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Metrics from the Factory Floor
by Marie Leone

This article was first published by CFO Europe (www.cfoeurope.com), a web site published by The Economist Group, a leading business magazine written and edited specifically for senior finance who work in Europe's largest organizations.
To Read this article on CFO Europe's web site, click here: Article

Lean accounting can bring big long-term benefits in budgeting and capital planning. But a shift to new accounting philosophies can also create some short-term strains. By Marie Leone
Amid the rumbling, rhythmic sounds of machinery and the whiz and ker-plunks of production lines, CFOs have found unlikely allies. Over the last century, theories such as Walter Shewhart’s “total quality management” at Bell Telephone, George Box’s practical application of statistics at ICI, and Taiichi Ohno’s just-in-time model at Toyota turned traditional manufacturing on its head.

Today, CFOs are increasingly bringing these “lean” ideas to corporate finance, highlighting the practical differences between cost accounting and cost management, and recognising how just-in-time manufacturing reveals a building tension between the income and cash-flow statements.

First applied to the manufacturing process by James Womack in his 1990 book The Machine That Changed the World, the term ‘lean’ describes the concept of driving out waste of any kind and matching production to demand with little or no additional capital expenditure. The seeds of lean, however, were planted much earlier, first when craftsmen were supplanted by mass production, and later when machines were fitted with changeable parts to mimic the craftsmen’s customised products.

To be sure, wringing out waste and streamlining the asset conversion cycle—without increasing capex—seems like an idea most CFOs would readily embrace. But the long-term gains offered by lean processes are accompanied by short-term strains that are rarely discussed.

For example, synching just-in-time (JIT) manufacturing with standard cost accounting can prove disruptive, especially to public-company CFOs and controllers. Shareholders and analysts expect quarterly gains, and they’re easily disconcerted by the temporary losses that the lean transformation imposes on the profit-and-loss statement. “Very often the income statement is taken as gospel,” says Jean Cunningham, CFO of Lantech, a US$80m manufacturer of pallet stretch-wrapping machines based in Louisville, Kentucky. She notes, however, that “it doesn’t reflect the real-time benefits of JIT.”

Free your mind

To be clear, lean accounting is not a single technique. It’s a philosophy, a way of thinking about business, emphasises Cunningham, co-author of the 2003 book, Real Numbers: Management Accounting in a Lean Organisation. Lean accounting doesn’t require huge investments in financial software, and there’s no big plan to put in place. But it is iconoclastic. It tears down an old accounting system that was developed to accommodate batch manufacturing and track inventory value—both of which, she maintains, are immaterial measures for companies that employ continuous-flow manufacturing processes.

And proponents of lean accounting are anything but inscrutable theoreticians. On the contrary, a major goal is to clarify financial statements and give non-financial managers an unobstructed line of sight into the company. Lean advocates also vow to send CFOs and controllers to the factory, to better understand what, and how, operations managers think.

“Once a week I send my accountants out to the shop floor,” says William Funk, director of finance for the North American division of The Chamberlain Group, an Illinois-based JIT manufacturer of automatic garage-door openers. The visits help finance department employees get an accurate picture about the impact of materials management, labour routines, and overhead spending. “It’s too easy to get subsumed by accounts payable,” says Funk. “The accounting staff needs to understand the bigger picture.”

For Funk, operational language is in his job description. A divisional finance chief, Funk reports to two executives at the group level—the corporate controller and the executive vice president of operations. The dual reporting structure fosters an interdependency between finance, operations, and suppliers that’s worthwhile in itself, and it’s one that suppresses many of the impulses to play accounting games, such as booking revenue prematurely.

Costly accounting

“Traditional accounting is a post-mortem exercise” that’s not suited for a JIT environment, asserts Anand Sharma, CEO of TBM Consulting, a North Carolina-based consultancy. Too often, he bristles, accounting information arrives late, is misleading and is hardly understood by anyone outside the accounting function.

But Sharma says that CFOs who adopt lean accounting should brace themselves—they will see lower profits, temporarily. They’ll need to put a little faith in the folks on the factory floor, and in the corporate commitment to go lean.

Alan Dunn, a self-described “factory rat” for 25 years and now the president of Pasadena, California-based GDI Consulting, explains how the shift works. When a company trims inventory to prepare for the transformation to JIT manufacturing, factory overhead isn’t reduced at the same pace. It takes more time to shrink overhead costs, such as warehouse space, utility fees and salaries. The mismatch causes overhead costs to spread across lower production volumes; in a standard cost accounting environment, this creates a temporary negative variance. Only as the company moves through the lean transition does the accounting system catch up with the new, JIT manufacturing system.

The standard accounting system hides the cost of carrying inventory, says Sharma, and management has to be patient with JIT-style improvements as they ripple through the organisation. “Getting lean is a long-term goal”, he says, “and it’s not for the fainthearted.”

CFOs from some public companies, however, know first-hand that patience is not always considered a virtue by investors and analysts. When dealing with these constituents, it’s difficult to defend the lean transition, says one CFO of a mid-sized US company who asked not to be named. Despite reduced inventory and increased cash flow over a year’s time, claims the CFO, the temporary negative variances contributed to a 10% slide in the firm’s share price. While the stock has recovered, the finance chief cautions that “institutional investors are neither forgiving nor patient.”

Ban the batch

Another lean lesson is to kick the batch accounting habit. Waiting to process payables or receivables on a monthly basis mars the cash conversion cycle with late payments, slow closes, and mistakes that go undetected for weeks, insists Cunningham.

Consider the Lantech CFO’s bold decision to eliminate vendor invoices. Cunningham worked with vendors to build a daily delivery schedule that would drastically reduce Lantech’s inventory, but her efforts let loose a flood of daily invoices that overwhelmed the accounts payable department.

So Cunningham wiped them away—the invoices, that is. Because Lantech’s purchasing department negotiates price and terms in advance, the CFO approved weekly payments to suppliers without an invoice paper trail.

Bob Kaiser, CFO of Hi-Tec Sports USA, a $150m manufacturer of athletic footwear, found another way to link his physical supply chain with his financial supply chain. Kaiser electronically linked his factory floor with the finance department using a web-based middleman called TradeCard, which is provided on an application service provider (ASP) model.

According to Kaiser, the just-in-time cash management tool wiped out the reams of paper—purchase and shipping orders, supplier acknowledgements and currency transfer documents—that were used to track and facilitate transactions. And TradeCard provided him with complete transparency into the overall supply chain, from the purchase of boot leather, to the factory floor, to the freight forwarder, to the store shelf, and back into accounts receivable.

Hi-Tec had been under tremendous pressure, says Kaiser, from customers who were asking for more-frequent shipments of smaller quantities. In other words, retail shoe outlets had embarked on their own just-in-time campaigns, and trimmed-down shipments would help them reduce inventory and boost cash flow. To satisfy those customers, Kaiser used JIT cash management to reduce the total cost of each shipment, allowing Hi-Tec to decrease the cost of delivered shoes by 20 cents per pair. Hi-Tec, in turn, could offer more flexibility in the form of smaller shipments—800 pairs rather than 3,000.

“There’s an amazing level of sophistication at our factories,” asserts Kaiser, who regularly steps out of the CFO’s office to tour Hi-Tec’s plants and leather suppliers. GDI’s Alan Dunn also counsels his clients to force the finance team to walk the factory floor. “Follow the manufacturing process to the end,” he says. “Go be a part for a day.”

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