A Brilliant Strategy Without Operational Excellence is Doomed
Production is an Engine for Profit
The production function can be a potent profit-generating machine. Traditionally, managers have regarded the production function as a necessary evil, a prerequisite to the real business of making money. This perspective is widely echoed in textbooks: the goal of production is “to produce widgets with minimal expenses and deliver them to customers at the lowest possible price.” This mindset pushes operational excellence efforts to focus on cost reduction.
Unfortunately, many managers fail to recognize that production is the foundation of competitive advantage. They myopically focus exclusively on cost reduction, overlooking the effect production has on the broader purpose of the enterprise. Saving money is fine, but focusing on customer-centric outcomes can make more profit. Customers are not as interested in a low price as they think; the outsized rewards go to suppliers that deliver quickly, reliably, and are responsive to their needs.
Throughput is the Key to More Profit
Most operational excellence efforts focus on improving efficiency – reducing labor costs. Suppose we reduce the labor we need to satisfy demand by 25%. What should we do with the 25% excess capacity? This excess labor capacity is typically seen as a waste and therefore ‘rationalized’ out of the firm, saving money and increasing profit. Here’s an example of how the P&L statement would look.
Improving profits by 25% is a win for the production department and the organization. But how long can the production department continue to improve by reducing expenses? How long can they deliver such significant improvements? There is a diminishing return on cost reduction efforts, more effort yields fewer results, and a limited opportunity – costs can’t be reduced to zero. Moreover, focusing on cost reduction and operational efficiency overlooks more significant profit prospects – shipping more product.
|
Before |
After |
|
|
Sales |
$100M |
$100M |
|
Raw Materials | $40M |
$40M |
|
Direct Labor |
$10M |
$7.5M |
|
Overhead |
$40M |
$40M |
|
Total Cost |
$90M |
$87.5M |
|
Net Profit |
$10M |
$12.5M |
|
% Increase |
25% |
Suppose we decide to use the extra capacity to ship more products. That 25% excess labor capacity could deliver 25% more sales. A 25% increase in product sales provides 150% more profit.
Throughput is a longer lever to improving the bottom line than reducing operating expenses. Finding productive work for idle resources (increasing “T”) is ALWAYS more profitable than eliminating them (decreasing OE). Furthermore, unlike cost reductions, the opportunity for increasing throughput is unlimited.
I am not suggesting managers disregard production costs; there are always opportunities for saving, and competitive pressures drive prices down. Competition on price is only one of many areas to find a competitive edge. Managers cannot just look inwardly for results, disregarding the most important factors of the competitive equation, for customers care about price less than they think.
Before | Reduce OE | Increase T | |
| Sales | $100M | $100M | $125M |
| Raw Materials | $40M | $40M | $50M |
| Direct Labor | $10M | $7.5M | $10M |
| Overhead | $40M | $40M | $40M |
| Total Cost | $90M | $87.5M | $100M |
| Net Profit | $10M | $12.5M | $25M |
| % Increase | 25% | 150% |
Superior Service is a Prerequisite for Growth
The production organization has a big part to play in the sustainability and growth of the organization; many studies show a direct relationship between service quality and profitability. This function delivers the ‘service’ to the customer satisfying the customer’s needs. Customers have deadlines to be met and have their requirements interpreted. The physical product comes wrapped with personal interaction, delivery methods, speed, installation processes, and payment terms. That wrapping is as important to your customers as the product itself; in the customer’s mind, the product is a single thing.
Leaders in production are not just makers of things; they are satisfiers of needs. The delivery of quality service is part of your domain. Not only do you have to deliver a quality product, but you must also deliver it well.
Reliability is the Highest Service Priority
What then defines delivering ‘well’? What is good service? Parasuraman et al. describe service problems as gaps between customer expectations and what they get.
The acronym RATER helps us remember the five dimensions of quality explicitly mentioned in the research instrument. These five dimensions represent the consumer’s mental checklist of service quality.
- Reliability: the ability to perform the promised service dependably and accurately – the customer receives the desired results in the time expected.
- Assurance: the knowledge and courtesy of employees and their ability to convey trust and confidence – the customer is in competent hands.
- Tangibles: the appearance of physical facilities, equipment, personnel, and communication – the product and materials are fit for use.
- Empathy: providing caring, individualized attention to customers – the supplier understands the customer well.
- Responsiveness: the willingness to help customers and provide prompt service – the customer receives the results promptly.
Research shows that poor service is the number one reason customers leave (45%), and reliability is the most valued of the five service qualities. In retail or distribution settings, stock-outs are the leading cause of losing business. If you can’t deliver the product when the customer expects it, you will have difficulty making money now and in the future.
Production’s essential function is delivering the product fit for use within the expected time. Your customers don’t care about your low price if you’re unreliable.
Responsiveness is the Second Priority
Responsiveness in a manufacturing setting means quickly and effectively responding to customer demands – short lead times. To accomplish that, the organization must maintain some slack to respond to the normal variation in the market. That means extra capacity or inventory is needed to support quick response, and it’s not free.
A singular focus on cost reduction and efficiency strives to eliminate that extra capacity. In doing so, it risks damaging the reputation and future throughput. It takes much longer to recover from reputation damage than cost ‘overruns’. Besides, if your plant is 100% utilized, your delivery performance will decline, and lead times extend. There is no room to take advantage of market opportunities.
By using ToC to create and manage responsiveness, manufacturers can better meet changing customer demands, keep lead times short, minimize investment in inventory, improve customer satisfaction, and gain a competitive edge.
Production as a Competitive Edge
Most companies confidently leverage the Theory of Constraints (ToC) in production with two applications: Drum Buffer Rope, which effectively slashes lead times and boosts throughput, and the Demand-Pull (Distribution) Solution, which enhances availability. By ensuring reliable delivery and shorter lead times, these companies can seize the opportunity to attract new customers.
Things you can do, and others have done with the ToC operations solutions without significant investment:
- Offer VERY short lead times on semi-custom products.
- Create 99% availability of the most profitable products while holding less inventory than competitors.
- Deliver custom products in half the time of the competition.
- Go to market with new products in half the time of the competition.
- Offer fresher inventory at a lower price.
- Quickly shift resources to different market segments.
- Double or even triple return on capital
- Eliminate customers’ inventory carrying costs.
- Significantly reduce customer’s capital risk (of buying your product)
ToC is different from Lean in its emphasis on efficiency and Six Sigma in its focus on quality; ToC strives to improve profit now and in the future. The production solutions are a means to an end. While the immediate outcomes of using ToC are increased throughput, reduced operating expenses, and inventory, it offers much more than that. Its most significant value lies in improving service in the dimensions that customers value the most. Doing so provides organizations with a decisive and lasting competitive edge. In other words, a ToC approach to production helps you sell more products that deliver more profit, to the customers who will pay more.
Bibliography
Parasuraman, A, Ziethaml, V. and Berry, L.L., “SERVQUAL: A Multiple- Item Scale for Measuring Consumer Perceptions of Service Quality’ Journal of Retailing, Vo. 62, no. 1, (1985), https://www.researchgate.net/publication/225083802_SERVQUAL_A_multiple-_Item_Scale_for_measuring_consumer_perceptions_of_service_quality
Moss, Hollye K, “Improving Service Quality with the Theory of Constraints”, Journal of Academy of Business and Economics, (2007)
Forum Corporation, Boston, Customer Focus Research Report, (2004)
Corsten, Daniel, and Gruen, Thomas, “Stock-Outs Cause Walkouts”, Harvard Business Review, (2004)
Sadun, Raffaella, and Bloom, Nicholas, and Van Reenen, John, “Why Do We Undervalue Competent Management?: Neither Great Leadership Nor Brilliant Strategy Matters Without Operational Excellence”, Harvard Business Review, (2017)
Institute for Operational Excellence, “What is Operational Excellence?”(2012), https://instituteopex.org/what-is-operational-excellence/