A collection of articles, essays, and blog posts that give you key insights into a variety of subjects from Value Stream Mapping to Outsourcing.

Moving Overseas a Mistake?

Many U.S. companies are considering moving their manufacturing overseas to take advantage of low labor rates in countries such as China, Hong Kong, Singapore, Taiwan, South Korea, Maylasia, Indonesia and India.

Case Study:

"MRA Digital will stop

outsourcing to China"

Other companies are considering moving closer to home, in Mexico, where wages are a bit higher, but they can import their products duty-free under NAFTA. For example, in May 2002, Honeywell, Inc., wrote letters to many of its machine shop suppliers, suggesting they move operations to Monterrey, Nuevo Leon, Mexico, as a way to reduce their prices back to Honeywell. The U.S. Department of Commerce, International Trade Administration, reports that 2002 U.S. exports of machine tools and metal forming equipment to Mexico totaled over $1 billion, and are expected to grow five percent in 2003. Monterrey, the "Industrial Heart of Mexico," has 13,000 manufacturers, who are buying up U.S. machine tools and taking over U.S. machining activity.

Are these companies making a big mistake?

In most cases, yes, they are making a mistake. The mistake is not necessarily just manufacturing overseas; rather, it is manufacturing products in one country for distribution in a different market. For example, manufacturing high-tech microphones in China for sale and use in the U.S. may incur both real and intangible costs that are not part of the traditional labor + transportation + duties equation. Recognizing all the intangible costs may change this equation significantly. Japanese and German car makers recognize many of these issues when they decide to invest billions in U.S. plants, building products in the U.S. for sale to U.S. customers.

The additional intangible costs are political, control and currency risks, and lack of protection for intellectual property. Additional real costs are incresased inventories and delays in time-to-market. These costs are hard to see and harder to measure, but they are real, and they can affect a company's bottom line.

There is an alternative. Manufacturers can compete with low-cost foreign labor by increasing their productivity. Lean manufacturing is a collection of techniques to improve manufacturing productivity, and overcome the apparent short-term cost advantage of overseas manufacturers.

Here are some of the pros and cons of overseas manufacturing:

Yes, labor rates are much lower. According to one manufacturer, while Mexico's minimum wage is about US$0.50/hour, the actual labor costs in Mexico are about half of U.S. labor costs. Supervisors in Mexico earn about US$23,000 per year.

Moreover, some temporary incentive subsidies may be available, in the form of abatements on taxes, permits, licenses and training. For example, the State of Coahuila offers no payroll tax for the first year, and will cover payroll during a 90-day training period.

Asian labor costs are even lower

One report puts the cost of educated professionals in China at 10 percent of comparable professionals in the U.S.

Northeastern University Prof. F. Gerard Adams reports that per capita income in China is a mere US$780 (exchange rate basis), compared to US$30,600 in the U.S.

Printed circuit board industry trade magazine CircuiTree reports that Microsoft found labor costs in China to be US$1/hour, compared to US$3/hour in Hungary.

The same article reports direct hourly rates for China at US$0.85, compared to the U.S. at US$9.60 (see table at right).

The official People's Daily quotes a senior Chinese researcher from the Chinese Institute of Industrial Economics, Academy of Social Sciences: "He said the statistics also show average labor costs of industries in China are only five percent of those in developed countries like the United States, Japan and Germany."

Productivity in companies in developing countries is typically measurably lower than in the U.S., which tends to raise overall labor costs relative to straight wage rate differences. Firms owned by foreign companies may be more productive than locally-owned firms, but evidence is scant; moreover, cultural differences present barriers to instituting modern high-productivity manufacturing processes. Anecdotes about rising productivity in Asia are not clearly supported empirically.

A manufacturer can save maybe about 80-85% of direct labor costs moving to China, and about 40-45% of labor costs moving to Mexico.

Labor costs are typically about 30% of total costs, for products produced in the U.S. Thus, labor savings on their face can save a manufacturer 24-26% of total production cost in China, and about 12-14% of total production cost in Mexico. But labor costs are not the entire issue! The manufacturer still has to get the product to market, reliably over the entire product life cycle.

Air freight costs from China are can run abut $350/lb. on FedEx; even with corporate discounts, this type of shipping would be used only for high-value, low-weight goods such as electronics. Shipping costs from Mexico are much lower.

Ocean shipping is much less expensive, but true economies require a full container-load. A partial container presents more difficult logistics. The highest cost of ocean shipping from China is the several weeks spent in transit. During this time, if the manufacturer has accepted delivery in China, the shipment may be a finished goods inventory asset on the manufacturer's balance sheet. A high level of assets drives down the company's return on investment. Alternatively, if the manufacturer has not accepted delivery in China, the shipment is a current encumbered liability while in transit. A high level of current liabilities strains the company's free cash flow and working capital, and may require additional short-term debt. Lots of other evils may befall this inventory as well, discussed in more detail below.

Other costs of international shipping include commissions, customs duties, demurrage, dryage, fees, insurance and licenses. The rules for these costs are very complex, and amounts are highly variable, as different local officials may interpret rules differently. Complexity and variability also open the door to local corruption, which can lead to both financial and legal costs.

Shipments from Mexico do not incur duties, under NAFTA rules. They are subject to other fees and costs, like other international shipments. Because of its closer proximity, shipping from Mexico—typically by truck or rail—does not burden the balance sheet for such a long time. A new land-based border crossing at Santa Teresa, NM, is fed by the new Samalayuca Bypass highway in Mexico, and features automated customs clearing and expedited truck/rail/air intermodal handling. Typically, Mexico shipments require only days, rather than weeks.

Domestic shipping rules are also very complex, but they are well-documented and much less subject to local variability and corruption.

An intangible cost--but very much real--is the political risk of manufacturing in other countries. Political risk is the probability that the local government may change the rules, making manufacturing more expensive or more difficult.

Political risk tends to be lower in democracies like Mexico, India and the Philippines, and higher in totalitarian dictatorships like China, but both provide different types of risk. While dictators tend to stay in office longer than heads of democratic states, they are more subject to radical changes in policy that can whipsaw manufacturing companies. These policies include nationalization of factories, or changes in labor rules, payroll taxes, business taxes, environmental regulations, tariffs and duties and a host of other ways government policies affect business. The Cultural Revolution and Tiananmen Square are examples of radical policy changes without regime changes.

Regime changes can also be traumatic for business in a democratic environment. Uncertainty caused by the unprecedented election of President Vicente Fox in Mexico caused temporary disruption before he took office and articulated an industrial policy. Revolutionaries in the Mexican State of Chiapas—not a major business center—engaged battles with federal troops. In the Philippines, seven coup attempts followed the election of President Corazon Aquino; the December 1989 attempted coup, suppressed with help from U.S. air support, was concentrated in the business haven of Makati, and cost the local economy US$1.5 billion.

Political unrest can also be costly for business. China has been plagued by repeated waves of labor demonstrations, involving over 10,000 protesters at a time, in 1999 and 2002. Issues include non-payment of wages, layoffs, contract disputes and conditions. An estimated 120,000 disputes in 1999 included demonstrations, strikes and violent confrontations with police.

Global anti-U.S. sentiment can be another manifestation of political unrest. In many cases, demonstrations target embassies; in other cases, vandalism targets are U.S. business assets or symbols, such as local Coca-Cola bottling plants or Marriott hotel.

Terrorism is a more extreme form of anti-U.S. sentiment. To date, actual attacks on U.S. business assets and symbols overseas have been few, but terrorism has become a way of daily life in many parts of the world, including some global manufacturing centers.

The probability of a political shut-down is typically small, but the effect can be serious for a manufacturer who has delivery and cash flow obligations. When political unrest strikes a U.S. manufacturer abroad, the effect is typically a complete shutdown until civil order is restored. In some cases, the shutdown may last mere days; in other cases, months may wear into years. While vandalism damage may be insurable, business losses from a shut-down is not. Many manufacturers do not consider political risk in evaluating a move overseas, and are surprised when they occur.

An essential task of any manager is to control the processes on which the company depends. Even when processes are outsourced to other firms, the manager must visit the contractor, review materials sources and specifications, evaluate compliance with production processes, ensure that products are made to specifications and ensure compliance with local laws and regulations. This review process can happen only with on-site inspection.

On-site inspections at overseas locations is more difficult and more costly than at domestic locations. Travel costs and travel time, coping with local transportation, food, customs, language barriers and post-return recovery time are some of the additional costs of controlling overseas manufacturing processes.

External forces occasionally prevent or make these overseas inspections more difficult. A local coup or terror attack, effective or not, can disrupt carefully planned activities. Kidnap for ransom, a profitable business in Mexico, Brazil, Columbia and some other countries, can disrupt entire lives, even with "K&R" insurance.

A recent unanticipated control risk was Severe Acute Respiratory Syndrome (SARS). Travel advisories announced by the World Health Organization and the Center for Disease Control led many U.S. companies to suspend travel to mainland China for two months, including Dell, Eastman Kodak, Intel, Microchip Technologies and Wal-Mart. This disease even shut down business travel to Toronto, Ontario, Canada, for several weeks.

Product piracy practices vary throughout the world, and are highest in Vietnam, China and Indonesia. A study for the Business Software Association estimates that the world-wide piracy rate—business software installed without a license as a percentage of total software installed in a country—was 39% in 2002.

Enforcement: Notable police actions to stop CD and DVD counterfeiting have occurred in a Philippines factory and a London factory full of Asian counterfiet products. The U.S. Customs & Border Protection agency names China as the top source for intellectual property rights seizures in 2002, representing nearly half of all IPR seizures. Taiwan, Hong Kong, Pakistan and Korea round out the top five sources, accounting for 84% of all IPR seizures.

Some of the most disturbing stories, however, involve piracy of other manufactured goods. One U.S. CEO attending a Beijing trade show reported finding a product exactly like his proprietary product for sale at a booth. The only difference was the name plate. Upon further investigation, the CEO discovered that the manufacturer he had contracted to make his product was using its third shift to make the product under a different brand name. It was not a knock-off; it was not a copy; it was exactly the same product, with a different name plate.

Trust: Any time a company exposes its intellectual property to another source, it incurrs risk; consequently, prudent managers disclose intellectual property only to trusted parties. Countries that have clearly demonstrated their untrustworthiness in terms of software and entertainment assets do not have the cultural or enforced legal recognition of intellectual property ownership that makes them trustworthy partners.

Inventory is inherently evil, and nearly all businesses should strive to maintain as little of it as possible. Inventory adds only to costs; it does not add to value. Costs of inventory include:

Capital: Inventory ties up capital, typically borrowed at 10-15% annual interest.

Space: Inventory takes up space, which costs 40-80¢ per square foot each month. Eliminating inventory can allow a company to allocate the space to higher and more profitable uses.

Safety: Wnen inventory spills out onto walkways, or gets stacked too high, it creates a safety hazard and causes injuries and lost time.

Quality: Inventory is subject to dings, spoilage and shrinkage, leading to increased scrap and rework.

Material Change: Materials stored in inventory get old and spoil, rust, temper, cure or age, leading to increased scrap, longer processing times or refinishing.

Transactions: Accounting for inventory and the transactions in and out of inventory storage adds to back office accounting cost. Time wasted rummaging through inventory for materials, parts or products increases as inventory increases.

Obsolescence: Things change, and materials, parts and products in inventory may no longer be useful to a new product line, customer, government regulation or business model. Obsolescence not only adds to scrap, but wastes the investment in producing the part or product in the first place.

Inventory carrying costs are typically about 20-25% of the value of the inventory. Few business actually calculate their total inventory costs, because the costs are hidden in overhead cost categories, like interest, rent, accounting, etc. But when companeis reduce their inventory, they discover that their productivity and quality increase, while down-time, scrap and back-office workloads decrease.

Overseas manufacturing increases inventory of products destined for domestic markets. Most of this inventory increase is due to the time spent in transit. Ocean shipping typically takes weeks just in transit, and even more time is spent in docks, loading, inspections, unloading, storage, customs, reloading for overland transportation etc.

Finished goods are the most expensive inventory, because they have the most investment tied up in materials, parts, labor, machine time, etc. Moreover, finished goods are also more likely to suffer damage if dropped in all the loading or unloading, and are more likely to be stolen by any of the multiple hands that cover the goods in the international shipping system.

Inventory reduces return on investment. Return on investment may be measured many ways, such as return on assets, return on equity or return on invested capital. In all of these measures, the numerator has to do with earnings, and the denominator includes a measure of assets. Inventory is an asset. Any company that can maintain the same level of earnings while reducing its assets will increase its return on investment significantly: reducing the denominator by half doubles the return.

Producing goods close to their ultimate markets minimizes shipping and handling of finished goods, eliminates the waste of international logistics, reduces inventories and increases return on investment. For products sold in the U.S., inventory will be minimized by domestic manufacturers and maximized by Asian manufacturers. Mexican manufacturers will create inventory between those two extremes.

A particular type of inventory cost—obsolescence—is potentially particularly costly when manufacturing overseas. The long logistics chain of manufacturing overseas, communications difficulties, cultural differences and governmental regulations all converge to increase obsolescence risk.

Time-to-market can be much higher for manufacturing new products overseas. Even with Internet, e-mail and ftp communications, communicating designs and specifications can be more cumbersome due to language difficulties and manufacturing customs and standards. Long logistics lines then add even more weeks to time-to-market.

Design changes can take even longer getting to market. Whenever a design change is required, three-to-six weeks of old-design products are already in transit. Bringing the design change to the market will either be delayed until the old designs are sold, or the old designs will be scrapped or reworked. Contrary to common belief, design changes represent a significant risk to overseas manufacturers because they are quite common and are not always subject to long-term planning. Major causes of design changes include:

Customer style and taste seem to change more quickly due to global television and other media. Agile companies can change products to respond to market opportunities, but companies with long logistics lines cannot.

Product upgrades are routinely necessary to meet competitors' product advances. Product upgrade cycles tend to shorten as an industry matures and stronger competitors vie for market share.

Defect correction occurs in any industry, as consumer use and complaints generate data about the actual performance of products in the field. Virtually any product may be recalled, including automotive parts, appliances, child safety seats, clothing, drugs, electronics, environmental controls, foodstuffs, furniture, household or outdoor products, lighting, medical devices, sports equipment, toys, etc.

Packaging changes happen all the time, primarily because of changes in marketing; for example, a marketing campaign may want to emphasize a new entertainment tie-in, or emphasize a differentiation feature, or meet a new market opportunity. If the new packaging is just for temporary use, old packaging may be warehoused for later use, but this approach just adds to inventory.

Regulatory changes may affect a product directly, or just its packaging. Labeling requirements change all the time, and vary all over the world. For example, U.S. nutritional information requirements change from time-to-time; country-of-origin labeling (COOL) requirements, generally applied to agricultural products, especially beef, are mandatory in Europe, New Zealand and Argentina, and discussed regularly in the U.S. and Japan; similar COOL regulations are proposed for recreational boats. Labeling requirements are ever-evolving.

Change is a normal part of business, but global integration and a speedup in communications technology and transportation now give a competitive advantage to the agile company that can turn on a dime in response to change. A company tied to long logistics lines and implicit large inventories cannot change quickly.

A key principle is to manufacture products near their markets. Manufacturing overseas may be the best solution if the products will be sold overseas. But for products to be sold in the U.S., manufacturing closer to home is generally a better solution.

Manufacturers can save a significant amount of labor cost by moving operations overseas. But the cost savings in labor are illusory: labor is typically not the most significant factor in a product's cost, rarely more than 30% of total cost.

Direct costs offset labor savings. Increased direct costs include customs, duties, fees, insurance, intermodal handling, licenses and transportation.

Too often, a manufacturer looks only at the labor + transportation + duty equation. In many cases, that equation will tell the manufacturer that overseas manufacturing is the cheapest solution. But that equation does not tell the full story. Overseas manufacturing also incurs some more intangible costs, intangible but nonetheless real. These intangibles most often take the form of risk.

Political risk is like a natural disaster, an earthquake, tornado or hurricane; it happens infrequently, but it can be devastating when it occurs. Political risks include radical regime change, anti-U.S. sentiment and even terrorism.

Currency risks can be intangible, in terms of the uncertainty of an exchange-rate change, or they can be real, in case of revaluation. Managers can hedge against currency fluctuations over the short run (months), but long-term investments—and the entire product cost structure—can be significantly wiped out in a currency revaluation.

Management control is significantly eroded when manufacturing is a long way distant from the market. Management cannot be two places at once; with overseas manufacturing, management is either paying attention to its market, or to its operations, but not both. The trick for successful companies, though, is to manage both at once.

Intellectual property is an intangible asset, but it may be the most valuable asset that many companies have. Protecting intellectual property is virtually impossible in some parts of the world; their cultures do not necessarily respect intellectual property rights, and their governments are reluctant or unable to enforce the laws they have.

Inventory, and all of its costs, are necessarily increased when manufacturing overseas, just due to the difficulties of long logistics lines. Inventory carrying costs are real, but they are generally absorbed in fixed cost categories, so the impact of inventory on operating expenses is hidden. Inventory adds cost but not value, and by definition reduces return on investment. Every military commander knows the dangers of long supply lines, and managers should recognize those same dangers in their logistics decisions.

Time-to-market is more important in today's world of global media than it was just two decades ago. Being first in a market can be a competitive advantage that cannot be overcome; by the time competitors catch up, the market has moved on to other products, and the competitor is stuck with obsolete inventory. Overseas manufacturing virtually always lengthens time-to-market, reduces a company's agility and becomes a competitive disadvantage.

Moving manufacturing operations overseas can be the right solution when markets are also overseas, but it is rarely the right decision when serving domestic markets.

Q: So how can companies keep their manufacturing operations at home and still compete with the price leaders who absorb the overseas risks?

A: They improve their productivity, by implementing lean manufacturing techniques.

A lean manufacturer will absorb higher hourly costs for labor, but will invest fewer labor hours in each product, because of higher productivity. A lean manufacturer will avoid the extra transportation, handling and duties costs. A lean manufacturer will not suffer political, currency or control risks, and will protect its intellectual property. A lean manufacturer will keep inventory to a rock-bottom minimum, and will be able to respond to market conditions in real time.

Many manufacturers find that they can beat lower overseas costs with increased productivity. Explore lean manufacturing alternatives before committing to long-term risks overseas.

U.S. companies that have their products manufactured overseas typically pay for those products with foreign exchange, the currency of the country from which they are purchasing the goods. They may buy foreign currencies in open markets, usually through international banks.

Most currencies fluctuate in open markets. For these currencies, the exchange rate—the price of one currency expressed in terms of another currency—is determined by the relative supply and demand for the two currencies. Supply and demand vary according to the health of the country's economy and its balance of payments. The more a country exports, the more of its currency overseas customers must acquire to pay for those exports; demand for the currency is high and its price—expressed in other currencies—goes up. Consequently, the cost of that country's export products increases—even though the price remains the same—just due to the change in exchange rates. For example, in 2003, the Mexican Peso (MXN, or MX$) traded between a low of US$0.0890 in early March, 2003, and a high of US$0.0989 in early May, 2003, a change of over 11% in just over two months. It was US$0.0921 in late August, 2003.

Note the key phrase, "...expressed in other currencies..." In normal practice, foreign exchange markets express the prices of only two currencies in terms of other currencies: the Great Britain Pound Sterling (GBP, £) and the Euro (EUR, €), which are normally expressed in US dollars (USD, US$). For example, the GBP recently traded at US$2.60, or £1,00 cost US$2.60; the EUR recently traded at US$1.16, or €1,00 cost US$1.16.

Most other currencies are normally expressed in terms of how many units of the currency are exchanged for US$1.00. For example, the Japanese Yen (JPY, ¥) recently traded at ¥110, or ¥110 for US$1.00. In these cases, when the demand for a currency increases, the price of the currency—expressed in terms of the number of units trading for US$1.00—goes down. The actual cost of the currency to the buyer goes up, because now US$1.00 will buy fewer JPY or other currency. This seeming inverse relationship is why, when the number price of JPY appears to go down (fewer JPY per USD), the currency is actually becoming more expensive.

Some countries peg their currencies to a specific value, usually in terms of the USD. In these countries—particularly in the less-developed world—the government buys or sells its own currency and other currencies, offsetting market fluctuations, in order to maintain an exchange rate within a very narrow band, relative to the currency to which it is pegged. For example, the Chinese Yuan (CNY, 元) is pegged to the USD within a band between CNY 8.2760 and CNY 8.2800 per US$1.00.

Countries that peg their currencies bring two types of risk to businesses:

First, they may change the peg suddenly, without warning; uncertainty and unpredictability are always business hazards, even when they work in your favor.

Second, the change may be in an unfavorable direction. Currencies that are pegged to the USD, like the CNY, will fluctuate in parallel to the USD relative to all other currencies, reflecting changes in the demand and supply for USD, which are mostly influenced by U.S. business cycles. To the degree that the economy underlying a pegged currency fluctuates in a different way than the U.S. economy fluctuates, the pegged currency will become out of balance with its own underlying economy.

For example, the U.S. has had a balance of payments deficit for many years; imports exceed exports, and U.S. investments in foreign countries exceed investments in the U.S. economy by foreigners. As a result, the rest of the world has an ever-growing supply of USD, and the value of USD generally trends downward, relative to most other major currencies (this trend is somewhat offset by the world's confidence in the safety of the USD; many foreign investors are content to hold USD because of its lack of political and economic risk).

China, on the other hand, has a balance of payments surplus. It exports more than it imports, and foreigners (including U.S. investors) invest more in China than China invests in the rest of the world. Consequently, the world's demand for CNY is ever-growing, and if market forces were in operation, the value of the CNY would tend to increase. But the CNY is pegged to the USD, so market forces do not operate; instead, the value of the CNY relative to other currencies generally trends downward, along with the USD. The CNY has therefore become severely undervalued relative to other currencies, including the USD. Some economists estimate the CNY is undervalued between 15% and 40%.

An undervalued currency gives China a significant advantage in world markets, and is one reason why its labor costs are so low. Its exports are relatively cheaper than they otherwise would be, and foreign goods are relatively more expensive. But this currency advantage is artificial; it results from government intervention. It is a form of government subsidy to Chinese exporters. Japan intervened in currency markets in an attempt to offset the undervalued CNY relative to the JPY. Other countries whose currencies float in world markets are also concerned. Politically, many U.S. companies, industry groups, labor unions and Members of Congress advocate the U.S. to pressure China to revalue its currency higher, more closely reflecting market conditions, but the U.S. government has resisted a China policy change.

China has so far resisted revaluation, saying only that it is considering widening the CNY trading band. But if China should relent, the change will no doubt be sudden and cause an immediate increase in the real cost of all goods manufactured in China.

The Blog

We're Moving Overseas! Are We Making a Big Mistake?

Moving Overseas a Mistake?

Pro: Lower Labor Rates

Con: Transportation & Customs

Con: Political Risk

Con: Control Risk

Con: Piracy Risk

Con: Inventory Risk

Con: Obsolescence Risk

Summary

Con: Currency Risk

By Phillip Blackerby, M.P.Aff

Lean Manufacturing techniques help manufacturers eliminate waste. Lean boosts a manufacturer’s gross margins and increases effective manufacturing capacity. These bottom-line improvements enable the company to make new strategic choices.

Lean Manufacturing will root out the eight wastes and help you to re-think every aspect of your business. It need not stop at the factory floor; much of the potential improvement may be in office operations, and in the interface between the office and the plant floor.

As you proceed down the Lean path, the entire culture of your organization will change. People will begin to work in self-managed teams, and workers and managers will find new roles and new ways of relating to each other. Everyone will be both individually and collectively responsible for product quality, cost and timeliness. Everyone will look for ways to improve the company. Everyone will participate in the rewards of success.

The Lean path is rewarding, but it is not an easy or a short path. The rewards can begin to appear quickly, but they require positive action. The company that fails to implement Lean will find itself falling behind, as competitors pass it by. More than a survival skill, Lean Manufacturing is a way to face and overcome the pressures of global competition.

Lean Manufacturing techniques help manufacturers eliminate waste. At the National Institute of Standards and Technology, Lean Manufacturing is: "A systematic approach to identifying and eliminating waste (non-value-added activities) through continuous improvement by flowing the product at the pull of the customer in pursuit of perfection."

Let’s examine what these results mean more closely:

Productivity is easy to see. An increase in productivity means you create more manufacturing capacity without having to add more labor or machines. You can produce more with what you’ve already got. Productivity increases because people stop doing things that add no value to the product, like looking for tools and parts, setting up machines on-line, waiting for work, transporting work from station to station, overproducing, etc.

WIP is a form of inventory. Inventory is inherently evil, because it adds to cost, but not to value. Reducing WIP means:

Lean manufacturing is not about doing more with less; it’s about doing less with less. Most manufacturers measure their lead time in weeks, but they can measure the actual amount of time spent producing a product in minutes. Typically, actual production time is less than five percent of the total time a product spends in the plant. The difference between actual production time and total lead time is a symptom of the wastes in a plant.

Lean Manufacturing recognizes eight types of waste, and the Lean Manufacturing techniques help manufacturers find and eliminate these eight wastes:

So what are these magic bullets that comprise Lean Manufacturing? Fifteen basic techniques help manufacturers eliminate the eight kinds of waste:

Awareness training is the first step in the Lean Manufacturing journey. A good awareness-building training course will introduce management and workers to the key concepts, the eight wastes and the basic tools in the Lean toolbox, and provide them a vocabulary for discussing manufacturing improvements within their teams.

Value Stream Mapping (VSM - click here for more information) is a basic planning tool for identifying wastes, designing solutions and communicating concepts. This graphic language helps the management team:

A recent development is the "Lean Office." With a few word substitutions, Lean techniques may be applied to front-office (management, marketing, sales, human resources, etc.) and back-office (accounting, purchasing, payables, receivables, etc.) operations: for "product," substitute "decision;" for "inventory," substitute "backlog."

Opportunities for improvement may be as great in the office as on the factory floor, particularly at points where the office functions interact with plant floor personnel. An easy way to gauge the potential is to compare the portions of overall lead time attributable to office and plant floor functions. More precise measures can come from the VSM process.

Lean Manufacturing is about eliminating eight key wastes from throughout the manufacturing process. The Lean Manufacturing toolbox includes 15 key techniques. The journey begins with awareness training and value stream mapping. Implementation should begin with the foundation tools: standardized work, 5-S, visual controls and plant layout. Then proceed to the more difficult: mistake-proofing, teaming, point-of-use storage, set-up reduction and batch reduction. Ultimately implement the more complex tools: quality at the source, total productive maintenance, cellular manufacturing and pull manufacturing. In time you will create the Lean Enterprise.

The Lean journey has no destination; it is a journey of continuous improvement. Along the way you will learn new things about your company, about your products, and about your suppliers, customers and competitors, adding to the richness of your business.

The Lean Enterprise will be a much more valuable company. It will have higher profit margins, and be able to choose its own strategic destiny. It will have almost no inventories, giving it the flexibility to respond to changes in customers and markets. It will grow, because it has the competitive advantage of a short lead time, and the financial resources to invest in new products and processes. And it will keep improving at an ever-faster rate, because it embraces continuous improvement.

Companies that use lean manufacturing just to reduce head count have limited their opportunity to profit

Lean's primary effect is to uncover "hidden" capacity in a plant; that is, a lean plant can produce more product with the same resources than a "traditional" plant. Thus, the lean plant has a higher gross margin (net revenue less cost of goods sold, as a percentage of net revenue).

By reducing head count, the company recognizes only a part (the labor and scrap rate portions) of its higher productivity, but it leaves excess machine and space capacity on the plant floor. The smaller leaner company is therefore applying only a part of its higher margin against its current sales base.

A better option is to apply all of the company's higher margin to an even higher level of sales. When a company launches a lean manufacturing initiative, it should simultaneously launch a marketing initiative. With management commitment and good scheduling, both initiatives should mature at the same time, and new sales will show up (just) in time to sop up the newly-uncovered excess manufacturing capacity. The message of this marketing initiative might be faster lead times: "Competitors quote 3-4 weeks lead time; Lean Inc. can now deliver in 3-4 days!"

An enterprise-wide approach to lean transformation looks at the entire Profit & Loss statement, not just labor costs.

1Phillip Blackerby is a Principal with Blackerby Associates, Inc., Phoenix, which helps organizations transform into high-performance enterprises. Blackerby Associates are experts in management and organizational development, and provide a single source for organizational transformation services. Mr. Blackerby has provided consulting services to manufacturers and others for over 12 years, and developed training programs for manufacturers and consultants at the National Institute of Standards and Technology. He managed finances, process improvements and planning systems for government agencies in Texas and Washington, D.C. He earned a Master of Public Affairs degree from the LBJ School at The University of Texas at Austin, and a bachelor’s degree in economics (honors) from Brown University, Providence. He has three daughters and dotes on his two grandchildren. Mr. Blackerby may be reached at 602-908-1082, Phillip@BlackerbyAssoc.com, or the web site: www.BlackerbyAssoc.com.

2Japanese: poka 「ポカ」(also poke「ポケ」): inadvertent errors; yoke「ヨケ」: from yokerie「除けりえ」: to avoid.

3German: der Takt: beat; pulse; cycle; stroke.

4Japanese: kanban「看板」: signal; sign; signboard; poster.

The order in which the remaining tools are implemented will depend on the company’s implementation plan, and will vary depending on a specific plant’s needs.

Standardized work is a process of documenting and standardizing tasks throughout the value stream. Most companies have "native lore," or undocumented ways each machine works and each product is made. Some operators do it one way; others another. The result is product variability, high training costs, downtime due to absenteeism, and managers who don’t understand why products don’t get to shipping. By standardizing work throughout the plant, products are replicated precisely, regardless who makes them, training costs are reduced and cross-trained employees can substitute for each other.

5-S workplace organization and standardization eliminates all the clutter ("Sort"); organizes each workplace for maximum efficiency ("Set in order"); cleans the workplace ("Shine"), inspecting equipment as it is cleaned; establishes "Standards" for workplace tools, inventory and processes, ensuring a continuous state of readiness; and establishes cultural norms to "Sustain" the workplace standards every day, indefinitely. The first three steps are fun and easy; the last two are more difficult and more valuable.

Visual controls are visual signals that give each operator and manager the information needed to make a right decision. They may be simple: lines delineate walkways; color coded waste bins; graphic instructions at each work station. They may be more sophisticated: "andon" lights show the status of each machine; asymmetrical parts can be assembled only one way; "Are you sure…?" warnings before deleting computer files. Visual controls reduce training requirements, overcome language barriers, increase safety and prevent variability and defects.

Mistake proofing is a series of techniques that prevent quality problems from emerging ("poka yoke"2 "avoiding inadvertent errors"). When parts are asymmetric, and fit together only one way, an operator cannot assemble them incorrectly; a kill switch prevents boxed products from running off the end of a conveyor; only right-sized products can fit through a screening process.

Plant layout techniques focus on eliminating transportation waste. Machines in a production sequence are linked together; resources needed for production are close-at-hand. A better layout reduces movement of people and resources; reduces WIP; improves product flow and communication among operators; and maximizes the capacity of machines, floor space and material handling systems.

Teams become self-managed. Lean value streams abandon traditional command-and-control systems, and even hub-supervisor team structures, in favor of self-managed teams. Nominal supervisors become facilitators, negotiating between the team and upper management. Managers learn to earn trust; promote and reward participation and "almost rights;" sell rather than tell; share ideas rather than control information; and provide training and systems that help operators complete work successfully. Workers seek out cross-training; actively participate in teams; propose ideas and take risks; make decisions and mistakes; share responsibility for implementing changes; and support continuous improvement as a cultural norm. Self-managed teams improve camaraderie and morale, and keep the organization aligned and focused on shared strategic goals.

Teams are where the cultural change generated by the Lean journey is most evident. As Lean concepts permeate throughout the organization, a profound culture change will occur: long-term patterns of behavior are disrupted, relationships are adjusted, values are re-examined, and value is redefined. This cultural change will cause conflict and disharmony, until new values and norms are established, accepted and practiced. A manager must be alert to these changes, and take action to deal with the issues that come up. Key elements for success include ongoing and personal commitment by the CEO and the entire management team; training and support; recognition of champions; tolerance for experimentation and pilot-testing; regular and frequent communications that share information organization-wide; multiple communication channels up and down the hierarchy; one-on-one attention to participants in disruptions; respect for people’s rights and experience; and empowerment at the lowest appropriate level.

Point-of-use storage puts small amounts of parts, supplies and tools at each workstation. This approach eliminates trips to and from central inventory storage areas and tool cribs, and keeps workplace clutter away. It gives operators a sense of beginning and ending to work, and helps the organization develop just-in-time supply systems.

Quality at the source places responsibility for meeting customer specifications and standards at each point of manufacture. To start, companies measure, communicate and reward high quality at every step in the process. They give each operator the training, tools and documentation to produce a quality product, and to inspect it against the specifications and standards. Managers empower subsequent operators to detect and reject non-standard products. Ultimately each manufacturing step is designed to make non-standard production virtually impossible. Even where human factors present opportunities for failure, process and product designs detect abnormal situations and intervene to prevent errors, to "mistake-proof" the process. When implemented fully, the value stream may completely eliminate non-value-added inspection and rework steps.

Total productive maintenance (TPM) goes beyond preventative maintenance, to optimize the operation of equipment. TPM brings together maintenance personnel, engineering staff, management and machine operators in a process to document and analyze machine performance, identify the root cause of performance issues, implement corrective actions, establish communication channels among all four parties, and empower all participants with a shared responsibility for equipment performance.

Set-up reduction (quick changeover) techniques can reduce down-time due to product changes by up to 90 percent. It allows the value stream to devote a greater percentage of time to actual value-added production; quality improves and scrap falls as fewer trial processes produce fewer defects; and the value stream gains flexibility; as the cost of set-ups falls, changeovers can occur more frequently, and products can be produced more to customers’ schedules than to machine schedules.

Batch size reduction is closely related to set-up reduction. As set-up times are reduced, the optimum economic order quantity (EOQ)—or batch size—may also be reduced. Smaller batches can get through the production process more quickly, reducing WIP and its carrying costs, and increasing throughput. Quality problems appear earlier, and consequent rework needs are smaller. Batches can be reduced to reflect customer order patterns, reducing finished goods inventory and related carrying costs.

Cellular manufacturing uses the "Leanest" batch size—one-piece-flow—where each operator makes one product and passes it directly to the next operation. With a carefully designed and calibrated work flow, cellular, or "flow manufacturing," can eliminate virtually all WIP and its carrying costs. Inside a U-shaped manufacturing cell, operators can move easily among steps, regardless of the production sequence. Creating a cell requires grouping functions based on the machines and other resources required; measuring the process time for each step ("cycle time"); sequencing the steps for efficiency; recombining steps to balance production station times; and designing the cell.

Pull manufacturing is a higher-level implementation of cellular manufacturing, where the pace of production is determined by the customer demand rate ("Takt3 time"). When you know how the rate at which customers demand a product, you can design the manufacturing cell to produce products at precisely that rate, with small, controlled inventories between each work station. A product "pulled" from the small finished goods inventory at the end of the cell sends a signal ("kanban4") that a product has been withdrawn. The last operator then pulls a nearly-finished product from the previous inventory, processes it, and replenishes the finished goods inventory. By pulling that nearly-finished product from the previous inventory, the operator sends a signal to the previous operator that a nearly-finished product has been withdrawn. That operator then pulls a less-complete product from his previous inventory, processes it, and replenishes his subsequent inventory. This continual pull-and-replenishment process repeats back-to-front throughout the cell. The overall effect is that products are produced only when customers demand them, and they are produced without backlog, at the same overall rate that customers require them. This approach eliminates overproduction waste, and controls WIP at a maximum level, just enough to fill the product pipeline throughout the manufacturing cell.

Overall, annual inventory carrying costs are about 25% of the inventory value.

Space requirements fall in part because you have less inventory on the floor, but also because your machines are closer together, work areas are more compact and less room is dedicated to walkways and storage. Space savings may not directly accrue to the bottom line, but if you feel cramped now, you won’t have to move to a new plant as soon, saving moving costs, down-time and aggravation. If you have additional facilities off-site, you may be able to consolidate, and eliminate some cost. The Texas machine shop discussed above converted an inventory storage area to an employee break room, contributing to a reduction in costly turnover!

Quality is a given today. OEMs don’t accept less-than-perfect products, and don’t order from sub-par producers. Lean Manufacturing techniques result in products that meet quality standards, and at less cost for inspection and rework. Those involved in Six-Sigma, ISO 9000 or other quality programs will find that Lean Manufacturing is a valuable adjunct to those efforts; in many cases, Lean Manufacturing makes your quality program easier to implement.

Lead time is the total time between customer order and product delivery. Henry Ford said: "One of the most noteworthy accomplishments in keeping the price of Ford products low is the gradual shortening of the production cycle. The longer an article is in the process of manufacture and the more it is moved about, the greater is its ultimate cost." (1926).

Cutting lead time has several benefits:

Gross margin is the difference between net sales and cost of goods sold, including both labor and materials, divided by net sales, and expressed as a percentage. A successful manufacturer will have a gross margin of at least 60%; this money will then be used for sales and marketing expenses (advertising, sales commissions, etc.), general expenses (rent, utilities, insurance, etc.), administrative expenses (management salaries, consulting, accountant and legal fees, etc.), interest on long-term and working capital debt, taxes, depreciation of plant and equipment and, of course, profit.

By implementing Lean Manufacturing techniques, a manufacturer creates additional manufacturing capacity. Management can choose what to do with this capacity: it can slough it off to reduce cash outlays, or it can increase sales to sop up the excess. Most companies do some of both. Whichever choice is made, gross margin increases.

A higher gross margin opens up new strategic choices that a company may have never considered before. With a higher margin, a company may:

By implementing these techniques, manufacturers can typically:

By implementing the Lean techniques, and achieving those performance results, a manufacturer can increase gross margins as much as 30 percent, and increase effective manufacturing capacity up to 30 percent, without more investments in plant, equipment or labor costs. This means you can make more gross profit on the things you make, and you can apply that higher profit rate to a higher volume of production!

Are these claims extravagant? The fact is that manufacturers all over the world—large, medium and small—are implementing Lean Manufacturing and achieving these results. Probably some of your competitors are marching down the Lean pathway.

For example, a 94-person machine shop in Arlington, Texas, saw $500,000 per month in billings as a "stretch goal." After implementing Lean techniques, they cut their workforce to 67 and billed $500,000 a month routinely! Lead time fell 87 percent, and value-added per employee increased 175 percent. More importantly, they stayed on an aerospace original equipment manufacturer’s (OEM) vendor list while thousands of other vendors were cut; later they picked up more work and expanded their work force to 85 over the next few years.

Using lean manufacturing just to reduce head count (click for more information) is rarely the right thing to do, but it was necessary in this case because (a) 80 percent of the company's business was with one customer (never a good situation!) and (b) the company was rapidly exhausting its cash. A better alternative would have been to apply its new, higher gross margin to an even greater level of sales. By launching a marketing initiative at the same time as it launched its lean initiative, new sales would have appeared, sopping up the company's newly-found excess manufacturing capacity just as it emerged. Profits, in both percentage and absolute dollar terms, would have shot up even more significantly.

Some companies continue their lean journey over a long term, and consistently generate two percent productivity improvement every month. Compounded, this rate of improvement translates to a 400 percent improvement over six years!

By Phillip Blackerby

• Increase productivity up to 30%
• Reduce work-in-process (WIP) inventory up to 90%
• Reduce space requirements up to 40%
• Improve quality up to 80%
• Reduce lead time up to 90%

• You reduce inventory, giving you a one-time permanent increase in cash flow.
• Working capital needs drop, so you borrow less from the bank at 10-14% interest.
• You don’t need a place to put WIP, so space requirements decrease, at $8-12 per square foot; those savings may not be money in the bank, but it means you can expand production without moving, or consolidate scattered sites.
• No one will trip over the WIP, so injuries, damage, scrap and rework decrease.
• The parts don’t become obsolete, so sunk production costs aren’t wasted.
• The WIP no longer rusts, cures, tempers or gets dirty, so production is easier, quality is better and customers are happier.

• The faster you convert orders to cash, the less working capital you need, reducing that 10-14% loan at the bank.
• Faster throughput—the primary way to reduce lead time—means you have less WIP lying around, and therefore lower inventory carrying cost.
• Faster throughput may allow you to order raw materials just-in-time, further reducing inventory carrying cost.
• Faster throughput may allow you to quit tracking the status of some orders, and turn off parts of your enterprise resource planning (ERP) system, saving data entry time and computer system costs.
• Faster delivery to customers can be a significant competitive advantage in some markets, allowing you to gain market share.
• Faster throughput gives customers less time to change their specifications, orders and minds.

• Develop new products, tap new markets
• Reduce prices, capture market share
• Invest in productivity improvement
• Invest in technology, training
• Pay employee bonuses
• Harvest the business
• Buy tax-free bonds
• Get off the grid
• Pay a dividend
• Pay off debt

• Overproduction of work in process
• Waiting
• Transportation of parts/materials/tooling
• Non-Value-Added processing
• Excess finished inventory
• Defects
• Excess people motion
• Underutilized people

• Identify each value stream;
• Describe the entire value stream ("current state") in a way that is easy to see;
• Measure inventories, flows and constraints;
• mIdentify opportunities for improvements;
• Describe how the value stream will function after implementing the major solutions ("future state"); and
• Describe an implementation plan that will move the company from the current state to the future state in a rational manner.

Introduction

Lean Manufacturing and Your Bottom Line

Lean Manufacturing Definitions

Lean Outcomes and Your Bottom Line

"We’re already pretty lean; we laid off three guys just last week!"

Lean Manufacturing Techniques

Lean Manufacturing Techniques

Summary

Using Lean Manufacturing to Reduce Head Count

Lean Manufacturing Outcomes

None of these eight wastes involves the addition of value (form, fit or function) to the product. Lean manufacturing does not focus on making the value-added functions more efficient; it focuses on eliminating, streamlining, simplifying, reducing or integrating the non-value-added functions. It fixes the 95 percent of the factory’s lead time that is waste, not the five percent devoted to production.