For profit-focused companies, ‘Lean’ methodology is like a pair of scissors in a drawer labeled ‘Swiss Army Knife.’ It serves some purposes well, but is far less than it is cracked up to be. ‘Lean’ management principles do not necessarily result in increased profit or increased Return on Invested Capital (ROIC). ‘Lean’ methods alone will not provide management control of capacity utilization.
In fact, the successful application of ‘Lean’ methods may coincide with reduced financial performance outcomes and the destruction of economic value.
Toyota Motor Corporation is the global icon of ‘Lean’ manufacturing performance. A new vehicle rolls off an operational Toyota production line every minute or so. Multiple optional configurations appear in balance with customer demand. Inventory (WIP) is reduced to a minimum. It is truly a production miracle. Taiichi Ohno is undeniably a god of modern management theory.
However, if ‘Lean’ methods are so advantageous, why did Toyota manage only a 4.89% Return on Invested Capital (ROIC) in 2016 while carrying a Weighted Average Cost of Capital (WACC) of 4.84%? It barely produced enough Operating Profit (after hypothetical tax) to cover its overall cost of capital in 2016. Toyota basically operated all year without generating any economic value. (ROIC/WACC data sourced at: www.gurufocus.com)
Is that the type of ‘Lean’ Taiichi Ohno had in mind? I doubt it. Has ‘Lean’ left something fundamental out in the cold?
This isn’t just Toyota’s dilemma.
Other major car manufacturers are also splendid examples of applied ‘Lean’ manufacturing principles and cutting edge automation. Among them, Ford’s ROIC performance during 2016 was just 2.18% while carrying a WACC of 3.47% – clearly destroying capital throughout 2016. General Motors managed an 8% ROIC while carrying a WACC of 6.54% while propped up with various tax credits and other government favors. Tesla was a ROIC train wreck, delivering a -18.4% ROIC while carrying a very heavy WACC of 13.5% and propped up with both Federal and State government price subsidies, tax credits, and other public favors. Another venerable Japanese manufacturer, Honda, managed only a 3.57% ROIC while carrying a WACC of 5.14%. Nissan delivered a ROIC of just 4.67% while carrying a WACC of 4.21%. Another weak result in an era of dirt cheap capital. How so?
Fiat Chrysler managed a relatively standout ROIC performance of 9.72% with a WACC of 7.21%. At least they made an economic spread of a couple of percent above their cost of capital! All this in a year where there were record unit sales for Nissan, Ford, Honda, and Fiat Chrysler, with sales for Toyota, GM and Honda only marginally down on 2015, or flat.
Isn’t ‘Lean’ methodology THE modus operandi of the automotive, or indeed, the entire manufacturing sector? How can a company be ‘Lean,’ yet fail to use its invested capital productively? What is missing in the ‘Lean’ thinking prescription? Why isn’t ‘Lean’ translating into better Returns on Invested Capital (ROIC)?
‘Lean’ is a wonderful tool set for optimizing cycle times, dealing with optional product variations, minimizing inventories, and improving quality performance outcomes. We incorporate elements of it into our overall approach as a rule. However, these positive performance outcomes all arise from within a myopic focus on the activated element of productive capacity. What aspect of ‘Lean’ thinking asserts control over idle capacity and the underutilized and unprofitable elements of activated capacity? How does ‘Lean’ thinking help to control the costs related to low capacity utilization and unprofitable sales? How does ‘Lean’ thinking help to minimize idle fixed costs and the variable costs associated with idle capacity and ‘uneconomic’ capacity (the capacity ‘used’ to generate sales units that generate no profit)?
Put simply, it doesn’t. That is the reason why many textbook applications of the ‘Lean’ approach, which undeniably result in certain extraordinary performance improvements, fail to improve or even sustain satisfactory ROIC outcomes.
Low capacity utilization is a blight on businesses across industry and the cost is measured in idle and underperforming capital, translating into excessive fixed and variable expenses.
ROIC is a measure of the productivity of capital. As is the case with all performance ratios, both the numerator and denominator must be controlled to deliver improvement. ‘Lean’ applications do not control invested capital or the amount of productive capacity acquired by a company. Therefore, they do not allow control of the ROIC denominator.
The largest global car manufacturers of our time are contemporary examples of the failure to systematically control capacity utilization. This is demonstrated in their ROIC performances and their Asset Turnover Ratios. Yet among them, you will find no better examples of ‘Lean’ manufacturing and automated environments. What’s missing?
While ‘Overall Equipment Effectiveness’ (OEE) may be 100%, capacity utilization is just 10%. That is what is missing.
Productivity Step Change (PSC) is a global Management Consulting Group based in the US dedicated to maximizing Capacity Utilization, improving Return on Invested Capital (ROIC), and increasing productivity for its clients across industry. Our enterprise-level, data-led, cross-functional business analysis typically requires 4-6 calendar weeks and is designed to provide evidence of your opportunities for overall growth. Please contact us if you would like to schedule time for a discussion and presentation.