The price of leanness.

EXECUTIVE SUMMARY

How have companies reduced inventories and decreased the volatility of capacity utilization? the answer is a mix of lean manufacturing, supply chain management, and capital management, very often brought together with complex enterprise resource management systems, Optimizing operations, enhancing supply chains, and improving capital management loom large in managers' plans

In a previous Industrial Management article ("Systems Integration: The Economic Case," May/June 2003) I put forward the economic case for flexible, mass-customized, lean pull production and the informational and management tools that make it possible. The key concept was the dilemma between the efficiency (through high utilization and economies of scale) of mass production, and the complex and unpredictable needs and demands of customers and consumers. In this article, I delve a bit deeper into the associated economic trends and try to make sense of them in light of the experience of the manufacturing companies served and surveyed by Lockwood Greene.

Capacity utilization needs to be high in the mass production model; since World War II, it has been falling. At the same time, inventories need to be low in the lean production model, and they have also been falling. At first glance, these two trends are related, and it appears that spare capacity has increasingly been used as a substitute for inventories. The problem with this hypothesis, however, is that capacity utilization has also grown less volatile. If spare capacity instead of inventory is used as a buffer for demand fluctuations, capacity utilization should become more volatile, not less. Have companies reorganized their production and distribution to achieve lower inventories and lower production volatility at the same time?

Capacity utilization: Lower, less volatile

The Federal Reserve has industrial capacity utilization data going back to 1948. There are two striking trends that become apparent by plotting the series. First, capacity utilization has been trending down, from an average of about 84 percent to about 78 percent today Second, volatility has dropped significantly, from a standard deviation of 5 percentage points in the 1948-1976 period to 3.4 percentage points in the past 20 years (Figure 1).

[FIGURE 1 OMITTED]

Let us examine these two trends in turn. Why has average capacity utilization been falling? Intriguingly, the drop in capacity utilization has been accompanied by a drop in the inventory-to-sales ratio (Figure 2). This measure of production and supply chain leanness keeps falling to new record lows. This means that manufacturers, distributors, and retailers keep getting better at managing their stocks of materials, work-in-process, and finished goods. They have very strong economic incentives to do so: Inventories need space to be stored in, run the risk of becoming obsolete or out of fashion, and, perhaps most importantly, tie up vast amounts of working capital. This positive story is not without its setbacks: In the past two recessions the inventory ratio increased as manufacturers were surprised (as they are in every recession) by the unexpected drop in demand. However, even though recessions still have a capacity to surprise, the general trend has been toward leaner and less volatile inventories.

[FIGURE 2 OMITTED]

Are these two trends of lower utilization and lower inventories related? It would stand to mason if they were. After all, demand is always volatile, and inventories have always been used as a buffer. If companies switch to lean manufacturing and distribution systems, production has to fluctuate more, and some capacity has to be kept in reserve to deal with the fluctuations. In a sense, excess capacity becomes a substitute for fat inventories.

This is an interesting theory, and I will be testing it more rigorously in a future scholarly article. The theory needs testing for two reasons. First, the financial benefits of substituting excess capacity for inventories are not at all clear. Inventories tie up working capital, but low utilization wastes physical capital. Which of the two would dominate decision making? Second, if excess capacity is a substitute for inventories, volatility in capacity utilization should have increased through the years as inventories became leaner and less volatile.

We have already seen that this is not true; on the contrary, capacity utilization has become measurably less variable. Part of the explanation may lie in general economic trends. It is true that general economic activity, as measured by gross domestic product, has also grown less variable. This is partly the result of the increase in the importance of services, which are not as volatile as manufacturing. Is a more stable economy leading to more stable manufacturing or is it the other way around? The chain of causality probably runs both ways, but lower volatility in manufacturing is more likely to have developed independently Manufacturing has always been a destabilizing force in the economy, most often leading recessions and recoveries. On top of the weight of history, there are strong indications that dramatic changes in the way companies do business have increased stability in manufacturing.

The big question and one way to answer it

What have companies been doing that has reduced inventories and reduced the volatility of capacity utilization? The answer is a mix of lean manufacturing, supply chain management, and capital management, very often brought together with complex enterprise resource management systems.

For the past nine years, Lockwood Greene has been running a program of industry analysis called Strategic View. It involves dozens of interviews with industry executives and analysis of the results combined with independent economic and industry analysis, and it culminates in an annual panel of executives and experts that discusses industry trends and company responses to the resulting challenges. In every annual cycle, optimizing operations, enhancing supply chains, and improving capital management always loom large in the responses of interviewees and the discussions of panelists.

Optimized operations

In the latest round of Strategic View, which centered on the food and beverage industry, respondents and panelists spoke in detail about all the initiatives they are undertaking to optimize operations. Two things quickly became clear. One is that such initiatives go beyond production lines. The other is that there are plenty of unexploited opportunities to optimize operations, and the pressures to seize them keep intensifying.

It could be argued that cutting costs is the main goal of optimizing operations; after all, lower costs can go to the bottom line, can be used as a competitive advantage to gain market share, or both. Beyond costs, optimized operations can increase speed to market, prevent product shortages, empower innovation, enable global expansion, and facilitate better decision making.

For the sake of simplicity and practical application, optimizing operations has traditionally been broken into concrete, isolated steps. Operations are generally broken down into manufacturing, supply chains, and corporate practices. Efficiency drives usually have started with manufacturing. Efficient manufacturing involves things like more automation, less waste, and lower energy costs. Usually, the first thing to be tried was automating labor out of existence to save costs. Companies quickly discovered, however, that labor-saving measures have definite limits, such as excessive complexity, which reduces flexibility and may lengthen change over time. They also found that focusing only on the production line is a narrow view of manufacturing efficiency Piecemeal changes have unintended consequences because they interact with many other parts of the company's business. The most successful companies have a holistic understanding of their operations and do not undertake change without examining its consequences outside its immediate application. Larger savings can be achieved through leaner and more agile operations, which entails rethinking the way production and logistics are organized at the enterprise level.

Among other things, lean and agile entails lower inventories and a migration from push to pull production. However, trying to design and implement lean and agile practices in manufacturing very quickly pushes against the entire supply chain. For example, just-in-time production requires just-in-time deliveries of materials, which means suppliers have to streamline and coordinate their own production and logistics; without these changes, low-inventory manufacturing will quickly grind to a halt. Efficient supply chains require information technology application and integration--and above all, a change in business practices, spread among all companies in the chain, from suppliers to distributors to retailers. The Internet has been a primary enabler of lean supply chains.

Enhancing supply chains

Every manufacturer, distributor, and retailer faces the challenge of enhancing supply chains. The food and beverage industry, with its plethora of mostly perishable products and the need to reach every consumer, faces perhaps the biggest challenge of all. Studies have consistently shown that wholesale and retail trade sectors have been among the biggest beneficiaries of a productivity surge, begun in the early 1990s, that information technology has made possible. This productivity surge has mainly been due to supply chain improvements. Food and beverage manufacturers are inevitably caught up in the process: They can either drive it themselves or be forced to adopt it by their customers.

An example of how the pressures go both ways is inventory. In the past 15 years, manufacturers have clearly gotten the message that excess inventory ties up enormous amounts of working capital. The recent period of low interest rates may have blunted the force of this argument a little, but interest rates are rising again. However, manufacturers face a dilemma: Customers want quick deliveries, and low inventories make this tougher. Retailers' increased power has passed many costs, including carrying inventory, back to the manufacturer. One respondent said, "They are all trying to drop the inventory that they're keeping, pushing it back to us. In turn, we are trying to make it into a made-to-order environment where we don't want to carry the inventory, either."

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