We usually hear the expression "value added" associated with the amount of enhancement and aggregation of materials and labor that a company applies to its products during manufacturing. However, adding value to products and services is only one element of creating value to customers and shareholders. The other important element is “separation”. Both Lean and 80/20 use separation as a way to purify processes (just like in chemistry) and deliver more value. Lean principles are based on value creation from the customer’s point of view. As you identify the work steps, you eliminate barriers that prevent a smooth production flow. Continuous flow is characterized by rhythm or “takt time” and is dictated by customer demand (pull). Throughout the process, you isolate and remove steps that do not add value or create waste (“muda”). In other words, you must have a free-of-interferences, undisturbed, customer-focused process to achieve lean. You need to separate waste from value-adding steps. Similarly, the 80/20 Business Process places an ultra-high focus on select groups of customers and products, avoiding distractions to the core work. The extreme focus helps capitalize on natural imbalances, implied by the 80/20 Principle. The separation part keeps the complexity created by the “trivial many” from contaminating the “vital few”. It turns the “eighty” into a center of attention. Separation is what keeps the “chaff away from the wheat”. It’s an important management concept and is applied to create focus, as well to impart autonomy. It’s not meant to build walls and create isolated fiefdoms. The main reasons to apply separation are:
Managers should understand (and make up their minds about) what is important and what is not. At a minimum, they should select the core segments to compete, the key customers to partner, the central products to lead with and the fundamental business processes to deliver value. Once they select the vital few, managers can separate and nurture these core areas, by asking the following question: how to increase the separation degrees between the core and the rest? To separate a core market segment from all others, for example, you can start by creating a dedicated sales and marketing organization for that segment. You can also set up distinct production lines and generate a “core segment P&L” to monitor progress. These are all part of what I call the first separation stage or degree. It’s one framework to build centers of attention around core activities. Add another separation degree and create autonomous business units, focusing on the core segments. The third stage is to operate with completely separate and autonomous companies, such as Berkshire Hathaway and most private equity firms do. Separation stages are closely coupled with the way companies grow. Stage three companies grow like a forest, spreading out and diversifying. Stage one companies bloom and expand like a shrub. In the same vein, we can say that stage two companies grow like trees, or they branch out into new market segments. Forests grow in fractal ways, or in patterns that repeat themselves at different scales (self similarity). We can see the resemblance of a forest to stage three companies, diversifying into different segments and industries, while keeping the value-creation model intact throughout different companies (self similarity). Call it satellite companies, divisions, business units, focused plants or service centers, the distributed and decentralized organization is better prepared to deliver value over the long haul. If executed with methodologies such as lean and 80/20, separation and decentralization have the potential to transform the business into a network of value-creating nodes. The benefits of this operating model are reflected in this quote from the 1979 letter from Warren Buffett to investors, which talks about his faith and confidence in the independence and empowerment of business units. The thinking can be summarized in this statement: “If you love the management, set them free”. “To the Shareholders of Berkshire Hathaway Inc.: Your company is run on the principle of centralization of financial decisions at the top (the very top, it might be added), and rather extreme delegation of operating authority to a number of key managers at the individual company or BU level. We could just field a basketball team with our corporate headquarters group (which utilizes only about 1,500 square feet of space). This approach produces an occasional major mistake that might have been eliminated or minimized through closer operating controls. But it also eliminates large layers of costs and dramatically speeds decision-making. Because everyone has a great deal to do, a very great deal gets done. Most important of all, it enables us to attract and retain some extraordinarily talented individuals—people who simply can’t be hired in the normal course of events—who find working for Berkshire to be almost identical to running their own show. We have placed much trust in them—and their achievements have far exceeded that trust.” [i] Some of the best performing companies in the world are decentralized: Berkshire Hathaway, GE, ITW, J&J and many others. They’ve evolved from conventional and monolithic structures to networks of companies and business units, while keeping their original values intact. The leaders realized early on that they needed to move from the “top of the hierarchy to the center of the network”. They went from “command and control” to “influence and connectivity”. They fostered segmentation and enabled value-creating nodes in the network to grow and to multiply. But let’s not get lost in the debate about centralization versus decentralization. You don’t need to wait until you are completely decentralized to start applying separation, as a management principle. You can start right away by selecting core areas and deciding how many degrees of separation to apply. The separation mentality can at a minimum be applied to customers, products and process, as shown in the table below. The key when applying separation to customers is to identify and place an extreme focus on the few customers that account for eighty percent of sales and margins, as well as on the few “twenty” ones that have strategic value to the business. Know everything there is to know about your “eighty” customers. Walk in their shoes frequently to understand their pain points and needs, and involve them in your product innovation efforts. The degrees of separation amongst customers start with sales and support differentiation, passing by the application of unique commercial policies, all the way to rechanneling and firing “twenty” customers, if necessary.
Many companies already treat their “eighty” customers special. At least they should. But the vast majority doesn’t clearly define the borders between core and the others, lacking defined ways to create separation, such as dedicated account teams and unique commercial policies. All customers need to be treated fairly, but treating all customers equally can lead to disaster. Stage three companies have separate value chains that align distinctly with “eighty” and “twenty” customers. The value created by each separate chain is proportional to what they deliver and to the complexity (overhead) each business has to live with. In most cases, customers are clearly told the difference between these different chains and appreciate getting a fair value for what they are buying. When it comes to products and processes, there are many ways to create separation. Starting from an extreme focus on “eighty” products, all the way to investing in separate businesses to distinctly deal with core and non-core. It means separating the mainstream, with less variation, from the infrequent products, which have greater complexity. Detached businesses have different value chains and are uniquely positioned in the market. Another separation technique is to outsource non-core products to specialized suppliers. Outsourcing makes it simpler to place a value on these items. The costs to make them available to customers come listed in the supplier invoice, while the internal costs of low-volume or specialty products are not always accurate, due to hidden complexity. The first separation degree at the shop floor is to distinguish the production methods between core and non-core. The “eighty” needs to be made in the most efficient way possible. This can be attained with lean manufacturing techniques, such as one-piece-flow, takt time and pull systems. A separation method used in lean, is to uncouple customer demand (pull) from orders to suppliers, improving production flow and rhythm. At a higher degree, companies use 80/20 techniques, such as inlining of high-volume products and MRD (market rate of demand) to further optimize and simplify production of the “eighty”. 80/20 also separates period costs from variable costs, when building products, improving the accuracy of contribution margins. Third separation degree is achieved by investing in discrete business units, or separate companies, to manufacture the core away from the low-volume or specialty. By having isolated plants and P&Ls for low-volume and specialty, it’s possible to understand the real cost of complexity, thus pricing correctly in the market. As the business expands, it will segment further and separate more complexity away from the core. But when we carve out a new business, plant or production line, it’s important to consider its ability to add value as a stand-alone unit. In order to do this, I have four types of questions that I ask the team and myself, which I consider the pillars for creating a new node in the network:
To finalize, I believe that most companies know the difference between core and trivial businesses. The problem is that managers don’t take steps to separate them, allowing the trivial to contaminate the core. The word “focus” is constantly used (or misused), but in many cases, there is no action behind it. What does it mean to increase focus? What is needed? Separation works because it forces the opportunity to stand out. It places a new visible node in the value-creation network. So let’s put some meaning behind the word “focus” and enhance value-creation not only by adding parts and labor to our products, but also by simplifying our business and putting some distance between what makes it great and what makes it go. [i] Warren E. Buffett, 1979 letter to Berkshire Hathaway investors (published March 3, 1980), http://www.berkshirehathaway.com/letters/1979.html - Retrieved on October, 2015.
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Almost every business starts simple and becomes complex as it grows and develops. As scale changes, simplicity gives way to layers of structure and controls. When complexity creeps in without control and is not properly measured and managed, it can push against value creation and profitability. In reality, the problem is not extra scale but extra complexity. Additional scale, without additional complexity, will always give lower costs. As a business grows, it wants to provide more services and products, which end up stimulating other overhead drivers, such sales and purchase transactions, manufacturing footprint, accounting systems, organizational structure and managerial habits, to mention a few. But of all the complexity sources, the swelling of the product portfolio and the elevated number of discrete components, can be the largest hindrances to attaining high levels of profitability, growth and customer satisfaction. When the product offering contains just a small amount of variation, the impact of adding new parts is relatively minor. However, as complexity grows in the form of low-volume products and customers, just a few additional part numbers can create a disproportional increase in complexity costs. Without deliberate and systematic actions to simplify the product offering, non-value-added complexity will prevail over time. On the other hand, part number de-proliferation can have a huge positive impact on profitability. Thomas Johnson and Anders Broms wrote about tackling product proliferation and how it can improve profitability in a 1995 article, in the AME Magazine[i], talking about Scania’s approach to dealing with complexity: “Everyone believes that a manufacturer will improve costs and profitability by reducing the number of different parts in its products. And for good reason. With fewer different parts, less effort and resources are required to design, make, and service a product line. Accordingly, activity-based cost management systems routinely use part-number count as a cost driver to estimate how much financial performance will improve by reducing the number of different parts. However, it is not well understood that cost-driver information may capture only a small fraction of the financial improvement that part-number austerity makes possible.” The good news is that product line complexity is easily detectable, such as in too many products and too many customers, or too many part numbers and too many suppliers and transactions. The number of discrete parts or products and number of transactions are two important cost drivers to estimate the financial opportunity of tackling complexity, since they are directly responsible for less apparent issues, such as too many systems, too many reports, too many procedures, and last but not least, too many people creating and maintaining part numbers and SKUs. Not to mention the complexity created by tailored parts that interfere with standard products everyday. But how do you tackle proliferation of part numbers and complexity in the product portfolio? There are three steps to do this: diagnosis, simplification and prevention. First you need to quantify and qualify complexity. Second you need to apply what I call "causative simplification", to reduce complexity. Third, you need to prevent new complexity from slipping into the system, by creating a filter to avoid new parts and products from entering without scrutiny; and you also need to measure product line complexity on an ongoing basis. Prevention can eventually lead you to create a vision for a product line architecture that is more modular and simpler, while extremely aligned with your business model. This approach to simplicity is very effective and long lasting, as seen in companies such as the European truck maker Scania. However, it is not trivial. If your company was not created with such product architecture in mind, you will have to muscle through the simplification work, before attempting to build such a system. Diagnosing Complexity Complexity can be quantified using metrics that are associated with the symptoms of having too many part numbers and SKUs. Shipping performance or shipping late and incomplete, for example, can be an indicator of elevated complexity. Sales performance of items that you normally carry in inventory, in terms of “turns and earns”, can be another good choice. Other metrics relate to the health (and sanity) of your engineering database, such as how many product designs are made for similar applications, but sold to different customers; number of subtle design variations in similar parts; and one of my favorites, the number of engineering change requests (ECRs) that enter the system every day or every month with little or no discussion. You would be surprised by the number of ECRs processed every day by many manufacturing companies, without really understanding the benefits and the impact to the cost of complexity. In many cases, it is useful to estimate the cost of complexity associated with each part number. People need to see and relate to the problem in order to get involved in the solution. And one of the best ways to estimate the cost of complexity is to calculate the impact of product proliferation on the overall cost of goods sold (COGS). This is best done by product line, if the P&L is structured that way, but an overall number also helps visualize the issue. Most companies use a “clean-sheet-based cost model” or design cost to determine the “should cost” for each part or SKU. Every month they take the total variable cost dollars, add the period costs and compare the sum with the total “should cost” (design cost multiplied by the volume in the same period). Even though the “should cost” is close to being a theoretical cost, the difference between the actual and should gives you a good benchmark to measure yourself against. The chart below shows a typical cumulative distribution of sales dollars versus part numbers or SKU’s, compared with a cost of complexity curve, using the method above. As parts-count increase, the complexity cost goes up exponentially. Limiting your portfolio to the high-volume SKUs or the sweet spot of the market is ideal, from a complexity standpoint, but not practical. The question is always how much complexity you can afford to let into the business, to be able to meet the needs of your core customers, and at the same time avoid getting into the “red” zone of complexity cost. In other words, complexity needs to be actively managed. To qualify complexity, we use 80/20 analytics. More specifically, we use the “customer versus product matrix” (CP Matrix) and the quadrant analysis (Quad Analysis). The analytics are extremely important to visualize the problem and the data patterns and to provide a path for the next step, or causative simplification. The figure below exemplifies the different areas in the CP matrix and the different approaches to simplification. Just by looking at the data and by performing the quad analysis, you can reach several conclusions that will lead to improvement. Do less than 20% of the products account for 80% of the sales? Is there a large number of SKU’s with minimal sales, while there is slow and obsolete inventory of such items? How porous or compact is your portfolio? How large is your low-volume offering compared to the high volume or sweet spot? The density or the sparsity in the portfolio, for example, can be very revealing, in terms of frequency of sales and effectiveness of the different product lines. The shape of the data – clustered or patchy and whether you have gradients or receding patterns – can reveal distortions in buying patterns and point to subsegments or regions that have different needs.
Causative Simplification The next step is to start unloading product complexity from your company, using the outcome of your 80/20 analytics to optimize the product portfolio, combined with a disciplined approach to simplify the product line. I call this phase “causative simplification” because it is designed to produce simplification. With the help of 80/20 analytics, you focus first on the business reasons, to outsource, consolidate, price-up or simply eliminate part numbers and SKU’s that are not aligned with your strategy. Low volume products sold primarily to low volume customers should be priced-up accordingly, to reflect the cost of complexity. You should also look how your inventory investment is performing for these low volume items, using the “turns and earns” index (inventory turns multiplied by contribution margin percentage), and adjust your commercial policies and inventory practices accordingly. In summary, you first let the market respond to your simplification measures (outside in) and then you apply a conscientious effort to reduce proliferation from inside out using PLS (product line simplification). Successful product line simplification is customer-centric and capable of identifying products or features that will satisfy application needs and address market pain points, as opposed to just offering a variety of designs to choose from. PLS cannot be driven by manufacturing, engineering, or purchasing in isolation from other areas. It needs to be a collaborative and multidisciplinary effort by different areas of the business with an eye on the customer application. PLS takes time and effort and is not an overnight exercise. There are three major goals in PLS: 1) to reduce parts-count or the number of discrete products within a product portfolio, consistent with your business strategy; 2) to define a clear position on tailored products: who should get them and how they are to be priced and produced; and 3) align manufacturing processes to support the streamlined product offering. PLS and portfolio optimization need to work hand-in-hand. PLS needs to support both parts-count reduction and overall margin improvement work at the same time. It should not be used to eliminate a complete business line or just the low-volume part numbers and by no means it is intended to leave customers without viable options to satisfy their application needs. The initial focus of PLS should only be whether a product or an item will be included in the product offering or not. Leave the make or buy decisions for later. At the beginning of the PLS process, it is a lot more important to decide what to drop and what to include. The decision to include a product is primarily made by the commercial people in support of marketing strategies, market pain points, and end user needs. Focus on high-volume and high-potential products first and compare your portfolio with the high-volume products of the market. Look at how much customization you are providing, and ask yourself whether it is done on the behest of the core or “eighty” customers. Then shift your attention to simplifying the low-volume products. Consider physically separating production of low-volume parts, outsourcing, redesigning certain products, and even dropping marginal products from the portfolio altogether. Creative strategies surface when the task force performing the PLS is truly multidisciplinary and has engaged participants from different areas. When a few core customers require a certain level of customization, for example, manufacturing team members may be able to devise a way to tailor a standard high-volume product at the end of the line (postponed customization). The engineering members may be able to redesign one product to perform the function of two or more products, for example. At the end, sales and marketing members need to consider what else should be pruned or eliminated at the bottom of the CP matrix where the sales density is very low. Preventing New Complexity The third action in reducing complexity is to control the introduction of new items and to create complexity metrics. The control step is central to avoid creating new part numbers that are not in line with the unique value propositions (UVPs) of the business. Any new part or SKU entering the development process needs to go through a two-stage screening process or filter. The first filter is a deal breaker that evaluates the product’s strategic fit. It asks whether the new product or part number aligns with both the needs of the core customers and the business’ UVP. It also tries to understand the contribution margin potential early on. It asks why a new product should be added to the portfolio and what types of evidence prove that it will make money. The second screening stage is conditional (yes, but…), establishing how the company will position the product to meet its profitability targets. It asks several questions: What is the minimum contribution margin acceptable? How are we going to price the new product? If the company is creating a “twenty” product, is it done for an “eighty” customer? How are we going to create availability? Can we produce it using an existing manufacturing line? Should we create availability by outsourcing this product? No product change request or new product charter should be approved without going through this screening process. Companies with effective screening processes have clear product complexity metrics that indicate how many new requests have been approved or rejected and provide a clear vision of the development pipeline. These metrics keep track of the numbers of products, part numbers, and SKUs that are eliminated from the system each month. I’ve talked about complexity metrics above and in previous articles, and there are several options that you can use, depending on your specific situation: sales dollars per SKU, contribution margin dollars per SKU, total number of items entering and leaving the system every month, etc. If the business has a strong distribution component, you may want to use the turns and earns index or CMROI (contribution margin return on investment), to monitor the profitability of your inventory. The point here is to pick only a few metrics that people can relate to and to stay with them overtime. In summary, in order eliminate complexity you have to create simplicity. Simplicity is the ultimate “lean transformation”. 80/20 analytics and PLS are excellent tools to help you create simplicity and increase your profitability. And once you’ve gone through this exercise you will be better prepared to envision new and better product line architectures that have simplicity in their DNA, like Scania did many years ago. [i] H. Thomas Johnson and Anders Broms, Association for Manufacturing Excellence (AME) Magazine - “The Spirit in the Walls: A Pattern for High Performance at Scania,” (May/June 1995). You can measure the financial performance of your business in many different ways. And you probably do so. Operating income, EBITDA margins, free cash flow, ROIC and others. All of these metrics are quantifiable and understood by the different audiences that need to know the status of your company, such as investors and markets in general. The audiences understand these metrics and they can easily compare them with targets and benchmarks. They are important, but at the end of the day, these metrics represent only a static picture of a fiscal period, and can only tell you so much about the fitness level of the business, therefore managers should not rely on conventional financial metrics alone to grow profitably. Then there are the KPIs, or key performance indicators. These are considered process metrics and often used to track specific areas. They should tell you whether you are making headway towards attaining your targets or not. They are internal to the company, but the line between KPIs and financial metrics is not always clear. KPIs measure activities normally associated with customers, suppliers, internal processes, workforce and so on. The difficult part with KPIs is that you can easily have too many of them, diluting focus and creating effort in the direction of the trivial many, versus the vital few. Managers need to be selective when choosing KPIs. I propose there are two other critical and often neglected pointers, which lie between the internal workings of the company and the financial results. These are business productivity (or efficiency) and complexity. I call them the “vital few success indicators” but they could very well be called the forgotten metrics, since only a handful of companies use them to evaluate their strength or fitness level. Whether you classify these two indicators under financial metrics or KPIs, there are hardly any established standards to compare them with. They are dimensionless and can only be tracked over time versus a baseline. In spite of their non-conventional nature, productivity and complexity metrics can’t be neglected if you want to grow profits consistently overtime. Usual KPIs, EBITDA margins, ROIC, or any other financial metric alone, can only tell you how the business looks like today, or in the recent past. They can’t easily tell you about the company’s robustness level to endure market challenges in the long run. It’s like judging the internal health of the patient by looking at a photograph! On the other hand, superior productivity and reduced complexity have proven time-over-time to be the best predictors of profitable longevity. And here’s why. Productivity is generally defined as a measure of output per unit of input. Broadly stated, business productivity should be measured in terms of total value captured from the market over the total value of resources being applied to capture that value. In financial terms, it’s the ratio of your total contribution margin dollars over your total fixed cost or overhead dollars. It basically tells you if you are earning enough with your products and services to cover for all the non-variable expenses associated with running the business, including SG&A. A productivity index (PI) of one or less than one, tells you that your products and services are either not being valued enough by the market, are using resources in excess or a combination of both. A PI of two, means that you are 100% efficient in capturing value from the market and are less vulnerable to its ups and downs, and so on. This is a powerful concept, since contribution margin is a better correlation coefficient between the market environment and the internal structure of the company. The ability of a company to profit adequately from a product or service starts with sound contribution margins and there is little or nothing managers can do to improve the profitability of the business, if there are negligible contribution margins to begin with. Cutting overhead alone will not make it in the long run. PI is a true indication as to whether the company is succeeding or failing in its market environment. As examples, manufacturing companies with products delivering contribution margins in the upper 30’s or lower 40’s, and total overhead in the range of 15% of sales, tend to have productivity indices in the area of 2 to 3. On the other hand, if the contribution margins are between 20% and 30%, the company will have to reduce overhead to close to 10% of sales, in order to have a PI in the neighborhood of 2. If you don’t have high value-added products and higher contribution margins you will need to lean out your company’s overhead more aggressively, in order to stay within a PI of 2. In our experience, manufacturing companies with a PI between 2 and 3 are the ones that can be called truly “scaleable” and those that can maintain higher profit margins during a significant revenue downturn. These scaleable companies return far superior profit margins as they grow and stay between a PI of 2 to 3. Those companies that wait to fix the PI, only after it has dropped closer to 1, are the ones that spend more effort and money to get back in shape during a downturn. Evidently you want to work towards moving the productivity index well above one by increasing contribution margins and reducing fixed costs (read complexity). I know these are not trivial tasks, but this is where the 80/20 business process can play a major role by optimizing your portfolio to increase contribution margins and by simplifying your company to reduce complexity costs (read overhead). And here is where complexity metrics come into play. Complexity inevitably creeps into the company as the business grows. It hides in too many products, too many people, too many plants and so on. Complexity is what drives the excessive overhead; therefore we can say that business productivity is the inverse of business complexity. It looks obvious when you tie the amount of fixed costs to complexity, but unfortunately it is not that intuitive. Complexity is a “silent killer” and builds up extra costs slowly over time. It does to your business the opposite of capturing synergies and actually creates discord when you have multiple growth drivers at the same time. Add more sales people to deal with more customers and you will eventually add more customer support people, more products, more plants and so on, increasing complexity overtime along with extra marginal overhead, without even noticing. Guaranteed! Part of the answer to tackle complexity before it destroys your productivity is to make it visible to the organization, developing leading indicators. The good indicators will give the company a warning sign, to look closer into its overhead levels, even as productivity indices get better. Some examples of commonly used complexity indicators are: product line complexity (contribution margin dollars per SKU, number of SKUs added or deleted during the month), transactional complexity (contribution margin dollars per sales invoice), supply chain complexity (process cycle efficiency) and a global complexity index (GCI) that you can use to track a dimensionless number or a combination of multiple complexity factors. A GCI example is as follows: Overtime, growth in these leading indicators can point to a pile up of complexity costs, signaling it is time to use 80/20 data analytics to pin point where the costs are hiding. You will never get rid of complexity entirely, but you can always make things simpler, for example, using simplification tools in the 80/20 toolbox to simplify the product line, streamline business and manufacturing processes, therefore reducing overhead and boosting productivity. One can say that 80/20 helps identify the vital few and simplicity helps deal with the trivial many. As John Maeda defines in his book The Laws of Simplicity[i], simplicity is about “subtracting the obvious and adding the meaningful.” By embracing business productivity and complexity metrics you have a better chance of knowing what is really important and weeding out complexity before it impacts you financial results. [i] John Maeda - The Laws of Simplicity (Simplicity: Design, Technology, Business, Life) – The MIT Press, 2006 |
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