Lean Accounting – Introduction
In the industry, Food and Beverage, we are always taking an old product and giving it a new name. This is true with Lean. Henry Ford, the father of Lean, probably called it “common sense.” Toyota called it TPS (Toyota Production System.) Someone else thought Lean was all about reducing inventory, and called it JIT (Just-In-Time.) But since the early 1900’s, no matter what we called it, it has been a philosophy of doing business that focuses on the Customer and eliminating Waste. Lean is not a fad, but a “system” for sustaining growth through all sorts of market turbulence. While fads have come and gone, Lean has been progressively getting better. More and more companies are looking to the Lean philosophy of doing business to create wealth and sustain corporate growth.
There are a number of issues that can get in the way of a successful Lean initiative. One is lack of leadership. Not having a solid Future State Implementation Plan is another reason for failure. A third deterrent to Lean is lack of passion. In my mind (and I am an accountant,) the biggest obstacle of all to a successful Lean initiative is…..Accounting!
Why Have a Lean Cost System?
Kaplan and Johnson wrote in Relevance Lost, “Corporate Management Accounting systems are inadequate for today’s environment.” (Kaplan and Johnson.1987) Business has changed dramatically since 1930. Accounting has not changed at all since that time! We need to move away from traditional Cost Accounting. “Cost Accounting is enemy number one of productivity.” (Goldratt, E. 1992. The Goal) By the time you complete the first two principles of Lean (creating Value for the Customer, and mapping the Value Stream), it is time to start thinking, “What accounting system will drive my people to make the right Lean decisions?” Certainly that system is NOT Standard, Absorption Costing!
Lean Accounting v Traditional Accounting
Standard Cost reports last year’s most representative actual cost. If that just rolls over as my goal for next year, am I going to get much better and be able to sustain growth? I don’t think so. Standard Cost gets in the way of business! Standard Cost is like a big cruise liner. It moves very slowly, it is huge, and it requires an army of people to keep it functioning. It cannot make quick turns, and it does not respond in timely fashion to changes in customer demand. What we get from a Standard cost system is mountains of inventory no one wants, mountains of reports at 3:00 am that no one reads, and a system that just cannot support the needs of Continuous Improvement on a daily (or hourly) basis.
Likewise, Absorption Costing tells us to keep all of the machines and all of the people busy making product so that we can cover our overhead. The traditional Absorption cost system was developed to accommodate making product in batches, and tracking inventory. This philosophy is totally contradictory to the Lean philosophy of ‘making one’ only when the customer ‘takes one.’ The traditional Absorption cost system encourages the building of inventory. We are encouraged to make more than the Customer wants so that we can defer the costs of those items we do not sell to the Balance Sheet as assets, thus reducing our costs in the P&L this month. This is what Jack Welch called “making-the-month.” The bottom line is this: a traditional volume-based cost system will not validate our Lean improvements.
‘Lean Beans’ in a Nutshell
All accounting data in business today arrives too late, is too complex, and is in a “language” that most non-financial people cannot understand. Lean says to keep it simple, create flow, and pull from the customer (internally as well as externally.) So why don’t we do this in Accounting?
Lean Accounting, or what I call ‘Lean Beans,’ follows these principles:
- Junk traditional Absorption Accounting
- Declare Standard Cost and Variance Analysis dead
- Keep Standard Cost only for valuing Inventory on the Balance Sheet
- Use cycle time to allocate overhead, as opposed to DLH or MH
We must get rid of Standard Cost and Absorption Accounting for managing the business. This is 1930’s thinking, when business was all labor, little material, and very little overhead. Today business is all material, very little labor, and moderate overhead. And we should be allocating that overhead based on some driver that focuses on what we want to improve. If we allocate overhead based on labor hours, the only way to reduce it is to get rid of people. If we allocate overhead based on machine hours, the only way to reduce it is to get rid of machines. However, when we allocate overhead based on cycle time, we lower our overhead by lowering our cycle time, and that is a “win-win” for everyone.
Lean Accounting is ‘Responsibility’ Accounting
In ‘Lean Beans’ we are going to do away with most allocations. Cost allocations only transfer costs from one product to another. In Lean we want to eradicate costs, not transfer costs. Cost allocation is a walnut shell game! While we reduced the cost of Product A with a new allocation, we have now increased the cost of Product B. Now, instead, let’s re-organize our business into Product Families (groups of products passing through the same machines or processes.) Then 90% to 95% of all of our costs are Direct Costs within each Product Family. This is good, as now we have made our Product Line Managers responsible / accountable for costs. We make people responsible by giving those associates in our business not just data but information that they can act upon__ and they cannot act upon ‘allocated’ costs. One of the main principles in Lean Accounting is that we will make as many costs as possible ‘direct’ costs and thus avoid allocations that only transfer costs but do not eradicate costs. One of my university students recently pointed out to me that he thought this Lean Accounting should be called “Action Accounting!”
New Set of Metrics for Lean Accounting
Lean Accounting also puts more emphasis on long-term rather than short-term goals. We will no longer reward Product Line managers for good Operating Income, but instead we will reward them for good Inventory Turns, fewer defects, and on-time delivery. If we stretch for the long-term goal, the short-term goal will come automatically. Thus our Metrics are another aspect of Accounting that is interfering with Lean. In a traditional organization, we tend to measure whatever is easy, and it’s always a financial metric. Today our business needs to measure what we want to improve, for example, Inventory Turns, Customer Service, and Productivity. Forget ROI and EVA – they’re too complex for real action! If the metric ROI is not what we believe it should be, which of the many ‘knobs’ do you turn to improve it? You don’t know. Lean tells us to keep it simple. We want measures that are simple, fit the Plan for the Future State, are mostly non-financial, motivate the right behavior, and measure processes (not people.)
Lean Accounting – The Right Choice
What will we use in place of our Standard, Absorption Cost system? We will use procedures, processes, and “management systems” that enhance and encourage the bottom line savings we get from Lean Implementation. Management Accounting can be very proactive! We are free to create any system that will drive people to do the right thing. In most Lean businesses in which I have worked, those new approaches become Target Cost and Actual Cost systems. Costs and profits don’t just happen! We plan our revenue. We should be ‘planning’ our profits. What are left in between are our targeted costs, or our ‘go-get’. We will compare these targets to our actual costs throughout the year, and look at trends rather than using standard cost variance analyses.
Rewrite the P&L
We are also going to rewrite the P&L so that operations people can understand it, and use it as a tool to make the business better! Instead of Cost of Sales as a laundry list of standard cost variances, we will give the Product Line Manager a Cost of Sales divided into three ‘check-book style’ categories that he/she can relate to: Material Costs, Processing Costs (factory wages, salaries, and benefits, services and supplies, equipment depreciation, and scrap), and Occupancy Costs (building depreciation and services.) These categories of cost will be in actual numbers that he/she can compare to last month or the targeted ‘go-get’ for this year-end.
My Financials Are Not Improving!
The financial people in companies which have been implementing Lean tell me that they don’t see much improvement in the ‘Bottom Line.’ I tell these folks that they just need to change their focus! Your company has been eliminating waste. And the biggest waste of all is the waste of Inventory. As you reduce Inventory and use existing WIP in your first year of Lean, your Income Statement will probably show a loss __ but look at the Cash Flow! And look at the available space and capacity! You will need a strategy to do something with that created cash, space, and capacity if you are going to increase Revenue and increase Operating Income.
Lean Accounting Supports Management by Value
Accountants today need to “change the way they think.” We need to lose old paradigms! We need to think in terms of processes, not transactions. We need to think Cost Management, not Cost Accounting. We need to be leading Teams, not reporting history. We are not going to go in after the war, count the dead bodies, and report that to top management. We are going to be proactive, and get into the trenches with the troops. We need to eliminate the myopic behavior created by Standard Cost, and the game-playing associated with Absorption Accounting. We need to concentrate on Managing by Value (MBV) rather than MBO. It is ‘how’ we achieve success that really counts if we want our companies to sustain growth, improve the bottom line, and remain competitive. That is “Action Accounting!” That’s real Lean Beans!
- This article was published by SME (Society for Manufacturing Engineers) March 9, 2006.