The Demand Driven Adaptive Enterprise. Carol Ptak

The Demand Driven Adaptive Enterprise

rel="nofollow" href="#fb3_img_img_4b96c1e9-2b86-5349-a1d9-f64a68bb6b7c.jpg" alt="img"/> Quality. When things are flowing well, fewer mistakes are made due to less confusion and expediting. This is not to say that qualities issues will not occasionally happen, but what it does say is that quality issues related to poor flow will most likely be minimized. This is important in industries with large assemblies with deep and complex bills of material and complicated routings to be scheduled. Frequent and chronic shortages cause work to be set aside to wait for parts, creating large work-in-process queues and then the inevitable expediting to get the work through the system.

Revenue. When service and quality are consistently high, a company is afforded the opportunity to better exploit the total market potential. This means higher revenue volume from both the protection and growth of margin and market share.

Inventories. With good flow purchased, work-in-process (WIP) and end item inventories will be minimized and directly proportional to the amount of time it takes to flow between stages and through the total system. The less time it takes products to move through the system, the less the total inventory investment. The simple equation is Throughput × Lead Time = WIP. Throughput is the rate at which material is exiting the system. Lead time is the time it takes to move through the system and WIP is the amount of inventory contained between entry and exit. A key assumption is that the material entering the system is proportionate to the amount exiting the system. The basis for this equation is the queuing theory known as Little’s Law.

It is also worth noting that to maintain flow, inventories cannot be eliminated. Flow requires at least a minimal amount of inventory. Too little inventory disrupts flow and too much inventory also disrupts flow. Thus, when a system is flowing well, inventories will be “right-sized” for that level of flow. What we will find out later is that the placement and composition of inventory queues will be a critical determinant in how well flow is protected and promoted and what “right-sized” really means in terms of quantity and working capital commitment.

Expenses. When flow is poor, additional activities and expenses are incurred to correct or augment flow problems. In the short term it could mean expedited freight, overtime, rework, cross-shipping, and unplanned partial ships. In the longer term it could mean additional and redundant resources and third-party capacity and/ or storage. These additional short- and long-term efforts and activities to supplement flow are indicative of an inefficient overall system and directly leads to cash exiting the organization.

Cash. When flow is maximized, the material that a company paid for is converted to cash at a relatively quick and consistent rate. Additionally, the expedite-related expenses previously mentioned are minimized, reducing cash unnecessarily leaving the organization. This makes cash flow much easier to manage and predict and will also lead to less borrowing related expenses.

Furthermore, the concept of flow is also crucial for project management. R&D and innovation efforts that flow well can impact and amplify all of the above benefits as the company exploits these efforts.

What critical business equation is defined with these six basic benefits? It is an equation that defines and measures the very purpose of every for-profit organization: to protect and grow shareholder equity. This is and always has been the basic responsibility and duty of every executive.

In its simplest form the equation to quantify this purpose is:

Net Profit ÷ Investment = Return on Investment

Net profit is a company’s revenue, which consists of total sales dollars collected through a particular period subtracting the operating expenses, cost of goods sold (COGS), and interest and taxes within that same period. Investment is simply the captured money in the system needed to produce the output. The simplicity of this formula can make it easy to manipulate depending on how one defines time periods, but essentially it is a measure of the money that can be returned by a system versus the money it takes to start and maintain that system. Thus, the output of the equation is called return on investment. The higher the rate of return on investment (both in the short run and the anticipated long run), the more valuable the shareholder equity.

Of course, a full DuPont analysis would provide a more detailed perspective incorporating profit margin, asset turnover, and financial leverage. The above equation is simply a conceptual shortcut that can be used to make a crucial connection between flow and return on investment via Plossl’s Law.

Hopefully, that connection is now readily apparent. The previously mentioned benefits of flow (perhaps with the exclusion of taxes) are all direct inputs into the ROI equation. This makes flow the single biggest lever in determining the objective of a for-profit organization. This can be expressed as the equation in Figure 1-4. This depiction first appeared in the book Demand Driven Performance–Using Smart Metrics (Smith and Smith, McGraw-Hill, 2014, p. 71).

FIGURE 1-4 Connecting flow to return on investment (ROI)

Explaining this equation requires first a definition of the elements and then how they relate to each other.

Flow. The rate at which a system converts material to product required by a customer. If the customer does not want or take the product, then that output does not count as flow. It is retained in the system as investment (captured money).

Cash velocity. The rate of net cash generation; sales dollars minus truly variable costs (aka contribution margin) minus period operating expenses.

Net profit/investment. Net profit divided by investment (captured money) is the equation for ROI.

The delta and yield arrows in the equation explain the relationships between the components of the equation. Changes to flow directly yield changes to cash velocity in the same direction. As flow increases so does cash velocity. Conversely, as flow decreases so does cash velocity. As cash velocity increases so does return on investment as the system is converting materials to cash more quickly.

When cash velocity slows down, the conversion of materials to cash slows down. The organization is simply accomplishing less with more. This scenario typically results in additional cash velocity issues related to expediting expenses. Period expenses rise (overtime) or variable costs increase (fast freight, additional freight, and expedite fees). This directly reduces the net profit potential within the period and thus further erodes return on investment performance.

The River Analogy

The simple analogy to this equation is the manner in which a river works. Water flows in a river as an autonomous response to gravity. The steeper the slope of the river bed, the faster the water flows. Additionally, the fewer number of obstructions in the river, the faster the water runs.

In service and supply chain management, materials and/or services flow through the network like water through a river. Materials are combined, converted, and then moved to points of consumption. Services are offered, scheduled, and delivered to customers. The autonomous response of these flows is demand. What else could it or should it be? Ideally, the stronger the demand, the faster the rate of flow of materials and services. And like rivers, service and supply chains have obstructions or blockages created by variability, volatility, and limitations in the “river bed.” Machines break down, critical components are often unavailable, yield problems

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