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Management Strategies

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LEAN ACCOUNTING: Novel Number Crunching


A few brave finance and accounting managers are changing how they track costs to support lean manufacturing and improve decision making.
> BY DAVID DRICKHAMER

S WARY AS EXECUTIVES ARE THESE

days of anything that smacks of creative accounting, theres a quiet revolution unfolding among lean manufacturers. The idea creeping into the heads of a few radical thinkers is that the financial numbers reported should actually reflect the underlying reality of the business. Armed with more relevant information, business unit managers could then make better decisions when it came to product pricing, make-versusbuy questions, and product and customer rationalization. Falling under the general heading of lean accounting, the approach does not require any new math or tricky algorithms. But it does demand a fundamental change in perspective. Wayne Thompson, global finance manager for value stream analysis at Southco, a Concordville, Pa., company that makes latches, fasteners and hinges, offers an example of this approach to decision making. A unit of his company had an opportunity to bid on a component with a market price of $3.75. The standard accounting showed it would cost $4.61 for the unit to make and sell the product. We took a look at it and recognized that from a traditional cost accounting standpoint, this would be a loser, says Thompson. When in fact, if you go through lean processes and
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look at out-of-pocket expenses, we actually come away with a very profitable application. Material accounted for $1 with standard cost calculations, and the remainder was for labor and overhead. But because the company had the capacity to make the product on existing equipment, and because the additional labor required to run the machine was negligible, the new product would essentially cost Southco only the price of the raw material. And the difference between the price and material cost would drop to the bottom line. Southco did successfully bid for the order, and reaped a six-figure contribution to quarterly profits. Standard cost tells you that for every dollar of material you bring on, youre going to have an incremental amount of labor and spending, and thats just not true, stresses Thompson. Essentially, the lean-accounting approach treats many of the costs typically regarded as variable as fixed, depending upon available capacity and the real investments in people and equipment required. written down. If sales remain flat, lower production volumes caused by the reduction of excess inventory also increase the overhead burden on the remaining output. Lean accounting proponents argue that lean production operations simply cannot be measured in the same way that traditional batch manufacturing is. Traditional accounting methods encourage high-volume production runs that fully absorb overhead and build work-in-process and finished-goods inventory. They reflect the era in which they were developed, which was characterized by less product variety and economy-of-scale thinking. Whats more, using the information generated by traditional methods can lead to decisions that are not only wrongheaded, but tragic. A manager at an IW 500 company tells the story of a plant in one division hit by a market downturn and subseADDITIONAL READING Although lean accounting techniques have not yet crept into the accounting textbooks or college classrooms, there are an increasing number of workshops and printed resources. Here are some of the best: Practical Lean Accounting, Brian Maskell and Bruce Baggaley, Productivity Press (2004). Real Numbers, Jean E. Cunningham and Orest J. Fiume, Managing Times Press (2003). Whos Counting, Jerrold M. Solomon, WCM Associates (2003).

HE LEAN ACCOUNTING MOVEMENT WAS

born of frustration. Many manufacturers that have used the techniques championed by Toyota to reduce set-up times and convert from batch production methods to workcells and one-piece flow, dont immediately realize the results on the bottom line. In fact, during the transition, which can stretch over a number of years, net earnings take a hit as obsolete inventory is

quent lower sales volumes. This reduced overhead absorption, which increased the overhead and led to an increase in prices that reduced sales even further. Hastening this death spiral, rather than source products from this plant, which had plenty of available capacity, other business units within the division purchased parts from outside suppliers because of non-competitive transfer prices based upon standard cost plus 15%. If the products had been priced to accurately reflect the incremental cost of production, the internal customers would have paid less in-house than they did outside. Eventually, company executives chose to shut down the under-utilized plant. At heart, the lean accounting approach takes a simpler look at what goes on between the inputs and outputs of a production process, tracking costs in less-minute detail, expensing material as soon as its pulled into production, and eliminating work orders, the tracking of transactions and the reporting of variances altogether. Many manufacturing plants today rely on such activities to monitor product costs and track the value of inventory. But, lean-accounting advocates say that such procedures are inherently wasteful. Before a manufacturer can drop such activities, however, the production operation has to be far enough into lean manufacturing to be organized by value streams, a customer-centric structure that pulls together all of the fulfillment functions from order receipt to delivery. Under a lean accounting system each value stream has its own, slightly modified, profit-and-loss statement. Traditional financial statements are still needed to satisfy audi-

Everything Is A Process
extends the push to eliminate waste within companies that have embraced lean manufacturing. Just as there can be excessive transactions on the plant floor, there are unnecessary transactions, reports and sign-offs within accounting processes. In fact, as part of the transformation to a lean enterprise, the same techniques need to be applied to administrative functions to free people to work on process-improvement activities, proponents argue. This may begin with cutting the number of vendors and identifying key suppliers that can reliably deliver material and components under blanket purchase orders, thereby decreasing the overall volume of transactions. The application of lean tools to administrative functions mirrors the transition on the plant floor where batch-processing methods are replaced by multi-functional workcells that speed the flow of paper and information and reduce the amount of queue time between value-adding activities.

S THE NAME IMPLIES, LEAN ACCOUNTING

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tors and reporting requirements, but these statements arent used to run the business. The ultimate result: Accountants give up their roles as traffic cops and start providing the type of analysis and reports that make decision-making more straightforward, rather than a battle over the accuracy of the numbers. From a financial perspective, when you create a true value streamcells with all of the workcenters connected to each otherthe investment decision when youre looking at equipment is so much easier to make, says Jerry Solomon, vice president of manufacturing, Marquip Ward United, a Hunt Valley, Md., company that builds complex machinery for making corrugated paperboard. Im sitting here in my office right now, and I have a value stream map hanging on the wall, Solomon says. I know I can improve certain operations in those data boxes I have up there, but it will do me no good in getting product through the system to the customer, unless I improve this particular operation first. Such constraints are invisible in a standard printout from accounting that lists how many minutes or hours are required at each operation. Solomon even wrote a business novel, Whos Counting, that describes the transition to a lean accounting approach within a manufacturing company. The story shows, even though the concepts pique a lot of peoples interest, why its so difficult to do and why so few companies have actually made the change. First, its hard for managers to give up methods taught in business school and abandon the metrics that theyve always used to track performance. Lean accounting also has a broad impact on the organization. In addition to adoption by the accounting and finance departments, it requires buy-in from managers in engineering, purchasing, IT and customer service. Getting all of these people on board is difficult, if not impossible, without a mandate from the top. TRADITIONAL Those who have begun to change Sales $ 9,570,000 ............100.0% the way they track financials say Cost of Sales $ 6,364,758 ..............66.5% its worth the effort. If asked directly, few CEOs and even conGross Margin $ 3,205,242 ..............33.5% trollers can explain what drives all Total Adjustments $ 270,007 ................2.8% of their variances or how they are Net Manufacturing Margin $ 2,935,235 ..............30.7% calculated. But when the numbers make intuitive sense, and business Other Operating Costs $ 738,164 ................7.7% performance isnt cloaked in acNet Operating Margin $ 2,197,072 ..............23.0% counting jargon, people at all levels Total Sales Expense $ 139,358 ................1.5% can make betterand more profitabledecisions. Net Operating Margin $ 2,057,713 ..............21.5% It allows the workforce to underSG&A Expense $ 195,973 ................2.0% stand what theyre spendingi.e., Net Earnings $ 1,861,741 ..............19.5% what the input is to get a certain level of output. Then they can focus on how to do it better, Solomon says. Still, making the transition reLEAN quires some convincing. When Sales $ 9,570,000 ............100.0% looking at whether Southco can Costs make an adequate profit at a certain market price, Wayne Thompson Procurement $ 910,184 ................9.5% says they often put a standard operConversion $ 6,388,710 ..............66.8% ating income statement next to a Distribution $ 337,509 ................3.5% modified one to prove the point that a product that might not meet a Support $ 762,116 ................8.0% gross margin test can actually be Total Costs $ 8,398,519 ..............87.8% very beneficial to the bottom line. Margin $ 1,171,481 ..............12.2% People know and breathe and die by standard cost, Thompson Change in Inventory $ 690,259 ................7.2% says. They want to see it side-byNet Earnings $ 1,861,741 ..............19.5% side and look at it incrementally and see where standard cost Comparison of a traditional profit and loss statement (P&L) and a lean-accounting P&L. In this exbreaks down and where we can ample, high conversion costs reflect a capital-intensive business. The top and bottom line are the make a better decision. same in both examples. One advantage of the lean accounting P&L is that the type of costs are bro-

Plain English P&L

ken down into recognizable categories. If the company is trying to rein in procurement costs, for example, the impact of such efforts would be readily apparent on the P&L.

ddrickhamer@industryweek.com

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