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The Lowdown on
Lean Accounting
BY KAREN M. KROLL
EXECUTIVE SUMMARY
LEAN MANUFACTURING PRINCIPLES FOCUS on eliminating waste
and producing only to meet customer demand. They also typically require a
company to move from a functional division of work to work cells where all
of the processes needed to manufacture a product or line occur next to
each other in sequence.
Lean manufacturing principles differ from mass production in several key ways. For
starters, the latter typically concentrates on efficiency and machine utilization, which
can lead to long run times and bloated inventory levels. “With lean, however, it’s all
about reducing waste,” says Alex Tawse, CPA, CFO of the Kaizen Institute of
America, a global management consulting company, in Austin, Texas. “The biggest
sin is to overproduce.”
Lantech Inc. shows CPAs how this can work. Before moving to a lean operation,
manufacturing a packaging machine could take up to 16 weeks, as parts moved
through nearly a dozen operations. The company kept large parts inventories, and
assemblies often sat idle while they waited to move to the next step. Not only did this
waste space, it often caused extra work as the machines would need touch-up paint,
having gotten nicked and dirty while traversing the factory.
Glossary of Terms
Hurdle rate. The rate of return a company requires before it will invest in a
product or operation. It should generally equal the company’s incremental
cost of capital.
Lead time. The amount of time a supplier requires to fill customer orders.
Typically, the shorter the time, the more efficiently the supplier is
operating.
Scrap rate. The percentage of products in a production run that fail to meet
specifications, and thus can’t be sold at full price. So, if a company has to
“scrap” 5 of every 150 products, its scrap rate is 3.3%.
Still, from its founding in 1972 until the late 1980s, Lantech’s production processes
largely were protected by patents and business grew. Then, its patents began expiring
and competition and price pressure increased. “We were having a hard time meeting
customer delivery times. We would build things partway and then put them on the
shelf, hoping we would have the right modules for actual customer orders,” says Jean
and space tied up in inventory.” (Cunningham now is the CFO of Marshfield Door
Systems in Marshfield, Wisconsin. She says she and her colleagues at Marshfield are
actively following lean accounting principles.)
To remain viable, the company went lean. Employees created work cells for each of
the four machine models it produced. Instead of having parts moving all over the
factory, a cell performed all activities needed to produce a machine in sequence in
one place. Workers were cross-trained to perform various operations, and suppliers
began delivering parts on a just-in-time basis. “Within a year, we were able to
manufacture a product—from cutting the steel to shipping it—in 15 hours,” says
Cunningham.
Why doesn’t standard cost accounting work? Under lean manufacturing some
nonfinancial measures including lead times, scrap rates and on-time deliveries show
significant improvements, yet they aren’t captured on GAAP financial statements. On
the other hand, net income usually declines—albeit temporarily—when a company
switches to lean manufacturing. That’s because as the company works through its
existing inventory, deferred labor and overhead move from the asset side of the
balance sheet to the expense section of the income statement. Even though short-
lived, the decline in net income causes concern among executives, investors and
other financial statement readers.
Given these difficulties it’s not surprising executives at Lantech and other lean
companies began looking for a better way to account for performance. “As a
company transforms itself from traditional mass production to lean manufacturing,
the ways you count, control and measure are different,” says Brian Maskell, CPA,
president of BMA Inc., a consulting firm in Cherry Hill, New Jersey.
What are the differences? When standard cost accounting was developed in the early
1900s, most companies’ cost structures consisted of 60% direct labor, 30% materials
and 10% overhead, says Orest J. Fiume, a retired vice-president of finance and
coauthor with Jean Cunningham of the book Real Numbers: Management Accounting
in a Lean Organization. Companies typically allocated overhead costs to products in
the same proportion as direct labor. “Overhead was so insignificant that even if the
allocation was incorrect, it wasn’t a big deal,” he adds.
Today, the percentage of direct labor in most manufacturing processes is somewhere
between 5% and 15%, says David Arnsdorf, president of the Alaska Manufacturers’
Association in Anchorage. So, is direct labor a good measure for applying overhead?
Arnsdorf and other lean advocates, not surprisingly, say it usually is not. Lean
proponents also view inventory differently. “Inventory is not an asset,” says Maria
Elena Stopher, manager of the national lean initiative within the National Institute of
Standards and Technology (NIST) at the U.S. Department of Commerce,
Gaithersburg, Maryland. “You have handling costs, it takes up floor space and
reduces cash flow.”
Equally important, the calculations used to value inventory usually are erroneous in
today’s environment of rapid technological change. “Historically, there’s been a bias
to overvalue inventory, because you presume it all will sell at market price,” says Jim
Womack, president of the Lean Enterprise Institute in Brookline, Massachusetts. As
lean adherents point out, products stocked in inventory often become obsolete before
the company sells them. As a result they often sell for less than market value.
Lean accounting advocates point out that the columns of variances from standard
costs, standard material usage, standard labor rates and the like that show up in
traditional financial statements make them nearly impossible for most nonfinancial
people to understand. “We underestimate the difficulty of interpreting financial
information,” says Caslavka of Landscape Structures.
Value streams cut across functional departments, so that’s why one stream can
include sales and marketing, production, design and cash collection costs. Ideally,
each employee is assigned to a single value stream, rather than being split among
several, as is traditional with most employees. “We define the value stream as best
we can,” says Maskell. Then, it’s a matter of gathering revenue and expenses for the
value stream to produce an income statement. While corporate overhead costs are
accounted for, they’re shown below the line on internal value stream reports, says
Maskell. The reason? Employees working in the value stream can’t control them.
Lantech’s experience shows how this scenario can play out. Previously, accounting
would look at the cost for each piece or work order and then add an overhead
allocation. During her tenure as Lantech’s CFO, Cunningham began reporting by
value stream as the company moved to lean manufacturing. “We tracked costs at the
product line level. I knew the revenue for the line, the material for the line, supplies
for the line, scrap for the line,” says Cunningham. With this information, managers
easily can see whether material use, scrap rates and labor costs for a product line are
moving up or down.
Inventory valuation also changes under lean accounting. Because of the focus on
producing only to meet customer demand, inventories tend to be much lower than in
traditional manufacturing operations. Thus, while the balance sheet includes a line for
inventory, valuing it may take just minutes. Lantech, for instance, completes its
yearend inventory count in several hours, says Cunningham.
In addition to making changes to their financial statements, companies that adopt lean
processes often include nonfinancial data in the statements. For instance, Caslavka of
Landscape Structures increased the level of detail on sales discounts. “Previously, we
viewed this as one undissected pool of money. Now, we’re taking a stronger look at
how we spend the dollars and the benefits we get.” For instance, the reports now
show the number of sales leads generated by different promotional discounts. (For a
comparison of traditional and lean financial statements see the exhibit.)
A PANACEA?
Is it possible lean accounting concepts are too good to be true? Even adherents
acknowledge some potential shortcomings. For starters, there’s the challenge of
accurately pricing individual products and determining profitability when CPAs
analyze performance by value stream, rather than by product.
One example: How would management decide whether to accept an order to make a
particular product for $10? First, accounting would look at the impact on the overall
value stream and determine how much material or labor costs would increase, says
Maskell.
However, if the calculations considered only the additional direct costs needed to
produce the order and excluded support functions from outside the value stream, the
company’s profitability eventually would be undermined because it failed to consider
the indirect costs. To prevent that, the company needs to determine whether the new
product will not only make money but also beat a “hurdle” rate that covers costs both
within and outside the value stream, he says. A hurdle rate refers to the return the
company requires before it will invest in a product or operation. It should generally
equal the company’s incremental cost of capital.
If practiced too rigorously, a lean approach could emphasize speed and quality almost
to the exclusion of cost concerns. For instance, machine shops that make stamped
metal parts frequently have lead times of up to several days if they haven’t applied
any lean concepts. Simply by reorganizing and better scheduling their work,
employees often can cut lead times to less than an hour. From there, decreasing them
to minutes or seconds usually means investing in new machinery. Arnsdorf says:
“You can’t just apply lean blindly. You have to look at costs. Faster isn’t always
better.”
Cheryl S. McWatters, PhD, CMA, dean of the faculty of extension at the University
of Alberta, Canada, offers another view. “After the fact you may want to know the
norm and what you spent,” she says. “Accounting information regarding variances to
budget can be a way to control employees’ performance.” For instance, if the
company’s annual budget calls for a 10% reduction in materials expenses but actual
expenses are the same as the previous year, the manager responsible will have to
account for the discrepancy.
Finally, one of the most significant concerns regarding lean accounting is whether its
principles conform to GAAP. Proponents say not only do lean financial reports meet
GAAP requirements, but they actually more closely follow the spirit of GAAP
because they’re more easily understood. “We don’t do anything that isn’t in
compliance with GAAP,” says Cunningham. “Lean accounting is simply about doing
the reporting in a way that is simpler and easier to follow.”
Lean adherents suggest a new way of looking at the numbers: Rather than
categorizing costs by department, CPAs can recommend companies organize
them by value stream, which includes everything an entity does in creating value
for a customer that it can reasonably associate with a product or product line.
When a company moves to lean accounting, CPAs usually will want to continue to
supplement the entity’s standard financial statements with additional information that
captures the related improvements rather than eliminating the statements outright.
“You can’t turn off the standard reporting system overnight,” says Fiume. “Instead,
dismantle it piece by piece as the underlying operations change. In the meanwhile,
prepare lean format financial statements on a parallel basis” to illustrate results both
ways. For a sample of hypothetical financial statements prepared according to the
traditional and lean methods, see the exhibit.
Fortunately, most financial officers find the cost information they need to prepare
lean financial statements already is available in their company accounting systems.
It’s just a matter of reformatting the data, says Tawse of the Kaizen Institute. For
instance, rather than including labor and overhead expenses in the cost of goods sold,
a lean financial statement will show materials, labor and overhead as separate line
items. That way the company will recognize labor and overhead expenses when it
incurs them rather that having them get wrapped into inventory on the balance sheet.
For more information or to order, visit www.cpa2biz.com or call the Institute at 888-
777-7077.
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