“It was not enough to chase the cost accountants out of the plants. The problem was to chase cost accounting from

my people's minds”

~ Taiichi Ohno, Creator of the Toyota Production System

Traditional Understanding of Cost

• We need lots of data to understand cost• We need to analyze costs to the most discrete level

possible (per unit, per hour, per ton, etc.)• Technology will give us the transactional control

necessary to gather information and calculate discrete costs

• Precise discrete costs will allow us to manage costs and increase profits

Traditional Understanding of Cost

• We need lots of data to understand cost• We need to analyze costs to the most discrete level

possible (per unit, per hour, per ton, etc.)• Technology will give us the transactional control

necessary to gather information and calculate discrete costs

• Precise discrete costs will allow us to manage costs and increase profits

FALSE

FALSE

FALSE

FALSE

All of these traditional assumptions are wrong

Overhead(Fixed)

Labor(Mostly Fixed)

Materials(Mostly Variable)

Old Fashioned Cost Accounting

Output(Variable, Unpredictable)

In old fashioned cost accounting, we spend excessive amounts of non-value added timetrying to allocate these, to these.

Overhead(Fixed)

Labor(Mostly Fixed)

Materials(Mostly Variable)

Old Fashioned Cost Accounting (cont.)

Output(Variable, Unpredictable)

Since material and output are both variable, they move in tandem. If you make more coffee machines you use more parts.

Overhead(Fixed)

Labor(Mostly Fixed)

Materials(Mostly Variable)

Old Fashioned Cost Accounting (cont.)

Output(Variable, Unpredictable)

But fixed costs have nothing to do with volume.

Overhead(Fixed)

Old Fashioned Cost Accounting (cont.)Despite the fact that real estate taxes have nothing to do with volume, we develop arbitrary methods (e.g. hours worked, unit volume forecasts, etc.) to allocate these costs.

Overhead(Fixed)

Old Fashioned Cost Accounting (cont.)HOORAY, POSITIVE VARIANCE!!!!

Overhead(Fixed)

Old Fashioned Cost Accounting (cont.)Our fixed real estate costs per unit went from $1.00 to $.50. We reduced costs per unit by 100%!

Overhead(Fixed)

Old Fashioned Cost Accounting (cont.)But real estate taxes didn’t change, and we spent 50% more on material (which is now in inventory).

Overproduction

Overhead(Fixed)

Old Fashioned Cost Accounting (cont.)So what if we actually sold less than was demanded?

Overhead(Fixed)

Old Fashioned Cost Accounting (cont.)Our fixed costs per unit will increase by 100% if our volume goes down by 50%.

Inadequate or unsatisfied

demand

So what does a negative variance tell us?$US in thousands

Projected Actual

Rent $735 $735 Insurance 55 60 Property Taxes 90 90 Utilities 110 116 Supplies 53 48 Period Fixed Costs $1,043 $1,049 Labor Hours 25,600 25,856 Fixed Costs per Labor Hour $40.74 $40.57

Total Labor Hours 25,600 25,856 Units Sold 19,650 18,668 Labor Hours per Unit 1.30 1.39 Standard Burden Rate $40.74 $40.57 Burden per Unit $53.08 $56.19

Labor Hour Variance $3.34 Fixed Cost Variance ($0.22)

So what does a negative variance tell us?$US in thousands

Projected Actual

Rent $735 $735 Insurance 55 60 Property Taxes 90 90 Utilities 110 116 Supplies 53 48 Period Fixed Costs $1,043 $1,049 Labor Hours 25,600 25,856 Fixed Costs per Labor Hour $40.74 $40.57

Total Labor Hours 25,600 25,856 Units Sold 19,650 18,668 Labor Hours per Unit 1.30 1.39 Standard Burden Rate $40.74 $40.57 Burden per Unit $53.08 $56.19

Labor Hour Variance $3.34 Fixed Cost Variance ($0.22)

We didn’t sell enough units

Old fashioned cost accounting (recap)

• Cost accounting unit cost decrease:• Increase “profit” per unit• MAKE LESS MONEY

• Cost accounting unit cost increase:• We didn’t sell enough stuff (not actually a cost issue)• OR we didn’t meet demand (not actually a cost issue)

• So at the end of the day, a cost accounting department:1. Spends substantial non-value add time running computations2. Figures out how to increase paper profits by making less money3. OR, tells us that we didn’t sell enough stuff

Nearly every bad financial decision can be traced to making decisions based on calculated unit costs.

Lean Accounting Recap

• In a Just-in-Time system:• You do not overproduce (creating positive variances)• You do not underproduce (creating negative variances)

• The essence of JIT is:• Produce exactly what is needed• Delivery it exactly when it is needed• Not late• Not early• With perfect built-in quality (“jidoka”)

Finance and OperationsIn a lean business system, lean accounting can’t happen without lean operations and lean operations can’t happen without lean accounting

Lean Operations• Fixed stock inventory• Fixed WIP• Separate processing

streams• Empowered team• Kanban / 1x 1 pull• Separate operators

from ERP

Lean Accounting• No cost accounting• Value stream accounting• Material JIT• Labor / OHD % material• Simple P&L, shared

broadly• Track quality, lead-time,

problems

Lean Accounting

Lean Accounting

STANDARD PARTS MATERIAL STOCK• Replenished at consumption rate• Kanban reorder• Purchases = CGS• Easy to count

(never changes)

Lean Accounting

STANDARD IN-PROCESS STOCK (SWIP)• 1X1 production• Kanban make / wait indication• Easy to count

(never changes)

Lean Accounting

STANDARD FINISHED GOOD STORE• 1X1 replenishment• Replenish at rate of consumption• Customer demand sets pace (takt)• Kanban make/wait indicator• Line stops when store full• Easy to count (never changes)

Lean Accounting

STANDARD NUMBER OF OPERATIONS• Each processing stream has its own team• Profitability, cost measured at value stream

(not product or unit)• Labor in value stream is the payroll• Number of operations equals total cycle

time divided by demand pace (takt)

Lean Accounting

DECLINING FIXED COSTS• Reduce (don’t spread) fixed overhead• Significantly reduce your space needs• Reduce occupancy costs• Focus on improving (“leaning out”) HR,

finance, accounting, engineering, R&D

Lean Accounting

KAIZEN / CROSS TRAIN• Remove waste, remove operators from process• People are most valuable resource• Don’t lay off, reassign to an area that needs help• OR add them to your kaizen (improvements) team• AND continue to grow without adding headcount• SO increase revenue per FTE (a measure that

actually counts)

Lean Accounting

BUILT-IN QUALITY (“JIDOKA”)• Detect abnormalities• Empowered TM to stop the line (“andon”)• Get immediate help (team leader response)• Capture data (pareto) on problems• Prioritized problems for 8-step problem solving

Lean AccountingSo what do we count?

• Direct material cost and value add (sales less direct material with no stacked labor or ohd)

• Marginal costs (the cost of increasing capacity by one more)

• Team member problem solving development

• Lead-time

• On-time delivery rate

• Defects, warranty and service root causes

• Value added processing time

• Wasted time (“muda”)

• Shortages and overproduction

• Value stream profitability

• Cash cycle

• Cash in the bank!!!

What we do spend time tracking8-Step

Problem Solving Reported Work Problems (Andons)

1/1/16 – 1/31/16

“The first rule of any technology used in a business is that automation applied to an efficient operation will magnify

the efficiency. The second is that automation applied to an inefficient operation will magnify the inefficiency.”

~ Bill Gates, Founder of Microsoft

Cost Accounting and ERP1. Scheduler creates jobs

2. Inventory issue material to job

3. Operator clocks into shift

4. Operator clocks into job

5. Operator marks operation complete (5-15 ops per job)

6. Operator marks job complete

7. Operator clocks out of shift

8. ERP applies burden on basis of labor hours, snowballs in material

9. Reconcile and rework all calcsendlessly

Not adding value

Before value stream costing at PVA, our number of annual ERP transactions (each taking a minute to complete) was counted in the millions and we had

continuous problems with compliance and mistakes.

The rules of automation apply to ERP:

Before value stream costing at PVA, our number of annual ERP transactions (each taking a minute to complete) was counted in the millions and we had

continuous problems with compliance and mistakes.

• Separate man’s work from computer’s work! • Ok to have a machine (ERP) serve or

wait on a man• ERP should detect problems and

notify (e.g. no supplier confirmation)

• Don’t make man work for machine (ERP)• Systems that require monitoring• Systems that require constant input and

maintenance

New Way (Value Stream Costing)

• Material IS the information• Track material through automation and keep operators away

from computers• Apply labor and overhead as a % of material once per

month by journal entry• Books close on the 5th, no rework • GAAP compliant• More accurate

Our cost allocations are now completed once per month through a single journal entry.

New Way: Interacting with ERP

1. Open container, take kanban

2. Scan auto re-orders from supplier

3. Receive to standard inventory

Materials debits inventory when received, credits CGS when finished good ships and BOM expensed. All reordering, labor and cost allocations done in the

background by the computer.

Apply Labor and Overhead as a % of MaterialOur rate updates monthly automatically

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

100.0%

1/1/16 2/1/16 3/1/16 4/1/16 5/1/16 6/1/16 7/1/16 8/1/16 9/1/16 10/1/16 11/1/16 12/1/16

Actual Cash Labor and Overhead Percentages of Material Cost

LTM Labor % of Materials LTM Burden % of Materials

Once you remove unit cost accounting noise, our labor and overhead rates are extremely

consistent and reliable and future costs are predictable.

Inventory Roll Forward for Auditors$US in thousands

1/31/16 2/29/16 3/31/16 4/30/16 5/31/16 6/30/16 7/31/16 8/31/16 9/30/16 10/31/16 11/30/16 12/31/16 FY 2016

Prior Month LTM Materials $15,543 $15,379 $15,038 $14,916 $14,929 $14,830 $15,961 $15,437 $16,842 $17,864 $18,358 $18,201 $19,047

Priort Month LTM Labor $4,809 $4,747 $4,730 $4,706 $4,701 $4,727 $4,756 $4,791 $4,780 $4,794 $4,838 $4,862 $4,868LTM Labor % of Materials 30.9% 30.9% 31.5% 31.6% 31.5% 31.9% 29.8% 31.0% 28.4% 26.8% 26.4% 26.7% 25.6%

Prior Monthl LTM Burden $1,870 $1,855 $1,849 $1,768 $1,949 $2,037 $1,829 $2,145 $2,177 $1,823 $2,300 $2,365 $1,919LTM Burden % of Materials 12.0% 12.1% 12.3% 11.9% 13.1% 13.7% 11.5% 13.9% 12.9% 10.2% 12.5% 13.0% 10.1%

Period CGS Material $778 $1,253 $1,022 $1,694 $1,063 $2,678 $1,050 $2,465 $2,119 $2,007 $1,031 $1,887 $19,047Period CGS Labor 241 387 322 534 335 854 313 765 601 539 272 504 5,665 Period CGS Burden 94 151 126 201 139 368 120 343 274 205 129 245 2,394

MaterialBeginning $5,656 $5,786 $5,868 $6,342 $6,179 $7,021 $6,731 $7,840 $7,820 $7,194 $6,559 $6,900 $5,656Purchases 908 1,336 1,496 1,531 1,905 2,389 2,159 2,445 1,492 1,372 1,372 1,328 19,732 CGS (778) (1,253) (1,022) (1,694) (1,063) (2,678) (1,050) (2,465) (2,119) (2,007) (1,031) (1,887) (19,047) Ending $5,786 $5,868 $6,342 $6,179 $7,021 $6,731 $7,840 $7,820 $7,194 $6,559 $6,900 $6,341 $6,341

LaborBeginning 485 890 923 1,022 957 1,180 1,109 1,261 1,277 967 701 764 485 Applied 645 421 420 469 558 783 464 781 291 272 335 412 5,852 CGS (241) (387) (322) (534) (335) (854) (313) (765) (601) (539) (272) (504) (5,665) Ending $890 $923 $1,022 $957 $1,180 $1,109 $1,261 $1,277 $967 $701 $764 $672 $672

BurdenBeginning 819 346 361 399 359 489 478 485 572 440 266 363 819 Applied (379) 166 164 161 269 356 127 430 142 31 226 209 1,902 CGS (94) (151) (126) (201) (139) (368) (120) (343) (274) (205) (129) (245) (2,394) Ending $346 $361 $399 $359 $489 $478 $485 $572 $440 $266 $363 $327 $327

Total Raw & WIP InventoryMaterial $5,786 $5,868 $6,342 $6,179 $7,021 $6,731 $7,840 $7,820 $7,194 $6,559 $6,900 $6,341 $6,341Labor 890 923 1,022 957 1,180 1,109 1,261 1,277 967 701 764 672 672 Burden 346 361 399 359 489 478 485 572 440 266 363 327 327 Other 101 102 105 97 100 97 97 96 92 89 92 82 82 Reserve (200) (200) (200) (200) (200) (200) (200) (230) (240) (240) (240) (240) (240) Net Inventory $6,923 $7,054 $7,668 $7,392 $8,591 $8,216 $9,483 $9,536 $8,453 $7,375 $7,879 $7,182 $7,182Check against GL - - - - - - - - - - - - -

Labor and overhead in

inventory declines over time as process gets

leaner.

Roll forwards very easy to follow, full schedule of labor and overhead fits

on page.

Labor and overhead rates very consistent

over time, applied as a percent of

material.

Change in inventory is

simple monthly

journal entry.

Summary of Lean Accounting

• Is GAAP compliant• Values accuracy over precision• Eliminates millions of transactions with ERP• Has standard inventory (easy to count)• Visually controls operations• Makes P&L easy for operators/managers to understand• Is necessary to achieve lean operations

Box Score

Before After(Through End of 2013) (2014 - 2016)

Cash FlowCash Conversion Cycle 180 days 90 daysOperating Cash Flow Margin 6% 15%Capex Planned to Warehouse Inventory $7 million $0

OccupancySquare Footage 145,000 110,000Buildings in Use 2 1

AccountingERP Labor and Overhead Tracking Transactions >1,000,000 12Time to Issue Monthly Financial Report 10 - 15 days <5 daysAverage Number of Operator ERP Interactions per Unit >100 0Quality of Information Inconsistent margins, not useful Ability to understand mix and price impac

Where to learn more:

Jerry is available to teach a full-day course on this

topic, which is highly recommended.