Review of Measurements for Effective Decision Making, Part 1
In my last post, I began a new series covering the decision making measurements manufacturers need to put in place to guide their companies toward profitability. I identified what I believe are the four most critical elements to be measured:
- Customer satisfaction relates to how satisfied current customers are with a company’s products and services.
- Competitive position refers to how a company’s products and services are seen by customers and non-customers alike, relative to competitors.
- Operational performance relates to the efficacy of managing manufacturing assets. In synchronous management, these are measured by throughput, inventory, and operating expense.
- Local indicators are measurements of individual activities that help evaluate how these activities affect customer satisfaction, competitive position, and global corporate profitability. These measures help relate specific local activities to the performance of the entire business.
In today’s post, I will continue this discussion by closely examining customer and operational measures. As I will be doing throughout this series, I will draw from  Measurements for Effective Decision Making written by M. L. Srikanth and Scott A. Robertson, 1995 Spectrum Publishing Company.
Rank your “price of admission” customer measures
A profit-building prerequisite in any business is to ensure a steady stream of revenue from existing satisfied customers. So the first question to ask is, “What do we need to improve so that customers will either buy more of our products or pay more than they currently pay for the same products?”
Manufacturing quality standards and expectations have never been higher, which makes measuring customer satisfaction tougher than ever. Customers are demanding near perfect delivery at parts-per-million quality before they even ask about the price of your products. Because of this new paradigm, your company needs to establish key customer focus measures as profit drivers. The measures I am proposing will describe your customer’s current “hot buttons” as well as their current and future satisfaction levels.
 Srikanth and Robertson tell us that in a buyer’s market, the critical buying factor is not price. Instead there are other prerequisites a company must meet in order to compete for customers and orders. Srikanth and Robertson tell us that a good way to start gaining clarity is by ranking the following “price of admission” attributes before considering any pricing changes:
- Product features
- Delivery reliability
- Lead time
Your target audiences may value lead time over features, or quality over delivery reliability. Once you have ranked these externally focused measures accordingly, your company can begin to design a set of measures that will drive improvement.
Use these operational measures to establish a link to financial performance
The next set of operational measures relate directly to the three standard measures of financial success: net profit, return on investment, and cash flow. The caveat is that these measures are sometimes difficult to translate into understandable shop floor measures when using traditional cost accounting methods. The standard cost system was once the link between shop floor actions and the company’s financial performance, but as I have written before, this system is no longer valid.
There are three basic operational activities that all manufacturing companies undertake:
- Purchase of raw material and/or component parts
- Transformation of raw materials and/or component parts into finished products
- Sale of finished products to customers
A much clearer link from the shop floor to financial performance can be realized by applying the three basic measures of throughput accounting:
- Throughput (T) is the money generated through sales, rather than through production. If you make many products and store them in the warehouse, that is not throughput; it’s inventory. Throughput (T) = Selling Price (SP) – Totally Variable Costs (TVC) = SP – TVC.
- Inventory ( I ) is the amount of money tied up in materials that the company intends to sell. Inventory is the combined purchased material value of raw material, work-in-process inventory, and finished goods inventories. One of the major differences between throughput accounting and traditional cost accounting is that in cost accounting, inventory absorbs labor and overhead as the material is processed. The assumption that the “value” of in-process inventory increases as operations are performed is highly misleading.
- Operating Expense (OE) is money spent converting inventory into throughput. This includes things like rent, utilities, and wages. This encompasses any money not included in (T) or ( I ). Operating expense includes all the money spent by the system with the single exception of inventory purchases. One of the major differences between throughput accounting and traditional cost accounting is that there is no distinction between direct labor and indirect labor, because both should assist in the conversion of inventory into throughput or in the flow of product to customers. All personnel-related expenses are included in operating expense.
From these three basic measures, we can calculate the following measures:
- Net Profit (NP) = Throughput – Operating Expense or NP = T – OE
- Return on Investment (ROI) = NP ÷ I or (T – OE) ÷ I
- Productivity (P) = Throughput ÷ OE
- Inventory Turns = Throughput ÷ I
Throughput, inventory, and operating expense include all of the spending under a manager’s control, not just the direct labor force. It should be clear that in order for a manufacturing company to maximize its profitability, throughput should be increasing while inventory and operating expenses should both be decreasing.
Coming in the next post
In the next post, we will continue our discussion by examining another category of measures referred to as “constraints measures.” As always, if you have any questions or comments about any of my posts, leave a message and I will respond.
Until next time.
 Measurements for Effective Decision Making, M. L. Srikanth and Scott A. Robertson, 1995, Spectrum Publishing Company
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