Leanness, value curves, and profit margins versus volumes

Long flights are opportunities to whittle down my stack of books to read about Lean. The one I took from San Francisco to Shanghai this time made heavy use of what the author calls a “value curve,” but I have to admit that it was a bit much for my jet-lagged brain. As I couldn’t quite make sense of this curve, it made me want to explore in more detail exactly what it is, what can be learned from it, and what actions it may support.

It plots parameters the author calls “Value available” and “Value required” against volume for a set of yearly data about a company. The author claims that companies that are not Lean have U-shaped profiles of “value required” that make them profitable only in the vicinity of an optimal volume of activity, while Lean companies have flatter value-required profiles that allow them to prosper under a broader range of volumes.

Following is the example he uses to introduce the value curve:

Figure 3.2 is about GM from 1926 to 1936, and, the parameter on the x-axis is a common measure of automobile industry volume, albeit one that commingles everything with wheels and an engine that goes on the road, from cars to trucks and buses.

Since the word “value” appears seven times on the chart, I had to check what the author meant by it. In the book’s glossary, he defines it as “A product or service that satisfies a customer need or desire even as it changes over time.” Since service organizations call their offerings “products,”  products are always intended for customers, and products are upgraded over time, I can’t see any difference between Value and Product, but why not? The next time I buy a haircut or a fish, I will know I should call them values rather than products. On the chart, however, replacing “Value” with “Product”  doesn’t makes it easier to understand, as seen below, so I must still be missing something:

I was also puzzled by the use of the expression “Behind the Value Curve” inside a chart called “Value Curve,” making the chart refer to itself. Clearly, it was not as simple as I hoped it would be. Looking further in the Glossary, I found the following:

  • “Value Available” actually doesn’t mean “Product available”. Instead, it has its own paragraph-long definition, from which I understood that is means Sales.
  • Likewise “Value Margin” is Net Income, as lifted from the company’s Operating Statement, and Value Required = Sales – Net Income. It is therefore a measure of costs that includes depreciation and taxes.

But Value Available is a flat curve on the chart, and therefore it can’t mean Sales, because GM’s sales were anything but flat between 1926 and 1936. The author explains that he makes it flat to show “the relationship between value available and value required.” Another way of saying this is that he wants to show the ratio of Net Income to Sales, usually known as Profit Margin. It seems that the unit on the y-axis should be “%,” as befits a ratio, rather than “Dollars.” It really doesn’t matter whether Sales and Net Income are reported in Dollars or Yens.

In the book’s appendix, the author provides the data he used to generate his chart, and I used them to plot profit margin as a function of volume. I also labeled each point by year so that we could follow the company’s trajectory on the plane of Profit Margin versus Vehicles Produced. To see if this chart supported the author’s assertion, I also retrieved and plotted the corresponding data for Toyota between 2000 and 2011, with the following results:

These charts clearly tell stories. The first shows GM through the growth of the twenties and the great depression; the second, Toyota through its 2001-2008 boom, followed by the financial crisis, the mass recalls of 2010, and the Fukushima earthquake and Thailand floods of 2011. It also shows how the economics of the auto industry changed in 80 years. In good times, today’s mature automobile industry yields profit margins that are barely 1/3 of what they used to be, on volumes that are many times higher. In the worst year of the great depression, 1932, GM made only 28% as many vehicles as in 1929. If the worst of the current crisis was in 2009-2010, Toyota’s drop in volume, while similar in absolute terms to GM’s in the great depression, was much smaller in relative terms, at barely 15% off from the 2008 peak.

But do these curves support the author’s assertion that Lean companies are better at coping with volume changes? I don’t see it. I happen to think it’s true, but I don’t see these particular charts as making this point.

8 comments on “Leanness, value curves, and profit margins versus volumes

  1. Thanks fir sharing your latest read, which got me confused now!

    How would it look if you used Toyota’s performance data for the same years as those of GM?

  2. Comment in the Global Lean & Six Sigma Network discussion group on LinkedIn:

    Hi, Michel –

    Interesting, thought-provoking discussion, as always. And I certainly like your charts a whole lot better than the article’s author.

    But does Lean really help companies absorb and survive shocks to the market and supply chain? As you say, the article doesn’t make its case. (Or maybe it does. Who knows? I can’t make heads or tails of it, either.) While I can understand the theoretical case for the affirmative, in practice – as we’ve discussed elsewhere – I’ve known companies who’ve unwittingly allowed their obsessive pursuit of Lean to paint them into a corner. I think we all agree that it’s a matter of balance. The question is, Where’s the fulcrum?

    Again, thanks for getting this ball rolling.

    Keith

  3. Comment in the Lean Six Sigma Worldwide discussion group on LinkedIn:

    @ Michel – As you illustrate the context from the chapter of the book it is clear that the author has made a great effort to confuse his readers, nice of you to not make the reference.
    I think the problem occurs when people try to express finance ratios out of accounting reports and when relate this to operation activities and benefits of these operation efforts. I do clearly understand the author’s need to illustrate lean activities to make in lean projects.
    We have earlier discussed lean efforts vs. bottom line; most of the respondents hesitate to use net profit to measure the effect of a lean project. Your analysis may raise the question which parameter influence the most lean six sigma projects or external market mechanisms, the wall street boy can destroy everything. However, what could express it better would be the use of two ratios from the finance decision making theory; in your analysis we have to look at the operation gearing (contribution margin divided with the net profit), this will illustrate how sensitive the company’s economics are to market mechanisms, the other ratio is the contribution margin, which should be the preferred measure for operation improvement projects as this measure the variable costs (which can be influenced be the improvement projects) to the turnover (sales), if we express our benefit with a ratio directly influenced by our improvement project we can prove to management (our clients) the effective gain. I believe we may have missed so many opportunities when we educate our Green Belts to have economic metric tools to justify the projects.
    Brian E. Vibenholt

  4. Comment in the Lean Six Sigma Worldwide discussion group on LinkedIn:

    Speaking of profit margins, we have some new ones: Toyota 1.66%, Honda 2.4, Microsoft 29.34, VW 9.92, Ford 39.38. So who is the “leanest” and who is most profitable? Love these numbers! A Mill Girl at Blue Heron Journal

    • @Patricia – Are these ratios for a quarter or a year? A few years ago, I compared the profitability of Toyota and Ford from 1992 to 2002, which were then roughly equal in size. During that period, Toyota profits were slowly rising, in both absolute and relative terms, while Ford’s profits oscillated wildly.

      The best explanation I could find was differences in the use of debt. Ford’s debt, at $160B, was four times larger than Toyota’s, and Ford was therefore more leveraged. This meant large profits in good times and large losses in recessions.

  5. Michel,
    You are covering an encyclopedia of subjects here but I thought that I would comment on the term “value’. To me, lean concepts are about business economics – the management of resources and their associated costs. “Value”, to me, is a marketing/sales term that refers to what a customer is willing to pay for a product or service. As a consumer I do not buy “value”. Also, what I am willing to pay generally has nothing to do with what it costs to produce it.

    Regarding economic decisions, the producer has to cover fixed costs (which are significant for an automobile) than strive to optimize the economy of scale which peaks at the economic threshold. Lean methodologies theoretically lower the economic threshold to an ideal (e.g. 6 sigma performance).

    All of these graphs and equations assume forcastable demand and perceived value. Unfortunately, things like fickle markets, tsunamis, and recalls add a dimension of variability that trumps ideals. So going forward management needs to keep their eye on the ball and respond to the impredictable in real-time. One lapse in focus can eliminate a lot of wasted “lean” efforts.

    • Actually, I thought I was covering just one subject: a curve and its interpretation. I would not describe Lean as “the management of resources and their associated costs,” as I feel the first phrase “management of resources” to be too broad and second, on “associated costs” to be too narrow. To me, what sets Lean apart is that it is the pursuit of concurrent improvement in all dimensions of performance.

      “Value” is a term I use sparingly because it means too many different things to different people. Whenever I use it, I include a definition to remove any ambiguity.

      The charts in my post are about historical data and require no assumptions. But they can, of course, be interpreted in different ways.

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