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Lead Time Reduction ROI

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  • #33297

    Isabel
    Participant

    I am preparing the launch of a Six Sigma project to reduce
    the order fulfillment lead time at my company, and
    accounting is having difficulties in providing hard savings
    figures for a lead time reduction from 12 to 8 days.
    Does anybody can share ideas for detrmining the ROI for
    this project?
    I would appreciate your assistance.Isabel

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    #89851

    DaveG
    Participant

    Your average time to delivery just fell by 4 days or 33%;  conversely, your delivery rate, and consequently rate of revenue generation, increased by 50%.
    Margin = Revenue – (Fixed Cost + Variable Cost).
    M1 = R1 – (F1 + V1).
    M2 = R2 – (F2 + V2).
    Assume Variable costs increase by some fraction of the efficiency increase (i.e. more materials and utilities are used).  Fixed Costs remain the same.
    Substitute R2 = 1.5R1, F2 = F1 and V2 = 1.X*V1
    Savings = M2 – M1 = 1.5R1 – R1 – 1.X*V1 + V1
    Savings = 0.5R1 – 0.X*V1
    Since R1 > V1 and 0.5 > 0.X, Savings > 0.

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    #89870

    Isabel
    Participant

    Dave,
    Thank you for your time and assistance. Your suggested approach really helps.
    Regards,
    Isabel
     

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    #89871

    DaveG
    Participant

    Isabel,
    I’m glad I could help.  Please post whether the model is adopted, any improvements you make to it, and the success of your project.

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    #90133

    Damian Ferguson
    Participant

    I’m very interested in this as we have struggled to quantify LT reduction benefits.
     
    My question is how do you get R2 = 1.5R1 ?  That implies that you are now getting 50% more revenue (i.e. sales).
    I can see there is a OTO benefit on the interest of 4 days worth of sales.  And also an efficiency benefit on future revenue again based on the interest on the cash flow (assuming payment terms are x days from invoice and not end of month).

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    #90136

    Burgos
    Participant

    I totally agree. In general you can say that it is hard to quantify the benefits of lead-time reduction. In the calculation that Dave showed us the weakness is the assumption that lead-time reduction will automatically increase revenue.

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    #90137

    DANG Dinh Cung
    Participant

    Good morning Dave,
    Your calcultation is correct but for calulating ROI, you should add to
    Savings = 0.5R1 – 0.X*V1
    the benefit from increasing your sales induced by reducing lead time.
    I agree it is very hard to estimate this benefit, but it is the main reason why we try to reduce lead time : a better service to customers.
    Best regards,
    DANG Dinh [email protected]
     

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    #90139

    DaveG
    Participant

    12/8 = 1.5.  I assumed that the extra capacity would be absorbed by demand.

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    #90144

    Jock
    Participant

    Isabel,
    Another way to look at this is to look at your increase in contribution margin as a result of increases in you inventory turns.  Using your reduction in lead time from 12 to 8 days: –
    Inventory turns – 365/12 = 30.42
    Assume contribution margin is $100k/yr (use previous years figure)
    Margin per turn – $100k/30.42 = $3.3k/turn
    Improved inventory turns – 365/8 = 45.62
    Increase in turns – 45.62 – 30.42 = 15.2 additional turns.
    Increase in contribution margin as a result – $3.3k x 15.2 = $50k
    Therefore reducing you lead time from 12 to 8 days will increase you contribution margin by $50k.
    Hope this is of help
    Jock.

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    #90150

    Henk
    Participant

    There is a one time saving of four days of  turnover.
    There is an anual saving of x% interest of the one time saving
    There is also a lower Work in Process since the turnover time is increased by 1.5.
    Every assumption regarding additional sales is in my opinion not measureable, nor repeatable.
    Henk
     
     

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    #90153

    John G.
    Participant

    One or the other or both …profit from lower order costs and/or profit from additional sales. I’d look at the cost to process the orders and the volume of orders from base period (at least what is representative..1 year unless a special cyclical business) and compare to cost and volume currently. Calculate the cost per order in both cases. Remember to consider order mix in the event some orders take shorter or longer to process. This may be hard for accounting today based on there current accounting practice(s) but part of the implementation is to establish new manning tables, a redesigned process for work and data collection/trends across the responsibilitiy matrix as the enablers to achieve the performance. Set the target, train, then track volome, costs and order mix in a weekly report. The relationship of cost per order will either go up or down and then the variance support system responds to problem solve (with people that do the work) based on the trend. Remember that a volume increase over the base also gives you a revenue gain which is in addition to the reduction in order processing costs. You may have to sort out with sales whether that was due to a more responsive ordering/delivery system or some new super star that just got hired  Good luck.

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    #91487

    D_
    Participant

    The problem of course is that many Six Sigma projects are based on cost savings, rather than enhanced customer service.  Maybe this is a reflection of the weakness of our accounting systems, which are ‘cost-focused’ (actually they do a poor job of measuring costs — thus the drive to activity-based costing, TOC accounting, lean accounting, etc. — but even these have shortcomings), or the Six Sigma process relying so much on cost-reductions.  Companies have gone out of business trying to cost-justify actions that they take — read Christensen’s, ‘The Innovator’s Dilemma’ for the problems faced by established companies.  In the end, the lowest cost position is to have no costs….no employees, no machines…..no business.  There needs to be a major change in accounting systems and measures — the accountant needs to progress from scorekeeper to being a player on the team.  Any thoughts on how to drive some leading-edge thinking & systems in the accounting ‘industry’? 
    This hasn’t helped your question…..but some thoughts.  Bottom-line — you can only save money if you pay your suppliers or employees less money.  Forget about saving hours– you can’t save less than one employee.  Even if the employee is used elsewhere, the cost to company is the same.  So, if you’ve shortened your order fulfillment process and no one has been laid off as a result (or if there is no decrease in inventory), then there would be no real cost savings.  On the other hand, maybe there is an customer service enhancement resulting from the shorter lead times — if a longer fulfillment process causes customers to purchase from other suppliers with shorter lead times.  The problem is that you probably don’t have a measure of number or customers leaving & the $$ order size.  With these data, you could determine the effect if you don’t shorten the lead time.  It gets back to good problem definition and what are you really trying to measure and improve — many times you may find that you need to develop a measure and method prior to starting the project.  In the end, maybe your customers don’t mind the long lead times, maybe no one has been laid off, and maybe you don’t have less inventory — in that case, maybe the project doesn’t have as much value as expected.

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    #91501

    DaveG
    Participant

    So, if you’ve shortened your order fulfillment process and no one has been laid off as a result (or if there is no decrease in inventory), then there would be no real cost savings.
    The above increases the plant’s gross efficiency:  greater output with same input, except marginally more material and utility consumption.  Of course, they need to sell more product, which is where the shorter lead time helps.

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    #91508

    D_
    Participant

    DaveG
    Agreed!  But the accounting department will still not be able to calculate a cost savings.  In fact, if the greater volume requires more resources (added labor & materials) than the project will result in overall higher costs, albeit, the costs should be offset by the contribution from the added volume. (not always true…..).  If this is the desired outcome, then there needs to be some correlations developed between shortened lead time and increased sales (not easy to do…..) to justify the project.  Maybe shorter lead times are the right thing to do to remain competitive, and the accounting department should stay out of it.  A baseball analogy — if they want to keep score, let them keep score at the end of the game, rather than trying put a $$ on every pitch in the game. 
    My concern is that the mantra of the accounting department is reduced costs — I don’t think this should be the goal of any business.  The goal should be increased profitability and growth — with this model, costs will go up since people may be hired and more materials purchased.  There are some other accounting perspectives out there — R.T. Yu-Lee, ‘Explicit Cost Dynamics’ — as one example; and maybe these are better models for understanding the real benefit of a Six Sigma process.  Toyota is a pretty profitable company (ask Ford & GM), and they have set their sights on European growth now…..  I think I read somewhere that they don’t allow cost systems into the mfg. plant.  I don’t know how that works, but it sounds like they may have a better formula.

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    #91524

    DaveG
    Participant

    We’re on the same page!  Many executives, much less Accountants, don’t understand that value flows.  Interesting point about Toyota that I didn’t know (about rejecting cost systems), but fully consistent with what I do know.  Remember the story about Detroit Execs touring Toyota and asking why Toyota was so open with their operations?  Paraphrased:  “Because we know you will not change.”

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