Lean Accounting and Finance
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Awhole industry has developedaround helping companies become"Lean." Books and articles have
been written, seminars have been present-ed, and consulting firms have started Leanpractices. In spite of this, most companiesthat attempt to transform themselves toLean either fail or attain only a portion ofthe benefits possible. Why is this?
Certainly the principles of Lean areeasy to agree with. No one argues that thebenefits are not worth pursuing. But aseasy as it is to agree with, the reality is thatLean is hard to do. Most people look atLean as some "manufacturing thing" andonly implement elements of it such as cellsand Kanban. Very few companies under-stand that Lean is a business strategy, not amanufacturing tactic, and are unable, orunwilling, to address changing the otheraspects of the business.
Like any strategy, in order to success-fully implement Lean, everything the com-pany does has to support it, and whateverdoesn't has to be changed. Thus, productdevelopment processes, sales terms andmarketing programs, human resource poli-cies and procedures, and accounting sys-tems have to be examined in order toinsure that they do not contain elementsthat contradict the Lean strategy. In most
companies the accounting systems, and theaccountants, tend to be the most significantbarrier to successfully implementing Lean.
Incompatible AccountingIn 1987 H. Thomas Johnson and
Robert Kaplan in their book Relevance Lost:The Rise and Fall of Management Accountingclearly stated that traditional managementaccounting was inadequate for today'senvironment. If that was true then, it is cer-tainly truer now as companies attempt toaccount for the Lean enterprise with toolsthat were developed in the early part of the20th century.
In its simplest form accounting and theinformation it produces, such as financialstatements, are nothing more than a mir-ror, which when held up to the operationsof the company gives the reflection of thoseoperations valued in dollars. Today we stilluse accounting systems based on principlessuch as absorption, standard costs, andvariance analysis which where developedto deal with operations that were based onlarge batches, long leadtimes and lots ofinventory at every stage of production.When these systems are used to accountfor operations based on flow, short lead-times, and very little inventory, the results
Lean Accounting and Financec„™‹@‰’•ž@šˆ’’™@š‹ˆ@š„’ˆN
Orest (Orry) Fiume
Target Volume 18, Number 4
that are being reported are distorted, just asa trick mirror at the carnival fun house dis-torts our image when we stand in front ofit. Even worse, it's not mere distortion, butfor companies successful in reducinginventory these systems report the resultsas negative! In effect, management isbeing lied to by the traditional accountingsystems. More about this problem later.First, let's look at accounting in support ofthe Lean enterprise in its broadest sense.
The Four Dimensions of LeanAccounting
There are four dimensions of trans-forming accounting to support the Leanenvironment:
1) Transactions appropriate for the man-ufacturing practices employed
2) Performance metrics that measure theright thing and motivate the right behavior
3) Accounting processes, cost manage-ment techniques, and financial report-ing that adhere to Lean principles
4) Recognition that investment manage-ment decision making is defferent.
The first dimension is relativelystraightforward. It recognizes the fact thatplanning and control of flow/pull schedul-ing processes is simpler than that forbatch/push scheduling processes.Flow/pull processes are set up to produceto actual customer demand whereasbatch/push processes are set up to produceto a forecast. From an operational stand-point many of the mechanics of MRP sys-tems are replaced with systems, such asKanban, that are much more visual. Manyof the transactions that support MRP, suchas labor tickets and move tickets, can beeliminated. A simple principle to keep inmind is that transactions that exist in thefactory should serve an operational pur-pose. They should not exist just foraccounting.
The Right Performance MeasuresIn the second dimension, most of the
performance measures that exist in tradi-tional batch and queue operations shouldnot be used in a Lean operation. Measuressuch as direct to indirect labor ratios, laborefficiency, machine utilization, and earnedlabor dollars can lead one to make poordecisions in the Lean environment. Forexample, one of the fundamental principlesin Lean is to manufacture product to takttime, which is the rate at which customersbuy products measured in time. For exam-ple, if we operate one shift with 450 min-utes available each day and customers buy900 units per day on average, the takt timeis 30 seconds. If we can produce one unitevery 30 seconds we will satisfy the cus-tomers' demand. If we can't, we haveunhappy customers.
On the other hand, machine utilizationis geared to "reducing" the piece part costby producing as much as possible. Thebehavior this generates is to overproduce,resulting in excess inventory.
Another fundamental principle of Leanis the total elimination of waste. This prin-ciple recognizes the fact that:
PRODUCTIVITY = WEALTH
If our focus is to eliminate waste, suchas increase productivity, then many of ourmetrics should measure this. A workingdefinition of productivity is the relationshipbetween the quantity of output and thequantity of resources (input) consumed increating that output. If we get more outputwith the same level of input we have a pro-ductivity gain. Therefore, measuring pro-ductivity gains focuses on quantities, notdollars.
In our education and experience weare trained to focus on measuring things indollars, but productivity cannot improvethrough financial engineering. Only physi-cal change can influence the relationshipbetween quantities of output and quantitiesof input. Therefore, these metrics should bequantity-based and maintained wherework is done.
7Fourth Quarter 2002
In most com-
the account -
ants, tend tobe the most
Unlike the traditional metrics that arefocused on results, most metrics in theLean environment should focus on theprocess. If we focus on the process andremove non-valued activities such asunnecessary movement, excess wait time,rework, and the other "Seven Sins ofWaste," the results — improved productivi-ty — will come.
Once we recognize that many of thetraditional performance measures are inap-propriate for the Lean enterprise, the ques-tion arises, "what should we measure?" Inthis environment, some metrics are close tobeing universal — customer service, pro-ductivity, defect reduction, takt time, andcycle time. Others depend on the specificbusiness. However, it is possible to identi-fy some of the attributes of a good perform-ance measurement system, as shown inFigure 1.
Walker Systems, Inc., a Wiremoldcompany, is a good example of measuringthe process and not the people. There,when we started measuring the reasonsthat we did not meet takt time, cell by cell,we discovered that two reasons represent-ed more than 50 percent of the occur-rences, material unavailability, and un-planned downtime. The third most recur-ring reason was people-related, but wasdue to inadequate training, not inadequateeffort. Thus it too was really a manage-ment problem, not a people problem.
Lean AccountingAccounting processes, cost manage-
ment, and financial reporting are the heartof what the accounting function is involvedin day-to-day. Whenever we get involvedin discussions regarding the implementa-tion of Lean in other companies we hear allkinds of excuses why it doesn't apply tothem: They make different products, theyare bigger and more complex, they aresmaller and can't devote the resources toimprovement. In some way they are differ-ent, so it won't work there.
However, the reality is that from busi-ness to business there are more similaritiesthan differences. Whether in manufactur-ing or in service, each company has to takean order from a customer, deliver a productor service, send an invoice, and collect.Each has to purchase things, receive them,and pay for them. Each has to produce thatproduct or render that service. Each wantsto develop new products or services. Eachhas to hire and pay people. These genericbusiness processes may differ in detail fromone business to another, but they are simi-lar in attempting to do the same basic func-tions. And each is similar in containinghuge amounts of waste.
From an accounting perspective thework content of most of these processeshas a high degree of clerical activities and alow degree of analytical content. And eachis similar in that the same principles ofprocess improvement that make the factoryLean can and should be applied to them. Indoing so the work content can be changedFigure 1.
Supports the Lean strategy
Motivates the right behavior (such as, eliminate waste)
Number of metrics not excessive, so as to maintain focus
Simple and easy for people doing the work to understand; the connection between their actions and each measure is clear
Measures the process, not the people
Measures compare actual versus goals
Avoids indices, as they are not actionable
Must be timely: hourly, daily, weekly as appropriate
Displays trend lines to mark continuous improvement
Make them visual and post where everyone can see them.
8Target Volume 18, Number 4
Attributes of a Good Lean Performance Measurement System
so that less time is spent on non-valueadded clerical content and more time isdevoted to value added analytical content.This is just one of the ways the accountingfunction can contribute to the Lean trans-formation.
The traditional manufacturing envi-ronment devotes significant resources to"cost accounting," which emphasizesdetermining the cost of each product madeand trying to control costs by adhering tobudgets. In the Lean company, account-ants must take a broader view … one ofcost management. As the company tries todeliver products and services that are morecompetitive in terms of functionality, cost,quality, and delivery, cost managementfocuses on providing information regardingthe profitable use of resources in providingthese things. This broader view of costmust include cost planning in addition tocost control and cost accounting.
Cost Planning: Target Costing
Several studies have estimated theamount of a product's life cycle cost that iscommitted during the product designprocess. Results vary, but range between85-95 percent of the total life cycle costs. Inother words, everything we do day-to-day,short of redesigning the product, affectsonly 5-15 percent of life cycle costs. Andyet most product developers focus only onfit, form, and function and are blind to costsuntil near the end of the product develop-ment cycle when the accountants figure outthe "cost," add a profit to determine theselling price, and marketing decides if theycan sell it at that price. If they can't (that is,the market price is lower) the only alterna-tive is to redesign the product (which itselfis waste) or accept a lower profit.
However, incorporating target costinginto the product development process canavoid this no-win cycle. Michiharu Sakurihas described target costing as "a cost-planning tool used for controlling designspecifications and production techniques.Therefore it is oriented much more towardsmanagement and engineering rather thanaccounting."
Target costing recognizes the realitythat the old cost-plus method of pricingdied many decades ago. The market setsthe price. Instead of Cost + Profit = SellingPrice, the current reality is Selling Price -Cost = Profit. In target costing the market-ing group must identify the selling priceduring the product conception stage andthen apply the formula: Selling Price - Profit= Target Cost. The target profit is estab-lished by management and can only bechanged by management.
The target cost becomes part of theproduct specification. At every tollgate ofthe development process that cost is esti-mated. If it is above the target cost by anamount that cannot be corrected in thefuture stages of the development process,the project cannot move forward. Thus,even at the product concept stage, the costcan be estimated, and if it is not acceptable,the concept can be changed before signifi-cant resources are committed to a conceptthat will not yield an acceptable profit. Inaddition to target costing, if the companyapplies the principle of designing the man-ufacturing process concurrent with design-ing the product, life cycle costs can be sig-nificantly reduced.
Cost Control: Lean StyleIn addition to cost planning, the con-
cept of cost management includes costcontrol and cost accounting. Cost controlhas become a euphemism for cost reduc-tion, and in the Lean environment the prin-cipal method of cost reduction is by thekaizen process. This is a team-basedapproach of studying a problem and imple-menting improvements … all within a three-to five-day period. It has a bias for actionbecause it doesn't look for the perfect solu-tion, but allows for partial solutions. Aslong as some improvement is made, that'sall right. Another kaizen event will look atthat same area again and additionalimprovements will be made in the future.
The other major tool to reduce costs inthe Lean environment is a system of per-formance metrics, most of which are non-financial. The cost of waste is the mathe-
9Fourth Quarter 2002
matical product of the frequency of defectstimes the severity of them. Non-financialmeasures are aimed at reducing the fre-quency of defects. If defects can be elimi-nated then severity becomes a non-issue.
Cost AccountingIn the traditional batch and queue
environment the typical method of lookingat cost is through standard cost accounting,absorption, and variance analysis. Figure 2represents a "text book" standard cost P&L
for a company that had an increase in salesbut no increase in gross profit. In thisauthor's experience, most people do notunderstand a standard cost P&L so that thispresentation of the information is virtuallyuseless. It gives virtually no meaningfulinformation as to why sales increased butprofit didn't. Worse still, if this company'sVP of operations had convinced the CEOthat they should start implementing Leanand these were the reported results, hewould most like get an order like, "I don'tknow what you are doing, but stop it, it'skilling us." In addition to the inability of thispresentation format to provide meaningfulinformation, the mechanics of absorptionaccounting underlying it motivates thewrong behavior.
In standard cost, absorption account-ing overhead rates are set based on anoverhead spending budget and the numberof labor or machine hours expected to beincurred. Then on a month-by-monthbases overhead is "absorbed" based on theactual hours "earned." If the number ofhours earned is less that the budgetedhours, an unfavorable overhead volumevariance is created.
Although most first-line supervisorsmay not understand the ins and outs ofstandard cost accounting, they quickly learnthat unfavorable variances are bad and thatunfavorable volume variances can beavoided by creating enough hours. Thus atthe end of the month they search around tosee what parts can be made that will createthe largest number of hours, regardless ofwhat MRP or any other schedule calls for.The problem is that there is no connectionbetween hours and what the customerwants. The result — avoiding the unfavor-able variance creates excess inventory.
The other significant problem withstandard cost accounting is that it attemptsto calculate individual product costs by allo-cating overhead costs based on hours. At atime when overhead was a fraction of directlabor cost, this was appropriate. However,because of the changing profile of costs,overhead has become a multiple of directlabor cost. Overhead rates between 200percent and 400 percent of labor are notFigure 2.
This Year Last Year
Net Sales100,000 90,000
Cost of Sales:Standard Costs 48,000 45,000
Purchase Price Variance (3,000) 10,000
Material Usage Variance (2,000) 5,000
Labor Efficiency Variance 7,000 (8,000)
Labor Rate Variance (2,000) 9,000
OH Volume Variance 2,000 2,000
OH Spending Variance (2,000) 8,000
OH Efficiency Variance 16,000 (17,000)
Total Cost of Sales 64,000 54,000
Gross Profit 36,000 36,000Gross Profit as a Percent of Sales 36% 40%
10Target Volume 18, Number 4
Standard Cost Comparison: Traditional Case
unusual. As an accountant I know that theamount of overhead allocated to variousdepartments, and therefore to products, isdependant on the allocation methods Ichoose.
Choosing one method over anothercan make an individual product's cost varysignificantly. And yet most companies be-lieve they "know" their product costs — outto four decimal places — a classic case ofconfusing precision with accuracy. Howmany companies make decisions to discon-tinue a product because the accountingsystem makes it appear to be unprofitable?Or how many companies run end of quarterspecials of those products that the account-ing system reports as very profitable? If Iwere to choose different allocation meth-ods, would the decisions be different?
If the standard cost P&L is not a usefulmanagement tool, can we create some-thing that is? At Wiremold, we addressedthis issue in the early 1990s and decided touse the following principles to guide us:
-Must be usable by non-accountants-Must eliminate complexity in presenta-tion
-Must have a higher degree of assignablecosts and a lower degree of allocated costs
-Must include both financial and non-financial data
-Must motivate the right decisions.
Figure 3 shows an alternate presenta-tion for the same company displaying infor-mation about the prime costs incurred.From this presentation we can see that themanufacturing group has actually done apretty good job. Labor costs are down, asare services, supplies and scrap. Benefitcosts clearly showed up as a problem inFigure 2, so I know that I have to addressthis.
The "bottom line" as to why grossprofit did not increase as sales did, is that inour Lean implementation we have success-fully reduced inventories. This has a nega-tive impact on profits in the periods that wedo this. Inventory turns have improved, as
has cash flow, but the traditional standardcost statements lied to us. They told ussomething bad was happening.
Why is that? The item called "invento-ry" on the balance sheet is comprised of twothings. The first is the material content ofthe entire inventory. This is what's physi-cally there. The second element is deferredlabor and overhead. This represents thecost incurred to produce inventory that we
This Year Last Year +(-)%
Net Sales 100,000 90,000 11.1
Cost of Sales:Purchases 25,300 34,900 (25.7)
Inventory (Inc)/Dec: Mat'l Content 6000 (6000)Total Materials 31,300 28,900 8.3
Processing Costs:Factory Wages 11,000 11,500 (4.3)
Factory Salaries 2,100 2,000 5.0
Factory Benefits 7,000 5,000 40.0Services & Support 2,200 2,500 (12.0)
Equipment Depreciation 2,000 1,900 5.3
Scrap 2,000 4,000 (50.0)Total Processing Costs 26,300 26,900 (2.2)
Occupancy Costs:Building Depreciation 200 200 0.0
Building Services 2,200 2,000 10.0
Total Occupancy Costs 2,400 2,200 9.1
Total Manufacturing Costs 60,000 58,000 3.4
Inv, Inc/(Dec): Labor & OH Content 4,000 ( 4,000)
Cost of Sales 64,000 54,000 18.5
Gross Profit 36,000 36,000 0.0
Gross Profit as a Percent of Sales 36.0% 40.0%
(This example corresponds with that in Figure 2.)
11Fourth Quarter 2002
Lean Manufacturing Cost Summary
have not sold yet. When we do sell it thesecosts become a non-cash charge to profitsin the period it is sold.
The alternate format P&L clearlyshows this. The change in inventory hasbeen displayed separately in its two ele-ments. The material portion is nettedagainst purchases, because as we consumethe inventory we can reduce our purchases.The labor and overhead element is added tothe total manufacturing costs and there islittle, if any, offset. During the transitionperiod there is little opportunity to tem-porarily reduce overhead until we normal-ize the inventory levels since most over-head is fixed.
Some would say that since we are notreplenishing inventory at the rate it wassold during this period, we don't need all ofthe labor force. However, we must alsoinsure that our human resource policiessupport the Lean strategy. Companies thatsuccessfully implement Lean quickly learnthat most of the good ideas for productivityimprovements come from the people doingthe work. They know where the problems
are and in most cases have good ideas as tohow to correct them.
But people will not work themselvesout of a job, so in order to get significant pro-ductivity gains over the long haul the work-force must be given a qualified employmentguarantee. This generally takes the form ofa statement such as "No one will loseemployment as a result of productivitygains." Therefore through this inventorytransition period the only "relief" that can beobtained regarding labor costs is throughreduced overtime and natural attrition.What do you do with the "excess" labor?Training, kaizens, aggressive implementa-tion of the 5 Ss, insourcing from suppliers …
Cash Flow Tells the Tale
Almost anyone in accounting andfinance can follow an argument based oncash flow, and as previously mentioned;even though this company did not reportincreased profits it improved its cash posi-tion. Figure 4 shows cash generated frommanufacturing for the last two years.Because of the improvement in inventoryturns in this example, cash generated frommanufacturing improved in excess of 23percent. In order to estimate in advancethe amount of cash that can be freed upfrom inventory we believe that companiesthat successfully implement Lean should beable to double their inventory turns in twoyears and quadruple them in four years.
Investment Management The last dimension in transforming
accounting to support the Lean enterpriseis rethinking investment management. Inmost companies "investment manage-ment" makes people think of capital expen-ditures. In the Lean environment it takeson a broader definition. For example, mostcompanies don't "plan" working capital. Inthe Lean business you should, month-by-month. Improving inventory turns is notsomething that should happen at the end ofthe year so as to make the metrics lookgood. It needs to happen continuouslythroughout the year, because in addition to
This Year Last Year
Gross Profit 36,000 36,000
Equipment Depreciation 2,000 1,900
Building Depreciation 200 200
Change: Labor & OH in Inventory 4000 (4000)
Total Cash Flow from Manufacturing 42,000 34,100
12Target Volume 18, Number 4
Comparison of Cash Flow from Manufacturing
conditions, customer demand, and prod-ucts are always changing.
Therefore, in the capital justificationprocess we have to consider factors thatmay not be easily quantified. These includeimprovements in flexibility, quality,throughput, delivery, etc. In addition, in thejustification process we should allow adirect offset for a permanent reduction ininventory. After all, if a particular capitalexpenditure can lead to a permanent reduc-tion in inventory we are just trading oneasset for another. Which is better ... inven-tory that can become obsolete or damaged,or plant capacity that is flexible enough torespond to changing customer demand ona timely basis?
Communicating the ChangeWe may all agree that transforming
the value delivery process to Lean will yieldsignificant benefits and recognize that it isa business strategy and not just some man-ufacturing tactic. However we have anunavoidable earnings problem to explain.As we bring inventories down, we create anegative charge to current income. How dowe deal with that?
The answer is communication, andlots of it. We need to communicate witheach of the stakeholders in the enterprise toinsure that each one understands the bene-fits, and effect, on them. This includesemployees, unions, suppliers, and eventu-ally customers.
We need to communicate the purposesand logic of the accounting changes withauditors, banks, the board of directors, andshareholders. We need to communicatewith the auditors because changing the busi-ness and accounting systems will have aneffect on their audit plan. Waiting until theyarrive on the scene to commence the auditcan only cause confusion, and extra audithours. That can be avoided if auditors areincluded in the discussions along the way.
If we have financial covenants that arestated in conventional terms (such as work-ing capital ratio of 2 to 1) we may need tostart a dialogue with our banks to modifythem. Boards of directors and shareholders
freeing up cash, it frees up lots of space,which accelerates the Lean transformation.
In addition to working capital, theinvestment plan should consider the num-ber of people employed. We have beenconditioned to think of people as expense,since that's how we account for them. Butif we think of them as investments wechange our behavior.
In the current economic environmentmost companies certainly have placedsevere restrictions on hiring. But in goodtimes it is relatively easy to "justify" anadditional staffing position. If that positionbecomes a permanent addition to the com-pany's infrastructure then we have madean investment.
Suppose the wage and benefit cost ofthat new position is $50,000. Then over a30-year career, using an 8% discount rate,that position has a present value of$563,000. In your company, what type ofjustification do you have to go through tobuy a half-million dollar machine?
We look at people as part of our infra-structure. When we consider the lifetimecost of each person, it becomes apparentthat as we implement Lean and attritiontakes place, we have to be very reluctant toreplace that attrition. That's how the pro-ductivity gains that we achieve becomeactualized.
Becoming Lean also changes the waywe look at capital spending. The first prin-ciple is "creativity before capital." Forexample, in the traditional environmentwhen we talked about reducing machinesetup time the engineers started talkingabout how much they would have to spendto achieve it. In the kaizen environment welearned that we could reduce setup timesby 90 to 95 percent with a five-day kaizenevent with no capital spending.
We also learned that full automation isexpensive and tends to create a productionenvironment with little flexibility. However,semi-automation (letting the machine domachine work and people do people work)costs a tiny fraction of full automation, plusit creates much more flexibility. The payofffrom flexibility is great because operating
13Fourth Quarter 2002
need to be educated about the benefits ofLean and also of the short-term effect ofreducing inventories on reported profits. Ifthe short-term positive cash flow is shownside by side with the negative profit effects,the complete picture can be seen. It's pos-sible to do; I've done it.
If the company is publicly traded, com-municating with shareholders at this levelof detail may be difficult so the target audi-ence should be the analysts that follow thecompany's stock. They need to be educat-ed in Lean and helped to understand all ofits implications. And having them partici-pate in a kaizen event probably wouldn'thurt.
Get Your Accounting Team onBoard
What are the first steps to take to pre-vent the accounting team from becoming abarrier to the Lean transformation? The
first steps are education and participation.The accounting team must be included inall of the Lean education offered to operat-ing employees. And they must participatein shop floor kaizens. They cannot beallowed to opt out. Only by doing so willthey gain a full appreciation of the implica-tions of Lean on the economics of the busi-ness and on the accounting systems. In thisway they can become a full partner in thetransformation process and not justbystanders throwing hand grenades of mis-information.
Orry Fiume recently retired as vice presidentfinance and administration from TheWiremold Company.
© 2002 AME® For information on reprints, contact:Association for Manufacturing Excellence847/520-3282www.ame.org
Target Volume 18, Number 4