Well, it’s not actually everything, but it does cover a pretty broad spectrum from product design (R&D, perhaps) and product life-cycle management (PLM) all the way to P&L statement and financial ratios.
If you look carefully at the accompanying “Financial Cause & Effect Diagram,” you might notice that one—and only one—box has arrows leading into it, but no arrows coming out of it. That box is the metric ROA (return on assets).
Profit alone does not measure the performance of the whole system, because it doesn’t take into account the amount of money tied up in the producing of profit. A $160,000 annual profit might be okay for a small business with assets of $1 million. However, that same $160,000 in annual profit would certainly not be satisfactory to a global enterprise with $650 million in assets at work.
Profit, therefore, isn’t really the bottom line. The real “bottom line” is ROA or ROI.
If we work backwards from the “Low Return on Assets” result, we can see two causes:
- High inventories or investments
- Low profits
This makes perfect sense!
In calculating ROA/ROI, we use a numerator (profit) and a denominator (investment or assets). Therefore, if investment is too high or profits are too low, we get low return on assets. Inventories are highlighted here because (a) inventories are a part of the total investment, but also because (b) inventories are typically the most volatile and most manageable of the assets in the enterprise.
While we will see that so many of these factors are interrelated (after all, that is the very definition of “a system”), let us begin by working backwards from the “Low Net Profits” entity next. There are only two (2) inbound arrows to “Low Net Profits”—much simpler to work with than the “High Inventories or Investments” entity with its five (5) inbound arrows.
Low net profits can come from two sources:
[NOTE: Here, we use some very specific definitions. We calculate “Throughput” as revenues less only Truly Variable Costs (TVC), where TVC are only those costs that vary directly with incremental changes in revenue. We permit no allocations in this figure. We calculate Operating Expenses as all of the rest of the money the system pays out on a regular basis in support of turning Throughput into profit—except for those costs included in TVC.]
High Operating Expenses
Again, taking the path of least resistance (and fewest factors), we can see three (3) factors contributing to high operating expenses:
- Poor control of G&A expenses
- High carrying costs on inventory
- High levels of inventory obsolescence or shrinkage
Of course, there are many reasons that Operating Expenses could be too high. Just plain poor management of expenses is uncommon. Nevertheless, it is not unusual for us to see operating expenses escalate over time—almost imperceptibly—because the organization hires more and more people to pick up the slack where others are drawn away from productive work to do “firefighting.” Firefighting is non-value-added work that leads to increased operating expenses while adding nothing to the value delivered to the customer.
Sometimes, the firefighting happens in the warehouse—especially in the shipping departments. This, in turn, leads to higher carrying costs for inventory—the warehousing staff is bloated to cover for waste (non-value-added) activities that soak-up time that should be spent providing value to customers.
And, of course, it is a general rule that, the more inventory you have, the more you will be paying of carrying that inventory—even if you hold the carrying cost percent steady.
Last, we see the cost of inventory obsolescence or shrinkage contributing to high operating expenses due to write-offs and write-downs. Too much inventory—especially of the wrong things (which is always the case, because if they were “the right things” they wouldn’t end up being obsolete)—leads to more waste. That waste may take the form of shelf-wear, damage from too much handling, and more.
These are all real problems that we encounter nearly every time we start working with a client.
We will continue our discussion of “Everything that can go wrong…” in future articles. Stay tuned.
In the meantime, we would like to hear from you regarding your experiences. Please leave your comments below.