Huwebes, Disyembre 23, 2010

Complexity: A Silent Killer by Jolito Ortizo Padilla

GA Consultancy and Services is  now in the Middle East Countries

Complexity extracts a heavy toll on a business. It often grows undetected, sapping strength and vitality and, without treatment , it could be fatal. Business failures are often attributed to losses caused by changing markets, increased competition , or lowered efficiency. Although these factors can be killers in their own right, complexity is often the true cause death. It causes businesses to sell unprofitable products that are manufactured at a loss to that customers they can't afford to do business with.

Complexity is defined as performing an excessive number of low-value activities. These types of activities have a disproportionate cost to value relationship that are responsible for a significant portion of a company's overhead, but generate little profit.

If four or more of the following warning signals are true for your company. then you may well be suffering from this problem:
  - Operating income as a percentage of sales has declined
  - Sales of high volume products are under increasing pressure from competitors
  - The break-even point for the company is increasing
  - Customers are complaining about delivery performance
  - Product quality levels do not meet company or industry standards
  - Salaried workforce levels have increased at a greater rate than production employees
  - Inventory as a percentage of sales is growing
  - Low -volume items represent an increasing percentage of sales
  - Employee morale and enthusiasm are not what they used to be

Table1: Example of Pareto Analysis of medium sized manufacturer
 Top 25% of customers                    78of total sales
 Top 25% of product                        83% of totals sales
 Top 25@ of pars stocked                89% of inventory
 Top 25% of suppliers                       91% of total purchase
 Top 25% of manufactured parts       78% of total labor

To illustrate this definition, Table 1 shows a Pareto Analysis of a medium sized manufacturing firm with annual sale of $25m.

A traditional organizational  performance analysis is likely to focus on these high volume areas, with two probable results. First , immediate improvements would result from the focused attention on these areas. Second long term improvements would fall far short of original projections.

The reason these types of efforts often yield such frustrating results can be better understood by further examination of the balance of the organization's activity profile

Table 2- Example data for the lower 50% of the medium sized manufacturer's activities.

                                                  Top 25%      Lower 50%
Customer as % of total sales          78%            4.5%
Products as % of total sales           83%            3.8%
Parts stocked as % of inventory     89%            4.0%
Suppliers as % of purchases          91%             1.1%
Manufactured parts as % of labor  78%             3.5%

Table 2 shows the comparable data for the lower 50%  of these activities. This data demonstrates that whereas the top 25% of customers were responsible for 78% of sales, the lower 50% accounted for only 4.5% of sales. While the value added within any category is concentrated on a limited number of items that have little value. Because of the value added within the any category is concentrated on a limited number of items, significant activity is required to support those items that have little value. Because of the relationship between these areas, the cumulative effect on the overhead structure of the organization is substantial.

The repeated occurence of these results leads to the rule 50/5. This rule says that 50% of a company customers, products, suppliers, and manufactured parts will account for less than 5% of the organization's value added. The presence of these low- value activities within an organization is one of the driving forces of operational inefficiencies and excess cost.

Standard Cost Systems
There are two predominant cause of complexity within an organization : standard cost systems and performance measurement and reward systems.

There are two symptoms of standard cost systems: standard costs for low- volume items are too low and standard costs for high- volume items are overstated. This is because overhead is applied to individual parts without any regard to the actual or proposed volume of the item.

The typical standard cost for an item has individual elements for labor, material and overhead. These are expressed as standard per piece  or standard per hundred pieces. The first step in setting standard costs is to determine the material and labor portions of costs. These can be readily identified and assigned to each item.

However, overhead cannot be specifically assigned to each individual part. It is simply impossible to accurately allocate costs such as salaries , depreciation , telecommunications or training to specific part numbers. As a result, most businesses develop an overall overhead rate  then apply this rate to the standard direct labor. Since the calculated overhead rate is applied to standard cost will be the same at any volume level. This is a major flaw in standard systems.

The cost distortion in a typical standard cost system is substantial. While each company has its own unique characteristics, it is not unusual for high volume items to have the costs that are 7-10% lower than the calculated standard cost. Conversely, the standard cost on lower volume items is often understated by 300-800%

Performance measurement and reard systemsPerformance measurement and reward systems are a second cause of complexity. Most management yardsticks to measure this still continue to rely on standard cost data. As a result , these systems encourage the continued growth in the number of low volume items and jeopardise the viability of high volume parts.

The increase in the number of parts manufactured is universally decried by top management. Managers try to limit the number of parts added to a system , due to costs. However, despite these good intentions new items continue to flood into organization, therefore increasing complexity. Let's look at some examples of why this happen.

Cost Reduction Program
Decreasing profits are often the impetus for a major cost reduction programme. Engineers are given a target for bringing the standard cost down to an acceptable level.
For example, assume that a cost reduction target has been established for vehicle model 215, the smallest version in a total line of six models that has annual sale of 400 per year.

One area the engineer will explore is the common parts used on all models. A bracket used on all models has a standard cost of $3 and an annual production of 20,000 pieces. The engineer may determine that using a smaller brackets won't damage the model's functional integrity so a proposed design change is submitted for a part that uses 10% less material. Table 3 illustrates the result:

Table 3: Example of proposed costs for new design:

                                            Current part      New part
Standard material                      $1.80           $1.62
Standard direct labor                  0.12              0.12
Standard overhead (900%)         1.08             1.08
Total Standard cost                   $3.00           $2.82

The engineer has achieved a 6% cost reduction , gets a gold star and moves on to the next opportunity area. In the meantime , a new low volume part has joined the ranks of the manufacturing population , bringing with it new tooling , service parts and inventory.

Product requests from the marketplace
Another major source of added complexity is the addition of market-driven products. Assume that a sales representative has a request from a specific dealer for a special metric version of model 215. The estimated volume would be 100 per year, which would represent a 25% increase in existing small vehicle sales. In addition , the dealer will pay a 5% premium if the model is made available.

A sugnificant element of the decision process will be the determining cost of this new version. The likely analysis would report the new standard cost to be about the same as the existing model and because of the higher projected selling price , it would have a better gross margin than its higher volume counterpart. However, a huge number of new low volume parts would be added to the system.

Pricing
Gross margin is a key element in pricing decisions. Standard cost is an integral part of this equation and  impacts on items at both ends of the volume spectrum. then high volume parts are overpriced , competitors are invited into the market. When low-volume parts are underpriced, even though manager might still claim they are the most profitable part of the business, often a much higher profitability could be achieved. While margins of 75% and 100% are not uncommon, these perceptions of profitability would change dramatically if the cost portion of the equation for low volume items was increased by 500%.

Purchasing quotes
The procurement function is driven by an equally destructive measurement and reward system. Despite rhetoric to the contrary, unit price continues to be the key measurement for purchasing success. Buyers seek new sources of supply , looking for an adequate product at a lower price.

When a new quote is received the predominant yardstick is how this price compares with current cost. Seldom does the savings analysis require quantifying the indirect costs of adding a new supplier such as supplier visits and qualification, engineering approvals , specification maintenance , inspection procedures , inventory segregation and storage.

The Answer
There are three significant steps that can be taken to mitigate the effect of complexity. These actions are a framework for achieving structural change that represents a commitment to a new manufacturing strategy.

Step 1: Eliminate
The first priority should be to eliminate as many low- value related cut off point such as "X hours of production per year," or "$X direct labor per year."Require a volume estimate for every new item being added to the product line and use this cut-off to evaluate current production. an action programme for elimination will include a combination of these five elements.
    - Dropping options and products from the line
    - Pricing
    - Running all time requirement
    - Revising obsolescence policy
   - Outsourcing parts/and or products
World class manufacturing is a worth -while goal , but it must be kept in perspective. Can anyone really afford to look world class manufacturing methods on an item of less than 8 hours per year?

There is a common misconception that eliminating items will stunt company growth . In most cases , the opposite is true.By reducing overhead and structure and focusing on truly significant products, organizations can take full advantage of their competitive edge. The usual result is more a volume and greater profitability. An additional benefit is a sizable increase in manufacturing capacity without a major investment in equipment.

Make a commitment to an aggressive supplier-consolidation programme. Establishing a goal to reduce your supplier base by 50% a year for the next three years is not an unreasonable objective. Use the leverage offered by increased volume as a basis for developing real supplier alliances . Use the additional time and human resources to undertake formal quality improvements and cost reduction programme.

Step 2:  Develop volume adjusted standard cost
Swimming against the tide is never easy. Even though everyone intutively accepts the current standard costs are inaccurate, the numbers are ingrained with every system. Many of the actions outlined in step 1 will appear to be bad decisions if measured against current data. For this reason and to stop further complexity in the future , a volume-adjusted standard cost should be considered.

The challenge should be to develop better costs for use in management decisions, not perfect sosts. Complexity reduction will not be enhanced by adding a cadre of accountants whose mission in life is accurately assigning telephone expense to 8,000 part numbers to get a specific overhead cost. Better costs , obtained easily and quickly , will result in better decisions.

Using this premise , this method could be used to volume-adjust existing standard costs:
 1. Stratify your existing manufactured items and assign a group designation to each item-for example , the groups could be by quartile or by tenths.
 2. Develop a volume factor for each group.
 3. Use the standard cost value calculated by your current system and multiply it by the volume factor.
 4. Require a volume estimate on all new parts , so they can be assigned to their proper group and costed accordingly.
The volume factor is determined by conducting a true cost study of two to four of the highest volume parts. While current systems cannot accurately charge individual parts with every specific element of overhead , there is significant amount of data available at department level.

Using this data , the high volume parts can be charged their fair share of the department totals. For example .if the highest volume part is responsible for 80% of a department's direct labor it should be charged 80% of the department's fixed costs.

So assume that you chose to have 10 volume groups. Your volume factor for an item in the top 10% of your parts might be -7%. If your existing cost is $100, then the volume-adjusted standard cost would be $93. At the other end of the scale, the factor for the lowest 10% might be +400%. Thus, an item with an existing cost of $100 would end up with a volume adjusted cost of $400.

Step 3: Revised measurement systems
Better standard costs will mitigate many of the problems noted but they are not a total solution. Many of the organization's current report cards must also be re-evaluated. Engineers cannot be expected to reduce proliferation if the measurement system shows there is no activity cost associated with adding new item. Engineers will not be encouraged to use common parts until the system in place gives credit for this decision.

Salespeople will continue to seek new lo-volume customers as long as the system treats every sales dollar as having equal value. Sales people should receive an equal commission for 20 accounts of $1,000 or one account of $20,000. Purchasing will be encouraged to add new vendors until the measurement systems more accurately reflects the total cost impact of these decisions.

A Golden Opportunity
These are only a few examples. The key points is that people making decisions in functional areas are guided by systems that measure their results. If your systems do not consider activity costs or volume benefits. ccomplexity will thrive.

A comprehensive compelxity reduction programme is a major profit opportunity for any organization. In addition to the direct benefits, time will now be available for people to focus on truly significant items.

Given today's system , it is almost  impossible to measure the impact of complexity creeping into your operation. It is equally impractical to measure the effect of a single item going out of the system. This means that when the cummulative improvements begin  to occur, the employees get credit for the results. People  want to be winners. Given the resources and opportunity, they will succeed.

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