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Health checkMany cost savings promised never become reality!
In their drive for increased profitability, many top managers challenge their reports and teams to come up with cost savings ideas. They sometimes even establish special teams to focus on this issue, targeting them on the amount saved – such as Six Sigma Green Belts or Black Belt projects. In order to demonstrate value – these cost savings projects are conducted in specific areas or functions. However, there is a flaw and when all the local cost savings are added up they do not appear on the bottom line of the organization. Under Throughput Accounting we know well that the “bottom line impact of the whole is less than the sum of the impact of the parts”!
How do we identify what is a good operational decision?
You need to subject all ideas for improvement (or investment) to the test of T, I, OE. The first answer to be obtained is what is the increase in Throughput that will be realised if this idea is implemented? This means asking – how much more product will we sell because of the improvement – this should give the increase in Sales – then deduct from this figure the TVC – totally variable cost – of the increased sales. The answer is the increase (beware it could be a decrease) in Throughput (T)
Next ask – what is the change in Investment (I) needed to implement the “improvement”? Then ask – what is the change in Operating Expense (OE) resulting from the implementation of the idea? Be certain by asking - will this saving really exist or will it just move the costs to another department or cost centre.
From these calculations you can determine the Net Profit effect – T minus OE and you can determine the ROI – NP effect divided by I.
If the company does have a major bottleneck resource within its process (this means consistently far more orders than the resource can possibly handle) – then any idea that increases the capacity of the bottleneck should produce more T with little or no additional OE. This means it is a good operational decision.
If the company does have a major bottleneck resource within its process – then any improvement of any other resource is unlikely to create more T – unless the bottleneck gets capacity by better support from the other resource.
If the company doesn’t have a major bottleneck resource within its process – then its constraint lies in the market (not enough orders) and any improvement idea must produce more sales – otherwise it has no long term value.
