Connecting manufacturing performance to business performance
The reason any commercial company is in business, is to make money. That's the single naked truth for all businesses - it may seem like a crass statement, but making money is what it boils down to in the end. So, if the goal of any business is to make money, we should connect all primary performance measures to making money. There are 3 key Financial Performance measures that are most connected to how and whether business makes money:
Net Profit (NP) - Revenue minus Expenses - A very basic measure of financial performance - take all the revenue received for products sold and subtract all expenses (costs) that had to be incurred to produce and deliver the products that produced the revenue in a period. What's left is NP - the money the business made that can be distributed to owners, shareholders and employee profit sharing. NP is important because it's the base measure of whether and how much money a company makes.
Return on Assets (ROA) - Net Profit divided by Assets Deployed - Every manufacturer has to invest in equipment, materials and other tangible assets to produce products. What this performance measure does is determine what rate of return the business achieves from using the assets - i.e. how effectively and productively the assets are used. Return on Investment (ROI) is a similar, more common measure, but ROA is generally more appropriate for manufacturing. Why is ROA important? - businesses need investment capital, providing investors with better ROA on their investment than alternatives is key to attracting sufficient capital at a reasonable price.
Cash Flow (CF) - Cash Income minus Cash Expenses - Similar to NP, but this performance measure distills NP into cold hard cash. All accruals, deferrals, amortization and other non-cash accounting entries are removed. CF is all the actual cash received for products sold minus actual cash expended for producing the products in a period. Cash is the lifeblood of any business - you're dead without it. As managers of many companies have discovered to their detriment, it is possible to make a Net Profit and not have positive Cash Flow at the same time.
It's relatively straightforward to determine the fiscal heath of a business using the above measures:
» All 3 financial performance measures must be Positive to Make Money
» Business Performance is improving when all 3 financial performance measures are increasing simultaneously.
Given that the superordinate goal of any business is to make money, we now have 3 elemental financial performance measures to determine whether a business is making money and whether performance is improving. It is also reasonably straightforward to identify the macro level problem area(s) of any underperformance.
Now that we have the 3 key financial performance measures determined, we need to connect a supportive set of key manufacturing performance measures that provide a clear and concise picture of manufacturing performance. The financial performance measures primarily deal with 2 key activities - how much did we sell and what did it cost. It would make sense that the key manufacturing performance levels are primarily connected to what was sold and what it cost. Based on these requisites, the following are the 3 key manufacturing performance measures that really matter:
Throughput (T) - the volume of money generated by the Factory from sales. There is a very important distinction between Throughput and the traditional measure of factory output. Throughput is only counted when the output is sold. Only when the produced products are converted into Revenue (connected to NP & CF) is it counted as Throughput. What's the point of producing vast amounts of output if it's not being sold? The logical answer would be to have Finished Goods inventory available for sales and good service levels. That's okay, if that's what a business wants to do, but just because it is finished goods doesn't mean it is produced revenue. So why should the factory care? That's a key point of Throughput - connect the factory to actual demand, produce according that demand and make the factory accountable for producing product that can be sold at the quality, quantity and time the customer wants. Throughput should be considered the primary manufacturing performance measure - it is the key to overall performance. Throughput as a manufacturing performance measure is a significant change in perspective for factory management and supervision - it directly connects production activity to customer demand and production to the rest of the organization.
Inventory (I) - the money expended for Materials to Fabricate Products to sell. Every factory needs materials as input to a conversion process to produce products. Factories have to spend money to buy these materials. Materials that sit in storage areas waiting to be used are Inventory, which is equivalent to having money or assets lying around storage areas (connected to NP, ROA & CF). From one perspective, Inventory is an asset - we convert one asset (money) into another (inventory) in anticipation of producing Throughput. Another perspective is that Inventory is an expense - we spend money on additional materials not immediately required or consumed for producing Throughput. Inventory isn't easily convertible to money, so it's a dubious asset from a money perspective. Theoretically the only reason we have inventory is uncertainty of supply/demand and variability of operations - if a factory knew exactly what was to be manufactured (Throughput) for every minute of every day for the next year and nothing ever went wrong, it wouldn't need Inventory. But that's not reality - we need an inventory of materials to compensate for the uncertainties of a dynamic market and variability of the manufacturing process. The only question that remains is - how much inventory is enough? This performance measure deals with optimizing Inventory to facilitate the required Throughput rate - i.e. reducing the expense and asset investment related production materials Inventory.
Operating Expense (OE) - the money the Factory spends to convert Inventory into Throughput. Operating Expense is defined as all operational expenses that are not totally variable. Operating Expense includes direct and indirect labor, inventory carrying costs, machine costs, facility costs and overheads. The only cost that is totally variable is direct materials. The traditional view that labor is variable is invalid in the context of Theory of Constraints (TOC) and Throughput Accounting, while labor costs are somewhat flexible they are not totally variable relative to daily or weekly volume of demand and Throughput. Another way of defining OE is that OE is all manufacturing costs except direct materials (connected to NP, ROA & CF). However, it is still important to understand the components of OE for performance measurement and determining where to focus initiatives for performance improvement. OE is a key manufacturing performance measure to determine and analyze the processing related costs for producing Throughput.
A Key objective of TOC is to minimize the time between spending money to produce, and receiving money from selling products and services. These manufacturing performance measures fully support the objectives of TOC.
Correlating manufacturing and financial performance
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