specific product line is shown at the
bottom of the brand coverage bar in Figure 13.1 and at the bottom of
the customer coverage bar in Figure 13.3. The verb/noun combinations
suggest how you can set objectives to increase your coverage for each of
these bars. The verb/noun combinations will form a considerable part of the
marketing plan you will follow to increase your market share. The percent
coverage for each bar has an accumulative effect to determine your market
share for each product line in each segment you serve. It’s this cumulative
effect that makes it difficult for any one business to achieve much more
than 35 percent to 45 percent of the total market.
One good source of factual data for estimating the annual sales, number
of employees, product lines, and market segments for your competitors is
a business directory put out annually by CorpTech ([Link]).
 Projects to Increase Market Share 217

Analytical Assessment of Market Share

• When selling through a direct sales force there are four coverage aspects
Product
coverage

Portion not
covered Price
(wrong type,
size, design, coverage
materials,
and so on) Prospect
Portion for coverage
lower-priced
Portion products
Customer
of the Portion not seen, coverage
market Portion
or called on, by
“covered” your sales force
of the
by your market Portion that
existing segment your sales Portion your
products competitor
that is force sees gets
premium (that is, is
price, called on, (Exclusive
Your quality, or target of customers Your
share or value other direct and accounts sales
shared with
of the marketing) competitors)
market
Total market $
(All products, all
types, all vendors)

Figure 13.3 Marketing strategy evaluation—selling through the direct

sales force.
Source: The Richmark Group ([Link]). Used with permission.

It can be found in the business section of many large public libraries or

online. Another source for similar information is the Thomas Register busi-
ness directory, which can also be accessed online at [Link].
If you sell through distributor or dealer channels, you can design mar-
keting objectives and plans from the following verb/noun combinations:
• Increase product coverage
– Design new products
– Acquire another company
• Increase price coverage
– Reengineer existing product line
– Acquire an existing product line
– Have a new line private-labeled
218 Chapter Thirteen

Some of the Potential Approaches to Increasing Coverage

• Design new products
• Acquire another company

• Reengineer existing line

Product • Acquisition
coverage • Have a new line private-labeled

• Change channels
• Add distributors
Price • Pull more through existing distributors
coverage • Enhance lead qualification/generation
Prospect • Change pricing/
coverage discounts
• Improve service/
Customer support
coverage • Increase customer
satisfaction
• Segment customers
based on
their needs

Total market $ $ $ $
(All products, all
types, all vendors)

Figure 13.4 Marketing strategy implementation—selling through the

direct sales force.
Source: The Richmark Group ([Link]). Used with permission.

• Increase channel coverage

– Change channels
– Add distributors
– Pull more through existing distributors
• Increase promotion coverage
– Improve delivery
– Implement telemarketing
– Change advertising
– Target specific industries
– Improve sales force training
• Increase brand coverage
 Projects to Increase Market Share 219

– Increase sales force contact

– Change discount structure
– Reduce conflicts and/or improve distributor relationships
If you reach end users primarily through your own sales force, design
marketing objectives and marketing plans from the following verb/noun
combinations:
• Increase product coverage
– Design new products
– Acquire another company
• Increase price coverage
– Reengineer existing product line
– Acquire an existing product line
– Have a new line private-labeled
• Increase prospect coverage
– Change channels
– Add distributors
– Pull more through existing distributors
– Enhance lead qualification/generation
• Increase customer coverage
– Change pricing and discounts
– Improve service/support
– Increase customer satisfaction
– Segment customers based on their needs.

Rationalize Your Coverage and Market Share

This exercise helps you rationalize why you must have a high level of cover-
age in each of the coverage elements if you expect to achieve and maintain
a high market share for each of your product lines.
Figure 13.5 can be used as a guide to help with the arithmetic required
to use your estimate of coverage for each coverage element to make an esti-
mate of your market share.
220 Chapter Thirteen

Channel Prospect/ Customer Market

Product Price coverage promotion or brand share
50% × 50% × × 50% × 50% = 6%
50% × 50% × 50% × 50% × 50% = 3%
60% × 60% × × 60% × 60% = 13%
60% × 60% × 60% × 60% × 60% = 8%
70% × 70% × × 70% × 70% = 24%
70% × 70% × 70% × 70% × 70% = 17%
80% × 80% × × 80% × 80% = 41%
80% × 80% × 80% × 80% × 80% = 33%
100% × 100% × × 50% × 50% = 25%
100% × 100% × 50% × 50% × 50% = 13%
100% × 100% × × 80% × 80% = 64%
100% × 100% × 80% × 80% × 80% = 51%

Figure 13.5 Market share estimator.

The bold lines in the figure apply to the market share you should be
receiving for sales you are attempting to capture by selling through distrib-
utors and/or dealers. The other lines in the table apply to sales you attempt
to capture through your direct sales force.
For example, looking at the first line, if you are selling through your
direct sales force and if you estimate you have only 50 percent coverage for
the product, price, prospect, and customer elements, you can expect only
a six percent market share. If you know you have more than a six percent
market share, it probably means you have higher coverage in one of the cov-
erage elements than you realize.
By looking at the 80 percent line for direct selling, you can estimate the
increased sales you should receive to be between six percent and 41 percent
of the market share. Then you can compare the profit from the increased
sales to the investment and increased annual expense to maintain the 80
percent coverage. Then, using the Chapter 5 evaluation form, you can deter-
mine whether your ROA will be increased or decreased and whether your
marketing objectives in your marketing plan will be achieved.
You can review the lines in bold type, which add the “channel cov-
erage” column, to make the same comparisons for sales you capture by
 Projects to Increase Market Share 221

selling through distributors or dealers. Don’t conclude that you won’t want
to use or expand a distribution network because it appears to yield a lower
market share than direct selling. You use distribution networks because
they allow you to transfer some coverage costs out of your financial state-
ments and into a distributor’s financial statements and because you expect
the distributor or dealer to operate at lower coverage costs than you can
by selling through a direct sales force.
These kinds of trade-offs are the main reason you need to rationalize
your coverage and market share as your first step toward setting marketing
objectives and toward designing a marketing plan to increase market
share. This is where you connect your marketing plan with your business
plan. However, I suggest you keep your initial marketing plan separated
from your business plan until you have decided on the actions required to
increase your market share. It’s only after you have proven with a market-
ing plan that you truly understand your marketplace that you can design the
most profitable business plan. The market share plan determines how much
your stockholders will invest to capture the increased sales resulting from
increased market share. The business plan determines how much you will
spend each year to maintain the increased sales and share.
By looking at the last two lines in the figure you can see why few com-
panies can afford to achieve much more than 50 percent of the market.
These two lines also demonstrate the influence a full product line has on
a high market share. The key to this decision is whether the investment in
product development and related coverage expenses will translate into a
profitable business decision. These two lines should also signal you that by
buying a competitor you might consolidate coverage costs and increase your
coverage at a lower cost per sales dollar, which translates to a higher profit.
This is one of the reasons companies with a high market share usually oper-
ate at a high net profit and a high ROA.
Just keep in mind that your sales and marketing knowledge resources,
wherever they exist within company departments, are participants in the
continuous improvement process to discover specific projects that will
increase ROA a specific amount within a specific time period. Therefore,
if you know your coverage is at a high percent and you know that its related
expenses are already high for a given coverage element, additional invest-
ment and/or expenses will likely lower the ROA. This is true because at
some point each incremental increase of coverage expense won’t guarantee
a profitable increase in sales. On the other hand, if you know your coverage
is too low for a given coverage element, that particular element should be a
primary target for a market plan project.
222 Chapter Thirteen

MARKETING OBJECTIVES
Make a marketing objectives list to document consensus reached by your
group of companywide knowledge resources to get companywide input, as
well as key customer input.

Relate Marketing Objectives to Business Objectives

Business objectives should be focused on ROA percent. Marketing objec-
tives must be focused on market share percent. You won’t achieve your
business objectives for increased sales without a marketing plan. And you
can’t design a marketing plan without specific documented marketing and
market share objectives.

Document Marketing Objectives for All Product Lines

To help simplify marketing objectives for your marketing plan, focus
on products that are in the last half of their lifecycle. In the first half of
each product’s lifecycle, sales may be made primarily by your direct sales
force and you may not be considering distributor and dealer strategies. In
the second half of each product’s lifecycle, the maturity portion, individual
product lines are probably sold mostly to end users through distributor and
dealer channels.
In these two stages the sales force plays different roles. Marketing
objectives and marketing plans must be focused on each product’s proper
place in its lifecycle so you can correctly communicate the objectives,
plans, and actions your sales force uses to increase market share. If you
have more than one product line, you may have different marketing objec-
tives for each:
• You may not be able to increase ROA from more investment
in market coverage for products that already have a high
percentage share.
• Products in a rapidly expanding market may need to grow at a
higher rate than other products.
• The product and/or business may not be in the right phase of
the economic business cycle to increase ROA the quickest or
most profitably.
• Management may have to restrict share growth or coverage
growth because of the inability to commit financial or
knowledge resources.
 Projects to Increase Market Share 223

• You must allow adequate calendar time for objectives that

require new product design or new manufacturing equipment
and facilities.
• Clearly identify the key individuals and knowledge resources who
set growth objectives so differing viewpoints can be debated and
resolved on a nonsubjective basis. This is the best place to start
gathering facts. Then let the facts resolve the differing viewpoints.
• Recognize that some parts of your marketing plan may fail. You
must free individuals who are most responsible for achieving a
given objective from the fear of failure by making all objectives a
team requirement companywide.
• Use the project evaluation form to improve the ranking of
objectives when trade-offs must be made to achieve the results
within the allotted market plan time frame.

Set Growth Objectives Based on Market

Share Percent
There are good reasons to express marketing objectives in terms of market
share percent:
• Market share percent is immune to sales dollars caused by
inflation or the variation of annual sales during the three to five
years of an economic business cycle.
• Although an accurate market share percent is difficult to measure,
it is still a true measurement of your product’s competitive
position in the marketplace. You can improve the accuracy of
your market share measurement as you more accurately state the
percent of coverage for each of the coverage elements in Figures
13.1 through 13.4.
• Manufacturing projects that reduce lead times, reduce setup costs,
decrease the ratio of total company salary-related costs divided
by sales dollars, provide less quality variance in products,
and deliver a very high percentage of customer orders by the
promised date dramatically increase sales dollars and market
share. On the other hand, marketing projects that increase
market share and sales dollars will, by economies of scale,
allow the manufacturing operation to be more profitable. This is
another reason I encourage you to make market share planning a
companywide exercise.
224 Chapter Thirteen

• The financially justifiable cost to increase coverage in any one

of the coverage elements will tell you when to slow down or stop
market share growth of your product lines. At some financially
logical point it will be better to take the excess cash generated by
continuous improvement projects and invest it in the acquisition of
a competitor, another business, or a new product line not directly
associated with your current lines.
• Market share forces the key knowledge resources, those setting
marketing objectives, to focus new marketing projects on potential
sales you don’t see or don’t get.
• For product lines in the maturing phase of their lifecycle,
increasing market share is the only way to increase sales.
• Exception: If you are a small business in a large market, setting
marketing objectives based on sales dollars in specific market
niches is better than measuring and planning on the basis of
increased market share.

Set Sales Forecasts Based on Marketing Objectives

and the Current Economic Business Cycle Phase
Long-range sales forecasts are often based on increased sales dollars every
year of a four- or five-year business plan, without regard for what’s going on
in the economy. In these cases, the annual operating budget for each year
of the long-range business planning period may be too high to be prudently
used to make sound manufacturing capacity and other business decisions
during each year. You’re admitting with this kind of plan that you don’t
have a financially sound marketing plan.
I suggest a more logical approach that helps the sales force meet the
market share growth objectives rather than sales dollar objectives that may
be impossible to achieve because of the economic business cycle.

Documenting Objectives Forces You to Be Specific

Both sales dollars and ROA go up and down significantly during each three-
to five-year business cycle. This same logical approach must be applied to
manufacturing to provide an appropriate level of manufacturing capacity
to ship customer orders on the promised delivery date.
First, start with where your company or each product line is in the
business cycle. When you know that the business is in an economically
 Projects to Increase Market Share 225

depressed phase, you know not to set sales dollar goals that force you to
increase manufacturing capacity at an unreasonable pace.
Second, if you have lost market share for specific product models,
factor that into your forecast so you won’t overstate your business plans and
capacity requirements.
Third, increase sales dollars by the amount of inflation you plan to
pass on to customers. If continuous improvement is working as it should,
consider passing some of the profit improvement on to your customers if
such a move will increase your market share. Controlling price increases at
a rate lower than inflation is one of your customers’ primary satisfiers.
Fourth, look at market share objectives and the marketing plan through
specific marketing projects and increase your sales forecast for the next few
years accordingly.

Select a Time Frame for Marketing Objectives

Business conditions change so rapidly that marketing objectives that span
more than a two-year time frame are unlikely to deliver the desired results.
The time frame is most critical when you have ambitious market share
growth objectives that may require a separate set of long-range objectives
as far as timing is concerned.
If your objectives require introduction of a new product, include these
in a longer-range set of marketing objectives. Or you may consider buying
or licensing an existing product line or acquiring a competitor. Or you may
consider distributing a product from a manufacturer of similar products to
yours but in a market segment in which you don’t currently participate.
The best marketing projects may require expansion of equipment and
facilities that take more than one year to plan and implement. An expansion
objective may also cause you to consider acquiring a competitor that sells
through existing market segments or distribution channels.

Openly Document Constraints and Limitations

Imposed by Management or Stockholders
Force these issues out into the open so they can be discussed and under-
stood by the team that will document marketing objectives and design the
marketing plan.
For each marketing objective that can be boiled down to a specific proj-
ect, use the evaluation form in Chapter 5 to force agreement about invest-
ment dollars and knowledge resources required for implementation. The
increased ROA from these marketing projects should be compared with
226 Chapter Thirteen

your manufacturing projects as a way to allow marketing projects to com-

pete head-on with manufacturing projects.
Document an understanding of the limitations management or stock-
holders impose on coverage elements, so unacceptable ideas won’t be con-
sidered until the constraint is lifted.
If you don’t have a full-time marketing function, separate those func-
tions or personnel assigned to decide marketing objectives and design the
marketing plan from those who have the sales force responsibility. This will
help clarify roles played when each group comes on stage to perform its
part to increase market share.

THE MARKETING PLAN

Just as new products or new processes must be tested to see if they meet
design requirements, marketing objectives must be tested against what your
team knows about the marketplace as you generate your marketing plan and
the probability that it will deliver the objectives.
The primary goal of a marketing plan is to communicate to manage-
ment the changes related to policies, constraints, limitations, and investment.
Another goal is to inform the sales force about the discipline, structure, and
tools they must use to deliver the planned market share growth during the
designated time frame defined by the plan.

Consider the Many Marketing Plan Alternatives

As with the manufacturing projects you name and rank using the verb/
noun continuous improvement process, there are more marketing alterna-
tives than you will have the financial and knowledge resources to include in
a marketing plan for the next one to three years. Therefore, look for those
that are:
• Available to you to increase market coverage. For example, if
you already have a full product line compared to competitors,
that alternative isn’t available. On the other hand, there may be
marketing segments or distribution channels that are available
to you.
• Attainable within limitations of financial and knowledge
resources stockholders are willing to commit, including both
one-time investment and ongoing annual expenses. You can accept
or reject various alternatives with the help of the project evaluation
 Projects to Increase Market Share 227

method in Chapter 5. If a set of projects will increase both market

share and ROA, it has the best chance of making it into your
marketing plan.
• Deliverable within the time frame for which the marketing plan
is designed.

Consider Both Numerical Facts and Your Gut Feelings

Those in your company with lengthy experience in your marketplace may
have intuitive insight that is equally as valuable as factual information. Just
be sure that this insight is put into the best words possible and treat it as a
fact until market plan testing proves it right or wrong. If this insight helps
your team understand how your marketplace functions, it may be as impor-
tant as knowing your share of the market.
The point is, to make good marketing decisions, you must understand
how and why potential customers make their buying decisions, how they
are going to use your product, and why your product does or doesn’t fit their
application. For example, for a particular product, your key customer con-
tact may be an individual in their purchasing function or a group in their
engineering function or a combination of both. At the other extreme, your
key contact could be part of the customer’s top management.

Apply the 80/20 Rule to Your Marketplace

Another way to gain insight into your marketplace, so that you discover
additional marketing objectives, is to remember that 80 percent of market-
place sales come from 20 percent of potential customers and end users. And
only 20 percent of the sales come from the other 80 percent of the potential
customers and end users. Put another way, 80 percent of marketplace sales
are from a few big, well-known customers whose buying habits are also well
known and 20 percent come from the 80 percent of the marketplace uni-
verse that is too diverse to rationalize into one set of buying habits.
I suggest you consider dividing your customers into at least three
groups to sharpen your marketplace insight.
The first group is a small percentage of the largest companies or the
biggest buyers in the marketplace, perhaps the five percent that buys 40 per-
cent to 50 percent of the type of product provided by you and your competi-
tors. These well-known big buyers are critical for the design of a marketing
plan to increase or maintain market share. Not only do they represent a large
percentage of marketplace dollars, they are where emerging technologies,
228 Chapter Thirteen

new applications, and changes in product requirements are seen first. They
are where you are made aware of each competitor’s marketing plan or the
lack of one. These are customers and end users with whom you want to
maintain direct contact, even if they are being serviced by a distributor or
rep. Your marketing plan needs to define the role of your sales force with
these customers and the role of marketing and management in providing the
appropriate tools. These customers, such as OEMs, may insist on buying
direct from you at equal or better than distributor discounts, even though
you might prefer that a distributor would serve them.
The second group of well-known medium-sized companies or buy-
ers is probably the next 15 percent that buys 30 percent to 40 percent of
the products in your marketplace. They are important because the way the
marketplace is structured is well known, even though it is more diverse in
its buying habits than the first group. You may need to reach this group
through a combination of direct sales and dealer/distributor marketing. If
you rely heavily on distributors to capture these sales for you, your market-
ing plan will need to focus on a marketing program that you design to make
it more effective for your distributor and dealer customers to make a buying
decision in your favor.
The third group, the 80 percent of buyers who provide only 20
percent of the marketplace sales, shouldn’t be ignored even though they
buy infrequently in small quantities. If all your competitors are ignoring
them, you obviously have an opportunity to increase your market share at
a very low cost and with a high return on your project investment. These
customers and end users may be too small for your distributors to service
economically. You must make it easy for these customers to find you and
your distributors or dealers. For these potential sales you may utilize the
Internet, or direct mail to those whose names you know. Or you may use
targeted advertising and Web site search wording for those whose names
you don’t know.

Apply Distributor/Dealer Marketing to

Increase Share
Distributor marketing may seem complicated because you must sell through
another independent business to reach OEMs and other end users to eco-
nomically maximize your market share. It’s important to understand why,
under the appropriate conditions, you can capture more share at a lower
cost through distributors than with a direct sales force. I learned the follow-
ing questions about marketing and selling through distributors from Frank
Lynn & Associates.
 Projects to Increase Market Share 229

Why Do End Users Buy from Distributors and Why

Are They Needed by Manufacturers?
Distributors have a role in the marketplace because they can do more effec-
tively and more economically what a manufacturer and its sales force and
reps don’t do well or can’t do at all. It’s these advantages that distributors pro-
vide to your customers for which you pay them with a distributor discount.
You pay them for their inventory investment to provide product closer
to your customer so delivery can be made more quickly. They invest in
inventory that you would be required to maintain at the factory. The only
way you can match the distributor’s delivery is to locate a branch closer to
the customer than the distributor location.
You pay them for taking credit risks, for processing customer orders,
for providing customer service, and for absorbing shipping costs for a large
number of small-quantity shipments you would handle less economically.
You pay them for overhead costs you no longer budget.
You pay them to maintain a sales force, and for advertising and pro-
motion to a much broader audience than you can reach with your own sales
force. You pay them because your customers can do one-stop shopping for
other products, related to your product lines, that you don’t market.

How Does Distribution Evolve in the Marketplace

As Products Mature?
New products and new technologies normally require the missionary work
that your sales force can do better than a distributor. As more applications
or new innovations are identified for a new product, the selling emphasis
is on technical selling to communicate directly to the marketplace. Over
time, as the product and market matures and servicing of individual cus-
tomers becomes the most important customer need, distributors replace the
direct sales force and the technical specialists. To economically increase
share you must recognize and define in which product lifecycle phase each
of your products is living so you can provide your new customers with the
attention that best fits their individual needs.

What Is the Best Design for a Distributor Discount?

The function of a distributor discount is to transfer cost out of the manu-
facturer’s business and into a distributor’s. The distributor makes a profit
by performing the transferred activities more economically than the
manufacturer. A multi-level distributor discount based on distributor order
230 Chapter Thirteen

size is the best way to fairly transfer marketing cost from the manufacturer
to the distributor.
It rewards the distributor with a large discount when their purchase
orders are combined into one order, paying them for the many transactions
the distributor will perform when the actual customer sale is made. If the
distributor orders are always very small and frequent, minimal transactions
are being transferred and don’t deserve a large discount. A multi-level dis-
count penalizes distributors for frequent orders that don’t really transfer
sufficient cost, and rewards them with a larger discount for large, infre-
quent orders that maximize the transfer of transactional costs and inven-
tory investment.

What Role Do the Manufacturers Play in Distributor

and Dealer Marketing?
The manufacturer is responsible for promoting the product and brand name
to end users. The distributor is only paid to supply the product as soon as
economically feasible and to service the customer. The demand must be
created by the manufacturer, especially if one of your competitors is using
the same distributor to transfer out some of their costs.

What Is the Role of the Sales Force in Distributor and

Dealer Marketing?
Every distributor services only a specific portion of the marketplace in a
given geographic territory. Their coverage is based on their various product
lines, their customer base, and their business goals. The share of the market
you capture through each individual distributor depends on which of your
potential customers come to them for your type of product. In some cases
you need to consider more than one distributor in a given geographic area
to maximize market share. Therefore, your maximum market coverage in
a given territory will depend on how well your sales force and marketing
plan have selected the best distributors for each territory that has potential
new market share. There may be some customers your sales force will still
call on.

What Major Mistakes Do Manufacturers Make When

Marketing Through Distributors?
Here are a few:
• Manufacturers think they sell to distributors, not through them.
 Projects to Increase Market Share 231

• Distributors are not your customers. They are a channel through

which you reach customers.
• A sale isn’t made until your product moves out of a distributor’s
inventory and into the hands of an OEM or end user.
• Distributors don’t develop markets. They service existing
markets you and your sales force develop as a specific action in
your marketing plan.
• Market acceptance depends on which brands a distributor sells.
• Inventory turnover determines the brands a distributor stocks.
If your product doesn’t move, they won’t stock it.

Connect Your Marketing Plan and Marketing Projects

with Your Manufacturing Projects
A business that maintains a competitive advantage in the areas of control of
price increases to customers, consistent, predictable quality, and consistent,
predictable shipment of products on the day they are promised should pro-
mote these advantages to customers. Manufacturing projects, particularly
those that claim an incremental increase in sales, should be integrated into
the marketing plan. By doing this, the contribution of the manufacturing
function to increasing market share can be recognized and encouraged.
For example, if your sales and manufacturing personnel are spending
considerable time expediting manufacturing schedules to meet customer
delivery date promises, why wouldn’t you include in your marketing plan
a project to improve your material control system and its performance as a
marketing objective to maintain or increase market share?

Focus a Marketing Plan on Its Appropriate Audience

There are primarily three groups of personnel to whom you must
clearly communicate your marketing plan and from whom you must get
a clear commitment:
• Management must commit money and knowledge resources
required by the plan. This may include changes in policy and
changes in limitations placed on the various coverage elements
included in the plan.
• The sales force must agree to perform selling tasks the plan
requires, to use the selling tools the marketing plan will provide,
and agree to specific performance and evaluation measurements.
232 Chapter Thirteen

• Manufacturing personnel must agree to the marketing objectives

and actions related to delivery date promises, cost control, quality
improvement goals, and other issues included in the marketing plan
that are under their control and are made an integral part of the
market share strategy.

Communicate a Marketplace Perspective and Insight

If you had a picture puzzle of your marketplace that would show the rela-
tionship between such things as competitors, marketing channels, segments,
geography, the market share pie divided by competitors, the market share
pie and your share of the pie divided by segment, and how your marketing
plan fits all these picture puzzle pieces together, you would have a picture
or perspective of your marketplace.
The key to perspective and insight is understanding the relationships
between the puzzle pieces. In your company’s marketplace you may see
some puzzle pieces I have left out. This is where you generate facts that
improve or prove your gut feelings about your perspective of your market-
place. This is the place where you focus your mind’s eye on the details of the
big picture to help your marketing plan achieve your marketing objectives.
Here are details you can add to draw a big picture in a verb/noun format:
• Make a list of company strengths and weaknesses.
• Make a list of your competitors and their strengths and weaknesses.
• Make a list of distributors available to you, and the ones also used
by your competitors.
• Prepare a list of end users.
• Estimate the size of the marketplace and the share currently
claimed by you and your competitors.
• Identify the coverage areas in which you can most likely take
market share away from competitors.
• View the market geographically by competitors, distributors, end
users, and marketing segments.
• Make a list of end user applications and the market segments in
which they are applied.
• Document in which segments you have a large market share that
must be protected or defended because of competitive activities.
 Projects to Increase Market Share 233

• Analyze the market coverage elements that account for a large

share of specific segments.
• Determine in which segments you have a small market share and
which market coverage elements should be increased that should
increase your share the quickest and at the least cost.
• Outline the marketing/selling programs you can use to
win more share in each segment in which you want to see
an increase.
• Document marketing programs that are out of tune with how
your low-share segments function now.
• Reach agreement about where each product is in its lifecycle: a
new product with new technology, a mature product, or somewhere
in between.
• Relate your constraints and limitations to the real picture you see
in your marketplace.
• Identify marketing activities that have minimal impact on
achieving your marketing objectives.
• Identify marketing activities that have maximum impact on
achieving your marketing objectives.
• Look at the market in terms of the sales and share you don’t get
as well as in terms of sales you now get.
• Revise the verb/noun combinations in this whole section into
vocabulary that fits your company.
• Add verb/noun combinations not included in this section that are
unique to your marketplace.
• Look at the big picture again to see more clearly where you fit
into it and how your marketing plan must redraw it so you can
see yourself in places you didn’t appear before.

Prototype-Test Your Marketing Plan, Programs,

and Tools
Just as a new product should be tested in the laboratory and/or in the field,
test your marketing plan, program, and tools and make appropriate design
changes that work better than your original conclusions.
234 Chapter Thirteen

Explain the Key Elements of the Marketing Plan to Its

Appropriate Audience
At this point you have gathered, analyzed, and organized facts and perspec-
tives and related them to each other so that they will tell you what things to
do, when to do them, and who will be responsible for actions required:
• Explain planned market coverage changes.
• Explain major marketing programs.
• Explain the time frame and schedule to implement the plan,
highlighting the few most critical events and decision points for
both management and sales force commitments.
• Explain how and why the marketplace has its own way of
making buying decisions that is independent of your company’s
way of selling.
• Explain how the plan takes a specific approach for each
specific product line, each specific marketing segment, and
each specific group of potential customers.

INCREASING MARKET SHARE

THROUGH ACQUISITIONS
One logical answer to the question, “How do I increase market share?” is,
“Acquire a competitor.” At some point you may want to turn to a consultant
to help decide if acquisition is a good option to increase the ROA.
In this section I encourage you to think about acquiring a competitor
as you complete your marketing plan to use market coverage to take market
share from competitors. In the next section of this chapter I provide a pro-
cess for you to use to place a value on your own company and your competi-
tor’s so you can decide whether it’s more profitable to increase market share
by investing in greater market coverage or by acquisition. In the section
after that I describe the process and the team you might use to complete
an acquisition.

Guess What Your Competitors Are

Thinking About!
It should come as no surprise that your competitors are trying to take market
share from you and may desire to acquire your business. It shouldn’t come
as a surprise to your competitors that you may plan to use acquisition as a
 Projects to Increase Market Share 235

logical strategy to acquire their market share. Therefore, it should come as

no surprise to them that both of your financial conditions could be dramati-
cally improved if your two companies were consolidated.
It’s not illegal to talk to a competitor about acquisition possibilities,
since both may be thinking about it anyway. If both of you have a large
market share, ask how you would legally defend your position if the con-
solidation resulted in a very large share of the market. Logically, if you are
applying a continuous improvement process so that you can increase prices
at a rate lower than inflation, you could also prove that consolidation would
enhance that trend and the wastes that exist in both businesses.

Which Share Strategy: Acquisition or

Market Coverage?
In this chapter, I proved that you won’t permanently increase sales if you
don’t increase market coverage. Also in this chapter, I contended that
you won’t increase share without a marketing plan to increase coverage.
Now I say, “It’s perfectly logical for you and your competitor to get together
so you can prove to yourselves that a consolidation might make both busi-
nesses more profitable.”

Integrate Acquisition Strategic Thinking with Your

Continuous Improvement Projects
If you decide that acquisition of a competitor is the way to increase market
coverage and market share, look at your current projects and those of a
potential acquisition to see if there is some synergy that makes acquisition
more logical and valuable. You may want to acquire similar products you
can manufacture in your current facilities and/or sell through your existing
distribution channels.
For either acquisition strategy there are some basics about acquisitions
you should understand.
Link an acquisition strategy with your current continuous improvement
projects. This will show whether there is a big gap between the cultures of
the two companies. If they are practicing good continuous improvement
principles, you can justify paying a higher price for the acquisition. If the
acquisition target is better than you are in most areas and is earning a larger
ROA than you are, you might consider paying a premium price.
Link your acquisition strategy with marketing projects. A market anal-
ysis for your plan to increase market coverage performs much of the analysis
required for the potential purchase of a competitor or for other products that
can be sold through existing marketing channels.
236 Chapter Thirteen

As you design a marketing plan, consider acquisition so this same

information can be used if or when there is an acquisition opportunity.
If you decide you will never be interested in acquisitions, you’ve
decided that the only strategy you will use is to invest in additional market
coverage. However, if a competitor surprised you by asking if you are inter-
ested in buying them or selling to them, might you reconsider your acquisi-
tion position and what price your stockholders would accept if a premium
price were offered?

Simplify the Acquisition Process

Pretend that you are buying a competitor and use the exercise to learn
acquisition language, the valuation process, and the information gathering
and analysis process. By focusing on acquiring a competitor, the process is
easier to understand and apply.
The knowledge required to transact acquisitions is too complicated to
describe in these three sections. Authors of a 1000-page merger and acqui-
sition handbook titled The Art of M&A state that even their composition is
far too small to adequately cover this complicated subject.
Selling a business may be a one-time exercise in your career. Even
though you may hire an experienced consultant to help with this infrequent
event, you need enough knowledge to understand some vocabulary, and the
process, so you can test the advice they are giving you, or test the advice I
am giving you. My organization of the process and the arithmetic should
help when you decide to explore an acquisition opportunity.

Define Your Acquisition Criteria

I attempt to simplify acquisition so you can quickly accept or reject acqui-
sition opportunities with a minimum of time and expense. I suggest you
pretend to buy your competitor because that will be one of the most simple
acquisition scenarios. The evaluation of each opportunity may cost up to
$30,000 in expenses for your personnel and a consultant. Your up-front
investment for an acquisition will be much less if you prepare for it as an
integral part of your marketing planning.
You can go to the Web site for a corporation such as Dover Corporation
to get ideas about acquisition criteria. In a few words with a seller, Dover
can quickly consider or reject an opportunity using the following criteria.
Does the company:
• Manufacture high-value-added equipment or machinery
products?
 Projects to Increase Market Share 237

• Sell to a broad customer base of industrial or commercial

end users?
• Sell through strong national or international distribution?
• Hold a position as a niche-oriented market leader with number
one or number two market share position?
• Have strong management teams in place with skill, energy,
and ethics?
• Have earnings before interest and taxes (EBIT) above 15 percent
and $10,000,000?
• Show expected significant real growth over time?
• Have lower EBIT requirements for “add-on” business that make
good sense?
Dover’s EBIT expectation gives a clue that they would value acquisitions at
five to 10 times the EBIT dollars, depending on how strong or weak they
judge it to be in other product, market, or management areas. (See the next
section for a valuation process.)

Acquire to Increase Market Share or Product Lines

The same process can also be applied when you have an opportunity to
expand with related products that use similar manufacturing processes and/
or sell through your distribution channels. This means your initial interests
will be related to a business you may have analyzed to some extent during
your market planning exercise.
Consider seeking product lines that are in the first half of their prod-
uct lifecycle, particularly if your products are in the second half of their
lifecycle.
One of the things you’re looking for with an acquisition strategy is
to consolidate with a competitor to reduce overhead costs and minimize
investment to maintain the combined market share. The combined sales
will be the same as the total before the acquisition but the combined profit
dollars will be larger than before the acquisition, and the combined invest-
ment should be lower per sales dollar, resulting in a higher combined ROA.

A Summary of Acquisition Steps

Whether you are buying a competitor or company with similar products
and channels, there’s a logical step-by-step process.
238 Chapter Thirteen

Select an Acquisition Team. This team will include your best knowl-
edge resources to gather and analyze financial information, product design,
and manufacturing processes.
Gather Facts About Every Facet of the Potential Acquisition. Pre-
tend that you will duplicate a company that is exactly like your acquisition
target, including knowledge resources. Lay this information side-by-side
with your company and compare the strengths and weaknesses of both.
This exercise will help you decide if the acquisition target has some features
for which you might be willing to pay a premium price.
Analyze the Facts to Determine the Fit. Gather facts about products,
market segments, distribution channels, market coverage, technical knowl-
edge, organization structure, processes, management, leadership skills,
employee empowerment, employee efficiency, inventory control (setup
cost and lead time reduction), and financial history (past P&L statements,
balance sheets, and annual budgets). You will be looking for similarities
and contrasts to see how the two fit together.
Determine a Range of What You’re Willing to Pay for the
Acquisition. In the next section I show ways to place a value on an acqui-
sition by comparing your financial statements side by side with those of
your acquisition target. This exercise will allow you to estimate what your
financial statements will look like if costs and knowledge resources are
consolidated.

PLACING A VALUE ON A BUSINESS

Perform the Financial Analysis First
Most merger and acquisition experts might not agree with my back-door
approach. It’s like reading the last pages of a mystery novel to see “who done
it” before you know the whole story and its characters. The reason I sug-
gest this approach to considering the acquisition of a competitor or a com-
pany selling similar products through your distribution channels is that you
already know most of the story and most of the characters. Some personnel
on your staff may even be former employees of your acquisition target.
Note: When considering an acquisition, you are using past historical
facts to predict the future funds that will return the buying price within a
reasonable number of years. To get the best answers about a consolidation,
look critically at predicted future financial numbers related to existing and
combined market share.
 Projects to Increase Market Share 239

If, during initial analysis of a potential acquisition, you use your finan-
cial statements to place a future value on your company, it is relatively easy
to place a competitor’s factual information or estimates side by side with
your company’s numbers. Since your marketing plan should have given you
an idea about how much you are willing to invest to increase your market
coverage to take market share from your competitors, this initial financial
exercise will give you a feel for whether acquisition is a better market share
strategy than investing to increase coverage.

What Methods Are Used to Value a Business?

To place a future value on your business or a competitor’s business, there
are methods that estimate what a business may be worth in the future. In
the final analysis, a business is worth what someone is willing to pay for
it. This value varies widely among potential buyers, because the decision
is finally made on a subjective gut-feeling basis. If you can imagine you
and a competitor openly looking at your two businesses side by side to esti-
mate what both businesses would be worth in the future, separated or con-
solidated, it is reasonable to imagine that a consensus would eventually be
reached that is fair to both sets of stockholders.
Various valuation methods are described in the handbook titled The
Art of M&A. I briefly describe these before going through the valuation
exercise I prefer to use.
• The replacement value method. This method helps estimate the
cash costs to start from scratch and duplicate your own business
or a potential acquisition. For an acquisition that appears to be
profitable, but where information about things that produce
the profit are lacking, this is a valid method. It includes the
investments for facilities, equipment, tooling, and accounts
receivable, plus costs for such things as product drawings,
recruitment, training, market creation, development of customer
and distributor bases, and other costs unique to that particular
business. Once replacement cost is estimated, a projected cash
flow can be estimated to justify the investment using the internal
rate of return method.
• The average rate of return method. This method yields a percent
rate of return (similar to ROA) by dividing average annual
return (profit in dollars) by purchase price. This compares with a
company’s average ROA over a full economic business cycle
of three to five years. Or it compares to the ROA rating of your
240 Chapter Thirteen

continuous improvement projects ranked by the form in Chapter 5.

Later in this section I will demonstrate this method using the
sample company financial statement found in Chapter 5.
• The payback method. You may currently use this method to
justify purchase of major manufacturing equipment. Normally
you would like a new piece of equipment, including freight,
installation, tooling, operator training, and process documentation,
to pay out in four to five years. You can compare this payback
period to your highest-ranked verb/noun projects. Later in this
section I demonstrate this method using the sample company
represented by the financial statement in Chapter 5.
• The internal rate of return method. When you place a value on
an acquisition, you guess about what a future financial statement
will look like. This method, though complicated, gives you a way
to assign a present day value to future cash flows. If these more
sophisticated approaches are important to your financial
management, it will give you one more value on which to arrive
at a fair price. I don’t provide sample calculations for this method.
• The market value method. This method uses the published price/
earnings multiples of comparable publicly traded companies to
estimate a range of values for a purchase price. If your company or
your acquisition target is publicly traded, you may want to consider
this method. I don’t provide sample calculations for this method.
• The discounted cash flow method. The authors of The Art of
M&A claim that this is the only proper way to value a company.
It discounts future cash flows or earnings to estimate their net
present value. A reason this is a good method is because it forces
buyer and seller to look at future annual estimates, based on
logical predictions of the future, including opportunities that
might not otherwise be uncovered. I don’t provide sample
calculations for this method.
• Buying/selling price based on multiples of EBIT, earnings before
interest, taxes, depreciation, and amortization (EBITDA), and
cash flow. This is a valuation method often used to place a value
on a business. It is similar to the approach of buyers like Dover
Corporation who mention the EBIT in their acquisition criteria.
See the sample form shown in Figure 13.6.
The idea is to predict the EBIT, EBITDA, or cash flow (earnings before
depreciation and amortization [EBDA]) for several future years. This
 Projects to Increase Market Share 241

prediction for future years is based on financial facts from the most recent
years and the market share/business growth plans for future years. Once the
past, present, and future financial numbers appear to be realistic, the buyer
must multiply the EBIT, EBITDA, or EBDA by some number to determine
the highest price that can be justified.
Using EBITDA dollars, the multiplier could range between three and
10. For example, if it appears that much more investment is required to
make the acquisition financially sound, a multiplier of three or less might
be the maximum offered. Or, for strategic reasons, if the acquisition is
a very profitable business that provides big advantages to the buyer, the
multiplier could range between seven and 10. Most acquisitions are settled
at four to six times the EBITDA.
If the seller is very anxious to sell a business quickly, a price equal to
assets for buildings, equipment, inventory, and accounts receivable might
be enough to satisfy the seller. The buyer would then need to divide the total
assets by the EBITDA to determine if the multiplier is equal to or greater
than the business justifies.
If you want to estimate the payout period in years, divide the buying
price range you are willing to offer by the average annual future EBDA.
Or, make a pro forma financial statement for future years and add together
the EBDA, year by year, until it totals the buying price you are willing to
pay. This number of years will be larger than the EBITDA multiplier you
will consider because the EBDA is smaller than the EBITDA by the cost
of interest and taxes. An EBITDA multiplier of four to six might relate to a
payout of six to eight years.

Design Your Own Acquisition Valuation Worksheet

Start with your P&L statement. Then add lines for EBIT, EBITDA, and
EBDA. See the simplified form in Figure 13.6.
For your acquisition target, compare these lines for the previous three
to five years to visualize a full economic business cycle. You may extend
each line for seven to 10 future years to cover at least two future economic
business cycles. The reason I suggest consideration of business cycle peri-
ods is because pro forma financial statements, which show a sales increase
every future year, are not likely to be realistic. This variation is because of
the ups and downs of annual sales as the economy cycles.
After studying Figure 13.6 for the sample company, make some imag-
inary financial statements considering a variety of scenarios to see what
your future financial statement might look like if no acquisition were made,
for the acquisition target if the businesses were not combined, and if the two
businesses were joined together.
242 Chapter Thirteen

Sample Your Acquisition

company company target
$ % $ % $ %
Sales 10,000,000 100
Less direct MLO 7,000,000 70
Gross profit 3,000,000 30
Less SG&A 2,000,000 20
Before-tax profit 1,000,000 10
Less tax 400,000 4
After-tax profit 600,000 6
Plus interest
and taxes 500,000 5
EBIT 1,100,000 11
Plus depreciation
and amortization 600,000 6
EBITDA 1,700,000 7
Less interest
and taxes 500,000 5
Cash flow (EBDA) 1,200,000 12
Sample company assumptions:
Tax (40% pre-tax profit) 400,000
Interest 100,000
Depreciation 560,000
Interest 40,000

Figure 13.6 Sample acquisition value worksheet.

Make pro forma financial statements for several scenarios:

• A scenario, separate from your company, if the company retains
its market share but makes minimal improvement in its profit
performance. This helps establish the minimum price range you
would expect to pay.
• A scenario, separate from your business, predicting its market
share if your market share plan works to capture some of its share.
• A scenario for your company, separate from the acquisition, if
your market share plan works.
 Projects to Increase Market Share 243

• A scenario for your company if consolidated with the acquisition

target and including market share you expect to capture from other
competitors if your market share plan works.
• A scenario for acquisition looked at separately but consolidated
with your company. This might help you establish the maximum
price range you would offer.
• A scenario for a consolidated statement showing future years with
both companies consolidated into one so you can rationalize
whether you will have a higher ROA by using the acquisition
to increase your market share. Also use this scenario to decide
whether investing in market coverage is a more profitable strategy.
This scenario may tell you whether you can justify a premium
price to acquire this competitor.

Practice the Acquisition Process by Valuating the

Sample Company in This Section
This is the same sample as the manufacturing company sample shown in
Figure 5.1, page 43. Look at the sample company as a competitor who is
willing to sell. Look at it from the viewpoint of a buyer and a seller, openly
deciding on a price that would be fair to both sets of stockholders.
The sample acquisition value worksheet is designed for you to insert
some actual numbers for your company to decide what its value might be to
a buyer. It also provides places to insert educated guesses about a competi-
tor. If you knew your competitor’s actual numbers, you might be surprised
how similar your costs compare with each other.
We will evaluate this play-like acquisition of the sample company by
asking several questions, assuming the financial statement is a reasonable
average for the next seven to 10 years’ annual performance:
• What minimum price will the seller accept? If a seller is anxious
to sell the business, the minimum selling price could be the value
of the total operating assets. For the sample company the seller
would be willing to settle for $10,000,000.
• What would be the EBITDA multiplier the buyer would have
to accept? At a selling price of $10,000,000, the multiplier is
$10,000,000 ÷ $1,700,000 = 5.88. With a multiplier this high,
the buyer may only be interested in considering this price for
strategic reasons to capture the market share or obtain
manufacturing capacity. Based on cash flow, the payout period
is $10,000,000 ÷ $1,200,000 = 8.3 years. This equates to
244 Chapter Thirteen

12 percent ROA for the investment. Since this competitor is

operating at a low ROA of 10 percent, this acquisition doesn’t
look like a very exciting investment because it may require
additional investment over the next three to five years to double
the ROA. As the buyer, you would need to evaluate whether
you can obtain the same market share increase by investing in
additional market coverage.
• What maximum price would the seller ask if not in a hurry to sell?
Using the replacement value method, the buyer will want to recover
a reasonable value for technical drawings, manufacturing process
documentation, and supplier, customer, and marketing channel
development, in addition to the $10,000,000 value of assets. For
this company, if the seller uses 10 percent of annual purchased
material for supplier development replacement cost, 50 percent
of annual manufacturing salaries for manufacturing replacement
cost, and 100 percent of SE&A salaries and overhead for sales,
engineering, and administrative replacement cost, the total
replacement cost would be $3,250,000 + $10,000,000 assets
= $13,250,000.
• Will a buyer consider paying $13,250,000? We’ve established, at
$10,000,000, that this is a questionable purchase for asset value.
To pay the maximum asking price, the buyer would settle for an
EBITDA multiplier of 7.79 ($13,250,000 ÷ $1,700,000 = 7.79)
and a payback period of 11.04 years ($13,250,000 ÷ $1,200,000
= 11.04 or 8.8% ROA).
• What would the seller need to do to make this business more
salable? I boastfully suggest that the seller (or the buyer if they
are willing to pay a 5.88 EBITDA multiplier) must implement
improvements to increase the ROA from 10 percent to 24 percent,
slightly more than double, as we demonstrated in Figure 5.7, page
58, for this sample company. At 24 percent ROA the EBITDA
would increase from $1,700,000 to $3,290,000 for an EBITDA
multiplier of 3.18, based on assets increased to $10,440,000
($440,000 for increased inventory because of 10 percent increased
sales). After these improvements have been completed, the seller
would claim the replacement cost would be $13,690,000 (because
of $440,000 more inventory assets), resulting in an EBITDA
multiplier of 4.16. The corresponding payback periods would
be 3.8 years (26.3 percent ROA) and 5.0 years (20 percent ROA)
respectively. This acquisition, for you as a buyer, makes more
sense in this scenario than in the first four, particularly if much
 Projects to Increase Market Share 245

of the sample company’s increased sales came out of your market

share. If the sample company takes some of your market share, it
may have a better marketing plan than you do. You can estimate
how much more valuable your company will be if you double your
ROA percent.
• What price would the rate of return method place on the sample
company? The rate of return corresponds to the ROA evaluation
of projects in Chapter 5. The higher you elevate your company’s
ROA through continuous improvement projects, the more
difficult it will be to justify an acquisition that has a lower ROA
percent than the project rating for a project that invests in
market coverage to increase market share. In the preceding
scenarios we showed the rate of return (ROA percent) in
parentheses beside the payback period. (100% ÷ 8.33 years =
12.0% ROA, 100% ÷ 11.04 years = 8.8% ROA, 100% ÷ 3.8
years = 26.3% ROA, and 100% ÷ 5.0 years = 20% ROA). Pay
attention to the ROA of a business you might buy and relate
it to your current and projected ROA. If buying a company
significantly reduces the ROA for current stockholders, you must
be prepared to rationalize why the acquisition decision is better
than investment in manufacturing and marketing projects over the
following years.

THE ACQUISITION TEAM

AND PROCESS
Putting together an acquisition team is the first step after preliminary valu-
ation of an acquisition target. The final step will be a revision of the prelim-
inary valuation after these remaining steps reveal facts to set a final offer.
Your acquisition team should perform the valuation of your own com-
pany as well as guessing at the value of the acquisition target you are
considering.
The most logical acquisition team comprises the personnel who helped
design the marketing plan. Also consider personnel who will visit the acqui-
sition target to perform due diligence studies to gather the facts that will
help make your decision for you. This could include continuous improve-
ment team leaders who are trained and tuned to the most critical things that
affect ROA. If it’s an open and friendly acquisition effort, identify employ-
ees of the acquisition target who can give you the most in-depth facts.
Pick your most competent knowledge resources who can analyze his-
torical and current financial statements and budgets. This shouldn’t be only
246 Chapter Thirteen

accounting knowledge resources. Include management, manufacturing, and

marketing personnel who understand financial numbers.
Pick product design personnel who can analyze the products of both
companies, including material and component suppliers and manufac-
turing processes. There will be instances when you discontinue some of
your products or those of your acquisition. Include someone who has the
best imagination about what future product lines and technologies may be
required by your market.
Pick knowledge resources who know the marketplace and distribution
systems. Include those who design marketing plans and can define how
the consolidation will affect the marketplace. This part of the team could
include personnel from your acquisition target, if it’s an open and friendly
effort. Include someone from distributors you trust to give unbiased predic-
tions about the acquisition’s impact on the market.
Pick manufacturing process designers, those who can evaluate the con-
dition of capital equipment and facilities, quality system leaders, your best
equipment operators, and material control personnel. They are valuable
participants in due diligence reviews, particularly if there is going to be a
consolidation of manufacturing equipment and facilities.
Start designating some of your knowledge resources for acquisition
activities as soon as acquisition is an option in your marketing plan to
increase market share.
There’s no reason to be overly secretive about the fact that you are open
to acquiring a competitor if the price is right, even if they are not the mar-
ket share leader. The stockholders of your competitors aren’t very astute
businesspeople if they don’t have a marketing plan that considers buying
your business as a way to increase their market share. If a competitor doesn’t
operate in your marketplace, directed at taking share from you, that might
be one of the reasons you wouldn’t pay a premium price to acquire them, or
it could be a good reason to pay a premium price if they have products and
market segments that greatly expand your marketing opportunities. If they
aren’t following continuous improvement principles, that’s another reason
to reject a premium price. Obviously, the opposite is true. If they are fol-
lowing continuous improvement principles, they’re probably experiencing a
high ROA and you won’t get them if you’re not willing to pay a premium.

Gather Facts and Analyze the Acquisition

As you gather and analyze facts about each facet of a potential acquisition,
compare it to your own business so you can discover other verb/noun proj-
ects to enhance the consolidated business, or to implement in your own
business if you can’t reach an agreement to complete the acquisition. While
 Projects to Increase Market Share 247

gathering and analyzing facts, put a price tag on the acquisition’s strengths
so you can justify a premium price if required to reach a price agreement.
If your marketing plan is doing its job well, you already have pub-
lished information about each competitor. Bring this together so it’s avail-
able to the acquisition team. Include such things as product brochures, Dun
& Bradstreet reports, their Internet site, and magazine articles.
Make a checklist of facts you will accumulate. Remember, if you gather
enough facts related to any decision you need to make, the facts themselves
will tell you what your decision should be. If the decision isn’t one you can
make with confidence, keep adding questions to your checklist until you
feel confident about the decision you will make individually or as a team.
To build a checklist, you might consider going through the verb/noun
combinations in all chapters of this book and list those that relate to the
acquisition. This exercise will generate more verb/noun combinations and
may even discover many other verb/noun project names you haven’t yet
evaluated and ranked for your present business.
Use your checklist to write a documentary novel to tell the story of the
potential acquisition. The prime audience is your stockholders. A second-
ary audience is the group of people within your own company who must
be inspired to believe in the acquisition to help make a successful consoli-
dation. The third audience is the group of people in your acquisition target
who must agree to a price and their continued role in the consolidated busi-
ness. These three groups, as a whole, are the people needed to grow the
consolidated market share at the projected ROA.
In addition to checklists you generate, I will provide you with some
acquisition process steps to serve as a pattern to write the story. My goal is
to save you time by giving you a pattern to follow when you want to con-
sider an acquisition strategy.

Step 1: Document the Target’s History. Your business and the tar-
get’s business have their own individual personalities. Each company’s
personality has been formed by management leaders and the various stock-
holders who have provided the investment for the company to perform on
the marketplace stage.
Much of the target’s personality is documented in your marketing
plan. Explain how their products, markets, ownership, strategies, and man-
agement leaders evolved. Many businesses publish historical information
about themselves that they want their customers to know about. One of the
things you must include in this chapter are the important truths in their past
and present that they don’t want you to know. Your story must talk about
strengths and weaknesses in ownership, management leaders, products, and
markets, from the beginning up to the present time.
248 Chapter Thirteen

Step 2: Talk About the Organizational Structure and the Key

Personnel. You aren’t buying only physical assets, product designs, and
market share. You are also buying information and knowledge assets that
may or may not enter into your valuation for a buying/selling price. Buyers
such as Dover only buy businesses with strong management. Knowledge is
very valuable.
The personality of a business is heavily influenced by past and present
leaders and how effectively they organize their knowledge resources. This
is where you describe the key personnel in every function of the business
to discover their general attitudes and their specific attitudes about the pros
and cons of being acquired and the practice of continuous improvement.
Evaluate the level to which the acquisition has empowered employ-
ees. Your company probably has a company culture bias that a high ROA is
only achieved by business leaders who empower employees at every level.
This is because managers are forced to delegate to employees at every
level to make financial decisions hour by hour. The point is, you will be
more willing to pay a premium price for a business that has engendered a
culture of empowerment. If the target’s leaders haven’t been successful at
employee empowerment, you will want to pay less for the company because
you will need to invest money and time to build the culture of empower-
ment into the acquired personnel.
Look at the compatibility of policies, procedures, and operating systems
so you can evaluate the fit and mismatch between the two organizations.
Consider using your continuous improvement culture as a standard to
compare your company story to theirs and to dramatize whether the target
is a fit or a misfit with its present organization and condition.
Step 3: How Do All Products Fit Your Marketing Plan? Many com-
petitive products are designed to serve the same functions equally. How-
ever, products aren’t always equal when tested under the same conditions.
For example:
• You and the target may provide a product for the same function and
market, but one has a lower safety allowance, a shorter life, and
a lower cost. The key is, if both can compete head-on in the same
market segment, one product may be giving the market more than
it is willing to pay for.
• It’s possible you or your target are providing more product features
than the customers want. This implies that one product may need
to be phased out.
• It could be that one product line is specifically designed to serve
a distributor market with a need for a broad range of product
 Projects to Increase Market Share 249

configurations and applications while the other is designed for

more standard requirements of one or more OEMs.
• Perhaps your target is brand-labeling a product to keep you from
capturing that market share.
• It could be that your target has a product line that has captured a
big market share in a segment you haven’t been able to penetrate
with your product line. This product might also use marketing
channels that don’t fit any of your products.
My point is that this chapter of your story, as well as chapters you include
about distribution, market segments, and market coverage, must include your
company, your target, and other competitors as characters in the story.
The reason I suggest you do a financial analysis first is that as
you gather and analyze facts in each chapter, you find logical financial
reasons why you should or should not offer a premium price to capture
more market share.
Step 4: How Well Do the Target’s Market Segments and Distri-
bution Channels Fit Your Market Share Plan? This is where you look
at your marketing plan to see how much the acquisition would impact each
market coverage element. Your checklist and story should consider:
• How much does the acquisition increase each coverage percent?
Remember, the only way to increase market share is through the
cumulative effect of increasing the percent coverage in each of
the market coverage elements.
• How comparable is the economic business cycle of the target’s
product lines to your own? For your target to have a business cycle
that is out of sync with your own may be a positive aspect that
justifies a premium price. Having out-of-sync business cycles
might offer more consistent utilization of capital equipment after
the consolidation is completed.
• Has the target raised selling prices at a rate lower than inflation?
If they can do this and you can’t, obviously you have something
to learn from them that may justify a premium price. Determine
if they are a price leader or follower. Find out if they have a
documented pricing policy and compare it to yours, if you
have one.
• How critical is product service and the quick supply of spare
parts? How does their service compare to yours? Do your dealers
and their dealers perform customer service?
250 Chapter Thirteen

• Is their adherence to industry quality standards the same

as yours? Is their measurable level of quality higher or lower
than yours?
• Are they ahead of you or behind you in successful new product
development? Do they have patents that can be exploited?

Step 5: Compare Each Manufacturing Facility. See if this review

gives you any reason to justify a premium price. Some questions to
ask are:
• How many days does it require for them to convert a customer
order to a purchase order or shop order? This will give you a clue
to determine how many days of inventory investment you might
remove from their component inventory if you can shorten this
lead time.
• What percent of their direct labor cost is for setup? This will help
you calculate how much you can reduce their component inventory
if you initiate projects to invest in setup cost reduction.
• How does their purchasing and manufacturing lead time compare
to yours? How does the ratio of in-process inventory assets divided
by sales compare to yours? Answers to these questions will tell
which of your businesses has the better lead time controls and
material control.
• How does their ratio of total company salary and wage costs
divided by sales compare to yours? Measure this ratio, not only in
total, but for direct labor, total manufacturing labor, indirect labor,
and SE&A labor. Compare their ratio to yours to determine which
of you is most efficient in various areas. You can make the same
comparison for nonlabor cost categories to determine opportunities
for increased profit from the consolidation.

Step 6: Finalize Pro Forma Financial Statements. Now we’re back to

where we started in our valuation process when I suggested you perform a
financial analysis first. I provided you with a simplified P&L statement so
you could calculate the EBIT, EBITDA, and EBDA for seven to 10 future
years. The reason for at least seven to 10 years is to cover at least two eco-
nomic business cycles and force both buyer and seller to be more realistic
about their forecasts of future years.
For the finalized pro forma financial statements, buyer and seller can
make adjustments to more accurately state what can be expected from a
consolidation and what facts can justify a premium price.
 Projects to Increase Market Share 251

IMPROVING CUSTOMER SERVICE

A company’s products are often viewed as commodities. State-of-
the-art customer service is one thing companies can do to stand out
from the crowd. Customer service concepts in this section are taken from
[Link] training manuals to provide customer service that
differentiates a company from rivals. Utilize Gilbreath’s “I CARE” attitude
(see pages 253–54) so every member of your company, particularly those
who have direct customer contact, can get a feel for things they might do
differently to make customers feel at home.

Why Implement Customer Service Projects?

This section has a profit motive designed to discover customer service proj-
ects that will increase your stockholders’ ROA. You owe it to both your
stockholders and customers to consistently demonstrate an “I CARE” atti-
tude at a level competitors will find it hard to match.

How Does a Company Gain Superior

Customer Service?
Start with a project named “Implement Customer Service Training.” Or,
as an umbrella for all customer projects, consider “Implement Customer
Service Attitudes.”
Ask the question, “If our company became a customer service super-
star, by what percent should sales increase?” Using the evaluation form in
Chapter 5, estimate how much attitude and behavior changes might increase
ROA. Using the sample company from Chapter 5, we can calculate that a
one percent sales increase would increase ROA from 10 percent to 10.47
percent. A percentage sales increase from improved customer service may
be subjective and difficult to prove but the training investment will be very
low. Therefore, subjectively we can agree that sales and profit will increase
as customer loyalty increases.

Who Needs Customer Service Training?

Three groups of company personnel play unique roles to provide champion-
ship customer service that increases customer loyalty, market share, sales,
and profit.
• Company leaders, owners, and managers must make a commitment
to customers by promising superior customer service as a business
way of life.
252 Chapter Thirteen

• Good coaching from managers and supervisors helps even the

best customer service performers do a better job of taking care of
the details as they communicate with customers. Managers and
supervisors too often overlook the coaching job.
• The performers, those on the customer service stage, the 20 percent
of employees with 80 percent of the direct contact with customers,
must be well led and coached because they deliver 80 percent of
your customer-committed service.

How Do Customer Service Principles Help These

Three Groups?
Customer service principles provide a solid foundation for mastering the art
of developing customer-oriented employees:
• For company leaders they are a blueprint to reveal day-to-day
operations of companies known for great customer service.
• For manager/supervisor/coaches they contain step-by-step
approaches for giving ongoing coaching to service employees.
They provide tools and techniques to coach employees to high
levels of customer service.
• For the employee performers, who directly deliver 80 percent of
the customer service, they provide guidelines for the skills and
attitudes needed to score high with customers.

Define and Communicate Customer

Service Objectives
There are some broad, subjective objectives that need to be stressed, such
as “keep the customer happy” or “treat every customer like a guest in your
own home.” Here are some specific objectives that can be measured:
• Model behavior that delights your customer.
• Communicate and practice techniques that deliver good
customer service.
• Learn ways to avoid problems for your customers.
• Learn how to handle difficult customers.
• Learn how to handle service breakdowns.
• Distinguish your performance against competitors’.
 Projects to Increase Market Share 253

• Promote your customer service commitment.

• Increase sales and profit with great customer service.

Understand the Importance of Customers

A Wal-Mart quote by Sam Walton says, “There is only one boss. The cus-
tomer. And he can fire everybody in the company, from the chairman on
down, simply by spending his money somewhere else.” A logical question
is, “How do I communicate this understanding through my day-to-day cus-
tomer contacts?”

Demonstrate Customer-Committed Behavior

Communicate to your customers that you and they are on the same team.
A way to communicate this understanding is to demonstrate and commu-
nicate to customers that you and your company are obsessed with looking
after their needs and wants:
• Cultivate lasting relations based on trust, respect, and
understanding.
• Deliver unequaled solutions to customer problems.
• Listen to customers’ wants and needs, so well that you can repeat
them back to their satisfaction.
• Complete the details of every transaction.
• Help customers immediately to solve each problem.
• Keep customers informed frequently as a problem is being
resolved.
• Be consistent and predictable about the service customers can
expect from you.
• Become addictive when you question your customer about their
needs and wants.

Show an “I CARE” Attitude

Committed behavior flows from a caring attitude. You become what your
mind thinks most about. A caring attitude approach summarizes attitudes
that owners and leaders, coaches, and performers must internalize to be the
customer service champions in the marketplace:
254 Chapter Thirteen

• I for information understood. Be sure to understand everything

customers tell you they want or need and verify that you really
understand.
• C for courtesy. Treat everyone like a guest. Use your best manners.
When with a customer, act professional, gracious, refined, polite,
and respectful until it comes natural to you.
• A for attention to details. It’s the special touches or extra things
you do that set you apart. Understand every aspect of a customer’s
needs and wants. Assure that every detail of those needs is
delivered in a timely and accurate manner.
• R for responsibility. Show customers they are valued. Be available
and ready as customers present themselves. Respond quickly. Keep
customers informed about the status of transactions.
• E for every time. Every time, in every way, every day, practice these
attitudes from your mind-set. Your customers will be extremely
satisfied and impressed with you and the company.

Ask Questions to Get Information

To get and understand the right information when helping a customer, ask
the right questions so you can give the right answer:
• Ask background questions such as name, company, phone, order
number, and so on.
• Ask open-ended questions that begin with how, why, what, when,
which, and where to get all the information.
• Ask closed-ended questions that are answered “yes” and “no.”
These begin with is, are, do, does, have, has, can, will, or would.
• Ask illustrative questions to get the customer to describe a problem
or situation.
• Ask clarification questions to be sure you understand.
• Ask consequence questions to find how the situation, or your
suggested fix, will affect them.
• Make sure you know, and can express back to them, what they
need or want.
• Close with a thank-you question. “Thank you. Is there anything
else I can help you with today?”
 Projects to Increase Market Share 255

Build Customer Service on a Foundation of Courtesy

There are several ways you can demonstrate courtesy, good manners, and
being a gracious host to a guest.
• Show your best manners by saying, “How can I help?” “Please!”
and “Thank you!”
• Show friendship with a smile. Show a personal interest in them
by listening. You can hear a smile over the telephone or read a
smile in an e-mail.
• Prove that their needs and wants come first with you.
• Put the person ahead of the paperwork.
• Talk the customer’s language and vocabulary. Avoid jargon,
abbreviations, and terms unfamiliar to them.
• Don’t rush a transaction. Make them feel important.
• “Make their day” by turning their contact with you into a
memory they will turn into a story to tell to others.
• Use their name and yours and “invite them back.”

Design a System to Pay Attention to Details

A star performer on the customer service stage isn’t finished when the cus-
tomer audience leaves. A star immediately prepares for the next perfor-
mance with each customer. To do this you need to design a system that fits
you and your customers:
• Organize your work area into a system of reminders and
checklists for transactions that require follow-up.
• Arrange easy access to up-to-date, reliable information.
• Keep notes that are up to date and specific.
• Manage your time and actions with day planner “to do” lists so
you can be more responsive.

Measure Your Responsiveness with a Stopwatch

How quickly do you appreciate or expect a response from others to whom
you ask a question, ask for help, leave a phone message, or send an e-mail
or letter? Perhaps a stopwatch isn’t always the most appropriate measuring
instrument, but it makes the point.
256 Chapter Thirteen

• Be available. Respond quickly.

• Keep customers informed on an ongoing basis.
• Return phone calls and e-mails quickly.
• Answer mail promptly and prove it by acknowledging your
receipt date.
• Share your time plan with a customer if a response will require
hours, days, or weeks to meet their needs.
• Give the customer truthful and reliable delivery dates.
• Notify customers at once about delayed delivery dates.

Measure Your Every Time Performance

When you spend money or time to watch or listen to a star performer, you
expect a star performance every time. That should be what you expect your
customers to expect from you. The key to major-league performance for
you as a customer service professional is to practice caring behavior every
time, in every way, every day!

Mimic Your Best Suppliers, Companywide

Ask your purchasing function to provide a list of your own suppliers with
whom they are highly satisfied. These are suppliers who seldom come up
in company conversation because they seldom create problems for you and
your customers. They probably provide superior customer service, reliable
quality, and on-time delivery.
I remind you that manufacturing and material control personnel can be
unsung heroes in your company’s commitment to heroic customer service.
Also, consider your personnel who design and implement your market-
ing plan, and its continuous improvement projects, to increase your mar-
ket share.
Train company leaders, customer service coaches, and customer ser-
vice performers. Company leaders are shown the important attitudes that
must be a company culture element for your business. Training ideas for
leaders and coaches are customized to speak directly to their individual
roles. Training ideas for customer service performers, those who have 80
percent of the direct contact with customers, include many additional details
required for them to effectively deliver your customer-committed service.
 14
Plotting Your Economic
Business Cycle

A
ll through this book I’ve encouraged you to plot and use your eco-
nomic business cycle to make business decisions and to determine
the best time to implement continuous improvement projects. With
minimal effort you can use your three- to five-year business cycle to know
more precisely when to implement major and minor projects or make major
business decisions.
Your sales will cycle about every three to five years in concert with the
national economic business cycle and various economic indicators such as
bond prices, stock prices, housing starts, and the Business Week index.
It helps you make confident business decisions six months to one year
sooner than your competitors. It also helps you understand why net profit
and ROA cycle up and down as your business experiences the national eco-
nomic cycle.

A BUSINESS CYCLE PICTURED AS THE

PERCENT RATE OF CHANGE
Take a few minutes each month to plot a picture of your company’s busi-
ness cycle. To calculate the percent rate of change (ROC) you divide your
total sales for the last 12 months by the same 12 month total for the same
month one year earlier. The percent will be either greater than or less than
100 percent. A perfectly smooth ROC curve would look like Figure 14.1 as
it cycles above and below the 100 percent line.
An actual ROC curve would look like the picture of a real manufactur-
ing business for a period from 1973 to 1997 shown in Figure 14.2.

257
258 Chapter Fourteen

Rate of Change
Prosperity

Growth Warning

Recession Recovery

Depression

Cyclic Phases

Figure 14.1 The generic business cycle.

Peak Peak Peak Peak Peak Peak Peak

3.8 3.7 3.2 3.5 3.8 3.5
200

150

100

50

%
73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
3.7 3.2 3.7 3.1 2.7 2.9
Valley Valley Valley Valley Valley Valley Valley

Rate of change
Incoming orders
Shipments

Figure 14.2 Rate of change cycle for a manufacturing business from 1973
to 1997.

REASONS TO PLOT YOUR BUSINESS

CYCLE EACH MONTH
There are three reasons to plot a business cycle monthly.
First, as you gather a large inventory of potential projects, there are
certain phases of the business cycle when each project can be imple-
mented best. Large capital investments or introduction of new products will
pay back the investment in the least calendar time if implemented at the
 Plotting Your Economic Business Cycle 259

beginning of the growth phase. During the recession and depression phases,
you may be reluctant to invest cash in projects. You can save smaller
projects that will pay back in less than a year for implementation during
these phases. Your net profit will be greater with the implementation
of these projects even if you treat the investment as an expense. I make this
point to show you that there’s never a time during a business cycle to not
implement projects.
Second, your business cycle helps you to confidently make business
decisions sooner than you would without it. It allows you to stay one move
ahead of competitors. Later in this chapter I provide a list of other deci-
sions you can make with great confidence six months to one year earlier
than your competitors.
Third, profit measurements usually go up and down as a business cycle
goes through its phases. It’s important to realize that the return on assets
improvement must be viewed over a period of time approximately equal to
your most normal company business cycle time period. If you don’t want
to calculate and plot your company business cycle, you should use your
average financial performance over a three- to five-year period to be more
confident that projects are yielding improved overall results.

CALCULATE AND PLOT YOUR

COMPANY’S BUSINESS CYCLE
Your company business cycle can be calculated and plotted to look some-
thing like the preceding figures. Each month calculate and plot a percent
value to represent the rate at which sales are changing. When the percent-
age is more than 100 percent you know the rate at which annual sales are
growing. When the percentage is less than 100 percent you know the rate
at which sales are shrinking. Historically, for many companies and indus-
tries, each cycle covers a period of about four years. It’s actually a picture
of the peaks and valleys of a nation’s economy reflected in the sales peaks
and valleys of your business. Presidents of nations or individual businesses
have almost no control over it. It will take about thirty minutes each month
to calculate and plot it. If you have the information, you can plot both ship-
ments and incoming customer orders. Plotting both expands how many
months you can get the jump on your competitors.
We learned the ROC concepts from William L. Schubert. The basic
concepts and calculations were conceived by Chapin Hoskins, a Harvard
MBA and managing editor of Forbes magazine in the late 1930s. See
Related Web Searches in the Bibliography for up-to-date contributors about
this tool.
260 Chapter Fourteen

INTERPRETATION OF A BUSINESS
CYCLE PICTURE
Referring to the preceding ROC chart (Figure 14.2) for a manufacturing
business in the oil well drilling and construction equipment segments, you
can visualize why this business was more profitable than its competitors
during the period from 1977 through 1984. The business cycle signaled in
mid-1976 that the depth of the valley had been reached. Based on the peak
in 1974, it could make a good guess about the timing of the next peak and
could make business decisions much sooner than its competitors.
When the curve is initially above the 100 percent line and is trending
upward, it means new orders and shipments are increasing at an increasing
rate. As this sample curve turns downward at the peak in 1978, it means
sales were continuing to increase but at a decreasing rate. Notice that the
next valley occurred in early 1980, above the 100 percent line. This simply
means that sales continued to increase during 1980 and 1981.
Usually, business cycles are significantly influenced by national inven-
tory levels. As you can imagine, businesses in the industry segment repre-
sented by our sample curve were adding capacity and were building raw
material inventory to match the new capacity requirements. In the latter part
of 1981, the managers of this business were alerted by the downward trend
that the warning phase had arrived. They were also warned because distrib-
utors had already cut back on new orders six months earlier in mid-1981.
Early in 1982, end users, dealers, and distributors began to cancel
existing new orders. There was no merit for this company to force its cus-
tomers to accept shipment for their purchase orders and contracts because
their cash was also tied up in inventory. In this particular business cycle, it
wasn’t until after the peak in 1985 that inventory was reduced enough that
competing businesses could have a decent ROA again.
As you can see from this real-world example, there are times, such as
the period 1990 through 1995, when the peaks and valleys aren’t as pro-
nounced as other periods. However, that doesn’t invalidate the fact that your
company will have business cycles that, if monitored, will allow you to
make better business decisions sooner than your competitors.

COMPANY DECISIONS DURING EACH

BUSINESS CYCLE PHASE
We could have titled this section “Management Decisions During Each
Business Cycle Phase.” As you look at the verb/noun combinations shown
in italics in the next few pages, you will realize that many of these decisions
 Plotting Your Economic Business Cycle 261

can be made at various levels of responsibility as soon as company manage-

ment declares in which business cycle you are currently operating. Look at
these verb/noun combinations to generate your own list that allows you to
quickly delegate actions that fit your business cycle. I will suggest some of
the major categories of decisions to help you get started.
For example, some time during the warning phase, you and your dis-
tributors can start taking actions to minimize your inventory and capital
equipment capacity. Then, at the beginning of the growth phase, you and
your distributors can slowly increase inventory, ahead of actual demand,
to provide faster delivery before your competitors realize it is time to start
increasing their capacity.

Manufacturers Should Link Shop Order Start Dates with Busi-

ness Cycle Transition Points. One of the places reduced or increased
incoming orders will first be revealed is when shop orders begin to reveal
whether more or less manufacturing capacity is needed to meet shop order
start date demands. Watch this carefully when you get an indication that
the business cycle curve is about to cross the 100 percent line. The key is
to monitor the shop order start date/capacity demands in concert with the
business cycle curve as it moves up or down toward the 100 percent line.

Control Inventory Levels. In Chapter 10, I covered ways to control

inventory levels by utilizing a financially sound lot sizing formula based on
existing setup costs and inventory carrying cost percent. You can prudently
manipulate your lot sizes as your business cycle curve prepares to cross the
100 percent line to make the transition from one phase to another.

• Reduce inventory levels in the warning and recession phases.

Consider distributor inventories to maximize distributor loyalty
by helping them minimize their inventory as well as your own.
To minimize inventory during the ending of the warning phase
and the beginning of the recession phase, the best way is to reduce
lot sizes by increasing the inventory carrying cost percent in your
lot sizing formula for a reasonable period of time. This action
temporarily reduces inventory investment while your material
control system automatically reduces usage rates.

• Increase inventory levels during recovery and growth phases.

With this action you improve distributor relations and their ROA
by helping them increase their sales. Here you reduce the inventory
carrying cost percent so it will slightly increase lot sizes across
the board. Temporary adjustment to the inventory carrying cost
percent is a simple method to manage inventory levels. It yields a
262 Chapter Fourteen

temporary, balanced automatic adjustment to items you must

carry in inventory.
• Maintain inventory levels during the prosperity peak and
depression valley by using the true inventory carrying cost
percent. These two periods of time account for 80 percent of the
months included in each business cycle. Be sure to use the project
evaluation in Chapter 5 to decide if each specific action will
increase the ROA over a full business cycle.
Adjust Employment Levels. Business cycle peaks and valleys are often
too extreme to only consider attrition as the only way to adjust employee
levels. That’s why layoffs are often necessary after a business cycle down-
turn. On the other hand, you want to be sure you maintain your key
knowledge resources during the recession and recovery phases. You also
want to look at projects that will pay back in less than one year and be sure
to maintain a number of project teams. Remember, these teams, if your
project evaluations are accurate, are never an expense and should always
result in increased profit and increased market share, even in the valley of
your business cycle.
• Increase project team levels during all phases at a level to
which stockholders will commit funds.
• Control manufacturing employment levels during growth,
prosperity, and warning phases to meet capacity demands
signaled by shop order start dates.
• Minimize addition of new employees during all phases to reduce
salaries and wages per sales dollar as you implement increased
employee efficiency.
• Consider more overtime during the later portion of the warning
phase, as dictated by shop order start dates, to avoid hiring and
training employees that may need to be laid off.
Use your own imagination to time projects to increase sales and market
share:
• Introduce new products
• Enter new market segments
• Add new distributors
• Implement new discount structures
• Implement new marketing programs
 Plotting Your Economic Business Cycle 263

• Eliminate low gross profit product lines

• Add or subtract capital equipment investment
• Dispose of excess or underutilized equipment
• Order new equipment or facilities to increase or maintain
capacity

THE CALCULATION AND

PLOTTING PROCESS
In a very few minutes each month you can perform the simple arithmetic to
calculate and plot the rate of change for your total sales or for sales of each
product line if you decide you want that much detail. You can perform man-
ual calculations and plot on graph paper or design a computer spreadsheet
that will perform the calculations and plot a computer-generated curve (see
Figure 14.3).

Sales/Shipments 12 Months Running Total (12MRT) Rate of Change (ROC) %

1996 1996 1996 1997 1997 1997 1998 1998 1998 1999 1999 1999
Monthly Monthly Monthly Monthly
Month Sales 12MRT ROC Sales 12MRT ROC Sales 12MRT ROC Sales 12MRT ROC
JAN 417,700 457,500 5,226,000 589,600 6,259,000 120 580,800 7,441,700 119
FEB 379,200 441,800 5,288,600 707,100 6,524,300 123 613,400 7,398,000 113
MAR 426,500 483,400 5,345,500 676,700 6,717,600 126 584,900 7,256,200 108
APR 381,800 506,600 5,470,300 602,500 6,813,500 125 530,900 7,184,600 105
MAY 408,100 538,600 5,600,800 629,300 6,904,200 123 482,900 7,038,200 102
JUN 375,500 519,000 5,744,300 534,700 6,919,900 120 469,500 6,973,000 101
JUL 501,900 538,800 5,781,200 678,700 7,059,800 122 533,900 6,828,200 97
AUG 437,200 536,900 5,880,900 660,600 7,183,500 122 441,800 6,609,400 92
SEP 446,800 530,300 5,964,400 611,700 7,264,900 122 484,100 6,481,800 89
OCT 501,300 569,200 6,032,300 698,300 7,394,000 123 521,000 6,304,500 85
NOV 434,700 545,000 6,142,600 538,200 7,387,200 120 525,700 6,292,000 85
DEC 477,000 5,186,200 459,800 6,126,900 118 523,100 7,450,500 122 366,500 6,135,400 82

Incoming Orders 12 Months Running Total (12MRT) Rate of Change (ROC) %

Incoming Incoming Incoming Incoming

Month orders 12MRT ROC orders 12MRT ROC orders 12MRT ROC orders 12MRT ROC
JAN 458,100 779,200 5,900,600 550,200 7,190,400 122 500,600 6,829,100 95
FEB 394,400 727,300 6,233,000 652,200 7,115,300 114 567,200 6,744,100 95
MAR 434,300 532,700 6,331,400 957,200 7,539,800 119 503,400 6,290,300 83
APR 480,700 582,200 6,432,900 500,800 7,458,400 116 697,200 6,486,700 87
MAY 472,700 638,200 6,598,400 668,700 7,488,900 113 488,200 6,306,200 84
JUN 544,700 432,900 6,486,600 599,400 7,655,400 118 437,600 6,144,400 80
JUL 399,100 396,600 6,484,100 706,600 7,965,400 123 344,100 5,781,900 73
AUG 426,500 553,600 6,611,200 436,500 7,848,300 119 365,400 5,710,800 73
SEP 525,400 781,100 6,866,900 604,300 7,671,500 112 338,500 5,445,000 71
OCT 511,700 746,900 7,102,100 216,600 7,141,200 101 397,700 5,626,100 79
NOV 289,400 599,500 7,412,200 417,300 6,959,000 94 544,800 5,753,600 83
DEC 642,000 5,579,500 649,200 7,419,400 133 568,900 6,878,700 93 344,600 5,529,300 80

Figure 14.3 Spreadsheet showing rate of change calculations for sales and
incoming orders.
264 Chapter Fourteen

The spreadsheet in Figure 14.3 will serve as a pattern and example of

the calculation process:
• Create a spreadsheet for sales/shipments and incoming orders.
Plot these two curves on the same graph so you can see them
move in concert.
• Initially plot as much history as you have available. The
year-to-year curves will tell you whether or when the curve
will become usable for predicting future transitions from one
phase to another.
• Divide the 12-month running total (12MRT) for each month by
the 12-month running total for the same month one year earlier
to obtain a percent rate of change (ROC). (Example: DEC 1996,
$6,126,900 ÷ $5,186,200 = 118%)
• For the first historical year you decide to use, you will list the
monthly sales or monthly incoming orders in their appropriate
columns. (Example: JAN 1996, $417,700)
• For the first historical year, record the annual sales or annual
incoming orders in the 12MRT column on the DEC line.
(Example: DEC 1996, $5,186,200)
• For each month of the second historical year list the monthly
value in the sales and incoming order columns.
• Each month of the second year, calculate a 12-month running
total in the 12MRT column, beginning with JAN 1997. To make
the 12MRT calculation for the latest month, subtract the monthly
value for the same month of the previous year from the 12MRT
for the previous month and add the results to the monthly
value for the new month, and record the results in the 12MRT
column for the new month. (Example JAN 1997, $5,186,200 –
$417,700 + $457,500 = $5,226,000).
• Beginning with DEC of the second historical year, DEC 1997,
calculate the monthly ROC percent. This is obtained by dividing
DEC 1997 12MRT ($6,126,900) by the 12MRT for the same
month of the preceding year ($5,186,200 for DEC 1999) to obtain
118 percent.
• Starting with JAN 1998, and for future months, values are recorded
in the monthly sales or monthly incoming orders columns and
 Plotting Your Economic Business Cycle 265

calculations are made for the 12MRT and ROC columns.

(Example: For JAN 1998, the 12MRT is obtained by subtracting
the JAN 1997 sales value [$457,500] from the DEC 1997 12MRT
[$6,126,900] and adding the JAN 1998 monthly sales value
[$589,600] to obtain the JAN 1998 12MRT [$6,259,000].)
This same recording and calculating is repeated for each
following month.
The ROC percents are recorded on the spreadsheet and the calculations are
recorded on the graph in Figure 14.4. Since I knew the actual ROC values
for the years before 1998 (for Figure 14.2) and after 1999, I included them
to give a better picture of what the business cycle looked like for this manu-
facturing business.

Sales/shipments Incoming orders

160

140

120

100

80

60
Dec
Mar
Jun
Sep
Dec
Mar
Jun
Sep
Dec
Mar
Jun
Sep
Dec
Mar
Jun
Sep
Dec
Mar
Jun
Sep
Dec

1996 1997 1998 1999 2000

Figure 14.4 Graph of rate of change calculations from Figure 14.3.

266 Chapter Fourteen

This curve clearly shows that you can gain an advantage over your
competitors by realizing that your curve for incoming orders is going to lead
your shipment curve. These curves should also give you a tool to time the
implementation of projects to increase your ROA during both the peaks and
the valleys. The peaks and valleys will also explain why your ROA should
be evaluated over an entire business cycle because the lower sales and lower
net profit during the valleys also force a lower ROA in the valleys. This is
another reason why you want to time your inventory and capital equipment
investment changes so you can minimize their impact on ROA during the
valley. I encourage you to take this long-range view so you will reserve
much of your excess cash for continuous project investment at the peaks,
including investment for project team personnel.

LEADING AND FOLLOWING

ECONOMIC INDICATORS
The chart in Figure 14.5 shows another way to use the ROC as a planning
and management tool. There are several economic indicators whose ROC
cycles in a predicable fashion. The ROC of your business will cycle in a
similar pattern and timing to one of these economic indicators.
These indicators are status indicators on your company’s dashboard
just like light indicators and gages on your car’s dashboard. They serve to
inform you that the economy is going well and sometimes they warn you
that it’s time for you to pull over to the curb and check some things before
you continue on your financial business journey.
Some of these indicators cycle ahead of the Business Week index and
some cycle behind it. It happens that the ROC for the sample business I’ve
used as an example cycles very similarly to the Business Week index.
The dotted line on the chart in Figure 14.5 shows the ROC of the sample
company from Figure 14.2. It’s not a perfect match, but close enough that
our sample company should pay attention to bond prices, stock prices, and
housing starts to get an early indication of what to expect in the next one
to two years.
When these economic indicators are watched, you will greatly build your
ability to make risky business decisions with much greater confidence.
 Plotting Your Economic Business Cycle 267

12 Month Moving Average Rate of Change—Lead–Lag Relationships

ROC %
12/12—Rate of change (growth rate) Bond prices—long term rates inverted
120 A G I
C D E F
110 B H
100
90
Stock prices—S&P 500
120
110
100
110
100
Housing starts
90 A
110
100
90 New orders—durables
105
100
110 Business Week index
105
100

Durables inventories
110

100
Business borrowing—
commercial and industrial loans
90
’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97

Figure 14.5 Economic indicator business cycle sequence.

 15
Continuous Improvement
versus Creativity

M
any businesses that have implemented companywide improve-
ment programs such as Six Sigma, ISO 9000, total quality
management, lean, or something like the innovative version of
continuous improvement using verb/noun combinations from the seven
critical business elements presented in this book, have had the debate that
these programs hamper creativity. This issue is particularly pronounced for
businesses whose sales depend on the invention of new products.
I happen to come down on the side of creativity. It is my conclusion that
not all functions of some businesses must participate in the companywide
activities for efficiency in operational functions that are the focus of these
various improvement programs.
Every business must have creative personnel whose creativity can be
successfully applied to all seven of the business elements from an opera-
tional point of view. However, there are a very small percentage of knowl-
edge workers who must be allowed to exercise their imaginations to dream
up new products or applications of new technologies.
If you can factually prove to yourself that a high percent of your annual
sales, from year to year and over several recent business cycles, are con-
sistently made up of new products, you have a basis to identify and make
allowances for these few specific knowledge workers.
Some businesses, whose sales and market share depend on these kinds
of new products or applications of new technologies, should purpose-
fully excuse these few people from the obvious restrictions that are clearly
required to double your ROA over a period of three to five years. It doesn’t
mean they shouldn’t be exposed to and trained in these practices, which
they may consider to restrict their creativity and inventiveness. They need
to know what other employees are doing to generate cash so they can be
allowed to create new products to feed the operational functions.

269
270 Chapter Fifteen

I don’t know a good short-term way to measure the ROA for true inven-
tors and their trial-and-error process of imagining new possibilities. Any
business will be blessed to have one or more individuals who possess this
magical thinking process, if that’s what the business requires.
If you want to allow this kind of individual the freedom to experiment
with new products or new applications of ideas, you may have to almost
completely remove them from the restrictions imposed on the operational
employees to implement a successful year-in-and-year-out continuous
improvement program that demands relatively short-term financial payback
for improvement projects.
However, this doesn’t mean you don’t measure the long-term perfor-
mance of these inventive activities. It’s obvious that your stockholders, and
even key customers you consult with, won’t want you to keep investing end-
lessly if new sales or market share don’t pay back the investment by increas-
ing the ROA above what it would have been without it. You don’t have to
let these creative people see your measurement process because, for them,
measuring is just another restriction they don’t need to be concerned with.
I encourage your management to accept the reality of the tension that
results from your most creative people, even those in the operational func-
tions, bowing to the restrictive financial arithmetic required to greatly
increase your ROA. I believe that your creative operational knowledge
resources will always respond positively when they are recognized by both
management and peers as helping elevate the business to new financial
heights.
 16
Seven Sources
of Entrepreneurial
Innovation

M
uch of the knowledge in this chapter was learned from the fol-
lowing books: Managing for Results by Peter Drucker, Innova-
tion and Entrepreneurship: Practices and Principles by Peter
Drucker, and The Definitive Drucker by Elizabeth Haas Edersheim.
There are three goals for this chapter:
• To convince managers of any business that they can become
successful entrepreneurial innovators.
• To get you to read, study, and apply the knowledge found in
these books, and any other Drucker books.
• To show you what I’ve learned from Drucker about what an
entrepreneurial innovator looks like.
This chapter is directed to the managers in your business, who should
desire to apply an entrepreneurial style of management to discover opportu-
nities to grow and expand the current business through what Drucker calls
the “seven sources of innovative opportunity,” in concert with continuous
improvement projects from the seven critical business elements, to double
your ROA. Now I will make it clear that the reason to generate cash assets
from projects to double your ROA is to have investment funds to perform
entrepreneurial innovation.
One of Drucker’s goals in his 39 published books on management is
to show that entrepreneurship and innovation are things any hard-working
manager can do by using a systematic thinking process.

271
272 Chapter Sixteen

THE THREE GROUPS OF

KNOWLEDGE RESOURCES
In Chapter 1, I introduced the concept that there are three separate but inte-
grated knowledge resource groups that each requires its own policies, prac-
tices, and measures of performance. The first two groups are focused on
the seven critical business elements. The third group focuses on the seven
sources of entrepreneurial innovation.
In very large businesses, these may be distinct groups that infrequently
share the same knowledge resources. Small- to medium-sized businesses
will find it necessary to include a few individual knowledge resources in
all three of the groups.
Each group requires its own unique systematic process to effectively
manage its allotment of the company’s knowledge resources. Each group
causes major change in the culture of the business. Because of this change,
each group requires top-level managers, those who hire and allocate the
major knowledge resources, to be the champions of change.
The operations group uses the principles contained in the seven busi-
ness elements to assure on-time delivery of high-quality products at the
lowest cost in all phases of each business cycle. The bottom-line measure is
maintenance of the ROA, established over several business cycles.
To move the company culture to the point of delivering on-time, lowest-
cost, high-quality products and services 95 percent of the time requires top-
level management to commit to and champion this mission so all the right
knowledge resources are allocated.
This group may resist the belief that consistent quality, consistent low
cost, and on-time delivery of products and services 95 percent of the time
is actually achievable until a management champion trains them and shows
them that it can be done.
The continuous improvement group also utilizes the seven business
elements to discover and implement continuous improvement projects, with
a goal to double the ROA over a three- to five-year business cycle. One
purpose of the dramatic ROA increase is to continually provide the cash to
support both continuous improvement and entrepreneurial innovation.
To change the company culture to accept and implement company-
wide continuous improvement to double ROA requires top-level manage-
ment to champion this mission and to make the investment and allocation
of knowledge resources necessary to discover and implement a massive
number of continuous improvement projects during every phase of every
business cycle.
 Seven Sources of Entrepreneurial Innovation 273

This group may resist the idea that the ROA can be doubled over a
three- to five-year period unless a manager proves to them that it can be
done and proves to them that the necessary investment in money and people
resources will be made.
The entrepreneurial innovation group uses the seven sources of inno-
vation to assure long-term survival of the business by replacing products,
market segments, or distribution channels that no longer fit, and by looking
for opportunities to start new businesses that fit with or extend the exist-
ing business.
To change the culture of top managers to the point that they become
managers of entrepreneurial innovation requires top manager commitment
and participation to manage this group of knowledge resources so they
will set a course to extend the life of the business many business cycles into
the future.
As surprising as it may seem, this group of professional managers can
be expected to resist becoming innovative entrepreneurs on the basis that
entrepreneurs are “born that way” and can’t use a systematic process to do
the job. Or it could be that they don’t yet realize that ensuring long-term
survival and growth of a business is a basic requirement of professional
managers, each and every year of business cycles into the future. Perhaps
they haven’t been given the tools and training to identify the changes that
occur every year in the lifecycle of a product, service, market segment, or
distribution channel.

MANAGING ENTREPRENEURIAL
INNOVATION
The pure definition of innovation is, “The introduction of a new idea, a new
material, or a new device.” I suggest that this book is an innovation because
it presents the seven critical business elements as the only source of projects
to double the ROA with continuous improvement projects. I know of no
other source for this particular approach.
The pure definition of an entrepreneur is simply someone who orga-
nizes, manages, and assumes the risk that a business will produce an accept-
able profit. This definition could easily apply to any employee at any level
who systematically makes financial decisions every day or hour.
In this chapter I expose you to a more elevated definition that Peter
Drucker explains in his book Innovation and Entrepreneurship. He
harnesses these two words together to go beyond what I covered in the
274 Chapter Sixteen

preceding chapters of this book. Just as I contend that employees at every

level can use this systematic approach to double the ROA of a business,
Drucker contends that managers at every level can use a systematic approach
to become top-notch innovators and entrepreneurs.
A September 2007 Tulsa World newspaper article reported that Procter
& Gamble’s annual sales “earnings per share grew 15 percent and operat-
ing cash flow improved 18 percent.” They claimed that growing market
share and innovation was a result of a “deep” understanding of consumer
demand, cost savings, and the integration of acquisitions such as Gillette,
Duracell, and Braun. Investors in Procter & Gamble (P&G) have experi-
enced an increase in dividends for the 52nd year in a row.
What explains P&G’s superior economic behavior? The answer—“inno-
vation and entrepreneurship”—from Drucker’s book by the same name.
By applying systematic processes to managing a business for the long
term, small- to medium-sized enterprises can demonstrate a record similar
to that of P&G. The key is to use a systematic approach to discover and
implement projects to exploit new opportunities that satisfy the needs
and wants of current and potential customers.
Just as good continuous improvement change agents and champions
accept change as a normal and healthy way to increase ROA, good innova-
tive entrepreneurs accept changes in the marketplace as fertile ground in
which to plant the seeds of innovation. Innovation is the seed that entrepre-
neurs plant to harvest year-to-year financial growth.
Entrepreneurial farmers manage risk by shifting their best knowledge
and financial resources from a less fertile field to one that will yield a bigger
and more profitable harvest.
Just as planning is the lowest-cost method of control in a material con-
trol system for a manufacturing business, systematic entrepreneurial inno-
vation is the lowest-risk system to grow a business from year to year and
from business cycle to business cycle.
And just as I have provided a way to financially judge continuous
improvement projects in Chapter 5, I point to a way in this chapter for you
to develop your own means to decide between innovation projects. Drucker
can show you how to discover business opportunities, evaluate their chance
of success, measure the risk of failure, and combine existing resources into
a new configuration that continues to satisfy customers and stockholders.
So, how do managers go about a systematic search for changes? How
do you systematically analyze opportunities the changes offer for innova-
tion? Drucker suggests two analytic exercises:
• A “business X-ray”
• Seven sources of innovation
 Seven Sources of Entrepreneurial Innovation 275

THE BUSINESS X-RAY

Once your company has overcome managers’ resistance to see themselves
as entrepreneurial innovators, a logical step is to apply what Drucker calls
a “business X-ray.” This is simply a systematic way to segregate products,
market segments, and distribution channels into groups or categories by
documenting:
• Which ones are growing old, are near death, and will soon need
to be abandoned or repaired
• Which ones are just wasting valuable knowledge and money
resources
• Which ones are young and need extra resources to grow through
various stages of development
In Chapter 8, I suggested a similar way to segregate and annually monitor
the sales and gross profit for product lines, market segments, and distribu-
tion channels as a way to discover continuous improvement projects. Gross
profit trends can help your teams discover problems and opportunities.
Drucker’s book gives a very comprehensive way to make this analysis,
which you can redesign to meet your own needs. His categories are:
• Today’s and yesterday’s breadwinners
• Investment in managerial ego
• Repair jobs and failures
• Productive, unnecessary, and unjustified specialties
• Development products, segments, or channels
My point is this: each year, entrepreneurs systematically analyze data to
know where to allocate knowledge and money resources to identify and
exploit opportunities to extend the life of the business. Study Drucker’s
and Haas Edersheim’s books to make this an integral part of your entrepre-
neurial thinking.

THE SEVEN SOURCES OF INNOVATION

Drucker recommends you monitor seven sources that offer entrepreneur-
ial opportunity. He calls these “symptoms” that are “reliable indicators
of changes that have already happened, or can be made to happen with
little effort.”
276 Chapter Sixteen

First is the unexpected success, unexpected failure, or unexpected out-

side event:
• An unexpected success may be hard for managers to accept
because it may be something for which they can’t honestly
take credit. Therefore, they fail to exploit it. Normal quantitative
financial reporting may not flag these successes nor recognize
the qualitative aspects. To exploit this marketplace symptom
requires you to analyze the symptom until you discover an
innovative opportunity. It should be apparent that a manager
should quickly shift knowledge and financial resources by
assigning specific individuals to analyze, innovate, and implement
entrepreneurial change.
• An unexpected failure can’t be ignored. It’s not usually viewed as
a symptom that provides innovative opportunity. If the original
design and marketing strategy for a product or service was well
thought out, there’s a probability that something in the product’s
use or value has changed. Therefore, go talk to the marketplace
and let it tell you what has changed. Then, accept the change and
assign resources to purposefully define the opportunity.
• An unexpected outside event may be a market change that opens
an opportunity to apply existing products or distribution channels
to some new use or application where a reconfiguration or
alteration will make it fit the marketplace.
The second source is an incongruity in reality as it is assumed to be or as
it ought to be. An incongruity exists when you have a dramatic increase or
decrease in weight and your clothes no longer fit. Incongruity is recogniz-
able when the musical notes of a choir or orchestra no longer harmonize
with each other. These are obvious symptoms that something is out of
balance. Incongruities signal change and reveal opportunities for improve-
ments where a minor innovation can yield big results. Lack of harmony
or better-fitting clothes can be qualitative as well as quantitative changes.
They are clearly visible, yet are often overlooked because we have slowly
become accustomed to the bad fit or the disharmony:
• Financial performance of products or services that is dramatically
better or worse than expected during the various phases of a
business cycle would be a signal to analyze good performance so
you can duplicate it or look at bad performance and correct it. An
opportunity or symptom might be signaled if a product performs
better than other products during the valley of the business cycle.
 Seven Sources of Entrepreneurial Innovation 277

If exploited, it and similar products might dampen the extreme

peaks and valleys of each business cycle and greatly improve your
capital asset utilization.
• Look for things that don’t harmonize in new products, new
services, or new processes. Look for an abnormal business cycle
phase because of war, major natural disasters, or major energy
shortages. Be aware of innovations that require unusually high
capital investment to meet current demand, which may not grow as
rapidly as the capital investment required for the current demand.
• Look for opportunities where there are long lead times, combined
with or separate from large capital equipment investment. A
Drucker example is the long lead time consumed to load and
unload cargo ships, a very expensive capital investment, before
the innovation of large cargo containers. Processing equipment
manufacturers executed a similar change when they provided
machines with large magazines of cutting tools combined with
multiple indexing tables and holding fixtures. This allowed many
individual parts to be processed with a minimum of setup time and
lead time on a very expensive piece of equipment. As a result, the
inventory investment for those parts was essentially eliminated,
allowing delivery to assembly once each shift or each hour.
• Search for the mismatch between your customers’ and your beliefs
about their needs and wants. The difference between the two is
a symptom and an opportunity for an innovative alteration to
make a better fit. If you hear yourself saying that customers are
irrational and unwilling to pay for certain features or services,
you may be blocking out the voice of reality, which is trying
to tell you that this mismatch is an opportunity for a simple
innovation. Just ask each major customer what they need or
don’t need in your product and service. Stop being so arrogant
in thinking that you know what is best for them.
The third source is innovation based on process need. Processes and proce-
dures exist in both your and your customers’ businesses. Visualize one of
your company procedures to see a picture of Drucker’s five criteria and two
constraints to discover and formulate innovations for a process need.
The five criteria are:
• A self-contained process
• A weak missing link or step in the process
278 Chapter Sixteen

• A clear definition of the purpose for the process

• A solution that can be clearly defined
• A consensus from the process users that there ought to be
a better way
The two constraints are:
• Some of the process users may not yet understand or accept
that there is a mismatch or that something is out of harmony with
its purpose
• Even if you understand the need for a change in the process or
procedure, you may not possess knowledge to make the alterations
so it will fit, or to change the notes to bring it back into harmony
The fourth source is “Changes in industry and market structure that catch
everyone unawares.” Wal-Mart stores in small towns brought a dramatic
change to many main street businesses. Many business owners and some
employees see Wal-Mart as a threat that will ruin their way of life and the
life of the town. Therefore, they ignore the opportunity. The innovators see
this change as an opportunity. They see it as a reality that can’t be ignored,
based on the fact that a Wal-Mart store creates many jobs in each small
town outside its walls. How can innovators be so sure of themselves? They
are businesswomen and businessmen who accept change and watch for the
indicators of change that will specifically affect their business.
Systematic innovators in the smallest business can easily spot rapid
growth in an industry that might affect them. All businesspersons and
political leaders in small towns were signaled many years in advance that
Wal-Mart might change the structure of their town. They didn’t conclude
that innovative opportunities were the best solution to their problem. At
the same time they watched Wal-Mart’s rapid expansion, they could have
looked at other industries that were growing faster than the economy or
population and, in advance, brought in those industries that could have
systematically and innovatively reconfigured the knowledge and assets on
their main street into something that fit the changed market structure.
Another change to look for is that as some industries grow rapidly,
they might become complacent and not realize that what originally satis-
fied their customers is in the process of changing. Innovative opportunities
may be found in the way the market segments itself, requiring innovative
changes in its products, services, or marketing channels to reach a chang-
ing customer base.
Rapidly changing industry structure also opens a door for innovative
opportunity when two technologies meet each other at just the right time.
 Seven Sources of Entrepreneurial Innovation 279

It’s like the rapid structural change that occurs in two people’s love lives
when they meet each other at just the right time. The wedding of telephone
and computer technologies has produced a huge family of products and
services, including support products such as cell towers and satellites.
Watch for new kinds of technology and their applications. Be ready to intro-
duce two of them to each other when the time is right.
An innovative opportunity may be waiting around the edge of an indus-
try that is dominated by one or two large companies. As structural changes
begin to occur, the companies with big market share may be neglecting
the fastest-growing market segment or distribution channel. An alert and
systematic entrepreneur can design simple innovations that can gain market
share and a foothold in that industry at a relatively low investment.
The fifth source is demographics. These are population changes in areas
such as geographic location, area size, age, employment, income, and edu-
cation. It’s an obvious place business managers should watch. Demograph-
ics are always in a very slow state of change. However, that’s the reason they
provide so many opportunities for the systematic entrepreneur. The very
slow rate of change is the reason many business decision makers ignore it.
Consider the irreversible national structural changes in the United States
created by illegal Hispanic immigration that has happened over a very long
period of time. Those who look for innovative opportunities that meet the
needs and wants of this demographic group may find significant markets
they can have all to themselves. Look for demographics that are changing
more quickly than the norm to find entrepreneurial opportunities.
The sixth source is “Changes in perception, mood, and meaning.” Both
individuals and industries have a perception. It is the way a person or indus-
try sees things. It’s a pattern of thinking. Sometimes as people get older
they have a broad range of experiences that change their pattern of thinking
and the way they see things. We sometimes say people or industries experi-
ence a paradigm shift. Changing perception is just another opportunity for
entrepreneurial innovation.
When a person has a change in their thinking, past facts haven’t
changed. Only the meaning or interpretation of the facts has changed. The
same concept is true of industry. The person or industry may not under-
stand it, but it’s a fact that significant change has occurred. For these kinds
of opportunities, timing is critical. To exploit changes in perception, the
opportunist must be the first one there with a relatively small initial idea
to offer.
The seventh source is “New scientific and nonscientific knowledge.” I
won’t use a lot of space talking about innovations from new knowledge. It’s
a complicated source because it takes a very long time between discovery
and the application of any new knowledge to technology. Then it’s another
280 Chapter Sixteen

long time before products and a marketplace are developed. If you need
to learn more about opportunities to be had from this change, refer to the
books mentioned at the beginning of this chapter.

MEASURING ENTREPRENEURIAL
ACTIVITIES
The entrepreneur must also have a way to measure entrepreneurial and
innovative activities. A critical truth to remember is that financial mea-
surements, such as ROA, aren’t appropriate because business development
is often a long, slow process that may take years to grow products, market
segments, and distribution channels. One way to minimize this truth is to
not wander far from the base and structure of your current business.
Drucker points out that these activities must be separated from normal
financial measurement until they have had time to develop, just as you don’t
expect a growing child, in whom you make a big investment over several
years, to become productive. Drucker points out that manager meetings and
business reports need to be broken into two separate parts, one for normal
profitable operations and one that primarily measures progress on creative
activities that have been agreed upon to keep the business moving in the
right direction.
Here’s my final point: the reason you use continuous improvement
projects to double the ROA is to have the money and knowledge resources
to invest in continuous improvement and new entrepreneurial business
enterprises.
 Bibliography

C
hapter 1 of this book listed the sources of knowledge I was exposed
to during my long career, which was used to describe an innova-
tive approach to continuous improvement. Few direct quotes are
used because much of the knowledge related to the innovative approach of
the book came from seminars, being exposed to consultants in the course
of being a manager in various functions of a manufacturing business for
many years, and experimenting and testing simplified business concepts
suggested in this work.
Other sources and acknowledgments are included in the same chapter
as the learned information. Every effort has been made to avoid infringing
on copyrights and to provide specifics about how the reader can access a
broader scope of related reading.

BOOKS AND STANDARDS

American Society for Quality. ANSI/ISO/ASQ Q9001-2000 Standard.
Milwaukee: ASQ, 2000.
Drucker, Peter. Managing for Results. New York: Harper & Row, 1954.
———. Innovation and Entrepreneurship: Practices and Principles. New York:
Harper & Row, 1985
Edersheim, Elizabeth Haas. The Definitive Drucker. New York: McGraw-Hill,
2007.
Reed, Stanley Foster, and Alexandra Reed Lajoux. The Art of M&A: A Merger
Acquisition Buyout Guide. New York: McGraw-Hill, 1998
U.S. Department of Commerce, National Institute of Standards and Technology.
Manufacturing Enterprise Partnership. Washington, D.C.: NIST, 2003.
VanDeMark, Robert L. Inventory Control Techniques. Dallas, TX: VanDeMark,
1972.

281
282 Bibliography

———. New Ideas in Materials Management. Dallas, TX: VanDeMark, 1967.

———. Production Control Techniques. Dallas, TX: VanDeMark, 1970.

WEB SITES
[Link], customer service and quality standards
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[Link], marketing planning

RELATED WEB SEARCHES

The Economic Business Cycle, [Link]
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Value Analysis, VEVA Seminars
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ever attended
 Index

A assets, four categories, 6

audits, internal quality system,
accounting precision, in project conducting, 209
discovery, 77 automation, misuse of, as waste, 88
accounting truths, 77–82 average rate of return, method of
accounts receivable investment, business valuation, 239–40
reducing, 14, 19
how to, 27
project group, 39 B
acquisition process, 245–50
acquisition strategy, integrating with base data
continuous improvement, accumulated new, ROA
235–36 improvement goals, 59–60
acquisition team, 245–46 in project prioritization, 73–74
acquisition valuation blanket orders, 182
process, example, 243–45 bosses, four sets of, 62
worksheet, designing, 241–43 brand coverage, increasing, 21
acquisitions budget expenses, segregating, 22–23,
defining criteria for, 236–37 82–86
increasing market share through, budget plan
234–38 as profit and loss statement, 79–81
simplifying process, 236 in reducing expenses, 34
steps in, 237–38 business cycle. See economic business
approvals, redundant, as cause of cycle
waste, 91 business knowledge, innovative
asset investment(s) approach to, 1
four necessary to improve ROA business managers and owners, 4
percent, 81–82 business objectives, relating to
minimizing, 11, 18 marketing objectives, 222
relationship to net profit, 7 business valuation, 238–45

283
284 Index

methods used, 239–40 continuing education, team building

Business Week index, 266 as, 68
business X-ray, 275 continuous improvement
change agents in, 63
versus creativity, 269–70
C innovative approach to, 1
integrating acquisition strategy
capital asset utilization, maximizing, with, 235–36
13–14, 19 knowledge resources and, 62–63
how to, 26–27 linking with ISO 9000, 199–211
project group, 37–38 programs, reasons for failure, 4
ROA improvement goals, 57 continuous improvement group, of
cash flow, in business valuation, knowledge resources, 272–73
240–41 continuous process flow, 149
cell design process, five-step, 150–55 poor understanding of as cause of
cells, manufacturing/processing, waste, 90
design and implementation, corrective action procedure,
149–55 documenting, 210–11
change courtesy, in customer service, 255
resistance to by employees, 63 creativity, versus continuous
using project teams to manage, improvement, 269–70
66 customer order processing
change agents, in continuous lead time, policy, 165–66
improvement, 63 lead time, reducing, 35
changeover time, reducing, 141–42 master plan for scheduling, 171
channel coverage, increasing, 20 customer requirements
coaching staff, building from determining initial, 202–3
knowledge resources, 67 failure to define as cause of waste,
collection period, invoice, improving, 90–91, 92
27 reviewing initial, 203
communication customer satisfaction, measuring and
with customers, 203–4 monitoring, 209
as source of waste, 91 customer service, improving, 251–56
competitors, and acquisitions, 234–35 customers
component inventory, 37 communicating with, 203–4
budget, calculating and comparing, types of, 114, 119
197–98 customer-supplied property,
component lead time, calculating, protecting, 208
166–67 cycle counts, versus physical
component unit cost, calculating, 174 inventory, 180–81
component usage rate, calculating, cycle time(s), and inventory
173 investment, 168
component usage value
calculating, 175–76
classifying by, 176 D
components, preserving and
protecting, 208 data
confidential financial information, analyzing accumulated, 210
use of by project teams, 74 reentering, as waste, 91
 Index 285

databases, redundant, as waste, 91 EBITDA (earnings before interest,

dealers, 114 taxes, depreciation, and
and channel coverage, 220–21 amortization), in business
in marketing planning, 228–31 valuation, 240–41
defect waste, 92–93 economic business cycle, 5–6, 8–9
design changes, controlling, 205–6 calculating, 259, 263–66
design inputs, relating to product and capital asset utilization, 13–14
requirements, 204 interpreting, 260
design outputs, relating to product and money and knowledge
requirements, 204–5 resource investment, 64
design specifications, ensuring as percent rate of change, 257
purchased component plotting, 257–66, 263–66
conformity to, 206 reasons for, 258–59
design validation, relating to product setting sales forecasts based on,
requirements, 205 224
design verification, relating to product using to time project
requirements, 205 implementation, 74–75
detail, attention to, in customer economic indicators, leading and
service, 255 following, 266
development changes, controlling, economic order quantity (EOQ),
205–6 131–33, 135, 138, 140
development inputs, relating to experimenting with, 138–40
product requirements, 204 and price breaks, 156–58
development outputs, relating to education, inadequate, as cause of
product requirements, 204–5 waste, 93
development validation, relating to 80/20 rule
product requirements, 205 in marketing planning, 227–28
development verification, relating to using in project evaluation and
product requirements, 205 ranking, 75, 82
discounted cash flow, method of employee asset utilization,
business valuation, 240 maximizing, 14, 19, 64–65
discounts, distributor, 229–30 how to, 27–29
distribution business lead time, project group, 32–33
reducing, 115–19 employee gain sharing, 70–72
distribution channels, in acquisition employee teams, empowering, 61–72
target, 249–50 employee turnover, as source of
distributor discount, 229–30 waste, 94
distributors, 114 employee value, measuring, 64–65
and channel coverage, 220–21 employees, and financial decisions, 61
in marketing planning, 228–31 employment levels, and economic
Dover Corporation, 236–37 business cycle, 262–63
Drucker, Peter, 4, 271, 273–74, 280 empowerment
of employee teams, 61–72
failure of, as cause of waste,
E 93–94
through project teams, 66–67
EBIT (earnings before interest and end item
taxes), in business valuation, inventory budget, calculating and
240 comparing, 198
286 Index

reorder method, determining, gross profit, formulas for, 78–79

172–73 gut feelings, in marketing planning,
usage rate, calculating, 168 227
entrepreneurial innovation, 1
managing, 273–74
measuring, 280 H
seven sources of, 271–80
entrepreneurial innovation group, of hiring practices, as source of waste,
knowledge resources, 273 94
equipment Hunt, Patton & Brazeal, 3
classifying by utilization rate, 169
inadequate, as cause of waste,
92–93 I
expediting, 183
expenses, relationship with sales, 10 “I CARE” attitude, 253–54
expenses per sales dollar, reducing, 7, identification, determining
9–11, 18 appropriate degree of, 207
how to, 22–24 increase market coverage (critical
project team, 34–35 business element), 7–9
projects for, 77–97 project group, 33–34
external setup, versus internal setup, increase return on assets (critical
147–49 business element), 5–6, 18
increase sales (critical business
element), 7
F project group, 33–34
ROA improvement goals, 45–49
facts, accumulating and analyzing to information communicated to
improve QMS, 209 suppliers, establishing
financial analysis, of acquisition requirements for, 206
target, 238–39 information flow, five-step
financial data, worksheet for improvement process, 123–24
gathering, 42–44 information flow lead time, 101
financial formulas, for project calculating, 166–67
evaluation, 78–79 innovation, seven sources of,
financial incentives, lack of, as cause Drucker’s, 275–80
of waste, 94–95 insight, employee, in marketing
finished product planning, 227
measuring and monitoring, 210 inspections, redundant, as waste, 88
preserving and protecting, 208 instructions, failure to provide, as
5S program, 95–96 waste, 89
flowchart internal audits, quality system,
current, 127 conducting, 209
future, 127 internal rate of return, method of
business valuation, 240
internal setup, versus external setup,
G 147–49
inventory
gain sharing, employee, 70–72 maintaining close to customers,
Gilbreath’s, 3 172
 Index 287

physical, versus cycle counts, providing, 201–2

180–81 three groups of, 1, 272–73
surplus, disposing of, 159–60
inventory analysis, for necessary
stock items, 101–4 L
inventory budgets, calculating, 196
inventory carrying cost lead time(s)
expenses, 134–35 component, calculating, 166–67
and surplus inventory, 159–60 customer order, 165–66
inventory carrying cost percent documenting current, 24
calculating, 174 documenting mismatches, 99–104
and lot sizing, 133 erratic, calculating, 178–79
inventory control(s) manufacturing, reducing, 104–15
calculated, evaluating, 194 paperwork, calculating, 166–67
improving, 165–81 received order, comparing to
options, determining item by item, current maximum or
177 average, 195
perpetual versus visual, 177 relationship to work-in-process
inventory investment inventory, 11–12
and cycle time, 168 work-in-process, reducing, 120–21
relationship to lot sizing, 13 lead times, reducing, 11–12
relationship to setup cost, 13 how to, 24–25
inventory levels, and economic project group, 35–36
business cycle, 261–62 projects for, 99–127
inventory waste, 91–92 ROA improvement goals, 51–54
invoice collection period, reducing, lean cells, design and implementation,
ROA improvement goals, 149–55
57–59 lean concepts
invoicing, lead time, 113, 118–19 building blocks, 95–97
ISO 9000, linking with continuous implementing, 23–24
improvement, 199–211 lean manufacturing
components that don’t mesh with,
145
J programs, reasons for failure, 4
lean quick changeover
just-in-case logic, as source of waste, concepts, 144–49
88 steps, 146
lean value stream, defining, 25
lean value stream mapping, 119–27
K preparation for, 122–23
process steps, 125
knowledge, sources of for book, 3–4 when to apply, 121–22
knowledge resources lean waste discovery, 86–95
for acquisition team, 245–46 load leveling, 183–84
building coaching staff from, 67 lot size
and continuous improvement, calculating for component
62–63 families, 140–41
investment throughout business decisions, commonsense, 130–31
cycle, 64 large, as cause of waste, 90
288 Index

manufacturing, reducing, 142–43 manufacturing lot sizes, reducing,

reducing, through product and 142–43
process design, 140–44 manufacturing personnel,
lot sizing communicating marketing plan
calculating item by item, 175 to, 232
commonsense, and setup cost, manufacturing projects, connecting to
129–31 marketing plan, 231
financially sound, 131–40 market coverage
relationship to inventory analyzing, 214–21
investment, 13 increasing, 7–9
lot sizing formula(s) five areas, 7–8
designing, 25–26 rationalizing, 219–21
economic order quantity market forecasting, as source of
(EOQ), 131–33 waste, 92
market segments, in acquisition
target, 249–50
M market share, estimating, 21
market share, increasing
machine utilization how to, 20–22
percent, calculating, 189–90 and marketing planning, 214
rate, classifying equipment by, project group, 33–34
191–92 projects for, 213–56
maintenance, unplanned, as waste, rationalizing, 219–21
89 setting marketing objectives based
management on, 223–24
communicating marketing plan strategy for, 235
to, 231 through acquisition, 234–38
decisions during business cycle market value, method of business
phases, 260–63 valuation, 240
documenting marketing marketing objectives, 222–26
constraints imposed by, documenting for product lines,
225–26 222–23, 224–25
management commitment, selecting time frame for, 225
documenting, 201 verb/noun combinations for
manufactured components, ensuring designing, 217–19
conformance to product marketing plan, 226–34
specifications, 206–7 and acquisition target, 248–49
manufacturers, role in distributor composing, 21
marketing, 230–31 verb/noun combinations for,
manufacturing capacity, calculating, 217–19
169 connecting with manufacturing
manufacturing cells, design and projects, 231
implementation, 149–55 considering alternatives, 226–27
manufacturing extension partnership explaining key elements to
(MEP), NIST, 3, 86 appropriate audience, 234
manufacturing facilities, of focusing on appropriate audience,
acquisition target, 250 231–32
manufacturing lead time, reducing, marketing planning
104–15 companywide, 213–14
 Index 289

dealers and distributors in, 228–31 O

including other functions in,
21–22 office layout, as source of waste, 90
marketing projects, connecting to operations group, of knowledge
marketing plan, 231 resources, 272
marketplace perspective, order quantity, comparing with
understanding, 232–33 received quantity, 195
material control system organizational structure, in
goal of, 165 acquisition target, 248
ideal, 164 original equipment manufacturers
improving, 24–25 (OEMs), 114
performance evaluation, 193–98 overengineering, as waste, 88
rationalizing, 161–98 overhead costs, reducing, ROA
material handling, 111, 117–18 improvement goals, 51
maximize capital asset utilization overlapping operations, 121, 189
(critical business element), overproduction waste, 87–88
13–14, 19 overtime, scheduling, 188
how to, 26–27
project group, 37–38
ROA improvement goals, 57 P
maximize employee asset utilization
(critical business element), PACCAR Inc., 9
14, 19 packaging lead time, 118, 192–93
project group, 32–33 paperwork lead time, calculating,
maximize net profit (critical business 166–67
element), 7, 18 paperwork processing cell, design and
measuring devices, controlling implementation, 149–55
accuracy of, 208–9 paralleling operations, 120–21, 189
minimize asset investment (critical payback, method of business
business element), 11, 18 valuation, 240
money, investment throughout people waste, 93–95
business cycle, 64 perpetual inventory controls, versus
monitoring devices, controlling visual controls, 177
accuracy of, 208–9 physical inventory, versus cycle
motion waste, 93 counts, 180–81
plant layout, as source of waste, 90
point-of-use storage, 96–97
N preventive action procedure,
documenting, 211
National Institutes of Standards preventive maintenance
and Technology (NIST) estimating allowance for, 170
Manufacturing Extension poor, as cause of waste, 92–93
Partnership (MEP), 3, 86 price breaks, evaluating, 155–59, 182
net profit price coverage, increasing, 20
formulas for, 78 procedures, quality system,
maximizing, 7, 18 monitoring and measuring,
relationship to asset investment, 7 209
nonconforming product, controlling, process design, as source of waste, 91
210 process setup, long, as waste, 88, 89
290 Index

processes, unverifiable, validating, project prioritization, using

207 profitability, 73–74
processing wastes, 90 project ranking, 73–75
Procter & Gamble, 274 project teams
product, nonconforming, controlling, investing in, 69–70
210 seven project groups for, 17–29
product changes, as source of waste, using to excite employees, 66–67
91 using to manage change, 66
product complexity, as source of promotion coverage, increasing,
waste, 92 20–21
product coverage, increasing, 20 purchase order, setup costs, 135–38
product design, as source of waste, 91 purchase order requirements
product design and development, ensuring purchased component/
planning and controlling, 204 process conformity to, 206
product families, 126 verifying conformance of
product flow, five-step improvement purchased components to,
process, 123–24 206
product lines, increasing through purchased components
acquisition, 237 ensuring conformity to design
product realization procedures, specifications and purchase
documenting, 202 order requirements, 206
product requirements verifying conformance to purchase
relating to design and requirements, 206
development inputs, 204
relating to design and
development outputs, Q
204–5
product specifications, ensuring quality
conformance of manufactured at the source, 97
components and services to, poor, as cause of waste, 93
206–7 quality infrastructure, providing and
production control, improvement, maintaining, 202
181–93 quality management system
profit and loss (P&L) statement accumulating and analyzing facts
budget plan as, 79–81 to improve, 209
formulas for performance documenting, 200
measurement, 79 requirements, defining, 200
segregating expenses in, 82–86 quality manual
profitability, using to prioritize controlling, 200–201
projects, 73–74 documenting, 200
project evaluation, 41–45, 73–75 quality mission, as investment in ROA
project evaluation form, 45 improvement, 199–200
project goal setting, 45–60 quality problems, upstream, as waste,
project groups, seven, for project 89
teams, 17–29, 31–39 quality procedures, controlling,
exploding into specific projects, 200–201
19–20 quality records, controlling, 201
project implementation, using quality system procedures, monitoring
business cycle to time, 74–75 and measuring, 209
 Index 291

queue times, calculating, 184 Richmark Group, The, 3

questions, asking, in customer service, routers, 185
254–55 rush orders, capacity allowance for,
quick changeover concepts, lean, 170
144–49

S
R
safety allowance
raw material inventory, 37 calculating, 179
received quantity, comparing with comparing with on-hand quantity,
order quantity, 195 194–95
receiving inspection, 109–10 salaries, reducing, ROA improvement
reduce accounts receivable investment goals, 50–51
(critical business element), 14, sales
19 increasing, 7
how to, 27 project group, 33–34
project group, 39 ROA improvement goals,
ROA improvement goals, 57–59 45–49
reduce expenses per sales dollar relationship with expenses, 10
(critical business element), 7, sales, engineering, and administrative
9–11, 18 (SE&A) expenses, 48
how to, 22–24 sales force
project team, 34–35 communicating marketing plan
projects to, 77–97 to, 231
reduce lead times (critical business role in distributor marketing, 230
element), 11–12 sales forecasts, setting based on
how to, 24–25 marketing objectives, 224
projects to, 99–127 Scanlon plan, 70
ROA improvement goals, 51–56 schedules, documenting, 187
reduce setup costs (critical business Schubert, William, 3
element), 12–13 service business lead time, reducing,
how to, 25–26 115–19
project group, 36–37 services, ensuring conformance to
projects for, 129–60 product specifications, 206–7
reorder timing calculations, setup
determining, 179 designing out of components,
replacement value, method of 143–44
business valuation, 239 external versus internal, 147–49
responsiveness, in customer service, setup cost(s)
measuring, 255–56 calculating, 175
return on assets (ROA) and lot sizing, 129–31, 132
formula for, 79 for purchase orders, 135–38
improvement goals, 45–60 relationship to inventory
increasing, 1–4, 5–6, 18 investment, 13
seven realities to internalize, for shop orders, 135–38
61–64 setup costs, reducing, 12–13
return on assets percent, formula how to, 25–26
for, 6 project group, 36–37
292 Index

projects for, 129–60 U

seven critical business elements, 1–2,
5–15 unbalanced workload, as source of
shipping, lead time, 113, 118 waste, 88–89, 92
shop orders, setup costs, 135–38 unit cost
Six Sigma programs component, calculating, 174
implementing, 23–24 and lot sizing, 133
reasons for failure, 4 un-level scheduling, as source of
skill resources, providing, 201–2 waste, 88, 89, 92
staging areas, large, as cause of waste, usage rate
89, 90 erratic, calculating, 178–79
standardized work, 95 estimating future, 174
start dates exceptions, adjusting, 180
calculating, 185–86 and lot sizing, 132
expediting orders by, 188 usage value, component, calculating,
linking with economic business 175–76
cycle, 261
scheduling orders by, 186–87
stockholders, documenting marketing V
constraints imposed by, 225–26
stock-out rates, calculating and value stream mapping, lean, 119–27
comparing, 195–96 process steps, 125
storage, point-of-use, 96–97 VanDeMark, Robert, 3
supplier setup, cost control, 155–59 visual controls, 96
suppliers visual inventory controls, versus
mimicking, for better customer perpetual inventory, 177
service, 256
unreliable, as cause of waste, 92
W
T waiting waste, 88–89
Wal-Mart Stores, Inc., 278
team building, 66–70 waste(s)
as continuing education, 68 causes of, 87–88
pattern for, 68–69 discovery, 86–95
teams, employee eliminating, 23
dynamics, 69 types of, 88–95
empowering, 61–72 waste reduction projects, timing of,
traceability, determining appropriate 87, 123–24
degree of, 207 work-in-process inventory
training budget, calculating and comparing,
customer service, 251–52 196–97
inadequate, as source of waste, minimizing, 35–36, 119–20
93, 94 relationship to lead time, 11–12
transportation lead time, 114, 119 work-in-process lead time, reducing,
transportation waste, 89–90 120–21