Principles of Lean Spending:

Doing the Most with the Least, Part II

By Diane M. Calabrese / Published May 2016

 

Editor’s Note: Part I on the topic of “Lean Spending” was published in the April issue of Cleaner Times.

 

Waste… it contributes to want. Haste makes more of it. In the first part of this article, we reviewed how lean-spending principles can help launch a business in our industry. By avoiding wasteful spending, it’s possible to start a company without going into debt, so that a new contractor or distributor is not left wanting.

Established companies of all kinds—contractors, distributors, and manufacturers—also make use of lean-spending principles. In doing so, they bring methodical analysis to their decision-making process. They do not act in haste (or on impulse), and in the process, they eliminate waste.

“Considering the lean principles in the financial areas of my business allows me to focus on specific areas I would like to see improvement in,” says Jim O’Connell, president, Hotsy Pacific in Modesto, CA. “As an example, we have decided that there are just a few metrics that we need to focus on to not just grow the business but to also show a profit.”

O’Connell explains that one of the “key components in any business is cash flow” and begins with that as an example. Scrutiny of cash flow has the owner looking at everything from gross margin down to collection.

It’s not sufficient to look just at sales, says O’Connell. “If you just focus on sales and truly don’t look at the other aspects of the financials, you are limited by what you can attain.”

O’Connell characterizes as “fairly accurate” our assessment that applying lean principles in a successful business has something in common with the time-honored method of bootstrapping the start of a business, or being extremely prudent and creative about spending. “It really is quite simple,” he says. “Take a few key metrics and focus on them. The rest will naturally fall into place.”

Labor (employees) constitutes a major expenditure for any company. O’Connell explains that labor costs provide a good illustration of the benefits of lean principles. “Our tendency when we get busy is to hire  more people to hopefully increase productivity, thus increasing sales,” says O’Connell. ”Most times, the opposite happens.”

Why? It’s because most businesses hire without knowing what their full-time equivalent (FTE) employee is. “Unless you have a good idea of what your FTE needs to produce in income, it is a shot in the dark,” says O’Connell.

Devoting adequate time to each decision made increases the likelihood of making the best choice. Just because an owner has the capital to do more, it does not mean that doing more—for instance, expanding in any way—is the best choice.

“We know that in order to hire additional employees, we need to have each employee generate a minimum $220,000 per year,” says O’Connell. And he explains he arrives at that number based on past history of his company and by benchmarking against other companies.

“The math is simple. Take your total sales and divide by the number of employees to determine the FTE. If you are not reaching your number [minimum to be generated by employee] now, it will not happen with additional employees unless you have a fairly substantial growth pattern.”

O’Connell cautions that one does not want to become so tied to lean spending that it becomes the only way to proceed. “Being prudent helps, but you must also be open to taking some risk if an opportunity develops,” he says.

In other words, sometimes it’s good to hire a new employee—or to expand in other ways. Before doing so, however, an owner must be able to predict how rapidly a gain will be made from the change.

Universal Application

Lean principles can be applied to any dimension of a business. “Our company has a fairly lean approach to inventory,” says Chad Rasmussen, general manager, Royce Industries, L.C. in West Jordan, UT.

There’s always a tug and pull when invoking lean-spending principles, of course. Consider an example concerning inventory. “Some approach inventory with the thought process of ‘You can’t sell it if you don’t have it,’” says Rasmussen. “Our thought process to inventory is something like, ‘If you sell a certain part once per year, you may not need to have it in stock—and you certainly do not need five of them,’ or simply, ‘Wait until you have a history of consistently selling something before stocking it.’”

It’s a matter of mirroring the flow of products. If there is stagnation—items sitting on shelves or in storage that is capital tied up as surely as if it were in a box at the bottom of an ocean.

Yet a company that sells must be able to be immediately responsive most of the time. Selling requires having products available. Customers do not want to be told there will be a wait any more than sales representatives want to inform them they have to wait, says Rasmussen.

By analyzing how long items reside in inventory, it’s possible to determine the right amount of product to have on hand, explains Rasmussen. Then, stocking can go from there.

“There are plenty of complicated ways to figure out how to pick stocking quantities,” says Rasmussen. “If I were to give an easy way to figure it out, I would tell you to look at the history of a product over a period of one or two years. Determine the quantity sold over that period of time and divide it by the number of months’ history you were looking at. This will give you an average quantity sold per month.”

From that point, just decide how much product (how many months’ worth) is wanted and stock accordingly, explains Rasmussen. “Obviously, this might not work perfectly with every part, but it does give you something to think about.”

As a corollary to reviewing average time in stock and then ordering to reduce that time, Rasmussen recommends restraint when adding new products. “We try to avoid ordering things we have not sold in the past,” he says. “Everyone has probably seen an employee get excited about a new product,” says Rasmussen. “They think they are going to set the world on fire with this product and bring in a large quantity of it so they can sell it.”

Too often, explains Rasmussen, by the time the product is in stock, sentiment changes. Perhaps the product did not perform as expected, or customers were not interested in making a change. “Whatever the reason, this new and exciting product ends up collecting dust and eventually gets thrown away or sold for a less than-desirable price.”

Inventory is just one of many examples of a cost center to which lean principles can be applied. As with other cost centers, the benefits of staying lean spill over and affect the other parts of a business.

“Having a lean inventory allows you to have the products your customers need and makes cash available for other things,” says Rasmussen. The cash could be used for outlays such as “payment discounts, marketing, payroll, and more.” Analyze every cost center now and then, even costs that seem unlikely to be reduced. There may be a way to shrink something.

Some of the cost centers to review periodically are the cost of a line of credit (it may be time to change banks), cost of connectivity (perhaps a new carrier is cheaper), cost of collecting on invoices (some procrastinating payers should be dropped), and so on. At the same time, every change made to save money may cost money, so choose carefully.

Relationships are important. If switching banks to save a tiny amount will sever ties with individuals who know your business so well they alert you to unusual activity on accounts, it could be an expensive move. Similarly, an Internet, phone, and fax provider may cost 10 percent more than its competitor but provide more reliable service.

As for slow-paying customers, if they are also the highest-paying, largest buyers, giving them more time to pay makes sense. Low-paying and slow-paying is the worst combination of customers; and at some juncture, considering what it costs to collect may suggest that some be jettisoned.

The more carefully each expenditure is considered, the more precise a company can be in targeting the spending that does the company the most good. Like O’Connell, Rasmussen sees a tie-in between lean principles and bootstrapping, or the way of pulling up—and building up—a business with minimum capital. Once the business is going strong, it’s about conserving capital so that it can be used for outlays that make the company stronger still.

“I do not think a comparison to bootstrapping is overly simplistic,” says Rasmussen. “Adopting lean principles is all about eliminating waste. Waste leads to losing cash. Losing cash limits your opportunity to do other things that will generate more cash.”

Waste not, want not.