Lecture 14

Performance
measurement for Lean
Manufacturing

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 Effect of performance measurement
•  It influences the way the factory operates and the way
people do their jobs.
•  It affects the factory culture & people s attitudes.
•  It causes people to focus on specific problems & what
behaviors are encouraged and rewarded.
•  It effects what decisions are made by the managers at all
levels.
•  What you measure is what you get.
•  If the production manager is evaluated on the efficiency of
the individual department, he/she will maximize the
efficiency of his/her department at the cost of performance
of the whole plant.
Copyright 2006 © by Dr. Govind Bharwani, Wright State University
 Explain the conflict due to performance
measurements in the following examples

Example 1: The production manager reduces the

setup time to achieve flexibility and reduce
inventory. His performance is measured on his
ability to keep assembly line supplied with parts.
Example 2: The purchasing department is
measured on price per piece from the vendor.
The transportation and inventory carrying cost is
charged to the Production Manager.

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

Three traditional performance measurements

1) Standard labor variance

2) Overhead absorption
3) Return on investment (ROI)

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 Standard labor variance
It is a method to compare the actual amount of work done to the amount of work
which should have been done given the standard production rate and the
number of hours worked. This comparison is known as standard labor
variance .

Based on the standard the department should have produced = 400 parts per
shift x 0.20 labor hours per part = 400 x 0.2 = 80 man hours
Number of operators needed in the department = 80 / 8 =10 per shift

The actual number of parts produced on Tuesday = 380 parts

The actual numbers of operators who worked on Tuesday = 10

Standard labor hours earned on Tuesday = 380 x 0.20 = 76 hours

Actual labor hours used on Tuesday= 10 x 8 hours per shift = 80 hours
Labor variance = 76 - 80 = - 4 hours
Labor efficiency = 76 / 80 = 0.95 (95%)
Copyright 2006 © by Dr. Govind Bharwani, Wright State University
 Standard labor variance (cont.)
If the department produced 380 parts with 9 workers then the labor efficiency
would be 105% based the following :
Number of operators needed in the department = 80 / 8 =10 per shift

The actual number of parts produced on Tuesday = 380 parts

The actual numbers of operators who worked on Tuesday = 10

Standard labor hours earned on Tuesday = 380 x 0.20 = 76 hours

Actual labor hours used on Tuesday= 9 x 8 hours per shift = 72 hours
Labor variance = 76 - 72 = + 4 hours
Labor efficiency = 76 / 72 = 1.05 (105%)

Generally the labor efficiency is calculated for the whole week to take into
account overtime used during the weekend to meet the schedule.

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 Disadvantage of using standard labor
variance as a performance measurement
•  The managers may produce larger production lots to
increase labor efficiency.
•  They may produce easier jobs earlier in the month to build
up labor efficiency.
•  It encourages postponing maintenance on machines to
improve labor variance.
•  It can encourage hiding defects and focus on quantity
instead of quality.
•  The above actions to improve labor efficiency will increase
process variability which is contrary to the philosophy of
lean manufacturing.
Copyright 2006 © by Dr. Govind Bharwani, Wright State University
 Overhead absorption
•  It is also called burden cost or fixed cost and does not vary with
production volume.
•  The inefficiencies in the labor costs are sometimes absorbed
(hidden) in the overhead expenses.
•  Overhead is any cost which is not material and direct labor. It
consists of indirect labor cost, utilities cost, management cost,
maintenance cost, cost of employee benefits etc.
•  Overhead cost is used to allocate cost to specific product as a
percentage of direct labor in order to determine product cost and
operating profit.
•  It is also used to compare production cost with outsourcing cost
for a specific part. The problem is that when you outsource parts
some of the fixed costs still remain in the plant.

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 Fallacy of allocating overhead cost
based on labor cost
•  As we use automation and robotics, the direct labor cost reduces but
indirect labor cost such as engineering, maintenance, and support cost
increases. The cost system based on direct labor will allocate a small
portion of the indirect labor cost.
•  A product which is old stable design and has been in production for
years, it may not require much engineering support. If the product is
labor intensive, it will be allocated high overhead cost and may
incorrectly show lower profitability.
•  The decision to make a part in-house or purchase from a supplier is also
affected by the overhead cost allocation. When the part is outsourced,
the management, engineering and indirect labor cost still stays in the
plant, which increases the overall cost of the remaining parts made in
the plant.

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 Return on Investment (ROI)
•  ROI = profit / investment = $ savings / $ investment
•  For capital investment on equipment, the engineer has to identify
savings compared to existing cost.
•  ROI can be improved by continuously producing parts. The more it
produces, the more the savings will be. However if it builds
unnecessary inventory, it is contrary to lean manufacturing
philosophy.
•  ROI can be counter-productive if it reduces critical investment in
employee training, research, updating equipment, technology,
facility improvement etc.
•  ROI focuses on a short term returns at the cost of long term
competitive advantage.
•  ROI can improved with high capacity (machine) utilization
Copyright 2006 © by Dr. Govind Bharwani, Wright State University
 Capacity utilization

•  Remember that the goal of lean manufacturing is to reduce cycle time .

•  At low capacity utilization, there is very little effect on cycle time.
•  As utilization increases, the cycle time also increases.
•  At high utilization levels, the cycle time increases dramatically.
•  In other words, the time required for parts to flow through the system is much longer if the workstation is highly
utilized due to build up of WIP.
•  Research shows that cycle time is also affected by process variability such as machine downtime, large
production lots, setup times,uneven production rates, batch production runs.
•  Low process variability at high capacity utilization can reduce cycle time.
Copyright 2006 © by Dr. Govind Bharwani, Wright State University
Work flow versus capacity utilization

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 Common traditional measurements

•  Customer lead time (order to delivery time)

•  Cycle time (throughput time)
•  Inventory turns
•  Supplier delivery performance (on-time delivery)
•  Quality measurements (scrap rate, ppm to customer)
•  Productivity (pieces per employee hours)
•  Absenteeism
•  Safety (number of days between lost time accidents)

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 Traditional Cost Systems

•  Although it may be impossible to determine the

exact cost of a product or service, every effort
is made to provide the best possible cost
estimate
•  The most difficult part of computing accurate
unit costs is determining the proper amount of
overhead cost to assign to each product,
service, or job

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 Overhead Costs

•  A single predetermined overhead rate is used

throughout the year for the entire factory
operation for the assignment of overhead costs
•  In job order costing, direct labor hours or costs
are commonly used as the relevant activity base
•  In process costing, machine hours are
commonly used as the relevant activity base

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 Activity-based costing

•  Allocates overhead to multiple activity cost pools

and assigns the activity cost pools to products by
means of cost drivers
•  An activity is any event, action, transaction, or work
sequence that causes the incurrence of cost in
producing a product or providing a service
•  A cost driver is any factor or activity that has a direct
cause-effect relationship with the resources
consumed

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 Lean Accounting
•  Lean Accounting is intended to replace traditional
accounting and measurement systems; it is not
intended be an additional analysis. Lean
Accounting is right for companies that are well on
the path toward lean manufacturing.
•  Lean Accounting is more than a set of tools
relating to measurement, capacity usage, value,
and continuous improvement. Together these tools
become a lean business management system that
is radically different from traditional management.

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 The Lean Transition
•  An important role for finance and accounting people in
the lean organization is to actively support and
participate in the transition to a lean enterprise.
•  A cornerstone of the lean business is performance
measurement. We have few measurements that are
focused on the creation of customer value and the
achievement of business strategy.
•  Measurements are primarily non-financial and are
established for cells, value streams, plants, and
corporations. Simplified costing and financial planning
methods support these measurements.

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 Operational Accounting
•  The problems of standard costing need to be
addressed. Standard costing is an excellent costing
method for traditional mass production; but
standard costing is actively harmful to lean
organizations.
•  Replace standard costing with value stream
costing. Value stream costing eliminates most
transactions and does not rely on allocation and
full absorption of costs.

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 Financial Accounting
•  While the majority of Lean Accounting affects
internal processes, Lean principles are applied
equally to the company s financial accounting.
There is much waste to be eliminated.
•  Finance and accounting people in the average
American company spend more than 70% of their
time on bookkeeping and very little time on
analysis and improvement.

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

Traditional Measurements
•  Net profit?
•  Efficiency?
•  Utilization?
•  Return on Investment?
•  Cash Flow?

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

Lean Measurements

•  Throughput
•  Inventory
•  Operating Expense

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 Traditional vs. Lean ranking
Traditional Ranking Lean ranking

•  Operating expense •  Throughput

•  Throughput •  Inventory or Assets

•  Inventory or Assets •  Operating expense

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 The Traditional approach
•  Decreasing operating expense is definitely #1
because we have relatively high control of our
expenses.

•  Increasing throughput is always important, but it

ranks #2 because we are at the mercy of the
marketplace and have less control over sales.

•  Inventory tends to fall into a grey area that we

don t know exactly what to do about it. Therefore it is
considered a necessary evil that must be lived with
to protect sales.
Copyright 2006 © by Dr. Govind Bharwani, Wright State University
 The Lean approach
•  Increasing throughput is unquestionably #1
because it has the greatest potential impact on the
bottom line.

•  Decreasing inventory is #2 because excess WIP

and finished goods jeopardize future throughput.

•  Decreasing operating expense is #3 because

significant reductions (workforce reductions)
usually jeopardize future throughput.
Copyright 2006 © by Dr. Govind Bharwani, Wright State University
 Conclusion
In the Lean manufacturing plants, constraints and
problems become the opportunities for the
management when the inventory is constantly
reduced and therefore the traditional measurement
tools can be discarded.

Supplier involvement and supply chain management

is another important element of lean manufacturing.

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 Supplier Involvement
•  Suppliers should be partners, not adversaries.
•  The reliability of suppliers can affect plant variability
and performance.
•  The customer-supplier relationship should exist
internally as well as externally.
•  The suppliers should undergo quality certification to
ensure the consistent quality of incoming parts.
•  Suppliers should be involved in design of parts.
•  Provide communication link with suppliers with real
time information on production schedules and inventory
status.
Copyright 2006 © by Dr. Govind Bharwani, Wright State University
 Advantages of supplier certification program

1) The supplier can deliver the parts directly to the

production line bypassing the receiving &
inspection.
2) The risk of part shortages due to poor quality is
eliminated.
3) The supplier can deliver in smaller quantities
since the material is no longer inspected.
4) It is a matter of pride and stability for the supplier
to be a certified vendor.

Copyright 2006 © by Dr. Govind Bharwani, Wright State University

 What is supply chain management?
•  Supply chain management is the
coordination and link with the supplier to
provide just-in-time deliveries.
•  The supplies should be delivered in small
lots and as frequently as needed.
•  The benefit to the supplier is that the
supplier can level-load the production.
•  The supplier can reduce its own production
variability.

Copyright 2006 © by Dr. Govind Bharwani, Wright State University