Consultant Jean Cunningham explores the benefits of applying lean principles to a company’s finance.
If your company is applying lean on the shop floor, there are many compelling reasons to apply lean accounting. Lean techniques applied to company product related processes (1) dramatically reduces waste, (2) completely change how work is done, and (3) demands real data—including financial data— be communicated in an understandable and timely fashion.
As these changes proliferate in product areas, traditional financial data and reports become more ineffective and the need to apply lean principles and tools in your accounting and other back office functions grows precipitously. A lean accounting function can adjust to these new requirements and even become a valuable partner in establishing a lean enterprise.
Lean accounting is comprised of two separate parts; lean for accounting and accounting for lean.
What is lean for accounting?
Lean for accounting is the application of lean principles to accounting operations such as paying bills, closing the books, collecting money and paying taxes. By applying lean concepts, accounting can eliminate waste and create capacity enabling accounting personnel to provide higher value analytical and consulting support.
What is accounting for lean?
Accounting for lean enables –and in some ways, ensures—that financial reporting, decision-making information, and metrics are aligned with your lean strategy, and, thereby, provide the highest value and most needed information throughout the lean company. Typically, a lean company will want to eliminate the standard cost accounting modules and align the financial reporting with the value streams or product lines.
What is the benefit of applying accounting of lean?
1. Create information that is simpler to understand. This is very important in the lean culture focused on employee empowerment and involvement.
2. Greatly reduce the number of transactions. As one piece of flow is implemented, collecting transactional information on each order or item is impractical and only wastes time by the operators.
3. Focuses on customer demand to drive production rather than equipment and labour capacity. Standard cost accounting is based on internal capacity and will always encourage excess and cash consuming production.
4. Align metrics with the lean behaviours desired by increasing the number of metrics that focus on the process itself, and not only the outcome.
5. Provide the correct information for decision making. Standard cost accounting merges together variable costs with fixed costs, as well as direct costs with shared costs. Lean accounting makes access to needed information much easier.
The benefits of the five points above are not subtle. Each has high value impact on both accounting and the company at large. The mind shift in accounting to being a partner with other functions is very positive for individuals and greatly raises the value of the accounting function in the eyes of those outside of accounting. Using revised terminology enables accounting to communicate effectively across the company from the CEO to the machine operator in a meaningful way. The new focus on customer demand and decision making requirements makes reports essential and in demand.
Collectively, accounting for lean not only eliminates low value, wasteful processes and data, but turns accounting into an essential component for decision making within operations, R&D, and upper management.
What is the value of time?
Is time money? Or, is time what you make with it? The following is a story about using time wisely.
A publicly-listed company decided they wanted to engage their accounting department in the lean journey. They setup a kaizen event. For their initial kaizen, the accounting team selected the close process with a goal to reduce the time it took to close the books. The close was over 10 days at the time. The kaizen was facilitated and the team made some immediate improvements, but also created a vision of a five day close and developed a detail plan that would take 12 months to execute.
It has now been 12 months and they did in fact meet their goal on schedule. Secondly, they did not miss any of the deliverables.
What did five less days mean to the company?
First, the team used to spend many nights grinding it out to achieve a 10+ day close. Now, the work life balance is in alignment for the entire team and they are able to close the books in five days. Morale is up in the department.
So work/life balance, capacity for higher value work – sounds good. In the third quarter, the company, for the first time in years, beat their main competitor by releasing earnings first to the market. This was very critical because the company was then able to set the message for the industry. Their message was one of increasing market share and increasing order size.
Days later the competitor’s earnings announcement message was that it was “a tough economy”. If the company had not issued first, their stock performance would have been tainted by the other company’s news. But instead they were able to set the mark.
Nothing makes the whole business cycle work like getting the money for the products and services you provided. Yet, many companies that have made huge strides in the manufacturing area, have not used the lean tools so effective at the shop floor, to shorten the collection time of money.
At a kaizen event, the perfect days’ sales outstanding (DSO: A measure of the average number of days that a company takes to collect revenue after a sale has been made. It is a measure of process optimisation for collections from a lean perspective) was calculated for each of the company’s four product lines. One of the product lines had a huge gap between the actual and the perfect. So, the kaizen team dug deeper in this area and found the root cause. A decision that had been made in earlier times and been put in place in the hopes of speeding up collections was being interpreted in a way that tied the hands of the collectors. When brought to light, it was determined that it could be changed immediately. This change affected the processing time of 30% of this Fortune 200 manufacturing company’s receivables. That will get a lot of cash in the door faster to pay bills, make the payroll, and borrow less from the bank.
Do you budget variances?
If you still use a standard cost system, do you budget for variances? In cost accounting courses at business schools, this would be a ridiculous question because the standard cost system was supposed to show the real cost of our products. If production varied from this amount, students learn that they should investigate why that would happen. Then if the variance was unfavourable, the students could expect an improvement plan. And if the variance was favourable, they could raise the bar and change the standard rates to this new level of improved method.
The real world
Sadly in the real world, it is much more common to hear of companies that budget for variances. In fact, it might be as high as 50% of the companies do this.
1. Setting standards every year is too much work. It can take weeks to figure out the new rates. In companies with lots of continuous improvement and reorganisation of the physical work, it is even more difficult to adjust rates from year to year.
2. People are used to the traditional relationships and get confused when the standards are reset. How can standard costs go from favourable variances at the end of the year, to no variances or negative variances at the beginning of the next year, just because the standards are reset? What does it mean? How can anyone manage-and most managers do not have accounting background-with this sudden and bewildering new information?
3. The standards are used for pricing and no one wants to affect customer prices. Perhaps a company has been really successful with their lean efforts and really doesn’t want to drop the prices of their products. So, what happens? In the end, all the systems use the standards plus some adder factor to set the prices.
4. Managers know their company is producing far under capacity, and they don’t want the standards to go up so high to absorb all the existing fixed costs.
Given the potential confusion and irrational workarounds, a better question might be, why have a standard cost system at all? For some companies, this question is heresy. They say they need their standard cost system (1) to understand their product cost, (2) to help with product pricing, and (3) to evaluate production performance. And yet, they budget variances. A true oxymoron.
What is the alternative?
It’s what’s called plain English financial statements. They retain material cost at a bill of material level, but separate the remainder of costs between:
1. True variable cost versus near term fixed costs (which means labour is fixed for most companies)
2. Direct cost incurred specifically for a product or value stream
3. Costs that are shared across the product or value stream
All labour and overhead is treated as a period cost expressed in simple to understand language. Inventory valuation is seen as an accounting adjustment and separated from operational numbers.
The reality of lean financial statements
If a CEO was wondering how to handle a significant downturn in demand.
Firstly, no financial statement can provide the complete and final answer to this question. While one of the most important purposes of a business is to provide a financial return, the financial statement serves the purpose of providing some of the outcome feedback for decisions. It provides data for what has been; not for what is to be. What is more important for decision-making (before-the-fact thinking) is to have the information that is actually needed to assist in the evaluation stage when establishing and considering options. This is where lean financial/management statements are crucial. The lean statement provides the information needed and it reflects real world costs unlike standard cost-based statements.
One of the characteristics of the statement is it separates (1) the costs driven by volume from (2) the costs that are variable only in the medium or fixed term. This is important for making decisions regarding elastic demand and how to address it.
Standard cost systems, on the other hand, assume all manufacturing costs are fully variable. As a result of this underlying assumption, when forecasting the impact of additional sales, the profit impact is underestimated. And, when forecasting the impact of lost sales, the reduction to profit is underestimated.
For instance, if the gross margin percentage (gross margin includes both variable and fixed costs) equals 25%, that implies for every dollar of lost/gained sales, there is £0.25 of profit impact. However, if the variable margin percentage (variable margin is based only on variable costs) equals 50%, a typical relationship, then the impact of lost/gained sales is £0.50 per £1.00 of lost/gain sales. And, of course, not every product has the same relationships.
In a lean financial statement, the difference between variable margin and gross margin is clear. Additionally, the GAAP specific accounting transactions for inventory valuation are separated from actual cost elements. This provides very direct and obvious clarity for decision-making.
Harvard Business Review published an article that indicated 50% of CEO decisions are made on intuition. Maybe with lean providing hard and accurate information, the use of intuition as the primary tool can be reduced adding confidence and reliability to the decision-making process, and in all probability, bottom line profits going forward.