Challenges and Results at Irving Oil
by William Lawler, Lawrence Carr, and Joseph Reny
A perfect storm of industry and other external forces was exerting intense pressure on Irving Oil to reduce costs and improve operations. For example, the economic collapse of 2008 significantly cut demand for petroleum products, creating global excess refining capacity. Moreover, environmental concerns led governments to implement more stringent vehicle fuel-efficiency standards and to intensify support for alternative energy sources, increasing the likelihood of structural changes in gasoline demand in the longer term. Irving is a privately held, profitable company with a strong, tradition-bound culture. All these factors contributed in some way to the need for a fresh perspective.
In 2008, senior management established a steering committee consisting of the three division leaders (refinery, commercial, and retail marketing) and their CFOs to oversee efforts to improve cost effectiveness. They called the program “Momentum E.” A benchmarked industry cost study showed that Irving had opportunities for improvement as compared to its peers. This led the committee to implement an initiative to eliminate $100 million of expenses, about $1 per barrel processed, by 2014 (all currency in this article is in U.S. dollars). The initial phase of Momentum E focused on the two largest expense items. An outside consulting firm was engaged to find cost savings in the purchasing activity, and an internal study group was charged with reducing outsourced professional service expenses.
These two efforts generated significant savings opportunities in the first year, but neither approach was suitable for the multitude of other annual operating expenses that, in total, were much larger than the initial two. Individually, however, neither was sufficiently large to justify the cost of either a consultant or an internal study group.
To address the myriad smaller expenses, Irving engaged our team to design and deliver a program that would drive the cost-reduction activities deep into the ranks of middle management. In addition to ambitious cost-reduction goals, the program had two critical requirements: (1) minimize disruption to managers’ jobs and (2) instill in middle management an understanding of its responsibility for sustained cost savings (in other words, change the culture).
To accomplish these goals, the team developed a workshop entitled Lean Budgeting. It was built on the existing annual budgeting process and employed a methodology that married Lean Thinking and activity-based cost analysis. The objective was to challenge managers to examine and change not only their budgets, but also the underlying processes and activity sets that drove those budgets.
The core message was that a budget is not an inanimate set of line-item costs to be attained, but rather a financial picture of a set of activities that the managers were responsible for and had the authority to change. The goal was to change processes and the related activities to reduce the cost structure, not go through a slash-and-burn, line-item, budget-cutting exercise that often creates no real progress. The company needed to become financially fit, not go on a crash diet.
It was clear from our initial discussions with top management that Irving Oil wanted to build a leaner organization. The lean model was developed by Toyota in the 1960s and was first identified as lean production in a five-year research study by the International Motor Vehicle Program at MIT (Womack, Jones, & Roos, 1990). Two follow-up studies by two of the three co-authors extended the focus far beyond lean production (Womack & Jones, 1996, 2005). To generalize their finding outside both the auto industry and production function, they expanded the definition to lean operations and sought out best-in-class lean organizations—cross-industry and cross-function worldwide. They found that leading companies have five elements in common: (1) managers understand the value they create for customers, both internal and external, in granular detail, (2) they understand how this value is delivered, not only by their processes but, more importantly, how their processes interact with all others in a systems perspective, (3) the resulting system flows with little waste due to idle resources/inventories, (4) the system is pulled by customer demand, not pushed by forecasts, and (5) this system understanding creates an environment where managers constantly improve the system. The research showed that although the five elements are each seemingly simple, sustaining the lean culture is very difficult. Like Irving, most companies want a quick fix, and building the behavior change into the work processes is the true challenge.
In the initial study, the authors conclude: “Lean production is a superior way for humans to make things. It provides better products in a wider variety at lower costs.” But the cost data presented to support this conclusion was insufficient for our needs at Irving. Numerous graphics show macro-level comparisons of various productivity metrics, such as capacity utilization, research and development (R&D) spending per unit, and hours per car. Application of the Lean Thinking model for Irving, however, required a thorough understanding of costs at the micro level for two basic reasons. First, in infrastructure-heavy industries such as refining where the majority of costs are fixed, Lean Thinking can produce idle capacity instead of expected cost saving (Kaplan, 1990). To address this, a thorough knowledge of the cost structures associated with each activity in the system must be understood. In addition, managers must realize that value-creating activities are not defined simply by a customer’s willingness to pay. They must be defined from an investor’s viewpoint. Shareholder value is created only when a customer’s willingness to pay is greater than the cost of an activity.
As a result, we needed to combine the Lean model with an activity-based costing module to help the Irving budget managers identify and eliminate nonvalue-adding activities—and expenses from their budgets. The activity-based costing (ABC) methodology was developed in the early 1980s, when it was recognized that as operations become more complex (because they are driven by consumer demands for more variety in offerings), microeconomic models for product costing were no longer adequate. Output alone no longer drove costs. The higher variety of products required different levels of activity to support individual products given the product mix. One has to look at business processes to understand the physical activities that drive costs (Cooper & Kaplan, 1988a, 1988b). The basic premise is that units of output alone do not cause costs: rather, some causal factor—called the cost driver—gives rise to the activities performed to produce the output. ABC uses this understanding of activities and cost drivers to assign indirect costs to outputs such as products and units of services, thereby producing a more accurate cost profile. In contrast to traditional cost sys¬tems that use volume measures such as labor hours or material value as a proxy to allocate indirect costs, ABC focused on how resources are consumed by the activities that produce outputs. For example, activities such as the number of moves, inspections, parts numbers, and customer-facing activities are central to developing the delivered cost of a product or service.
Although ABC was first developed as a product costing methodology, it soon became apparent that ABC might have even more value at the activity level. The technique has application beyond manufacturing: managers can gain an understanding of customer profitability by looking at such activities as the number of order changes, special requests, returns, and so on. For this workshop, the focus was not on the units of output—the cost of a barrel of refined oil—but on the activities that required the resources on each of the participants’ budgets. The enhanced base knowledge of activities and their true costs makes it possible for managers to focus on reducing the number of nonvalue-added activities or on changing the process to create more value-add.
To ensure the necessary focus on activities, the program used an interactive workshop design and a hands-on approach that required Irving managers to map the underlying activities that drove the line-item costs in their budgets. The goal was behavioral change, not academic enlightenment. All of the participants either explicitly or implicitly had budgets for their households. They understood the connections between the activities in their homes and the resulting monthly costs. With the downturn in the economy, they all had changed their activities—some by lowering thermostats, some by going out to eat less, and the like—to lower their household expenditures. We built the program around this base knowledge of ABC and made it clear that Irving Oil now was asking them to take this same thinking into their work environment.
The Lean Budgeting Program was designed to model an efficient, cost-effective process and set the tone for results Irving managers were expected to achieve. It combined online instruction and podcasts about the Lean Thinking and ABC methodologies along with scheduled online discussion and coaching. The program was rolled out to more than 125 Irving Oil budget holders—line managers with varying degrees of financial acumen. The faculty team kept the Lean Budgeting concepts simple, clear, and easy to apply and used actual Irving Oil examples to enhance familiarity and comfort for the participants. We served as coaches and facilitators, partnering closely with the business-area CFOs, who, in turn, functioned as the internal agents of the initiative, working as business partners for the participants and overseeing the program’s progress.
The Lean Budgeting Program began with a three-part, 45-minute online multimedia presentation that participants could watch from a link on their computers before the first hands-on session:
- First, a 10-minute video clip featured Mike Ashar, president and CEO of Irving Oil, discussing the environmental challenges to the refining industry and the need for cost containment. Ashar set the tone and need for the program: simply doing things the way they had always been done was not going to enable Irving Oil to remain competitive in the new and evolving environment.
- The next 30 minutes used Irving examples to illustrate Lean Thinking concepts and the ABC methodology. For example, the procurement study (mentioned above) found that Irving Oil spent just under $1 million per year in expedited freight costs for replacement-part orders. The need to expedite shipping was driven by the core Irving value of reliability—which translated into running the refinery as close to 24 hours a day, 365 days a year as possible. When a key part, such as a valve or flow controller, is shown to be operating outside control limits, it is immediately replaced with a part from inventory and the replacement is expedited. When the cost of this expedited activity, called a red flag, was fully understood, however, it became clear that not all parts had to be expedited. An experienced manager was assigned responsibility for assessing which were true red flag situations and which could be sent by standard shipping. The analysis and resulting change in activity generated a 44 percent decrease in shipping costs. We used such examples, along with household situations, to deliver the foundational knowledge of the methodology.
- The final part of the presentation established the assignment for the participants: to apply the Lean Thinking framework to identify the activities over which they had responsibility and, working with their financial support team, to discover the underlying costs of these activities in order to identify and propose opportunities for cost savings. Participants also had to identify both upstream and downstream process owners who needed to be informed of any process changes.
One week following the online presentation, we held a half-day, face-to-face session with the Irving Oil finance team to discuss program objectives, review the presentation, and clarify their roles and responsibilities as internal finance subject-matter experts and facilitators. In addition to serving as financial coaches for the operating managers, the business-unit CFOs and their staffs provided relevant accounting and cost data, a critical piece to link process changes to their impact on cost.
The budget managers were split into four groups—refinery, logistics and terminal operations, marketing, and corporate shared services—and two weeks after the multimedia presentation was available each group had a follow-up, two-hour online session with us to discuss questions and present their project ideas. Two weeks later, each group, along with their finance partners, participated in a 1½-day, face-to-face session at Irving Oil where managers made initial project presentations, followed by a Q&A discussion and proposed next steps. We closed this face-to-face session with a general discussion on the overall long-run objective of the program—budget managers continuously going through this process.
Three weeks after the face-to-face meetings, another two-hour online session was held for each group to review progress to date.
Each group made its final presentation to division and corporate managers during a half-day, face-to-face session at Irving Oil facilities. All program participants understood that these cost savings were to be embedded in the 2011 budgets that were to follow in approximately a month. The schedule in Exhibit 1 outlines the multiple steps and the very tight time line.
Given the Irving Oil mandate of minimal disruption to the work environment, the in-person classroom sessions focused only on the projects—the planned actions, projected savings, and progress. The online sessions worked effectively to deliver the program content given that our focus was to provide only the needed content and not full coverage of the methodologies. User groups then coalesced around common themes to develop and drive specific process changes. The faculty served as coaches and facilitators, working closely with the CFOs. As planned, the CFOs functioned as the internal change agents and took ownership for overseeing the progress in successive rounds.
Senior leadership also played a critical role, elevating the program’s visibility by participating in key events and ensuring it was seen as an important element of each manager’s job. The joint sessions were open for all participant comments, and the individuals learned from each other. Peer pressure was clearly evident as teams improved their analysis and presentations. Mike Ashar provided the following motivation via the video clip that was part of the Lean Budgeting online multimedia presentation:
“. . . by doing things differently and providing the cultural leadership to our people, we can achieve the $100 million expense reduction goal. I am counting on you to do your part with your peers to make sure that collectively we provide that leadership.”
A total of 61 projects were presented during the four final presentations, and were rolled into the FY 2011 budgets. Because many required initial startup investments, the projected savings for that year totaled close to $17 million but then increased to more than $30 million a year starting in 2012. The projects mirrored the lean research findings of Womack and Jones discussed previously, though only one project achieved saving from a more efficient process flow. This outcome was not surprising since Irving, like most refineries, runs its system (from crude procurement inputs to refining outputs and terminal operations to retail) based on a complex mathematical model of demand for finished products in the various markets served.
Through the years, every refinery had focused on flow through their systems, especially since a barrel of crude can now exceed $100. The single flow project came from the accounting and controlling group in the retail marketing division and focused on speeding the sale-to-cash cycle, producing a projected $10 million reduction in accounts receivable. A detailed study of the customer mix found that 20 percent of customers drove more than 80 percent of revenues and were efficiently managed through a key-account management system. The remaining 80 percent required closer oversight, and the function established a stricter set of credit conditions for these less frequent customers. The sales department was part of this study and indicated that these new conditions would have minimal impact on the top line. At an estimated cost of capital of 10 percent, this reduction would result in a savings of $1 million a year.
Most of the projects focused on the first two lean elements—understanding value created and driving efficiencies across interdependent projects. The refinery operated an internal lab, with a budget of more than $4 million, where tests were run on product quality factors such as octane across the multiple process steps within the refinery. The lab director converted his line-item budget to activities within his lab, identifying three high-level processes—in-lab, on-site, and third-party tests. He found that, in time, the reliability of the refinery technology had continuously improved but that the testing protocols had not been adjusted. Fewer lab tests were now required to maintain the same level of quality, and on-site saving in reagents and travel costs totaled more than $150,000. Charging third parties, such as shippers, for tests could save an additional $75,000 per year. The lab director stated that he was so busy overseeing all these tests that he never had the time to sit back and ask if they were really needed—that is, was his lab adding value to his internal customers?
Unlike the free-standing lab, most refinery activities that drove the budgets for the area refinery managers were highly interdependent. The refinery group quickly changed the structure of the program and arranged its 44 budget managers into six interrelated teams where members looked for savings opportunities across their budgets. Consistent with Lean Thinking principles, the refinery director was aware of the concern about a budget manager changing a process that would have negative impact either upstream or downstream.
Because the task of converting line-item refinery costs to activities was much more challenging and time-consuming than for the lab manager, these teams were asked to identify the one or two greatest savings opportunities. One of the more interesting was the security clearance activity for independent contractors. On any given day, more than 300 independent contractors work in various areas of the refinery, all of whom are subject to a thorough security screening when they enter at the multiple gates. One team observed this screening process for a number of days and found that it took on average a half-hour to clear each contractor—a total of 150 hours of lost productivity per day, 365 days a year. By designing a relatively simple system, similar to preboarding at an airport, the team proposed to cut this lost productivity in half with a conservative estimated savings of more than $600,000 per year without any negative impact on the security function, a perfect meshing of ABC and Lean Thinking.
Many of the projects across the divisions had similarities and were combined. When the accounting and controlling functions across all four divisions converted their budgets to activities, they each discovered that they spent a significant amount of time on nonvalue-adding reconciliations—averaging more than 40 percent of every eight-hour day—with a total cost close to $1 million annually. Further analysis revealed that nearly 1,000 reconciliations were conducted a month, requiring from 15 minutes to two days. The root cause of these reconciliations was simply expediency: many operating managers did not understand the Oracle financial system and minimized their administrative task time by using the miscellaneous account when entering transactions. A similar problem in other Oracle functions was identified, leading to solu¬tions that involved both an initial training program on use of the Oracle systems and a software add-on that performed a real-time query of any use of the miscellaneous account.
The Lean Budgeting program also uncovered issues of greater importance. Irving Oil had reorganized into 28 independent operating units to enable enhanced clarity on where value was created and captured within the company. In the course of identifying their activities, many of the corporate shared-service managers noted the additional cost of reporting under this new organization. For example, Corporate Tax now had to file the many tax forms associated with the fuel business in 28 localities. Treasury had to manage the multitude of accounts needed for these entities, and Accounts Payable had to track the voluminous transfers between them. In total, these transactions amounted to a significant incremental annual expense, which persuaded the corporate CFO to elevat
e the issue for top-management dis¬cussion. As a result, Irving subsequently launched a program, “Financial Effectiveness,” that is looking into the reconciliation, organizational structure, and other issues to streamline and increase the reliability of the financial operations.
One final project clearly illustrated the change in behavior that resulted from this program. Irving Oil runs an ancillary vertically integrated lubrication business, Coastal Blending and Packaging, which procures, mixes, bottles, distributes, and retails various automotive products, such as engine oil and windshield solvent. It also produces the containers. The production manager for the containers noted that one of the larger items on his relatively small budget was the carbon black used to make the distinctive black Irving Oil containers. When asked if this cost was justified by the distinctive brand value, the Coastal marketing manager answered in the negative. This is a perfect example of where there is value to the customer but not to the investor—the cost to create the value is greater than the customer’s willingness to pay. The containers are now white. Granted, it’s a minimal savings compared to other projects but one that exhibited exactly the behavior change that was the objective of the program. And, one that should help drive Irving managers to achieve the $100 million cost-reduction goal.
Linking Results to Budgets
The formal portion of the Lean Budgeting program concluded in early September 2010, with budget submissions due by October 1, 2010. Senior management made it clear to the participants and the supporting finance coaches that they expected the Lean Budgeting results to appear in the 2011 budgets. The budget holders were able to show the effects of their process changes in their forecasted budget. Linking costs to activities was starting to become a growing mindset at Irving, a sharp departure from past practice. To reinforce this principle, the CEO engaged an outside auditing firm to conduct an internal audit to ensure the Lean Budgeting commitments were reflected in the 2011 budget.
Although many view budget cuts as a necessary evil, the Irving Oil experience demonstrates that it can be accomplished with minimal pain. And, as the majority of our clients move toward virtual environments, the program design also can be replicated. This program illustrates that program content can be delivered effectively and with nominal intrusion into the workplace using online technologies.
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This article is excerpted from, “Rational expense reduction: Lean budgeting at Irving Oil,” Journal of Corporate Accounting & Finance, Volume 23, Issue 3, pages 61–69, March/April 2012. Download the full version.