The ROI of Lean Six Sigma for Services

Overview

“The lack of initial Six Sigma emphasis in the non-manufacturing areas was a mistake that cost Motorola at least $5 billion over a four year period.”

—Bob Galvin, former CEO of Motorola

Service operations now comprise more than 80% of the GDP in the United States and are rapidly growing around the world. Even within manufacturing companies, it’s common to have only 20% of product prices driven by direct manufacturing labor—the other 80% comes from costs that are designed into the product or costs associated with support and design functions (finance, human resources, product development, purchasing, engineering, etc.).

Moreover, in service applications, the costs related to work that adds no value in your customers’ eyes (“non-value-add”) is higher than in manufacturing, in both percentage and absolute dollars. The revenue growth potential of improving the speed and quality of service often over- shadows the cost reduction opportunities. For example, as you’ll see in the case studies later in this book, work that adds no value in your customers’ eyes typically comprises 50% of total service costs. This represents enormous “white collar” potential for achieving significant speed, quality, and cost improvements, all of which can give organizations a major strategic advantage over their competition.

Here are some typical organizations that needed Lean Six Sigma in their services and business processes:

Like many of its counterparts in the banking industry, Bank One had been reincarnated several times throughout the 1990s. Mergers and acquisitions meant that heroic efforts were needed every day just to get the basic business work accomplished. In an industry as competitive as finance, this condition couldn’t last long—and they had a long way to go to get the process under control, let alone achieve any kind of competitive advantage.

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In 1999, Lockheed Martin (LM) set a goal of eliminating $3.7 billion in costs. At the time, LM was a relatively young organization, having been formed by a series of mergers and consolidations in the aerospace industry in 1995. Its workforce was a conglomeration of almost 20 separate companies, cultures, and processes, with a core manufacturing operation surrounded by a much larger “service” component (procurement, administration, design/engineering, etc.). How could they bring everyone together to achieve such a challenging goal?

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At Stanford Hospital and Clinics (SHC), the future was clear: Patient volume was dropping because SHC kept losing contracts due to high costs. Physicians and management alike recognized that if they didn’t do something soon, they would continue to lose current patients and be unable to attract new ones. It’s one thing to want to provide high-quality patient care, but the pragmatists operated under this slogan: “No margin, no mission.”

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When Graham Richard, an entrepreneur and businessman, was elected as Mayor of Fort Wayne, Indiana, he had a simple vision: “I want Fort Wayne to be a safe city. I want it to have quality jobs. I want it to have excellent service and attract new businesses.” He knew the city couldn’t keep doing “bureaucracy as usual” if it was to implement this vision. But was there an alternative that would work in government?

Though these organizations come from a range of sectors, they represent significant service opportunities for applying Lean Six Sigma. Their goals and objectives may be different, their needs range from providing medical care to patients to providing logistical support for manufacturing, but they are all in the vanguard of a new movement. They realized the most effective way to achieve their objectives was by integrating Lean and Six Sigma principles and methods to improve service operations.

• Bank One’s use of these principles and methods started with an initiative in their National Enterprise Operations called Focus 2.0. Launched in February 2002, it began with a series of carefully selected, strategically important projects. As a result of their efforts, the NEO group has the opportunity to generate millions of dollars in revenue per year due to improvements in one operation and saved thousands of dollars in cost avoidance and waste reduction in others.
• Lockheed Martin developed a clear goal: “We want Lean processes with 6s capability.” They can cite a long list of service processes from procurement to design that now take a fraction of the time and cost they took before. In fact, over 1000 projects have been completed in the past few years in service areas alone. Their debt is down, revenues are healthy, they are going to exceed their cost-reduction target, and there are a record number of orders backlogged. They were able to offer their newest missile (with all the customer-required capabilities) at half the cost and one-third the cycle time of its predecessors due to significant and widespread use of Lean Six Sigma, not by using cheaper materials or cutting corners! They won the Joint Strike Fighter contract, which has an estimated value of over $100 billion. “There are a lot of reasons that contribute to these kinds of results,” says Mike Joyce, a vice president at Lockheed Martin, “but a fundamental contributor is LM21 (Lockheed Martin 21st Century), our organizational effectiveness initiative that’s based on Lean Six Sigma.”

  At the 4000-person Lockheed Martin Naval Electronics and Surveillance Systems plant, 75% of the Black Belt projects have been in non-traditional manufacturing or white collar areas, generating $5 million in savings in its second year alone.

• In just four years, Stanford Hospital and Clinics’ application of Six Sigma concepts (data, customers, quality) and Lean thinking (process flow, the preventable costs of unnecessary complexity) put them in a position to deliver higher quality patient care with lower costs—and regain market share from local competitors. Here’s an example of their results: mortality from coronary artery bypass graft surgery dropped by 48% at the same time costs in the cardiac unit dropped by 40%. Overall, material costs throughout the hospital are now running $25 million below previous levels per year.
• Fort Wayne Mayor Graham Richard has authorized the launch of numerous projects citywide that draw on Lean and Six Sigma principles and methods. Many city departments have seen improvements in some aspect of its citizen services (clearer communication, faster response times to queries or complaints), a significant drop in costs, or better use of city resources. A change in construction permits, for example, has dropped the response time from almost two months to less than two weeks, and removed the kind of hassles that dissuaded many companies from wanting to do business with the city. (See Case Study # 3 in Chp 12 for details.) Improvements in garbage collection have reduced costs nearly $200,000 a year for the subcontractor while providing better services.

Each of these organizations recognized several fundamental truths: (1) getting fast can actually improve quality, (2) improving quality can actually make you faster, and (3) reducing complexity improves speed and quality. However, this cycle doesn’t happen unless you apply both Lean and Six Sigma.

What Does Lean Six Sigma Mean for Services?

Lean Six Sigma for services is a business improvement methodology that maximizes shareholder value by achieving the fastest rate of improvement in customer satisfaction, cost, quality, process speed, and invested capital. The fusion of Lean and Six Sigma improvement methods is required because:

• Lean cannot bring a process under statistical control
• Six Sigma alone cannot dramatically improve process speed or reduce invested capital
• Both enable the reduction of the cost of complexity

Ironically, Six Sigma and Lean have often been regarded as rival initiatives—Lean enthusiasts noting that Six Sigma pays little attention to anything related to speed and flow, Six Sigma supporters pointing out that Lean fails to address key concepts like customer needs and variation. Both sides are right. Yet these arguments are more often used to advocate choosing one over the other, rather than to support the more logical conclusion that we need to blend Lean and Six Sigma.

How is it that Lean and Six Sigma are complimentary? Chapter 2 goes into more detail about what each of these methodologies brings to the party, but here’s a quick overview:

Six Sigma…

• emphasizes the need to recognize opportunities and eliminate defects as defined by customers
• recognizes that variation hinders our ability to reliably deliver high-quality services
• requires data-driven decisions and incorporates a comprehensive set of quality tools under a powerful framework for effective problem solving
• provides a highly prescriptive cultural infrastructure effective in obtaining sustainable results
• when implemented correctly, promises and delivers $500,000+ of improved operating profit per Black Belt per year (a hard dollar figure many companies consistently achieve)

Lean…

• focuses on maximizing process velocity
• provides tools for analyzing process flow and delay times at each activity in a process
• centers on the separation of “value-added” from “non-value-added” work with tools to eliminate the root causes of non-value-add activities and their cost
• provides a means for quantifying and eliminating the cost of complexity

The two methodologies interact and reinforce one another, such that percentage gains in Return on Invested Capital (ROIC%) is much faster if Lean and Six Sigma are implemented together. (Some people might question whether ROIC is a valuable metric for service businesses, and the answer is yes: Many service businesses—hotels, airlines, restaurants, health care—are very capital intensive. In most other service business—software development, financial services, government, etc.—the biggest costs are salaries/benefits, so invested capital is really the “cost of people.”)

In short, what sets Lean Six Sigma apart from its individual components is the recognition that you can’t do “just quality” or “just speed.” Empirical proof of the need to use Lean and Six Sigma in combination is found throughout this book; additional support is gained by analyzing performance data using specialized software (see sidebar and Figure 1.1).

Applying Lean Six Sigma to Services It s Not Just for Manufacturing!

The roots of both Lean and Six Sigma reach back to the 1980s (and beyond), a time when the greatest pressures for quality and speed were on manufacturing. Lean arose as a method for optimizing automotive manufacturing; Six Sigma evolved as a quality initiative to eliminate defects by reducing variation in processes in the semiconductor industry. It’s not surprising, therefore, that the earliest service applications of Lean and Six Sigma arose in the service support functions of manufacturing organizations—GE Capital, Caterpillar Finance, ITT, Lockheed Martin, etc. These companies were already adept at key Six Sigma and Lean skills: value stream mapping, data collection, analysis of variance, setup reduction, design of experiments. It’s impossible for outsiders to know how much of the stated gains in these companies are due to improvements in service operations vs. improvements in manufacturing, but Jack Welch stated that Six Sigma added $2 billion to GE’s 1999 profits of $10.7 billion—and service applications dominate profit at GE. In the May 2000 issue of Industry Week, Lou Giuliano (CEO of ITT Industries) announced increased profits of over $130 million in the second year of Lean Six Sigma implementation (based on a $12 million investment).

How Speed and Quality Are Linked

Approximately 30 to 50% of the cost in a service organization is caused by costs related to slow speed or performing rework to satisfy customer needs. The development of value calculations discussed in Chapter 4 provides the means for mathematically proving that only a fast and responsive process is capable of achieving the highest levels of quality, and that only a high-quality process can sustain high velocity.

Figure 1.1: Only Lean + Six Sigma = Lowest Cost

This figure shows the output from these calculations. The horizontal axis depicts the defect rate (the target of Six Sigma); the axis that goes into the page shows cycle time (the target of Lean).

The value of greatest interest on this chart is the vertical axis, representing costs that add no value to your product or service. The ideal state is in the lower left front corner—where costs are lowest. As you can see, reducing defects alone or reducing lead time alone bring some gains, but you can achieve the lowest cost only if you simultaneously improve both quality and speed.

Many people in service environments have heard about Six Sigma, the improvement methodology focused on achieving extraordinarily high levels of quality that has contributed well-publicized millions to the bottom line of companies like GE, Allied Signal, ITT, and Lockheed Martin. In contrast, few people outside manufacturing know much about Lean applications. Which is the problem. People hear “Lean” and automatically think “manufacturing” because that’s the way it’s always been used. In fact, Lean creates process speed (by reducing cycle time) and efficiency (minimal time, capital invested, and cost) in any process.

Like Six Sigma, Lean evolved in the manufacturing arena, but even more than Six Sigma, Lean sounds like it is at home only on the factory floor. Terms like batch processing, WIP, setup, workstation turnover, Pull systems, 5S’s, and Kanban have no inherent meaning for people whose job is to talk to customers, type at a computer, or coordinate services. And yet these concepts have powerful applications in services.

Here’s one example from Stanford Hospital of Lean thinking at work in a service environment: It is standard in medicine for every surgeon to specify his or her own surgical tray of instruments and supplies for any procedure. In Stanford’s cardiac surgical unit, that meant there were six different surgical trays for each type of case, one for each surgeon.

Learning to Recognize Waste

When applying Lean to a service environment, one challenge is calling something that’s accepted as “just the way work happens” by a new name: waste. All organizations need to develop Stanford’s willingness to challenge themselves: “Which of these costs contribute to improving patient outcomes?” The traditional mindset would have been, “How can we prepare each of these surgical trays most efficiently,” not “Are all these different trays really necessary?” The former mindset leads companies to do things like training staff to handle all the complexity—and completely ignore the hidden costs inherent in supporting that complexity! (See Chp 5.)

One of the central tenets of Lean Six Sigma, however, is that unnecessary complexity adds costs, time, and enormous waste. Stanford got all the surgeons to collaborate on developing a common surgical tray. Naturally, they were skeptical at first. But when pushed to examine the issue more closely, the surgeons realized that having six different trays had little impact on the quality of care provided to patients. Within the space of a few meetings, they were able to agree on a standard surgical tray.

Stanford went on to apply this simplicity principle and other Lean Six Sigma concepts throughout the hospital. The result? As noted earlier, annual material costs have dropped by $25 million.

Here is another example from the City of Fort Wayne. The transportation department has an annual budget of $2 million. Once a bid for any large expenditure was accepted, that money would get “locked up,” in their terms, inaccessible to other uses. Sounds like proper procedure, right? But what if the job came in underbudget? That would mean there was money sitting around that wasn’t needed but that the department couldn’t use for other jobs. Or say the job had cost overruns… then the city would have to scramble to find money it likely didn’t have.

The team assigned to work on this problem realized, for the first time, that there was a lot of variation between the bid price and the actual price of most jobs—ranging from about 23% below bid to 22% over. Their first step was to set a goal of having bids come in 10% of actual cost. (Was that a good target? No one knew at first! The point was that the city had never had a target before.) By Lean-ing the process (defining the flow of work and eliminating complexity) and using data to pinpoint problems, the team was able to greatly reduce the amount of variation in the bid-to-actual amounts, freeing up nearly $200,000 a year that would previously have been “locked up.”

Making the manufacturing-to-service translation

From a Lean viewpoint, the unavailability of money in a service environment is just like unavailable production capacity in a factory, with the same types of consequences. This book’s predecessor (Lean Six Sigma, pp. 57–58) showed that machine downtime coupled with variation in demand caused large amounts of work-in-process (WIP) and subsequently long delays in completing that work. In Fort Wayne, the unavailability of money had the same effect: projects whose costs varied on the high side had to remain as work-in-process (delaying completion) until the funds became available.

These examples are typical of the gains that can be achieved when Lean and Six Sigma tools are applied together in service applications.

Why Services Are Full of Waste and Ripe for Lean Six Sigma

There are three key reasons why service functions need to apply Lean Six Sigma (the following chapters go into more detail):

• Service processes are usually slow processes, which are expensive processes. Slow processes are prone to poor quality… which drives costs up… and drives down customer satisfaction and hence revenue. The result of slow processes: more than half the cost in service applications is non-value-add waste.
• Service processes are slow because there is far too much “work-in-process” (WIP), often the result of unnecessary complexity in the service/product offering. It doesn’t matter whether the WIP is reports waiting on a desk, emails in an electronic in-box, or sales orders in a database. When there is too much WIP, work can spend more than 90% of its time waiting, which doesn’t help your customers at all and, in fact, creates or inflicts substantial waste (non-value-add costs) in the process.
• In any slow process, 80% of the delay is caused by less than 20% of the activities. We only need find and improve the speed of 20% of the process steps to effect an 80% reduction in cycle time and achieve greater than 99% on-time delivery.

Does Lean Apply to You?

Lean methods and tools apply to anyone who…

• Chases information in order to complete a task (an “information shortage” in service is equivalent to material shortage in manufacturing)
• Must jump through multiple decision loops
• Is constantly interrupted when trying to complete a task
• Is engaged in expediting (of reports, purchases, materials, etc.)
• Does work in batches (collect a certain number of items requiring the same kind of work before embarking on the pertinent tasks)
• Finds work lost in the “white space” between organizational silos
• Doesn’t know what they don’t know

In short, people working in service functions typically find that most of the steps in their processes add no value to the service in their customers’ eyes. (You’ll find quantifiable proof of this in the case studies in Chapters 12 and 13.) Identify and quantify the non-value-added waste, eliminate it using Lean Six Sigma, and the results follow as the day follows the night.

This isn’t cost reduction, it’s process change

“What really irks me is that investment analysts always talk about ITT’s Value-Based Six Sigma effort, or other efforts like it, as cost reduction,” says Lou Giuliano, the CEO of ITT. “It’s not cost reduction. If you’re doing cost reduction you’re taking out people, you’re skimping here, you’re cutting back on an investment there; that’s cost reduction. This is process change. Yes, you might take out resources, whether they be capacity, dollars, people, material, whatever it is, but it’s not because you’re cutting them, it’s because you don’t need them; you’ve found a better way to get the work done.”

The Strategic Imperative of Investing in Lean Six Sigma

In manufacturing businesses, a significant investment in equipment may be required to improve labor productivity. In contrast, service operations are primarily driven by intellectual capital. According to Warren Buffett, “the best kind of investment to make is one in which a huge return results from a very small increment of invested capital” (Berkshire Hathaway, 1984).

By application of Lean Six Sigma, the numerator of the ROIC equation can be increased without increasing financial investment. At Lockheed Martin’s procurement center, for example, the key investment that enabled a reduction of 50% of procurement cost had a 5 month payback. At Stanford Hospital and Clinics, big savings came from bringing together a group of surgeons without any capital investment at all (details were provided earlier in this chapter). If Buffett likes this kind of investment, so will your shareholders.

The concept of linking Lean Six Sigma efforts to shareholder value is critically important but seldom discussed. If the link isn’t made, your organization may realize some gains, but it will be a crapshoot as to whether your investment in Lean Six Sigma will help drive your strategic goals.

To illustrate the principle of driving shareholder value, Tom Copeland, a renowned authority on business valuation whose credentials were established while a consultant to McKinsey, compiled the actual stock market value of several hundred firms (see Figure 1.2, next page), including data on their…

• Market to Book Value (vertical axis), which measures the premium that the stock market will pay for the net assets (book value) of the company. Some companies trade at 1 times, others at 6 times, their book value.
• Economic Profit (the y-axis that goes into the page), which captures the “spread” (difference) between the percent Return on Invested Capital (ROIC%) and the percent Cost of Capital (COC%), i.e., how much the percentage earned on assets exceeded the percent that could be earned if those assets were invested in a T-Bill plus some equity risk.
• Revenue Growth (horizontal axis), another key driver of shareholder value if Economic Profit is positive.

The graph in Figure 1.2, which was generated from stock market data from real companies not theoretical models, shows that ROIC—the ratio of profit to invested capital—is the strongest driver of high stock market multiples of book value (indicated by the steep rise as ROIC increases). Revenue growth is a strong second.

If Economic Profit (EP) = 0%, then the company’s ROIC% = Cost of Capital, and empirical stock market data shows that the company trades at about book value. If the ROIC% is 5% higher than its cost of capital, the company trades at 4–5 times book value. Companies that can grow at 10% or more per year with 10%EP stand a good chance of trading at 10 times their book value!

Figure 1.2: The “Value Mountain”: ROIC Drives Shareholder Value

Actual stock market data shows that improving Return on Invested Capital (ROIC) is the best way to drive shareholder value. Here:

...where invested capital is the total assets of the organization minus the current liabilities.

Thus there is huge value leverage in increasing ROIC. For this reason, all Lean Six Sigma projects should be prioritized based on their ability to contribute to ROIC% of the corporation—consistent with P&L managers’ judgment. (Chapter 4 goes into more detail on how this is accomplished.)

But does it really work? Figure 1.3 compares the performance of companies who have reached full deployment of Six Sigma or Lean Six Sigma (= 1% of the workforce is Black Belts) versus the S&P 500.

Figure 1.3: Stock Performance of Service Companies with 1% Black Belt Population

Here we see the stock performance of four Lean Six Sigma practitioners—Bank of America, First Data, Lockheed Martin, and Caterpillar—compared to S&P 500 performance.

Revenue Growth Drives Shareholder Value

Besides increasing ROIC by lowering costs and capital investment, Lean Six Sigma has an important role to play in revenue growth. This is only true for organizations or operations that earn more than their cost of capital. Here’s the basic financial argument first: As Warren Buffett says,

“The value of any business is determined by the cash inflows and outflows—discounted at an appropriate interest rate” (Berkshire Hathaway Annual Report, 1992).

This quote may sound exotic, but it really isn’t. What Buffett means is that a dollar earned next year is worth less than a dollar earned this year because of inflation. For example, if inflation is at 5%, the “discounted value” of $1.00 next year is only $0.95:

Discounted Value = $1 / (1+ .05) = $.95

A dollar earned two years from now would be $1/(1+.05)2 = $0.90, and so on. The notion of discount value is important because it affects the value of revenue growth, which must be captured as the “discounted value of growing cash flows” (yes, you may project that revenue may grow by $100,000 next year, but its real value to your organization should be represented as only $95,000 at 5% inflation). This principle is the same as the discounted value of Economic Profits.

If you are in the business of comparing potential Lean Six Sigma projects, you need to make three- to five-year projections for returns on those projects and represent them as their discounted (present) value, using best-estimate growth rates. That’s the only fair way to compare the expected return on different projects, and the only way to make sure your Lean Six Sigma projects will have the biggest impact on shareholder value. Is all revenue growth good? Remember the huge valuations of the dot.coms? Some grew at fantastic rates but generated no profit-after-tax, and hence their Economic Profits were strongly negative. If you look back at Figure 1.2, you can see that growth without Economic Profit creates no value—as you move right on the horizontal axis (= growth without profit), the curve barely rises at all, meaning little value is added.

Conclusion

Lean Six Sigma for services is about getting results rapidly. The kind of results that can be tracked to the bottom line in support of strategic objectives. The kind that leaves delighted customers wanting to do more business, that creates value for your shareholders, and that energizes employees.

What accounts for the rapid results? Lean Six Sigma incorporates Lean’s principles of speed and immediate action into the Six Sigma improvement process itself, increasing the velocity of improvement projects and hence results. Lean Six Sigma also incorporates the Six Sigma view of the evils of variation and reduces its impact on queue times. Finally, Lean Six Sigma uniquely attacks the hidden costs of complexity of your offering.

Combine Lean Six Sigma’s ability to achieve service improvements with its focus on shareholder value and you have a powerful tool for executing the CEO’s strategy, and a tactical tool for P&L managers to achieve their annual and quarterly goals. How you do that is the subject of the rest of this book.