Nick Katko, senior consultant at BMA Consultants brings his expertise of years as CFO at various financial organisations to LMJ and discusses the best way of implementing lean.

A chief financial officer (CFO) is responsible for an external financial reporting system as well as an internal management accounting system. The financial reporting system is regulated by accepted accounting principles and the CFO’s responsibility is to produce GAAP-compliant financial statements. The primary reason for this is so external users of the firm’s financial statements can fairly assess and understand the company’s financial condition.

A CFO also uses a management accounting system to control business operations and to make sound financial business decisions. As a CFO, they are the architect of the company’s management accounting system. They need to design around the operating practices of their company so it meets the needs of management.

In traditional manufacturing, operations are controlled by and measured against a production plan. Inventory must also be controlled because there is so much of it, which also has a material impact on financial reporting. Business decision-making that drives improving efficiencies and absorption, as well as lowering the cost of inventory is viewed favourably.

Lean companies have a different operating control environment, almost the 100% opposite of traditional manufacturing. Lean companies control production by producing to demand and creating flow. Business decisions that drive improving the delivery of customer value and productivity will drive profitable growth.

The day the company adopts lean, the CFO faces an immediate challenge: they must be the architect of a lean accounting system to replace the current management accounting system. The functional requirement of a lean management accounting system is to drive lean forward and achieve financial success. The foundation for a lean management accounting system is the economics of lean.

The economics of lean explains the strategic aspects of making money from a lean business strategy. Lean principles, practices, and tools can be very confusing to people, and companies, without prior lean experience. The economics of lean explains how the combination of lean principles, practices, and tools change the laws of supply and demand for the company.

Lean will do two things for the company:

  • Drive it to create more value for customers;
  • Continuously improve productivity.

Creating more value for customers drives revenue growth; improving productivity drives cost management, which results in increasing profits as lean matures. The economics of lean is the mantra as the lean CFO.

 

The economics of lean

The economics of lean can be explained in basic terms of supply and demand.

Let’s look at demand first. By focusing on creating and delivering customer value, the demand for the company’s products or services increase and the company can command better prices. Financially, this means the growth rate of revenue should increase compared to historical growth rate, and should be better than industry averages.

The supply side of the equation focuses on the firm’s supply of resources. The supply of people, machines and facilities are responsible for creating and delivering customer value. By focusing on creating flow and continuous improvement, the productivity of resources will improve. Using lean practices to create flow means resources will be able to maintain productivity levels regardless of short-term fluctuations in demand. Continuous improvement practices mean the productivity of resources will achieve consistent annual improvements in productivity of 10-20%.

The financial impact of maintaining and improving the company’s resources’ productivity is the rate of increase in the cost of those resources (i.e. operating expenses) will slow down and be less than the growth rate of revenue. The difference in growth rates between revenue and costs means the company will make tons of money with lean.

Sounds easy, right? Everything about lean sounds easy, but it’s hard to do because a company is basically working against itself when it comes to becoming lean. It takes a great deal of discipline to break away from traditional thinking, daily fire-fighting, and the inertia to keep doing things the same way. It’s about human nature. The comfort of the known, the current state of business processes and all the problems that go along with them, is more acceptable than totally different business processes that obliterate the current way of thinking.

Fortunately there is a solution: measures. A key to financial success with lean is measuring based on how lean works. As for the CFO, they are the resident expert on measurements.

 

The lean CFO – key to success with lean

So where does the CFO fit into all of this? A CFO charts the financial strategy of the company. Whatever the business strategy, they need to project the financial impact of the proper execution of the strategy. They also have oversight of the management accounting system: the measures and methods that are used internally to measure how well a company is performing at any time. How they present the financial benefit of lean and how they determine how to measure it will be the determining factor of whether a company adopts lean as the business strategy or thinks of lean as part of a business strategy.

As the lean CFO, they need to understand the economics of lean so they can align the financial strategy with how lean makes a company money. The CFO needs to make the necessary changes to financial measurement and reporting systems to measure the execution of the lean business strategy. I believe this is the single most important factor preventing companies from realising the true financial potential of lean. The ability to translate the language of lean into the language of money will make it clear to everyone in the business why the proper implementation and daily execution of lean practices are necessary.

As the resident expert (and owner) of the measurements. It is very important to change the financial and operational measurement system so the measures drive lean behaviours. Traditional measures, of course, will drive traditional behaviours. That is what they are designed to do. But these traditional measures will obscure and undermine the vital changes required by the economics of lean.

If the CFO changes to a lean business strategy, they cannot account, control and measure it using the old methods. The most important contribution of the CFO is to lead these changes. To go lean, a CFO must understand how the principles of lean create the economics of lean.

 

Five lean principles

The economics of lean are based on the five principles of lean:

  • Customer value
  • Value streams
  • Flow and pull
  • Pursue perfection
  • Empower employees.

Adopting a lean business strategy means these principles become the way of life for the company. These principles permeate the entire organisation: its cultures, operating practices, and management style. Let’s take a look at how these principles impact measuring and reporting.

The number one objective of a lean business strategy is to provide value to the customers and to the markets. This requires two things. First, a company must clearly understand value from the customer’s perspective. Second, it must actually deliver the exact value the customers want. By doing both, a company will change the dynamics of its relationships between itself, its customers, and its competition. These are the reasons why measurement and reporting systems need to be changed. The CFO needs to measure how well any operation delivers customer value, at any time.

What exactly is value and how is it delivered? It’s easy to identify when you look at the products or services customers buy. These products or services must meet certain quality specifications and delivery standards. Lean companies understand value is more than just the product or service. Customer value is created every time a customer has an encounter with the company. Think of all the encounters the customers have with the company outside of the actual use of a product or service. Placing an order, receiving and paying the invoice, after-sales support, navigating a web site and the ease of talking to a person in a company. This is the reason lean companies identify, organise, and manage by value streams. The second principle of lean is working by value streams.

Value streams are not departments. A value stream is the sequence of process steps from the time a customer places an order to the time the customer receives the product or service, executed at the proper time. Value streams are the profit centres of a business. These are the reasons why measurement and management systems need to be aligned around value streams, because the only way to increase profitability is for value stream performance to improve. All financial and operational measurements must be changed to focus on the performance of value streams.

A subtle, but important, difference between value streams and business processes is value streams focus on order fulfilment: meeting customer demand and generating revenue. Business processes also meet customer demand, but they do not generate revenue. As mentioned previously, lean is a comprehensive business strategy that impacts the entire organisation, not just the factory.

The responsibility of the lean CFO is to change measurement systems so the delivery of value can be measured consistently and frequently throughout the entire business. Every business process delivers value. Value streams create and deliver value to paying customers. Internally other business processes deliver value to internal customers or other stakeholders. Every business process needs the same basic measures.

Lean companies recognise its supply of resources creates and delivers customer value. A company’s resources are its people, machines and facilities. These resources work in the value streams and other business processes. The number one objective for every value stream is to maximise the amount of time it spends on creating customer value. The primary issue is every value stream and every business process contains waste, and waste prevents value from being created.

Lean companies want every value streams to do two things very well, all the time: flow demand through the value stream as quickly as possible, and relentlessly eliminate waste. In order to accomplish these two objectives, value streams need to be able to manage flow and waste. This requires a fundamental change in the measurement of operations away from traditional cost-based measurement systems. Measuring flow and waste will result in tremendous gains in productivity. The lean CFO must move the company away from traditional cost-based measurement systems in the early stages of lean. It’s vital everyone in the organisation learns how to properly execute a lean business strategy and the best way to do this is with new measurements.

For a lean strategy to work, it means everybody, everywhere, all the time focusing on creating value.

This is the principle of empowering employees. The primary objective is for people to take action: to deliver value, improve flow, and eliminate waste. Lean measurement and management systems need to focus on actions and outcomes, not simply reporting numbers. This means these systems need to be simple and easy for everyone. The right information needs to be reported as frequently as necessary to ensure the right actions are being taken. Measurement and management systems need to be redesigned with the users in mind: every employee.

The traditional approach to measurement and management systems is to increase the dependence on ERP systems. Lean takes the opposite approach and the CFO needs to lead the company away from complex measurement systems no one understands, to lean-focused ones.

 

Wrap-up

The economics of lean form the foundation for all the changes that need to be made by the lean CFO. There is a tremendous amount of money to be made from a lean business strategy but most people can’t see this because existing measurement and management systems are not designed with lean economics in mind. The lean CFO must redesign all measurement and reporting systems to unlock the financial potential of lean.