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Focusing on waste reduction can drop money to the bottom line

by Stephen Hawley Martin
for Virginia Business
May 24, 2006

One thing is true in just about any business. You get what you measure and you pay for. When people's jobs and livelihoods depend on something getting done, it almost always gets done. This means it's important to keep score in order to know precisely how the business is doing in each key area, and to hand out rewards to employees when the goals they've given are met.

That's why management might consider tying a percentage of everyone's compensation to achieving company goals relating to operating income, cash generation and revenue. In one successful business I know of, an individual could end up receiving nothing or achieve as much as 150 percent of his or her bonus percentage, depending on the results and how much of that individual's income was at risk. Those in positions that stood to have the largest impact on outcomes had the most to gain or to lose. Bonus levels as a percentage of salary ranged from 3 percent for hourly and some administrative employees to 50 percent of the CEO's compensation - with most executives above 25 percent.

William (Bill) T. Monahan, former chairman and CEO of Imation Corp., writes in a recently published book about a compensation plan he and his team implemented to get people focused on waste reduction. The idea behind it was to pay for performance - to set goals and tie the compensation of individuals to the achievement of those goals. The only question was how to do it. The first plan proved to be too complicated for people to understand. It measured EVA (economic value added) and paid bonuses based on that.

In simple terms, EVA is a way to measure economic profit that many feel is more accurate than simply looking at the bottom line, or EPS (earnings per share). In contrast to book earnings, EVA subtracts a charge for the use of all capital - equity as well as debt. So EVA deducts not just the interest on debt that everyone can see, but also an invisible charge for the use of equity capital - i.e.,shareholder funds - to recognize that shareholders also expect and deserve a return that compensates them for bearing risk. Unlike earnings per share, EVA doesn't begin to count profit until the shareholders receive a minimum acceptable return on their investment. In this way, retained earnings are no longer a free form of finance.

EVA may be an important tool for sophisticated investors to use to compare the performance of companies, but Monahan says calculating bonuses based on it was a mistake. Most people in the company did not understand EVA and how it related to their jobs and activities. What Bill and his team wanted more than anything was to have every employee doing what he could to generate or conserve cash. So the management team changed the metric from EVA to the amount of actual cash generated. This was something everyone quickly understood. As Ben Franklin wrote more than two centuries ago, a penny saved is a penny earned, so if you spent less, if you use fewer resources, you generate cash. If you increase productivity, you generate cash. If you reduce capital expense, you conserve cash. If you work only on financially sound projects, you generate cash.

Everyone in Bill's company soon got the message. If they reached their cash target, they got a bonus. This gave them clear and straightforward goals and unambiguous actions to achieve them. Yield goals varied by products based on what Bill and his team thought could and must be achieved. All people needed to do was to ask themselves questions such as: How much do I spend on supplies and materials and what waste can I eliminate? Production wasn't the only place money could be saved. In other areas of the business, people asked themselves questions such as: How much do I spend on meetings, advertising or any activity in the company that requires someone to write a check? What do I now waste that could be reused, which would mean that check wouldn't have to be written? In other words, how can I economize?

Everyone except the CEO and the CFO, who were totally corporate, had some percentage of their bonus incentive based on the performance of the business unit they were part of. The rest was based on the success of the corporation as a whole. Usually, the split was 70 percent for their business unit and 30 percent corporate. This put focus on what people could control.

This approach worked. Many factors went into the turnaround Bill wrote about in his book, but focusing everyone on waste reduction played a major role. Over a five-year period, the company went from half a billion in debt all the way to debt free and half a billion in cash. Hence the name of Bill's book is "Billion Dollar Turnaround."

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Stephen Hawley Martin is a former principal of The Martin Agency in Richmond and the author of more than half a dozen books including his newest, Lean Enterprise Leader: How to Get Things Done Without Doing It All Yourself. He is editor and publisher of The Oaklea Press, a book publishing business dedicated primarily to helping business executives increase productivity.