Is Your Operation Both Process- and Material-Efficient? Does It Need To?
Operational efficiency has two dimensions to it: fixed asset utilization and inventory turns. A "high-low" evaluation of each of these produces a 2x2 matrix that diagnoses the strategic fit of companies and their operations.
This article touches on one of the basics of operations management and the way I find most natural and convenient to visualize and analyze - with a 2x2 of course! The two dimensions are: process efficiency and material efficiency, each on one axis.
The two dimensions of efficiency
Process efficiency is all about how well we are using our fixed assets, for example, factory utilization. Material efficiency is about how low we can go on inventory while still guaranteeing a high enough service level to customers. Increasing efficiency in either of these means that the business can keep (or grow) the top line with fewer assets (lower capital employed), thus improving ROCE (Return On Capital Employed).
The four quadrants of efficiency
Look at the picture above. Which of the quadrants resembles your operation the most?
Bottom left, the problems everywhere quadrant. Your operational efficiency is low on all fronts. Your warehouses are full of inventory (but somehow the product your customers want is missing) and the factory is running at low OEE (Overall Equipment Effectiveness), usually due to high scrap and rework. The business is short on cash and performance improvement is urgent.
Bottom right, the optimized inventory quadrant. You have inventory under control (perhaps motivated by its high value density) but factory operations are limited in their efficiency. Low OEE may be due to external factors, like demand being lower than efficient scale (leading to low line line utilization) or internal ones (leading to high scrap and rework). The former case is a strategic consequence, the latter may need correction.
Top left, the optimized production quadrant. Unit economics is very important (for example in consumer goods) and as such "the assets must sweat". In addition, customers have high product availability expectations. This leads to large inventory to both keep the lines running and to guarantee service to customers (or to avoid penalties). Oftentimes, leadership underestimates the negative impact of inventory (handling costs and especially tied capital) on ROCE and doesn't prioritize inventory optimization initiatives enough.
Top right, the operational excellence quadrant. The factory is at the right scale, has high utilization and inventory is well under control. Trade-offs between the the two kinds of efficiency are well understood and managed as part of the regular planning process. Of course, operational excellence is not all. You must be wary of not reducing complexity too much only for the sake of efficiency. Some "good complexity" is required to support growth.
Should you improve on either or both kinds of efficiency?
The answer is not a categorical yes. There are cases in which it is perfectly acceptable to not be in the operational excellence quadrant, as long as a high enough ROCE can be delivered. Efficiency is all about the Capital Empolyed part of the equation, so it makes sense to consider the Return part as well to select your target quadrant.
The problems everywhere quadrant is too inefficient. This is the only one where there is no excuse to be in. With very low asset turns, it just requires too much investment to generate revenue. Companies with significantly low asset turns than their peers, especially if operating margin is at or below par, urgently need to shift to one of the adjacent quadrants. The direction (process vs material efficiency) should be determined by analyzing which one is less constrained by external factors and which one has the highest positive impact on ROCE.
The optimized inventory and optimized production quadrants generate an acceptable level of asset turns for companies with an above average operating margin (i.e., thanks to differentiated offerings). The reason to not go for full operational excellence is usually due to external constraints that affect the whole industry (e.g., demand below efficient scale) and strategic choices (e.g., product complexity to support price point). Internal sources of inefficiency do need to be corrected, prioritized by ROCE potential and in congruency with the company's strategy (i.e., not destroying differentiation points in the effort to increase efficiency).
The operational excellence quadrant generates the highest asset turns and is necessary to compensate for a lower operating margin. The relatively low product complexity that allows for the higher efficiency is characteristic of less differentiated offerings and thus lower operating margins. The combination should deliver a ROCE on par with other players in the industry, including the ones playing with a lower efficiency but higher margin.
Efficiency is an investment
The thing to realize is that efficiency is an investment - the amount of capital investors need to put in. A return is generated from that capital. High efficiency means investors need to put in less capital, so lower returns are acceptable. This is OK for companies whose strategy is to win in the low cost, high volume space. Low efficiency requires a larger capital investment, so investors will expect a higher return. This is OK for companies whose strategy is to win with a higher margin differentiated offering. In the end, you need to pick a quadrant to that supports your target ROCE delivery, on par (or higher) with investors' expectations.