Real Numbers

by Orest J Fiume

  9

  Lean Acquisitions

  It is often said that companies that are not growing are shrinking. There is no such thing as standing still. The company that adopts lean business strategies, that allows a culture of continuous improvement to take root in its processes and people, always ends up in a better position to grow. And lean organizations that choose to supplement growth by purchasing other companies will find they have advantages they never imagined in the competitive world of mergers and acquisitions.

  Consider the case of Wiremold. In less than two years, a lot of hard work improving processes and reducing inventory freed up over $11 million in cash (see Figure 9.1). This reduction in inventory must be viewed as a key element of the lean strategy and not just a better inventory management system. For Wiremold, the cash from that liquidated inventory financed the first five acquisitions in the second year.

  Keep this in mind as you consider inventory: If it is assumed that the carrying cost of inventory is 10 percent (most MRP systems assume twice this amount), then income has been enhanced by $1.1 million through inventory reduction. The five companies Wiremold acquired during the second year of lean, at a combined purchase price of $10 million, had total sales of $24 million and an average operating income of 10 percent, or $2.4 million. Therefore, converting cash from financing inventory to financing growth increased income by $3.5 million. For privately owned companies with limited access to capital this enables them to internally finance accelerated growth.

  Companies that apply lean lessons to the realm of acquisitions will find significant benefits, namely:

  1. Lean philosophies provide everyone with a clear game plan as teams confront the merging of another company with their own

  2. Excess assets in the target company, such as inventory and space, are quickly freed up

  3. Risk is reduced by lowering the net cost of an acquisition and reducing the payback period

  For Lantech, the same renewed focus on growth evolved over time. With the success of lean in product development, manufacturing, engineering, sales and accounting, profits and market share were dramatically increased. Proud and confident in these skills, Lantech had a thirst for more; it has continued to invest in new products and new markets. Improved profits and reduced inventory levels also meant the balance sheet showed cash strength and funds to invest. With its lean experience, Lantech leadership also knew similar results could be achieved at other companies and kept that in mind when considering acquisition targets.

  The biggest advantage a lean executive has in the marketplace is that he has learned to look at companies differently.

  Look at the key operating information that illustrates an acquisition target in Figure 9.2. This manufacturing company has slow growth and is not particularly well managed. We see low productivity, $70,000 in sales per employee, and a four-percent operating income. It is typical of most batch-and-queue companies, in terms of inventory management practices, with just 2.4 annual inventory turns. In the three years prior to acquisition, gross profit has remained flat at 25 percent, indicating no significant operational improvement. Although the target company’s operating income has increased as a percentage of sales, this has been done through aggressive cost reductions in non-manufacturing functions —sales, general and administrative —and slashed budgets for product development and training.

  The purchase price is high for this company, at 13.3 times the operating income, but the products it manufactures and sells are strategic to the buyer. It is worth a significant premium, the buyer decides, to keep this fish out of the jaws of the buyer’s competitors. Let’s say for a moment that the interested buyer was a typical batch-and-queue operator. His analysis of the target would probably look like Figure 9.3. We accept that the target company’s market is mature, so sales are projected to continue to grow at the historical rate of four percent.

  The buyer believes he can improve productivity by almost five percent per year and more than double operating income over a five-year period. He also believes he can improve inventory turns at the target company by 50 percent over that same period.

  Working with these assumptions, Figure 9.4 then shows that operating income in the early years will only be sufficient to pay interest and minimal principal payments on the acquisition debt. At the end of five years, only $30.4 million of the $80 million has been paid down. If the economy were to enter into a downturn after five years —no small risk —servicing the acquisition debt could become difficult and represents a potential risk to the buyer. Most acquisition models do not assume economic downturns and therefore generally present the best-case scenario. Recession risk is generally ignored.

  Now let’s step into the head of a lean practitioner who is considering the same target. His analysis looks like Figure 9.5. Experience has shown us that by the second year, sales growth can be accelerated due to better customer service and aggressive new product development. That same product development also shows better profits now, due to the employment of lean strategies. This is possible even in companies that are in mature markets.

  This example, which is based firmly on the authors’ experience, shows sales growth is assumed to accelerate at the rate of seven percent for the second year and 10 percent per year for the following years. Productivity gains of 20 percent per year are achievable and inventory turns will improve 15 times by year five. As a result, operating income can be improved to 12 percent, versus 7 percent in the traditional mindset. As demonstrated in Figure 9.5, all of the acquisition debt can be paid off by the end of the fifth year when the buyer knows lean.

  The buyer who comes from a lean environment knows these results are possible because he can spot the waste in a batch and queue environment and knows how to use kaizen to turn waste into positive dollars. Most importantly, he knows that the transformation begins on day one.

  If an acquired company is allowed to continue to operate in its historical manner for months after the acquisition, however, implementing lean will be more difficult. On the first day, everyone must be informed of the acquirer’s lean strategy. Widespread education and training must begin immediately. There must be an immediate recognition by the acquired company’s employees that the historical method of operating has ended and that a new way of thinking has taken center stage. When this happens, significant gains begin to occur almost immediately and a momentum quickly builds toward general acceptance —and even an embrace —of continuous improvement.

  A comparison of the key metrics of these two models shows that at the end of five years, the lean company has:

  No debt vs. almost $50 million

  10 percent growth rate vs. 4 percent

  65 percent more operating income

  37 percent less people

  75 percent less inventory

  55 percent less interest cost

  The lean company has also most likely cut its space utilization in half and improved customer service. If the economy were to enter into a downturn at this point, the company is in a much better condition to weather the storm than in the traditional mode.

  Please note: This analysis does not address the academic issues of whether maintaining some level of debt leverage is good, but simply looks at the issue of reducing the risk involved in an acquisition by reducing the payback period.

  Or, look at it in a simpler way: If we consider the total cost of the acquisition to be the entire debt service —principal plus interest, which is assumed to be 8 percent in this case —then the cost of the acquisition has been reduced by $21.1 million if a lean strategy is employed. Using this knowledge, a company can afford to pay a higher premium in a bidding situation and take strategic acquisitions away from the competition.

  In figures 9.6, 9.7 and 9.8, we have included some actual before and after results achieved by applying lean strategies to several acquisitions. The approach used in each company was identical.

  On the first day after the acquisition was complete, the buyer held a meeting wi
th all employees (each was a single location company) and introduced the employees to the company’s lean strategy. Using lean teachers pulled from other operations, the buyer then began an intensive education in lean and kaizen within the first two weeks.

  In the case of company “A” shown in Figure 9.6, the initial education was accomplished that first morning and kaizen events began that first afternoon. By the end of day one, a long conveyor belt assembly line was dissembled and hauled out to the parking lot. This represented a significant emotional event in the lives of those employees and sent a clear message that everyone was working under a different operating philosophy. As is readily apparent from this example, significant gains can be achieved in a short time when the lean strategy is rigorously applied from the outset.

  Figure 9.7 represents an acquired company that was the market-share leader in its product category. Upon acquisition, lean principles were applied to the company’s new product development process —getting the voice of the customer and creating cross-functional teams to ensure a profitable and workable product —with great results. In spite of its previous market share position, sales were increased by 133 percent within three years. The company did this by developing new products that grew the market, while at the same time increasing its market-share position with more user-friendly products. Significant operating improvements were achieved in both productivity and asset management, making it the low-cost producer.

  The company in Figure 9.8 had aggressively pursued a Total Quality Management program prior to being acquired. However, it was in a very competitive market and was trying to compete with products from foreign low-cost producers. The TQM activities enabled the company to achieve some gains, but not enough to be profitable.

  By applying lean principles, the business quickly improved its productivity, became profitable and, by emphasizing custom products that required short lead times, was able to grow at a rapid pace in spite of low-cost foreign competitors. Its ability to compete on the basis of time gave it opportunities that the long lead-time batch competitors could not match, regardless of price.

  In each of these cases, the application of lean principles as a business strategy —not just an inventory management program —allowed the lean acquirer to gain significant competitive advantage. In those cases where the acquirer was competing with other companies to buy the target company, it was able to offer a premium and win the target. In spite of this, in each case the purchase price paid was recovered in less than five years.

  10

  The Road Ahead

  There is a Chinese proverb that says, “In doing anything, the first step is the most difficult.” We have found that the second step is also tricky and important, as is the third; and the order in which the steps are taken can be critical. Because we are talking about such fundamental change to an organization, we are often asked for a roadmap or step-by-step guide to a transformation to lean management accounting. Of course, there is no simple answer.

  There are pivotal and universal steps that need to be taken, however, and a loose order in which most businesses will want to take those steps. The first and most important action is that all senior leaders must adopt lean as a business strategy and not a manufacturing tactic. The CEO, the CFO, and the rest of the management team must be committed to focusing on and transforming any aspect of the business that does not support that strategy.

  A lean transformation often represents a significant shift in a company’s culture and the CEO needs to be personally involved in change management. Virtually every business publication has published numerous articles discussing the subject of changing corporate cultures, but few have described culture in any detail. In its simplest form, a company is comprised of a group of individuals that hold some common values and beliefs. Those values and beliefs cause them to behave in a certain way, and when they get the results they expect and desire from those behaviors, their values and beliefs are reinforced. This self-reinforcing cycle represents culture.

  In order to change a culture, we must somehow break the current cycle. Although a CEO may make statements about adopting a new set of value and beliefs (e.g. “We’re going to become customer focused.”) this rarely changes culture because people usually continue to act and react in their same patterns. We are creatures of habit. Therefore, in order to change culture, there must be some intervention that will force people to behave differently. Once they do, and begin to experience different and better results, their values and beliefs will begin to evolve and a new culture will take hold. Figure 10-1 illustrates this principle.

  To create new behaviors, the first and most important action we can take is to begin immediately. Don’t establish a task force to spend six months studying lean and come up with a traditional economic (e.g. ROI) justification for it. Our strong recommendation is, simply, this: Lean works, so just accept it and get started.

  The second action is to create a clear statement about lean becoming the company’s business strategy and distribute it throughout the company. Repeat the message any way you can. Everything the company does must be measured against this strategy statement, so it needs to be clear and concise.

  Third action: get help. As previously discussed, the principles of lean are easy to agree with but hard to implement and sustain. There are several sources of good help and one of them should be chosen.

  Next, the CEO must begin to act in a way that requires others to change their behavior. Of the many things that need to be done, some of them are:

  Provide lean education to all management and supervisory personnel early in the process. Ensure that all leaders become ordinary team members on a kaizen event and develop plans to bring lean principles into their own functional areas.

  Provide “air cover” for early adopters. Don’t let naysayers get in the way.

  Flatten the organization and re-organize into product family-based operational teams.

  Provide an environment where it is acceptable to fail. When people try something new and it doesn’t work, they should not be penalized.

  Change the management incentive compensation system to include customer service and working capital objectives and to eliminate individual objectives.

  Hold weekly meetings with the CEO and senior management where product team leaders report on where they stand on the new metrics (see Chapter 3). Reports should include improvement actions taken during the past week, improvement plans for the following week and a list of resources or support needed from management.

  This last point is very important. By having product team leaders report every week on new metrics and process improvement efforts and successes, those leaders will quickly understand that achieving continuous improvement is now an important part of their job. These meetings go a long way in changing the company’s culture. (At Wiremold, it wasn’t until after year five of our lean transformation that the meetings were cut down to every other week.)

  Beginning a lean initiative in the accounting department requires a few additional actions. Before we begin that discussion, however, it is important to emphasize one of the most important principles: integration. All accounting professionals must participate in all the education received by operations personnel. This is a vital step toward integrating accounting with the business as a whole, as we have emphasized throughout this book. The financial staff must participate in at least two kaizen teams each during the first three months of a lean initiative. Every member of the accounting department should join one setup-reduction kaizen and one kaizen that creates a one-piece-flow cell. Do not let the accounting staff opt out of this important work, as these early months will establish tone and communicate your commitment. Besides, the staff will need a better understanding of the company’s work in order to fulfill their expanding roles.

  Both the financial staff and senior management will also need some education as to why the accounting processes, including the financial statements, must change. There will very likely be some reluctance
to change; taking a course together will provide a forum for everyone to air his or her feelings and come to a common understanding.

  Next, accounting staff should begin changing their business processes at a pace commensurate with the operational changes. If the business processes are changed too rapidly, that could create havoc in operations. If changed too slowly, accounting becomes a roadblock. See chapters 2 and 4 for detailed change plans and ideas for individual projects.

  Plain English financial statements similar to that in Figure 6-2 should be created as soon as possible. Most companies will not be able to dismantle standard cost statements immediately, but the new format can be prepared in parallel, in spreadsheet format. As these statements are created, the CFO should distribute them as an alternative view to other senior leaders and ask for feedback. This will help accounting create the most useful financial statements for the business and get others accustomed to the new document.