Lean Money Index (LMI)
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6 August 2013 - 0:11, by , in Lean Six Sigma, No comments

It’s fashionable for models and manufacturers to be lean, but not too lean.

The regional government of Madrid, Spain took an unexpected stance in September ’06. Being too lean is unacceptable! (1) North American manufacturers, service providers and governmental organizations would be well served to take note of Madrid’s imposed restrictions and adopt a similar stance, but at both ends of the scale… budgets that are too obese or too lean should no longer be acceptable!

Madrid banned models with a Body Mass Index (2) of 18 or less. For example, at 5 feet, 10 inches tall and 100 pounds, the BMI is 14.3, considered too lean, i.e., anorexic. Bigger is not always better. At the same height but 220 pounds, the BMI is 31.6, considered obese.

Manufacturing, service industry and governmental managers need a quick assessment tool, like the BMI, to assess whether budgets are too small (14.3), too big (31.6) or just about right (15.0). That measurement tool is called a Lean Money Index (LMI).

What is an LMI?
The Lean Money Index (3) (LMI) combines the principles of Lean Manufacturing with the practice of Activity Based Costing (ABC). By definition, lean is the systematic elimination of non-value added activities that do not directly create a product or service a customer wants when they want it. In complimentary fashion, ABC measures the financial resources, time and workload of those value and non-value added activities.

Initially named Lean Manufacturing because of its Toyota Production System roots, the principles and practices of lean have expanded in recent years to include lean offices, lean distribution and lean six sigma. Likewise, Activity Based Cost Management, initially viewed as an improved product cost system, has expanded during the past decade to include service industries such as banking, insurance, distribution, big box retailers, healthcare providers and government.

Lean thinking and ABC share common principles and practices, including the identification of activities, processes, output capacity and non-value added waste. Ineffective use of capacity is the largest non-value added cost in most organizations. “Capacity refers to an organization’s ability to ‘do something.’ An activity’s costs are in excess of what they need to be where too much capacity exists for a given activity. Thus, excess capacity drives up process cost to the organization.” (4)

A proven business proverb states, “You can’t manage what you can’t measure.” To identify and manage the non-value added costs of excess capacity requires a financial measurement method. LMI is that measurement method. LMI measures capacity cost at three levels within any organization:

  • Cost Center or Cell Level
  • Value Stream or Process level
  • Enterprise level

Level 1 LMI: Cost Center Assessment

Before drilling for oil, exploration companies use technologies to assess what may exist below the surface. Level One LMI’s provides managers and employees a quick assessment of what waste, if any, exists below the surface of traditional budget and accounting reports.

For example, the following traditional Customer Service budget report signals that all is okay because there is no variance to budget. Waste, however, does exist. This traditional report measures the resources provided to Customer Service but it does not measure what the employees did with those resources to create value or waste.

 

  Actual Budget Variance
Salary & Fringes $ 495,000 $ 500,000 $- 5,000
Space Costs 10,000 10,000 0
Supplies 15,000 10,000 5,000
Depreciation 40,000 40,000 0
Total $ 560,000 $ 560,000 $ 0

To determine how much waste exists in a cost center, combine (a) total spending; (b) three pieces of lean data, e.g., capacity, cycle time and customer demand; and, (c) a simple time-based Activity Based Cost modelThe Level 1 LMI quick assessment below indicates that $240,000 or 43% non-value added waste may exist in Customer Service.

Level 1 LMI

Annual Cost $560,000
Annual Capacity Minutes 700,000
VA Cycle Time per Output 8 minutes
Annual Customer Demand 50,000
LMI $ $240,000
LMI % 43%

The LMI Level 1 uses the following data and formula:

  • Annual Cost is gathered from the accounting system.
  • Annual Capacity Minutes = 7 employees X 420 minutes per day X 238 work days = 700,000 minutes. NOTE: If the department or cell is machine-paced, use the machine’s practical capacity minutes.
  • VA Cycle Time per Output is defined by employee interviews, sampling and observation.
  • Annual Customer Demand represents the actual or budgeted quantity of volume required by the customer.
  • LMI $ = Cost per Minute X Capacity – [(Customer Demand X Cycle Time)], e.g., $.80 X [700,000 – (50,000 X 8)]
  • LMI% = LMI $/Annual Cost, e.g., $240,000/$560,000 = 43%

Level 1 LMI’s are useful as a:

  • Quick assessment method to determine whether a department, cost center or cell contains enough LMI dollars to be a worthwhile target for applying lean techniques (i.e., Mistake Proofing, 5S, SMED, Kanban, etc.).
  • Payback predictor. A Level 1 LMI is a quick method to use before, during and after a lean kaizen event to calculate and confirm the financial impact and payback of activity and process improvements.
  • Muda measure. A Level 1 LMI serves as a performance measure that publicizes the importance of improving process lead time, eliminating bottlenecks, reducing cycle time, serving customers and continuously reducing non-value added activities, all forms of muda in a lean organization.

Show me the Muda!

An LMI measures the percent and dollars of muda contained in an organization’s value stream (5), business process, department or cost center budget. Muda is lean manufacturing’s word for waste, i.e., fat.

Muda is a broad and aggressive definition of waste, similar to the ABC/ABM concept of Non-Value Added. For example, both lean and ABC/ABM consider over production, excess inventory, ineffective use of excess capacity, waiting, transporting, long lead times and unnecessary tasks of a value activity as waste.

Unlike ABC/ABM, zero waste or zero muda is not the objective of lean. Lean systems are created with an objective of maintaining a small measure of excess capacity. A small amount of extra capacity provides flexibility to respond to customer’s needs and avoid the most sinister waste of all – overproducing product earlier, faster or in greater quantities than the next step in the process.

How much muda is too much or not enough? The answer lies in an LMI muda measurement table.

LMI Muda Measurement Table

Category Lean Money Index
Anorexic … too lean to respond Less than 5%
Underweight … no output flexibility 5 to 10%
Ideal … some output flexibility 10 to 15%
Overweight … too much waste 15 to 20%
Obese … waste becomes a burden 20 to 30%
Morbidly Obese … poor mortality Higher than 30%

According to the LMI Table, Customer Service’s LMI of 43% falls into the morbidly obese category. Waste reduction is highly recommended!

Lean’s prescription for Customer Service, however, is not reducing muda from 43% to zero. A LMI of less than 15% may indicate that no flexibility exists to respond to up ticks in customer volume. Having no excess capacity could create a bottleneck or constraint. To confirm that assessment and define specific targets to improve a morbidly obese cost center like Customer Service, a Level 2 LMI of the Value Stream that consumes customer orders is recommended.

Level 2 LMI: Value Stream Cost Assessment

Lean implementation teams commonly draw Value Stream Map of product or service families. Value Stream Maps are specialized ‘process maps’ lean implementers use to document the flow of information, material and activities to meet customer needs. Using the activities, cycle times and volumes defined in a Value Stream Map (6) coupled with time-based ABC, a Level 2 LMI measures each category of value and non-value costs.

Level 2 LMI report

Value Stream #1 Activities Cycle Time Minutes per Output Practical Capacity Output Budget Practical Capacity Minutes per Year Cost per Minute Actual Output Assigned VA Cost Assigned NVA Cost Over Production NVA Cost Unused Capacity NVA Cost Total Cost
Take Order 8 min. 52,500 $336,000 420,000 $0.80 51,000 $320,000 $0 $6,400 $9,600 $336,000
Answer Inquiry 44 min. 3,182 $112,000 140,000 $0.80 1,150 $0 $40,480 $0 $71,520 $112,000
Resolve Problem 50 min. 2,800 $112,000 140,000 $0.80 2,700 $0 $108,000 $0 $4,000 $112,000
Total Dept.     $560,000 700,000     $320,000 $148,480 $6,400 $85,120 $560,000
Customer Demand           50,000          
SUBTOTAL                      
LMI $               $148,480 $6,400 $85,120 $240,000
LMI %                     43%
All Other Value Steam Activities     $7,615,000       $5,680,000 $51,520 $983,600 $899,880 $7,615,000
Total Value Stream #1     $8,175,000       $6,000,000 $200,000 $990,000 $985,000 $8,175,000

A Level 2 LMI Value Stream Cost report augments a Value Stream Map with valuable financial information a continuous improvement team can use to apply lean’s waste reduction tools and techniques. The Level 2 LMI reports activity costs in four categories:

  • Assigned VA Cost is the exact amount of output or production required and valued by the customer to meet their needs.
  • Assigned NVA Costis output required to meet customer needs but not something a customer is willing to pay for, e.g., Resolve Problem.
  • Overproduction NVA Costis output not required (e.g., safety stock, work-in-process) to meet Customer Demand.
  • Unused Capacity NVA Costis unused output that could be created with the resources consumed.

For demonstration purposes, the Level 2 LMI shown above reports detailed lean financial information about the Customer Service activities combined with a one line summary of All Other Value Stream #1 activities that convert the order to a final product or service. Value Stream #1 has 27% waste, most of which is Over Production and Unused Capacity.

While many lean implementers will use only Level 1 & 2 LMI’s, some management teams need to measure the percent and dollar amount of value and waste in an entire organization. After Level 2 LMI’s are completed, they can be combined to create a enterprise-wide Level 3 LMI.

Level 3 LMI: Enterprise-wide Assessment

LMI’s can be used to measure the muda in one activity, one department, one value stream (e.g., series of activities), one process or an entire organization. Department and Value Stream LMI’s are shown on pages 3 and 5, respectively. To demonstrate LMI on a broader scale, compare the traditional P&L below to the enterprise-wide LMI perspective on the following page.

 

 

 

 

Traditional P&L
Traditional Income Statement Actual (000’s) Budget (000’s) Variance (000’s)
Sales $40,000 $38,000 $2,000
Cost of Goods 20,000 17,000 -3,000
Gross Margin $20,000 $21,000 ($1,000)
  50% 55%  
Overhead      
Sales $4,000 $4,100 ($100)
Marketing 3,000 2,900 100
Finance 2,000 2,200 -200
R&D 4,000 4,500 -500
Admin. 2,000 2,000 ——-
Total O/H $15,000 $15,700 ($700)
  38% 41%  
Pre-Tax Profit $5,000 $5,300 ($300)
  12% 14%  

Using the principles of Lean and ABC, the Traditional P&L above is converted into a Level 3 LMI P&L below. Sales and Pre-Tax Profit, $40 million and $5 million respectively, are the same in both P&L’s. The bodies of the P&L’s, however, are much different.

Level 3 LMI P&L
(000’s) Value-Added Non-Value Activity Excess Output NVA Unused Capacity NVA Total
Sales $40,000 $0 $0 $0 $40,000
Value Stream #1 6,000 200 990 985 8,175
Value Stream #2 5,500 150 850 0 6,500
Value Stream #3 6,000 1,500 0 1,300 8,800
Sales Process 2,625 500 0 375 3,500
Marketing Process 1,500 200 75 225 2,000
Compliance Process 1,000 25 0 0 1,025
Value Stream Enabling 3,675 500 0 825 5,000
Total Cost $26,300 $3,075 $1,915 $3,710 $35,000
           
Pre-Tax Profit $13,700 ($3,075) ($1,915) ($3,710) $5,000
  34% -8% -5% -9% 12%

The Level 3 LMI P&L offers three advantages over the traditional format:

  • LMI P&L’s provide a vision of potential profit. Traditional P&L’s infer that budget is the best the company can be. The Level 3 LMI instead shows that the organization could have a $13.7 million or 34% pre-tax profit if non-value added muda is eliminated.
  • LMI P&L’s promote teamwork. Traditional P&L’s divide costs into vertical functions, e.g., manufacturing, marketing, finance. LMI’s organize material, labor and expense resources into horizontal value streams that cross functional boundaries to serve customers.
  • LMI P&L’s encourage non-financial employee creativity. Instead of managing fixed and variable costs, LMI’s encourage people to focus on used, unused and ineffectively used capacity. And instead of classifying people as direct or indirect, the work activities of all employees are labeled as value or non-value.

Next Steps

  • Test it.Enter actual or budgeted data for one or more of your organization’s departments or work cells into a Level 1 LMI Excel template. Compare your findings to the LMI Table. Does your LMI seem reasonable?
  • Take it slow. Lean is not a crash diet. Take your time. Don’t rush to Level 2 without a Value Stream Map. And don’t rush to Level 3 until your organization has LMI results that can be celebrated.
  • Teach it. Don’t keep the principles and practices of Lean, ABC/ABM and LMI to yourself. Learn by doing and then teaching others.

Conclusion

According to The Wall Street Journal, it became fashionable in 2006 to implement lean manufacturing. “A year ago, it took 20 to 30 craftsmen to put together each Louis Vuitton tote bag. Over the course of about eight days, separate workers would sew together leather panels, glue in linings and attach handles. Today, clusters of six to 12 workers, each of them performing several tasks, can assemble the $680 shiny, LV-logo bags in a single day.” (7) The WSJ reports that Burberry, Cartier, and Giorgio Armani are also implementing lean systems.

Why did it take these fashion firms several decades to adopt lean manufacturing methods? The answer is likely “Management was watching the models, not measuring the muda.”

Improving an organization’s financial results never goes out of style. Use Lean Money Indexes, value stream costing and lean tools to help your organization to look, perform, and feel better.

 

 

(1) Yahoo News, September 8, 2006
(2) www.cdc.gov/nccdphp/dnpa/bmi/index.htm
(3) Pending trademark of ICMS, Inc.
(4) The Handbook of Process-Based Accounting, James Brimson, AICPA, 2002
(5) Process map of the current and future state value stream of information and material flow from customer to supplier used by Lean practitioners.
(6) Value Stream Map example: http://csob.berry.edu/faculty/jgrout/processmapping/Value_Stream/value_stream.html
(7) Louis Vitton Tries Modern Methods on Factory Lines, Christina Passariello, Wall Street Journal, October 9, 2006

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