CEOs want to know the return on investment of Lean Six Sigma projects, and CFOs want to compare the real financial results to “PowerPoint dollars.” A rigorous approach to calculating an improvement project’s impact is important to every organization.
The benefit to an organization deploying Lean Six Sigma is not limited to immediate financial gain from improvement projects. In fact, the cultural change generated by a fully accepted initiative is probably the best long-term pay back that a company can obtain. Having said this, however, it does not justify a lack of rigor in calculating the financial impact of Lean Six Sigma projects. That rigor is an imperative for the coherence of a data-oriented approach.
CEOs and shareholders want to know the return on investment of Lean Six Sigma, and CFOs want to compare the real financial results to those projected “PowerPoint dollars.” Additionally, a rigorous approach in defining how to calculate a project’s impact can be helpful for the project selection process since the potential financial impact should be a key criteria to select and launch a project.
To properly calculate the business impact of a project in a Lean Six Sigma deployment, it is important to have guidelines. These guidelines must be agreed to by the finance department and applied in the same way across the entire business.
Technical rules on how to calculate the financial impact can vary depending on the business, however, the main areas to be analyzed and measured are common to almost all businesses. They are:
- Customer satisfaction
Lean Six Sigma projects are not only related to cost reductions and productivity increases. They also can be aimed a boosting the revenue side of the business. While it is usually Design for Six Sigma (DFSS) projects that are more focused on revenues, DMAIC projects can lead to significant results as well. Revenue can be increased through increased sales volumes as well as the launch of new products or services.
Increased volume: Higher volume of an existing product/service sold due to increased customer satisfaction, better offer proposition, improved distribution (geographic coverage, number of shops, higher productivity of existing channels, etc.). The general rule to calculate the increased revenues at the time of successful project closure (N+1) compared to the time before the project starts (N) is simple:
Revenues N+1 – Revenues N = Increased Revenues
This rule can be easily applied in a situation of constant price and constant cost.
If revenue increase is obtained as a result of lower price (volume increase caused by price reduction), it is recommended to measure the impact at margin level.
If the result of the project is a cost reduction of the product/service that results in a price reduction, calculate this impact in the revenue line only for the volume increase (if any).
Note: It is not always easy to attribute the revenue increase clearly to a Lean Six Sigma project. Maybe there were other unknown factors or parallel activities that also influenced the increase.
New product/service: Revenue generated by a completely (or significantly) new product or service. When this is the result of a Lean Six Sigma project, that project is usually a DFSS project.
The is the area in which most Lean Six Sigma projects are concentrated. Under this saving line, are identify several different types of financial impacts – reduced material costs, productivity increases (labor cost saving), and reduction of the cost of poor quality.
Reduced cost: Any cost saving achieved; a reduction of a recurred P&L cost (a certain cost already incurred in the past) can be calculated in this category. The general rule is:
Cost N+1 – Cost N = Cost Saving
If direct cost, the following rule is applicable:
(Cost N+1 x Number of Items) – (Cost N x Number of Items) = Cost Saving
The “number of items” is the count of the items that the cost is related to (i.e., products, invoices, calls, etc).
Any reduction in capital used (assets), interest paid, working capital and stocks can be calculated as a reduced cost.
Note: Cost avoidance (costs not in P&L and not incurred in the past) cannot be included in this category. In financial businesses it needs to be clearly defined how to calculate the cost of capital.
Productivity saving: Refers to the increased amount of output per unit (minutes, hours, days, etc) of labor and is usually calculated in terms of time saved to perform a specific action or to obtain a specific output. It can be achieved as a result of simplification, automation or elimination of tasks (e.g., non-value-added activities).
To properly calculate a financial impact from productivity saving one of the following conditions has to be applicable:
- Headcount reduction: If the productivity saving leads to headcount reduction, the amount saved can be included in the financial impact. Redundancy cost, cost related to headcount reduction, also can be considered. The general rule is:
Cost of Labour x Headcount Unit x Period – Redundancy Cost = Productivity Saving
- Increased volume: If the business is growing and the time saved (units of labor) is utilized to increase the production, the amount of time saved can be included in the financial impact (up to the effective production increase).
Cost of Labor x Time x Number of Units = Productivity Saving
- No headcount reduction and stable volume: In this case, saving can be calculated only if it can be demonstrated that the time saved will be used in value-added activities not performed before.
Cost of Labor x Time x Activity = Productivity Saving
The cost of labor has to be clearly defined, i.e., Standard cost or actual cost? Does it include overhead? Etc.
Cost of poor quality: Internal and external failure costs, prevention costs, appraisal costs and others. Many of these costs are hidden and difficult to identify by measurement systems. In order to properly calculate the financial impact it is critical to capture the right measures.
Note: See the iSixSigma article “Cost of Quality: Not Only Failure Costs.”
Risk-related projects are becoming more and more critical, mainly in financial businesses. Types of risk-related savings include operational risk reduction and risk provision reduction.
Operational risk reduction: Basel Committee on Banking Supervision defines operational risk as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.” Operational risk can result in increased write-offs, additional expenses or loss of revenue. One of the best ways to capture operational risk reductions is the project’s failure mode and effects analysis in the Control phase.
Risk provision reduction: Any reduction in risk provisions allowed as the result of a project (i.e., stable process, higher performances, etc.) must be reflected in risk policies – in other words, better credit collection performances leading to lower provision for unpaid invoices, or higher residual value of assets leading to lower depreciation.
Note: Attention needs to be paid to double counting operational risk reduction and cost reduction (i.e., cost savings for reduced invoice errors counted as cost reduction and risk reduction).
Customer satisfaction is the declared goal of any Lean Six Sigma initiative. The customer satisfaction index is probably the best leading indicator for a business. Customer retention, customer penetration and customer winning rates are the business-related indicators that reflect customer satisfaction.
It is not easy – if not sometimes impossible – to link the impact of a single project to a customer satisfaction indicator or to customer retention, penetration and winning rates.
While it is not possible or efficient to capture the one-to-one relationship project/improvement, a cost-effective option is to identify projects and initiatives with impacts in those areas and measure projects overall impact on satisfaction, retention, penetration and winning rate in a defined period.
Note: Customer satisfaction index, customer retention, penetration and winning rates – as they are key business indicators – have to be clearly defined at business level (operational definitions).
Timing and Financial Impact
All project savings mentioned are calculated for a defined time period. This period is usually 12 months following the project go-live (when improvements are implemented).
Based on the type of the business or the amount of investment (such as the launch of a wide Lean Six Sigma initiative), periods of two to three years (or more) can be used.
In any case, it is critical to demonstrate that a process management activity is in place with stable process performances to calculate the savings.
Any further improvement has to be calculated starting from a clear baseline (in terms of performance and timing).
About the Author: Roberto Copercini is a director of Valeocon Management Consulting in Europe. He has a wide range of experience in helping multi-national companies deploying operational excellence programs and improving their strategy execution. Prior to joining Valeocon, he had senior positions at Merrill Lynch and General Electric. He lives in Geneva and can be reached at firstname.lastname@example.org.