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May 22, 2012

Lean Decision Making: It’s not all about cost

Suppose you are in charge of a business process. You need to decide whether to out-source a component you currently manufacture, or to keep it in-house. Or, perhaps, you are considering whether you should accept a “one-off” order at a price well below your current list price. These, and many similar decisions, are too important to be made on cost alone. In fact the first question you should ask in the decision-making process is: “do we have the capacity?


The purpose of lean improvement is to create free capacity that you can then use profitably. Lean eliminates “waste” (i.e. non productive time) creating spare capacity. However, the financial benefits of lean only come when you use the capacity you have created to generate more profit. Otherwise you just have idle capacity. You may have reduced material costs by improving quality; and you may have reduced the need for overtime; but the purpose of improvement is not to create idle capacity: it is to do more work with the same resources.


If you have spare capacity in your process (as a result of improvement or for other reasons) then the cost of doing any extra work is only the additional material cost you will incur (and any other consumables). That is because you are already paying for the machines and the people in the process. That means that, if you have spare capacity, you will likely save money by in-sourcing components or products that you currently out-source.


Similarly, if you have spare capacity, the cost of taking on an additional order will only be the additional material cost and any other consumables. However, that is not to say you should take extra orders at the marginal cost – that is a marketing decision which must assess the impact on existing customers and markets.


So in lean decision-making we first need to be able be able to measure the capacity of our process. This is fairly easily done and, in fact, only needs to consider any constrained steps in the process (since these set the capacity of the whole process). There are several ways of measuring capacity. One of the easiest is to calculate the total available time (i.e. number of working minutes or seconds); to take off productive capacity (the time spent producing the right parts right first time); and to take off the non-productive capacity (the time lost to scrap, downtime, set-ups, and other reasons); leaving the free (spare) capacity.


The second question we ask in lean decision-making is: “what is the impact on our lean metrics ?”. The lean philosophy is one based on flow. We must continuously improve the flow through our process in order to create spare capacity. The flow through a process is affected by many factors among the most important being inventory (stock), work in progress, downtime, and quality (scrap). Key measures of any process, therefore, include flow time (for example, manufacturing lead time, customer lead time, order entry to delivery, or other similar measure); first time quality (first pass yield, first time through, or similar); and customer service (on time delivery to request or similar).


If a consequence of a decision would be to permanently worsen one or more of these metrics then, in the spirit of lean improvement, we probably should not take it. Thus, outsourcing to a distant country will greatly increase inventory and flow time, and may affect quality and customer delivery.


The third question we ask in lean decision-making is: “what is the impact on direct costs and revenues ?”. Notice the word “direct” in this phrase. We are interested in the incremental (marginal) costs and revenues caused by the decision. This is nothing to do with the so called “standard product cost”, but the actual cash impact of the decision. For example, we have to run some overtime to make a product that is currently out-sourced, or we may wish to upgrade some equipment. The actual costs of these changes should be taken into account, to assess the impact on the profitability of the process. It will require some care to ensure that you fully understand the costs (and revenues) that will be affected by the decision, but it is becomes straightforward once you have a procedure in place for doing this.


The final question we ask in lean decision-making is: “what is the risk associated with the decision ?”. We need to assess the potential impact if things don’t go according to plan. This risk assessment will depend on the decision’s criticality for the organisation as a whole. For example, we would review the decision in the light of corporate strategy (for example to keep core skills in-house); we would assess the impact on customer service; the possible responses of competitors; the impact on other processes or parts of the organisation; and so on.


Thus, in lean decision-making, cost is not the first thing that we look at. In fact we should develop an “opportunity review” procedure which analyses the decision from at least four viewpoints:

1)             Do we have the capacity ?.

2)             What is the impact on our lean metrics ?

3)             What is the impact on direct costs and revenues ?

4)             What is the risk associated with the decision ?


Making a decision on cost alone is never the answer !