In this paper we will take a hard look at some deeply ingrained fundamental “truths” concerning the traditional objectives and measurement techniques of American Business. Much of this article will be comprised of case study problems. For each case, jot down your answers before reading on. Also, ask yourself if the case study is truly representative of the “Real World”.
Query almost any business executive as to what his/her overall objectives are and “making a profit” will generally be one of the responses. It’s sort of like Motherhood, the Flag, and apple pie. Everyone knows that we’re in business for one reason and one reason only: … to make a profit. Right?
Let’s dig a little deeper.
1: FIFO vs. LIFO
The ABC Company is currently on a first-in-first-out (FIFO) inventory valuation system. The company has been experiencing a consistent rise in purchased material costs, which comprise the bulk of ABC’s product cost. They have decided to change to the last-in-first-out (LIFO) method.
What is the likely impact on:
Will the company be better or worse off?
The LIFO method applies the most recent material and labor cost to the products being shipped out the door. If such costs are on the rise, LIFO will have the effect of raising the cost of goods sold and thereby lowering profits. If profits go down, so do taxes.
What then has happened to cash flow?
Revenues stayed the same. The amount of money we actually paid our vendors and employees hasn’t changed. But the amount of cash we send to Uncle Sam has gone down. So net cash flow is up.
You tell me: Is the company’s better or worse off?
2: Assets = Assets (?)
The JKL Company builds Jet engines (manufacturing lead time is in excess of one year). They recently had the opportunity to purchase a piece of equipment much needed for one of their front-end operations. The equipment cost $1,000,000 (substantially below the normal market price for such equipment). The JKL Company was extremely low on both liquid assets and credit. However, through an aggressive inventory reduction and control effort, active inventories were cut by over $2,000,000 and the machine was purchased.
What was the impact on profits (current period)?
Balance sheet assets?
Is the company better or worse off?
Since the purchased piece of the equipment affects a front-end operation, little impact would be expected on cost of goods sold, and thereby profits, for quite sometime. Depreciation, however, begins immediately. If our $1,000,000 piece of equipment is rated as having a five-year life (for tax purposes), then first-year profits will be reduced by approximately $150,000.
Second year depreciation could be in the neighborhood of $220,000. It should be noted that it is not at all unusual to make smart capital equipment purchases whose impact on cost of goods sold is not as great as the resulting depreciation “expense” during the first few years.
Since profits are down, taxes are down.
The balance sheet essentially shows a swap of one asset ($2,000,000 of inventory) for two other assets ($1,000,000 cash, $1,000,000 equipment).
Now let’s look at cash flow. Sales revenues have not been affected.
Actual cash cost of doing the front-end operations may have been reduced due to the new piece of equipment, but we’ll ignore such for this discussion. Taxes are a real cash expense. Reducing profits by $150,000 (depreciation) will reduce taxes by approximately $70,000. Reducing active inventory means that material and labor that would normally have been procured during this time period were not procured. Cash flow out, therefore, was reduced by approximately $2,000,000. And $1,000,000 cash left the company to purchase the new capital equipment.
The net effect: Profits and taxes are down: cash flow is up substantially: total assets remain essentially the same on the balance sheet; and the company has a new piece of equipment and $1,000,000 cash. Is the company better off, or worse off?
3: Increase Inventory; Increase Profits
The XYZ Company recently hired a new plant manager. XYZ is a “Bottom Line” kind of company and has tied the plant manager’s bonus to quarterly profits.
The plant had established a “fixed overhead” application rate of $10/standardhour based on a plan calling for 100,000 standard hours of production per quarter, $1 million/QTR fixed overhead, and therefore an overhead application rate of $10 per standard hour earned.
The new Plant Manager immediately increased production from the budgeted rate of 100,000 standard hours/quarter to a new rate of 130,000 standard hours/QTR. The additional 30,000 standard hours worth of product was added to inventory.
What was the likely impact on:
Profits? Taxes? Cash Flow?
Was the company better or worse off?
Actual fixed overhead spending for the quarter was: $1,000,000.
However, the plant actually produced 130,000 standard hrs and therefore “absorbed” $1,300,000 of overhead at $10.00 per standard hour.
Generally accepted accounting practice allows under or over absorbed overhead (the difference between actual overhead spending and the amount of overhead applied to production) to be reflected on the income statement as an adjustment to profits. Our over absorption of O/H results in an increase in profits for the quarter of $300,000 ($1.3 million O/H absorbed, $1.0 million actual O/H spending).
While the increased profit of $300,000 is most certainly “paper” profits, the amount of taxes paid on that profit represents real money leaving the company. Taxes will increase by approximately $150,000.
Now what about cash flow? Sales revenue cash coming in hasn’t changed.
Tax dollars leaving the company have increased, but that’s a drop in the bucket. The company’s cash flow has decreased by the total actual spending required to build 30,000 standard hours worth of product! We still had to pay our suppliers for the raw materials we used. We still had to pay our employees to produce the extra unsold product.
The net result? The new plant manager looked good! He accomplished his objective—Profits are up. So are taxes and inventory. Cash flow is down significantly. What do you think about company well-being?
The Bottom Line On Profits?
Let’s summarize the above cases:
|CASE STUDY||Profits||Taxes||Cash Flow||Co. Well Being|
|FIFO vs. LIFO||Down||Down||Up||Improved|
|ASSETS = ASSETS||Down||Down||Up||Improved|
|INV. vs. PROFITS||Up||UP||Down||Worsened|
In each case, profits went in the opposite direction from company well-being!
The correlation between cash flow and company well-being is not coincidental. We’re in business to make money, not necessarily profits. This principle is well understood in the area of real estate, where the very best investments rarely show a profit. The same principle is every bit as applicable in manufacturing.
The primary objective of any business is to maximize net cash flow. We do an excellent job of applying discounted cash flow analysis when evaluating capital equipment. Yet, when it comes to something as crucial as top-level executive and overall company performance measurements, we opt for profits as our parameter. The above examples have only scratched the surface of the “games” that can and are being played to manipulate profits.
Profits are a good long-term measurement. They can, however, be readily manipulated in the short term.
Be careful what you measure & reward!
PERFORMANCE TO STANDARD (PTS)
Let’s take a look at some other “motherhood” statements:
“Performance to Standard (PTS) is a good measurement of productivity”;
“Performance Against Standard provides an incentive for people to improve productivity”;
“Performance standards should be based on the current method/process being used and should be updated whenever required to remain accurate”.
Anyone who has had any basic industrial engineering instruction in the area of work measurement immediately recognizes these “Basic truths”. However, just in case any readers are from Missouri, we’ll walk through a few case studies.
4: “Performance” vs. Cost
The MNO Company measures production supervision by the traditional “performance to standard” method: Standard hours earned / actual hours spent. Standards are established based upon the method, or process, being utilized. The MNO Company prides itself on setting and maintaining highly accurate, detailed standards. Any method/process change is quickly reflected in a corresponding standard time correction.
Three months ago, Suzy Smith, a bright young shop worker, was promoted to supervisor in the printed circuit assembly area. The area had been running consistently in the 95% – 100% performance range with standard time and actual assembly time averaging 5 hours. Using group problem solving techniques Suzy and her assembly operators implemented a series of methods changes resulting in a reduction in the actual hours required, from 5 hours to 3 hours … with an improvement in quality level!
Soon thereafter, Industrial Engineers re-studied the area and produced a revised standard for printed circuit assembly of 2 hours.
What was the impact on:
Performance to standard?
Is this case study representative of the “real world”?
Performance to standard is calculated by dividing the standard time for an operation by the actual time taken to perform said operation. The old performance was 100% (5 hrs. std. ~ 5 hrs. actual). New performance is 67% (2 hrs. std. ~ 3 hrs. actual). Performance is down 33%!
What about company well-being?
It used to cost the company five actual hours of labor to assemble a PCB. Now it takes three hours to perform the same function (a 40% labor reduction). Company well-being has improved significantly.
The impact on Suzy Smith, and her assembly operators, has been unfavorable to say the least. Before Suzy took over the area, performance was consistently at or near 100%. Now, in less than three months, Suzy and her people have fallen off to 67% performance. Suzy will be lucky not to lose her job, and her department has received considerable “bad press”.
Now for the important question: Is this case study representative of the real world?
I posed that question to a group of industrial engineers. “It happens every day” was the response.
A standard is supposed to represent the time required for a fully trained and practiced operator to do the job. Whenever the method of doing a job is changed, the operator is no longer fully trained. It takes time and practice to become adept with the new method. If standards are “corrected” to reflect the new method, you would expect performance to fall off when the process is changed. And it invariably does.
Let’s define “working harder” as the technique of increasing output with no change in method, and “working smarter” as the technique of increasing output through the use of method or process changes. The above case study illustrates the following principle:
Performance to Standard ENCOURAGES working harder and DISCOURAGES working smarter!
But where do the really significant productivity improvements come from?
List any major productivity improvements you have seen. How many have been accomplished without a change in method? Yet so many companies persist in utilizing a measurement technique that discourages methods improvement.
Measurement plays an important role in improvement. It is critical, however, that the results of any measurement technique correlate directly with company well-being.
A spin-off of the Performance Against Standard logic has been applied in P&IC to determine the amount of inventory your company should have. The technique uses your current lead times, safety stock policies, lot sizes, etc. (the current METHOD) to calculate the “correct” amount of inventory. Allow me to save you some work. The amount of inventory you should have is ….. LESS THAN YOU’VE GOT!
Few companies have done the above “scientific” analysis and discovered they should have MORE inventory! The implication of this analysis is that inventory should be reduced without any methods changes, i.e. work harder. Yet the parameters used to calculate the “correct” amount of inventory are the very things that should be attacked in order to make significant inventory reductions.
Shorten lead times. Reduce/eliminate safety stocks. Force set-up times and lot sizes down.
What’s the bottom line?
Avoid any measurement technique that is tied to the current method of operation. It is in changing the method that the significant productivity improvements lie.
5: Standards Correction vs. Capacity Planning
The MNO Company does its capacity and manpower planning based on the forecast load, in standard hours, adjusted by historical performance levels. For example, the load projection for next week is 40 standard hours, the historical performance in this area is 50%, therefore we need to ”man” the area for 80 actual hours of work (40 Std HRS / 50% Performance = 80 Actual Hours Required). The MNO Company believes in setting and maintaining accurate standards. Any standards error discovered results in a standard time correction.
The milling machine area had a history of poor performance to standard (50% performance). A recent major Industrial Engineering re-study caused a significant adjustment (increase) to the standards for this area. The average standard doubled.
What is the impact on: Capacity/manpower planning? Area productivity?
What is the impact of on-going standards correction?
How do you avoid this problem?
The impact on capacity planning is easiest explained by using an illustration.
If, prior to the standards correction, the load would have been 100 standard hours, we would have manned the area for 200 hours of actual labor. Since the standards have doubled we now show a load of 200 standard hours and would man the area for 400 actual labor hours; twice the amount really required!
Needless to say, if you man an area with twice the amount of people required to do the work available, productivity will suffer.
The impact of a massive re-study & changing of standards is pretty obvious, and if one is astute it can be compensated for in manpower planning. On-going standards correction is much less visible and considerably more difficult to compensate for. The negative impact on good capacity and manpower planning, as well as productivity, is, however, just as real.
The way one avoids this problem is obvious. You don’t change the standard. Don’t even call it a standard. Call it a baseline and consistently measure against it. Now your capacity planning is accurate and your performance measurement is relative. If the baseline is constant, an improvement from 50% to 55% performance is a real improvement.
In our case study, going from 50% performance (before the “correction”) to 90% performance (after the “correction”) means we’ve really gotten worse!
Performance to standard does not correlate very well with company well-being.
Changing the basis of any measurement destroys continuity; i.e. you cannot tell if you’re getting better or worse. And what is the basic purpose of a performance measurement? To tell if you’re getting better or worse!
Performance isn’t absolute. Performance is relative. A good performance measurement correlates with company well-being. It will tell us if we’re getting better or worse. A good performance measurement encourages improvement.
If you feel you must have a current accurate standard, retain both numbers: baseline & current standard. And be certain that they are used in the appropriate applications.
Profits and performance to standard are widely used as productivity measurements. Yet each has been shown to occasionally run contrary to company well-being. Let’s recap the key points:
Companies run on cash, not profits.
Performance is relative, not absolute. The objective is continuous improvement.
Valid performance measurements correlate with company well-being.
Lots of games can and are being played in the area of profits and
performance to standard. Let’s make sure we don’t fool ourselves!