Recommendations for practical manufacturing performance measurement and management

The key question to be answered is how to actually measure manufacturing performance using Throughput, Inventory and Operating Expense. This section will provide recommendations on management-level statistics and measurements for manufacturing performance. An important consideration is what detail measurements are implemented further into the factory at the Supervisor, Machine, Labor and workflow level. It is critical that these lower level performance measures are supportive, inclusive and connected to the overall T, I & OE performance measures.

Measuring Throughput
It is critical that everyone in the company understands what constitutes Throughput as per the previous definition and explanation. Measuring Throughput from a Production Performance perspective requires 3 data points per measurement period:
  » Shipments against Customer Demands (Sales) - this is Throughput
  » Returns from Shipments/Sales - this decreases Throughput because it must have been previously counted as Throughput which should be reduced accordingly resulting in Net Throughput
  » Demand - Sales Orders by ship date (the date the factory needs to ship product to meet the customer's due date). This provides the Throughput goal per period.
More granularity of the above data will be needed by adding production line and product family dimensions.

Once we have these Throughput and Demand data, there are 4 categories of Throughput that should be measured:
  » Target Throughput - this measures the Net Throughput in a period for Demand that was scheduled for shipment in that period. This correlates Shipments with customer Demand for that particular period - i.e. Target Throughput is that subset of Throughput that was realized from shipments that occurred exactly when it was needed.
  » Early Throughput - this is the subset of Throughput recorded in a period what was shipped earlier than the specified Demand.
  » Late Throughput - this is the subset of Throughput recorded in a period for that was shipped late relative to Demand
  » Total Throughput - this is the sum of the 3 above categories of Throughput.
Early Throughput is just as bad as Late Throughput - there are usually misinformed opinions in a factory that completing and shipping an order early is good. The goal is to have 100% Target Throughput - i.e. produce and ship exactly to demand. However, the performance measure of Target Throughput is similar to measuring Service Levels. Although it is usually not economically and operationally possible to achieve 100% Service Levels, measuring Throughput in the above categories provides relative performance measures and uncomplicated goals.

It is advantageous to collect the data at the most granular level possible (date/time, product, quantity) for accuracy and flexibility of analysis. While the goal would be to track Productivity by hour, shift or day depending on circumstances, it should be possible to aggregate the data into less granular time periods during the early stages of implementing this performance measure. It will also be useful to plot the 4 categories for recording trends over time. As mentioned previously, additional dimensions for analyzing throughput by production line and product family will be necessary to identifying specific areas for performance improvement initiatives.

Measuring Inventory Performance
There are 2 key considerations for developing Inventory Performance Measures:
Manage and measure 3 separate domains of Direct Materials Inventory
  » Raw Materials (pre-production direct materials)
  » Work in Process (direct materials in production)
  » Finished Goods (production output, but not yet Throughput)
Measure Inventory levels in 2 ways
  » Value
  » Relative to Throughput
Note: If Indirect Materials Inventory is a major expense category, you should add a fourth domain for measurement purposes only - Indirect Materials are part of OE and should not be counted as I because it is not totally variable.

Measuring the Value of Inventory is a straightforward traditional measurement already done by most companies. However, just knowing the total value of direct materials Inventory is of limited use. Additional dimensions are required for more detailed measurement and analysis of Inventory Value for determining performance levels and trends. The first dimension is the Domain - where the Inventory resides - Pre-production Raw Materials or Work in Process or Finished Goods. This is key to understanding where the excess accumulation is and being able to direct appropriate improvements at the relevant domain. The second dimension is the Category - grouping materials with similar physical, usage, value or other pertinent characteristics together into categories. The categories could be reasonably large grained initially, evolving into smaller granularity as improvements are accomplished. For example, these two dimensions will enable identification of 'Seals in WIP' or 'Model XY12 in FG' constituting potentially excessive Inventory. Additional dimensions such as ABC Stratification by lower/higher value/volume or Inventory Velocity (turns) can contribute to the performance analysis.

Relate Inventory to Throughput
The next and maybe more important measure is to relate the above Value of Inventory measures to Throughput. For simplicity purposes, using total Throughput is fine, rather than trying to reduce it to direct material content of Throughput. Bearing in mind the very specific definition of Throughput we can track the following Relative Inventory Performance Measures:
Assume $5m Throughput per period with $0.5m in RM, $0.3m in WIP and $1.0m in FG Inventory average during the period:
  » RM/Throughput Ratio: 0.1 (0.5/5) - i.e. for every $1 of Throughput we have 10¢ in Raw Material Inventory
  » WIP/Throughput Ratio: 0.06 (0.3/5) - i.e. for every $1 of Throughput we have 6¢ in Work in Process Inventory
  » FG/Throughput Ratio: 0.2 (1/5) - i.e. for every $1 of Throughput we have 20¢ in Finished Goods Inventory
     (the above measures can be expressed as ratios or percentages)
There is no absolute good or bad standard - it's all relative to a specific manufacturer's circumstances - the only standard is that lower ratios are better. These measures provide immediate insight into where the problems might be. Adding the Category dimension allows us to drill into more granular focus. Charting the trend of Inventory performance changes and relationship to Throughput per period over time will provide even better insights. Performance improvement is achieved by a decreased investment in Inventory to achieve the same Throughput, or increased Throughput with the same level of Inventory, or ideally both decreased Inventory and increased Throughput.

Measuring Operating Expense
The key differences between traditional full absorption costing to determine operating costs and TOC-based OE are that OE consists of all production costs except direct materials and how the differences between production output and Throughput are translated into costs or OE. OE is part of the larger subject of Throughput Accounting,5 with significant business accounting ramifications that can't be covered in depth in this paper. Understanding how to measure OE is best illustrated by an example contrasting GAAP versus Throughput Accounting for a simple scenario:

GAAP Accounting Basis       Throughput Accounting Basis  
Revenue $10,000,000     Revenue $10,000,000
COGS 6,000,000     Direct Materials 4,000,000
Gross Margin 4,000,000     Throughput Margin 6,000,000
Selling & GA 3,000,000     Operating Expense:
Operating Income 1,000,000       Production 2,000,000
          Selling & GA 3,000,000
        Operating Income 1,000,000

At first glance the difference may seem trivial. This is because we have made the false assumption that Revenue, Production Output and Throughput are equivalent. The key differences are that GAAP assigns all production and material costs to inventory and inventory costs are not expensed until the inventory is sold. With Throughput Accounting, production costs are expensed immediately regardless of when the inventory is sold and production costs are not assigned to inventory. Expanding the above example to differentiate between Production Output of $9,000,000 and Throughput of $10,000,000 (decreasing FG Inventory) illustrates a more interesting contrast:

 
GAAP Accounting Basis       Throughput Accounting Basis  
Revenue $10,000,000     Revenue $10,000,000
COGS¹ 6,000,000     Direct Materials² 3,600,000
Gross Margin 4,000,000     Throughput Margin 6,400,000
Selling & GA 3,000,000     Operating Expense:
Operating Income 1,000,000       Production³ 2,000,000
        Selling & GA 3,000,000
        Operating Income 1,400,000
¹based on what was sold
²based on what was produced
³not totally variable, assume fixed for short term purposes

First observation is that nothing changes in GAAP Accounting. In Throughput Accounting, Direct Materials which are totally variable are based on what was actually produced, not what was sold. This is correct, and provides a more accurate picture of what happened. A more interesting observation in modeling different scenarios is that GAAP Accounting rewards organizations that build inventory and doesn't recognize reduction in inventory as a benefit - exactly the opposite of the performance improvement you're trying achieve! With GAAP increased costs can be hidden in inventory whereas with Throughput Accounting costs are expensed when they are incurred and inventory is not inflated with processing costs.

For performance improvement purposes it is still necessary to record the composition of production costs - Direct Labor, Indirect Labor, Indirect Materials, Overhead, etc. However, it would be even more useful to understand the activities that drive these costs - knowing what percent of Production Costs is Direct Labor is good, but knowing what activities drive Direct Labor costs is much better for determining performance improvement initiatives. This approach of assigning costs to cost drivers (activities) rather than apportioning costs to inventory is defined by the principles of Activity Based Costing (ABC).

The above example depicts an overall company view of OE. More granular performance measurement by production line and activity will be useful to determine areas to focus for performance improvement.


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