Lean Accounting and Accounting for Lean
Traditional Accounting Problems: Understanding What It Costs to Run Your Business
Often when companies implement Lean and it is not a top-down initiative we find that Finance tends to be the first barrier to the implementation. This is typically because, by traditional measures, Lean initially looks like it’s creating poor financial results. Lean uses process-focused measures that eventually provide great results.
Our goal with this chapter is not to undermine the accounting or finance profession, as the people in these roles are highly skilled and talented. While acknowledging there are rules and laws, such as internal, external, and government compliance and audits that must be followed, we need to create a different approach to accounting with Lean. It is interesting to note that many of the large accounting firms have or have had Lean consulting departments or have implemented Lean in their organizations.
Our goal with this chapter is to have the CFO begin to understand the implications that occur when Lean meets traditional accounting.
What Is Your Cost per Minute or Second in the Office, or on the Floor?
We recommend this exercise and find this is worthwhile for any company implementing Lean. People can understand the cost of waste if it is put into simple turns. It also helps to provide ROIs if companies still need them. If a company doesn’t fully understand the cost of waste, then opportunities to improve may go undetected. Finance’s new role in Lean should be to calculate the losses occurring every day in the office and on the shop floor and then take a leadership role to eliminate the waste.
Problems with Work Centers
A work center is an accounting designation given to a functional group of equipment. Operators are given a job card to record their labor against each work center in the factory and Accounting tracks the labor for each work center and compares it to the standards.
Once we set up a Lean cell, this system creates problems because we take equipment from each of these work centers to create a cell. Therefore, we often utilize equipment from five or six work centers to create just one Lean cell. This causes an immediate problem with accounting, along with the operators, as to what work center they should charge their labor.
Problems with Earned Hours
The following discussion is purposefully lengthy. The reason for this section is that this is another major conflict area with Lean. Our initial discussions with CFOs focus on cost accounting standards and how Lean treats them. The labor standard, if there is one, tends to be set based on the supervisor’s experience and day-to-day demands. We call this demonstrated capacity and we discuss it in more detail later in the book.
This cost accounting standard based on the earned hours system came to manufacturing from Frederick Taylor when he benchmarked the railroads in the mid to late 1800s and is very ingrained in companies today.
In this environment, the labor budget is set to labor standards typically based on a collection of companies in similar industries with similar processes. These are assigned for variable staffing, which is normally earned and directly tied to product volumes. The formulas include a variety of drivers, including output per person per square foot or other methods created for an area to earn hours for work performed. The formulas are derived to achieve the same goal: to determine labor hours needed so that earned labor or allocated labor dollars fluctuate and accumulate appropriately according to volume.
As the volume increases, more labor hours are earned, which may signal the need for hiring or justify overtime. If volume falls, then managers must adjust the staffing accordingly, such as proactively sending staff home early, transferring staff to another department, or reducing staff so as not to go over budget.
There is also a fixed staffing component for labor that will not be directly related to changes in volume. This can be both a blessing and a curse. If labor standards are generous and volume increases, then the department will have, in some cases, a budgetary allowance that exceeds what is truly needed. This can cause managers to manage more loosely because they know they will meet their budget. If the labor standard is inaccurate to the downside, however, the department will forever find itself justifying to management why it is over budget. This decrease in the labor standard causes the department to feel that they are continually fighting a battle to obtain adequate resources to provide the required service.
It used to be that standards were set by a time and motion study engineer. Most of these engineers have all but vanished, so standards in most companies are generally set by utilizing some sort of benchmark data. There are several companies whose sole existence is based on the selling of operational analysis (i.e., labor management reporting) reporting systems. There is always a concern with benchmark data because definitions can be interpreted differently across companies, and there may not be full transparency as to how the labor standard was created, thus the labor standard may not reflect that organization’s reality.
The Problems with Traditional Cost Accounting Standards
Cost accounting standards typically are calculated by the following equation:
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As stated earlier, cost accounting standards can be very misleading, and when utilized as metrics, can drive some crazy behaviors. There are several problems with these types of standards:
■ Who sets the standards? How do you know they are accurate?
■ How are they set? What is in the measure?
■ How often are they updated, and who is responsible to update them?
■ What exactly are we trying to measure?
■ When we use only direct labor in a standard, it can be misleading. How much indirect labor is necessary, and is it counted?
■ How and when do you define output?
■ What do we do with the standards data once you calculate and distribute it?
■ Are people really measured on the standards? Do they lose their job if they don’t meet them?
Problems with Allocating Overhead
If finance is spreading overhead by square foot (or some other method), we would argue that we will never know the true costs of the product. In Figure 3.1 we show the difference the Lean implementation made to the bottom line going from a 4% net profit to a 15% net profit for one unit (top) and then annualized with a 100-unit increase in sales. Review what it does to the overhead, which goes from 200% to 800%!
Figure 3.1 Batch versus Lean cost analysis for one unit and then annualized with 100 unit sales increase. (Source: Protzman, Charles. The Lean Practitioner's Field Book. Productivity Press.)
Another thing to consider: does it make sense for sales to discount items in the Lean environment? In the long run, all you are doing is creating artificial demand or moving the demand in sooner than needed and then discounting it. Meanwhile, it costs more labor (i.e., in overtime) to get it out the door.
For services firms, the allocation of overhead is often calculated using the concept of wrap rate. The wrap rate is the total percentage of indirect costs that are multiplied by the base direct costs to determine the final price to the customer. The key for introducing Lean in a services-based firm is to decrease the overall indirect costs, which are essentially the non-valued costs of the business. There are two main benefits to the business of introducing and driving Lean. First, the overhead rates will drop and the firm could charge more profit yet still remain competitive within the market. A second benefit is lower wrap rates will generally correlate to more wins as long as the business remains at high levels of technical and managerial competency.
Problems with the Machine Utilization Metric
When implementing Lean, machine utilization is no longer as important as it was in the good old days of batching. Depending on the cell configuration, some machines will not run all the time or, in mixed model, may not run at all while certain models are produced. The machine, which is the bottleneck, should always be running but not producing more than what we need (i.e., waste of overproduction). We define a true bottleneck as a machine that runs 24 hours a day and cannot meet TT.
Remember, people become more expensive over time whereas machines generally become less expensive over time.
Hidden Costs: The Sixth Level of Waste
This level is the waste that hides behind the obvious wastes and is difficult to see. It doesn’t show up in financial reports. Examples of hidden waste costs are as follows:
■ Cost of management—inefficient meetings and firefighting
■ Cost of setup times
■ Cost of not developing people
■ Cost of hiring any person to fill a position versus a qualified person
■ Cost of idle time and unnecessary searching
■ Cost of high attrition
■ Cost of waste built into cost accounting standards
■ Cost of expediting
■ Cost of sales lost due to existing (inefficient and non‑customer-focused) policies and systems
■ Cost of poor customer service
■ Cost of rework everywhere (first pass yield)
■ Costs associated with lack of flow and throughput time
■ Cost of layoffs and fractional labor in the office and plant
These are some of the examples of hidden costs. We could cite hundreds of hidden costs that occur each and every single day that contribute to lost profitability. If seriously pursued, eliminating the hidden wastes will positively impact the organization’s ability to grow, today and in the future.
Why Are These Costs Hidden?
The answer is because we don’t track them and have no system (financial or otherwise) in place to expose them. Firefighting becomes the norm because the root causes of the problems were never identified and fixed.
Lean Solutions
Lean and process-driven improvements are the answer to attacking the hidden wastes mentioned above. Lean is focused on managing by fact, deploying concepts that will drive elimination of waste and leveraging tools and data-driven formulas.
Once we implement Lean in an area, understanding what tasks are value-added to the customer and what it takes (the work effort based on time) to ensure the process done becomes more visible and clearer. The data is based on facts and backed up by video analysis.
It’s amazing how often we visit an area and find out they are planning on adding more space or equipment, but when we study the process and do the calculations, we discover it not necessary, and in some cases, they need less space. In the Lean environment, management should require that the Lean tools be applied prior to any requests for additional staff, space, or resources.
Lean finds other operational savings by eliminating wastes and streamlining processes in the office environment. When the overall revenue stream is targeted for improvement, we find many opportunities to improve accounts payable, accounts receivable, monthly closing, the capital allocation and budgeting process, and order entry to cash collection process. We also find improvements in the engineering design and document approval processes.
We must involve finance in the Lean teams up front; otherwise we find that it takes a series of Lean initiatives over a year or two until the transformation of Lean thinking takes hold for finance to begin to buy in. The threat is that finance can shut the Lean efforts down during those two years. Unfortunately, it is sometimes difficult with GAAP accounting principles to see a direct financial performance link to some of the Lean initiatives in the short term.
Lean accounting is different in that we put standards (i.e., standard work) in place based on data-based targets utilizing real-time metrics backed up by video analysis or floor observation. Standard work becomes the new labor standard!
The goal becomes to continually reduce the labor content (standard) over time with positive impact to quality, safety, and customer satisfaction. There is no longer a need for variance reporting if Lean is implemented properly, since this is addressed now as a real-time process-focused measure in standardized work and visual controls.
With Lean, we don’t need a published finance labor standard report a month later. We know the total labor time and takt time or required cycle time, and we can determine the proper staffing level in real time. We then put visual controls in place such as day-by-hour charts to make it immediately obvious.
When implementing Lean, another problem that surfaces is profitability. As we reduce the inventory in the system, traditional accounting statements will show a loss in profitability but cash and inventory turns increase and this becomes additional working capital. Many companies can get to a negative working-capital-days scenario, freeing up cash for growth and additional investment.
Accounting for Lean 1
In a Lean manufacturing environment, product is quickly pulled through the plant via one-piece flow, inventory levels are minimized as well as standardized, skilled labor operates multiple machines simultaneously, water spiders rotate into skilled positions as needed, and standardized materials are used to provide greater flexibility.
The overall speed of the operation is many orders of magnitude greater than a batch operation. In this environment, the traditional standard cost system and absorption accounting are not only ineffective, but may become a significant barrier to a successful Lean conversion.
Accounting for Lean is defined as follows:
■ An accounting system that provides accurate, timely, and understandable information to motivate the Lean transformation throughout the organization and improve decision-making, which leads to increased customer value, growth, profitability, and cash flow.
■ An accounting system that supports the Lean transformation by providing relevant and actionable information that enables continuous improvement at every level of the organization.
■ An accounting system that utilizes value stream costing, easy to review and understand profit and loss statements, box scores, and other straightforward means to convey performance activity.
■ An accounting system that meets the needs of all of its customers, including tax authorities, the board of directors, creditors, internal and external auditors (to ensure full compliance with all Customer and Government rules and laws), and internal customers such as manufacturing.
Lean accounting does not use traditional cost accounting standards at all. The need for earned hours disappears. Goals are set based on our future state map plans for improvement. These are derived from our demand, operations, and financial planning, which flows directly from our strategy deployment, via the strategic plan. It is then flowed throughout the organization via Hoshin planning.
Goal Deployment Planning, the Hoshin Process
We recommend the cost accounting staff work on process improvements and support the value-stream managers with improvements, information, and analysis. This often causes much concern and uneasiness for the financially focused individuals. We find that it generally takes about two to three years to get financial teams on board with the notion of standards and Lean accounting. The best use of cost accountants we ever saw was several years ago when a Rubbermaid plant converted its cost accountants to Lean project managers.
“Demonstrated Output Capacity”
We find at most companies that capacity is no longer based on any formal type of calculation, but is normally based on the supervisor’s experience. We developed a term for this phenomenon, which we call, “demonstrated output capacity.” “Demonstrated output capacity” is when companies or departments use their actual daily or weekly demonstrated output totals as a measure of what they feel they can produce and to which they subsequently schedule. This is opposite scientific methods like time and motion study, or published speeds and feeds, which would define exactly what should be produced. Ninety percent of companies we work with, including government and healthcare, initially have metrics based on “demonstrated output capacity.” Many companies use standard costs and earned hours to set and monitor their capacity and efficiency. The fallacy with this is the standards are seldom updated or are just plain wrong.
The Concept of Total Density
One of the eight Lean wastes is the waste of excess motion. One of the first concepts we advise when trying to identify wasted motion, is not to confuse motion with work. In offices this concept is revised slightly to the following: don’t confuse effort with results. Total density = work divided by motion. Not all motion is work. It is important to separate “needed motions” versus “wasted motions.”
The goal is “People Saving,” versus labor saving, at Toyota. When an automatic device is introduced it may result in a laborsaving of .9 of a person, but if the person remains, no manpower reduction has been achieved, while at the same time, significant money has been spent. Some still may call the .9 of a person laborsaving; but it is not “people saving.”
Summary
It is imperative to change the cost-management system simultaneously with the physical changes occurring in the operation; otherwise, traditional accounting practices will send misleading signals to management that might risk the entire Lean effort. This is why Lean was originally known as the Fragile Production System.
In the end, one must ask which cost system will allow for more accurate reporting of results, enhance the ability to analyze and improve operations, as well as provide proper incentive to continuously improve customer service, quality, overall cost, and inventory turns. The only answer is a Lean cost-management system supporting a Lean operation. In summary, as you embark on your Lean journey the Lean practitioner must understand and anticipate the challenges of the changing paradigms in Lean thinking that both management and workers will encounter and either embrace or contest. It is essential that there is a well-developed plan to bring all stakeholders along the journey to learn, grow, and adjust their views and practices to remove or manage barriers and propel Lean successfully forward.
Note
1. This section was contributed by Jerrold Solomon, Accounting for World Class Operations (Fort Wayne, IN: WCM Associates), 2007, Who’s Counting (Fort Wayne, IN: WCM Associates), 2003. Both books won the Shingo Prize.