The impact of lean on the financial performance of an SME
RESEARCH – What kind of financial results can a SME owner expect from a lean transformation? To find out, the author of this interesting research analyzed the performance of 100 Italian small and medium-sized companies.
Words: Arnaldo Camuffo, President, Istituto Lean Management, and Professor of Lean Management at Bocconi University in Milan, Italy
According to the International Finance Corporation, a member of the World Bank Group, small- and medium-sized enterprises (SMEs) represent a staggering 90% of business and 50% of employment worldwide.
We are used to think of lean as a management approach that is best suited for corporations (and indeed most large companies today use it to some extent), but imagine what the impact would be of bringing its thinking and practices to SMEs. The opportunities are almost too big to fathom.
Yet, the majority of SME owners and managers seem reluctant to embrace lean thinking and appear dubious about its potential. In order to convince more SMEs to take on lean and its teachings, therefore, it is necessary to demonstrate that lean transformations work – and that they can work in SMEs as well as they do in multinational corporations – and to provide a more accurate picture of what to expect in terms of financial performance during the transformation itself.
In other words, do lean transformations work in SMEs and what results in terms of financial performance can one expect?
Through my research I have been trying to answer these questions, using a sample of 100 Italian industrial SMEs that seriously undertook a lean transformation.
How did we select the companies? We asked local branches of Confindustria, the Italian employers association, to identify a set of SMEs (defined as firms with less than €0.5 billion in revenue) that are known as being serious about their lean efforts. We obtained 145 names, which we cross-checked using our knowledge of the Italian lean movement, the results of an analysis of secondary sources (press, magazines, web, the companies' financial reports), and a panel of consulting firms.
Our work resulted in a sample of 100 SMEs (of varying sizes, belonging to different industrial sectors, and at different stages of the lean transformations). For each of them, we listed the year their lean transformations started – which ranged from 2000 to 2011.
In order to evaluate the effects of lean transformations on the financial performance of these SMEs, we focused on two metrics that are often used in the literature and in practice because they are considered closely connected to the adoption of lean:
- The EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) Margin, which is a measure of the firm's profitability and is a proxy for the cash flow generated per dollar unit of sales;
- The ROIC (Return On Invested Csapital) ratio, which is a profitability measure that takes into account the capital, the firm's cash flow generation and its operating and structural efficiency.
We measured these two metrics as follows:
- EBITDA Margin = EBITDA/Sales Revenue (%);
- ROIC = NOPAT/Net Invested Capital (%), where NOPAT stands for Net Operating Profit After Taxes.
In order to assess the differential effect of undertaking a lean transformation, we had to be able to perform meaningful cross-firm comparisons, do this across industries (characterized by structurally different trends and absolute levels of profitability) and longitudinally (observing the subjects repeatedly over a period of time).
We wanted to find out whether or not financial performance of a SME undergoing a lean transformation improves, but also if and how that changes over time and if there is any difference with how the industry and its non-lean peers perform.
To do this, we normalized the financial performance of the sample SMEs – analyzing whether each firm in the sample over- or under-performed a set of "non-lean" competitors with regards to the above metrics – and transformed each dependent variable into an index number highlighting the differential performance of each company compared with a group of industry peers that were not in the middle of a lean transformation.
The underlying assumption is that, after controlling for industry specific factors and choosing peer groups appropriately (competitors that did not undertake a lean transformation), the differential performance of the analyzed firms should be reasonably attributed to their lean transformation. Peer groups comprised 10 to 20 "non-lean" competitors that were Italian SMEs belonging to the same national industry classification category as the analyzed lean SMEs and closest in size to them.
Once the financial performance data of each lean SME in the sample was industry normalized (against non-lean competitors), we calculated – for each of the analyzed firms and for each of the performance variables (EBITDA ratio and ROIC transformed into an index number) – the performance variations over time since the start date of the lean transformation.
We then calculated the industry (non-lean competitors) normalized financial performance percentage increase/decrease occurred between before the implementation of lean production systems and 2015. To avoid distortions due to particular events occurring right before the start of the implementation, we considered the average of the industry normalized financial performance measures of the three years before the lean transformation as the baseline performance.
This indicator allowed us to understand the overall performance change by each firm from the start of implementation to 2015 relative to their non-lean competitors.
The graph below reports the median percentage variation of the industry normalized EBITDA margins and ROIC ratio for the sample of one hundred lean Italian SMEs, showing by how much the lean sample has under- or over-performed its non-lean competitors in terms of performance change after one, two, three, four, five, six and seven years since the start of the lean transformation.
Taking the years before the beginning of the lean transformation as the baseline (it corresponds to zero), the graphs show by how much the lean sample improved or worsened compared to competitors. Observations in the negative range represent years in which the lean sample improved less than its competitors. Observations in the positive range correspond to years in which the lean sampled improved more than its competitors.
It was interesting to see how the lean transformations of the analyzed sample of lean Italian SMEs seemed to generate non-linear performance effects. Initially, performance worsens, with non-lean SMEs doing better in the first year of the lean SMEs' transformations. However, after the second year, lean SMEs tend to outperform their non-lean competitors, with spectacular performance differentials five years into the transformation. EBITDA margin improvements go from 11% after three years to more than 50% after seven years. ROIC progression is even steeper moving from 4% in year one of the lean transformation to 1,5 times after seven years.
This data is consistent with lean accounting literature suggesting that there is a time lag between the adoption of lean systems and financial performance improvements. Two main factors – one operational and one financial – explain this initial lag: the negative effects and operational disruption that the implementation of lean practices might have on business processes at first (plant layout changes, redefinition of work standards, changes in the logic of production planning and control, among others); and the accounting effects of the fact that the freed-up resources (the first main result of starting a lean transformation is typically waste elimination and variability reduction) are re-deployable for other uses in theory, but not in practice (due to resource stickiness, technological constraints or institutional rigidities) – unless or until complementary choices about their use are made by management.
In both cases, on the one hand the impact of kaizen activities on the income statement and the balance sheet is not immediate, but becomes visible later, with time lagged financial indicators. On the other hand, the effects of kaizen activities on the income statement differ contingent on management's strategic decisions, possibly leading to improvements in profitability either through revenue increases thanks to development activities or cost reductions.
Moreover, as lean transformations initially tend to focus on waste elimination through inventory reduction and destocking, inventory write-downs might also affect the income statement. Similarly, avoiding overproduction might imply that some of the indirect or general costs typically attributed to products through standard full costing techniques will no longer appear on the balance sheet as inventories (assets). Instead, a portion of these costs might surface and negatively impact the P&L statement.
These factors contribute to generating the static or even comparatively worsening financial performance that often characterizes the early stages of lean transformations and that is confirmed by our analysis of Italian SMEs.
LIMIT THE RISK, AVOID LAGGING
So, what can be done to de-risk a lean transformation in a SME?
Managers and owners of SMEs should be aware of the initial implications of a lean transformation, as they can have a discouraging effect and persuade them to discontinue their efforts or even to abandon the undertaking altogether. If they stick to it, however, they will see that in time (typically three years after the beginning of the transformation) they will have the opportunity to dramatically outperform their non-lean industry peers.
At the same time, our analysis shows that some firms significantly benefit from a lean transformation, while others don't. Indeed the graph above shows wide variation (standard deviations in EBITDA ratio and ROIC improvements are extremely high). Some lean SMEs do better than their non-lean counterparts, but the opposite can also be true. It is therefore extremely important that owners and managers of SMEs, rather than focus their attention on lean tools, spend as much time as possible making sure that such potential variation in the outcomes of their lean transformation is reduced. This can be done mainly by clarifying how lean fits in the overall picture: management should learn to see the methodology as a strategy rather than a set of tools, and framing the transformation as the development of a system for continuous improvement and learning rather than the simple improvement of processes.
What does this mean in practice?
The leader of a SME, who wishes to undertake a lean transformation, should:
- Make a serious and lasting commitment to transforming the organization (with a clear strategy in mind);
- Choose accurately the value streams that require more urgent improvement as defined by strategy deployment;
- Build enough capabilities and create an adequate lean infrastructure to sustain the transformation (a strategy-driven management system);
- Embrace lean completely, leading by example by going to gemba and creating a culture that goes beyond the visible devices and artifacts of lean tools.