Apr 26 2012

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.

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