In Lean Accounting, Better to Lead than React

My advice to accounting departments of lean manufacturing companies is to lead rather than react. As your company embarks on its lean transformation, begin proactively evaluating how the standard costing system is being used, especially in all operational and financial analytical practices.

The overall goal is to develop a lean management accounting system not based on standard costing.

Coming up with a plan is not difficult, as long as you understand the issues. Fortunately, these issues happen to be very common across lean manufacturing companies that use standard costing systems. Here are the primary issues that will have to be managed and some real-world examples from my experience as both a CFO and a lean accounting consultant.

Variance Analysis

A standard costing system generates rate & volume variances by design. Because standards are used to value inventory and cost of goods sold, actual variances are reported on the income statement to bring the financial statements back to actual. In a “traditional” manufacturing company these variances are often used as performance measures by operations itself, senior management and/or accounting.

Leading lean accounting practitioners understand that continuing to use variances as performance measurements in a lean manufacturing company will not work, period. Variances are designed to drive mass production manufacturing behavior – building inventory, long production runs and buying lots of raw material to get a lower price.

As a CFO, I was brought into the development of lean performance measurements by the “lean team” we hired at Bullard. This allowed me to learn why lean performance measurements are necessary and also how to relate them to financial performance. Once I learned the benefits of lean performance measurements, it was easy for me to “ignore” the variances.

Other CFOs and controllers I have worked with spend time educating senior leaders on the weaknesses of continuing to use variance analysis as performance measurements. In fact, one company’s senior leadership team created a policy where they would simply ignore the variances reported and focus efforts on understanding lean performance measurements.

Inventory Reduction

Most manufacturing companies begin their lean journey with high levels of inventory. Through the deployment of lean practices and methods, inventory will be reduced. The financial impact of inventory reduction, due to how a standard costing system operates in an ERP environment, is overhead absorption will be unfavorable (“under-absorbed”) and profitability will likely be understated for a period of time until inventory levels stabilize.

In one of my clients, the accounting team worked with operations to project the financial impact of inventory reduction over time using estimated improvement in days of inventory. After calculating this estimate, accounting converted the improvement of days of inventory into the dollar value of inventory reduction flowing through the income statement. This helped senior leaders understand the difference between operating profit and reported profit.

Decision Making

In lean manufacturing companies, continuing to use standard costing for business decision-making will create conflict and confusion throughout the organization because standard costing information drives mass production thinking. It’s also possible decision makers can draw incorrect conclusions using standard costing information in lean organizations.

Accounting must lead the company through the process of eliminating standard costing in business decision making. This may take some time depending on how ingrained standard costing information is in your company’s decision making process. This is also a learning process. Decision makers must learn how to use new information to evaluate business decisions.

The first step is to develop a lean-based decision making framework based on “lean financial thinking” principles, as opposed to standard costing. I call this framework the Economics of Lean. Jean Cunningham calls it the Lean Profit Model. The idea behind such a framework is for an organization to understand how lean works financially by linking lean principles and practices to their actual financial impact.

The next step is to begin using Plain English financial statements. Plain English financial statements are internal management reports. They are designed to show the actual revenue earned in a period and the actual costs incurred for the period being reported. All of the original lean accounting thought leaders (DeLuzio, Fiume, Solomon, Cunningham, Maskell and myself) developed Plain English-format financial statements in companies where they worked.

The final step is to incorporate capacity analysis in decision making. Improvement activities eliminate waste and the primary outcome is to create capacity. Creating capacity is creating economic value for the organization because that capacity can be utilized in many ways which will have a positive financial impact. Capacity needs to be measured and the impact of utilizing capacity incorporated into all financial analyses.

Inventory Valuation

The primary purpose of a standard costing system is to value inventory for GAAP/IFRS compliance. In most manufacturing companies with high inventory, this is the simplest and easiest way to value inventory. Most ERP systems are set up to do this, which automates the process.

inventory reduction in lean organizations creates a tremendous opportunity for accounting to move away from standard costing for inventory valuation to simpler, “leaner” methods. When inventory levels reach 30-60 days of inventory, the financial risk of inaccurate inventory valuation decreases significantly, and the risk of material misstatement of profit is reduced.

As CFO at Bullard, I was able to move away from capitalizing production costs on a part-by-part basis (using labor and overhead rates) to capitalizing production costs in total using a simple journal entry. The primary benefit of lean inventory valuation at Bullard was the elimination of unnecessary work. The time and effort of setting detailed labor and overhead rates was eliminated. The time spent analyzing, explaining, and reconciling product cost information, variances, and absorption was also eliminated.

Many other lean manufacturing organizations have moved to lean inventory valuation methods. Moving to lean inventory valuation methods is dependent of the rate of inventory reduction, so it’s best to think of this as a medium to long term objective.

This opportunity needs to be recognized by accounting early in the lean journey to develop a two-phased plan. The first phase is to simplify standard costing through the elimination of reporting transactions to fewer labor and overhead rates. The second phase is to understand the specific issues which need to be dealt with to create a lean inventory valuation methodology.

How Accounting can Lead

I mentioned earlier that accounting should lead the discussion on using a standard costing system in a lean manufacturing company. Here are 4 initial leadership steps accounting can take:

1.   Recognize it’s a company issue not an accounting issue. Information from standard costing systems is used in all areas of a manufacturing business, and for many different reasons. The entire company will have to be part of the solution.

2.    It’s a long journey not a short destination. It’s going to take time to adapt, improvise & overcome a standard costing system. Just like a Lean journey, there will be successes, and adjustments along the way. The larger the company, the longer it will take.

3.    Begin communication of the issues. The CFO needs to begin talking to senior management. The controller needs to engage lean operations management. The entire accounting function needs a continuing dialogue on this topic. Begin laying out the specific issues your company is going to face over the long run.

4.    Lean accounting practices provide a path to solutions to resolving these issues in your lean manufacturing company. Begin the lean accounting transformation.

Nick Katko was an early adopter of Lean Accounting. In the 1990’s, as CFO of Bullard, Nick implemented a complete lean management accounting system in conjunction with Bullard’s lean transformation, which included eliminating standard costing. Through this experience, he earned that existing management accounting systems and financial management practices for lean organizations must be made relevant to ensure the success of a lean strategy.

This article originally appeared in the Lean Post, the blog of the Lean Enterprise Institute. It is used with permission.