Month: September 2019

Lean companies organize their entire operations around value streams. The simplest definition of a value stream is all of the necessary process steps from receipt of a customer order to delivery of the order. Value streams cut across the traditional department structure. The goal of a lean business is to flow orders through their value streams as fast as possible, with the highest quality.

Most financial accounting systems are based on a traditional department structure. Accounting uses their financial accounting systems as a source of all internal financial analysis, such as departmental expense reports & profitability analysis. Accounting also uses their financial accounting systems to maintain compliance with external reporting.

For internal financial analysis, a lean organization needs to transition away from departmental-based analysis to value stream-based analysis.  This is necessary to create alignment between internal financial statements, financial management practices and value streams, which are the primary unit of organization and management in a Lean organization.

Value streams are the profit centers of a lean business. This means all internal financial information should be focused on the profit centers of the lean business. All direct value stream expenses should be assigned to value streams, and all relevant expense analyses should be at the value stream level. Analyze expenses and profitability at the value stream level. Think of expenses as the “cost of resources” and learn how value stream performance can be improved to manage these costs by using lean performance measures to link operational performance to financial performance.

Here are 3 general guidelines lean organizations  should follow for creating an effective financial management practices around a lean strategy.

The financial impact of any decision is based on the impact on total value stream profitability. Value streams are the profit centers of a lean enterprise and all financial analysis should be performed at this level.The dynamic cause and effect relationships between value stream operating performance, capacity and profitability are real and can be modeled financially.

Stop using cost allocations! Most cost allocations have a level of subjectivity in them, such as product costs in manufacturing companies. Other cost allocations are an attempt to make a fixed cost variable by linking it to units or services produced. Using rates in financial analysis is dangerous because they can make it look like costs are decreasing, when in reality they are not changing. It is critical to eliminate cost allocations and understand the relationships between operating performance, capacity and costs using problem-solving practices. This is done by creating an environment in which true root cause analysis can be conducted on cost behavior and operational solutions can be put in place to achieve the desired cost behavior.

Here is an example in manufacturing – direct labor costs. Standard costing systems assigns direct labor based on a direct labor rate & volume produced. If a manufacturing business was considering eliminating a product or product line, the financial analysis would show a “direct labor savings”, because direct labor is assumed to be variable. The reality in most companies is your full-time employees come to work every day and get paid a full day’s pay whether they produce 100 products per day or 500 products per day. Actual labor would decrease only if fewer employees were employed.

Lean Accounting Thinking is to begin to understand how costs change in a lean manufacturing company, without using cost allocations. If cost allocations are commonly used in a company’s in financial analysis, it’s time to begin migrating away from them by introducing the value stream income statement.

The lean idea that eliminating waste creates time – the time spent on waste is now available to create value (often described as “creating capacity”). Lean accounting incorporates this into financial management practices: the creation of time has no financial impact, but how the business uses that time does. A lean business can use this newly-created capacity to sell more products or services, and the financial impact will be increasing revenue without corresponding increases in costs.

Lean Material Cost Management

In lean accounting, a value stream income statement needs to show actual material cost, this and is typically defined as actual material purchased. Actual material purchased is used to align material cost to lean operating practices, so lean performance measurements can be used to do root cause analysis.

There are three operational stages for material after it enters a value stream:

1. Sold – material can be processed through the value stream and sold
2. Scrapped – material is defective and scrapped during operations
3. Stored – material can be stored as inventory, and subsequently either sold or scrapped

At the beginning of the lean journey, material in most value streams will likely be in all 3 stages. Then as quality & flow improves, the quantity of material scrapped & stored will reduce. Eventually if a company can reach 30 days of inventory, actual material cost will be what is purchased & sold within period.

As lean manufacturing operations improves quality, value stream material cost will decrease because less material is being consumed. Using a standard lean performance measure such as first time through or scrap rate, it’s not difficult to calculate the financial impact of better quality.

As lean manufacturing operations improves flow, it will also lead less material being consumed. Using a standard lean performance measure such as inventory days or inventory turns, the financial impact of inventory reduction can be calculated. This is very important to show on a value stream income statement, because the external financial statements will not show this as reducing inventory only has a balance sheet impact – improving cash.

One financial analysis accounting needs to move away from in a lean manufacturing company is simply analyzing material price. Don’t get me wrong – the logic of lowering material prices does have a positive impact of profits. But in lean manufacturing operations, material price is balanced with supplier quality, delivery & lead time.

The price of anything is a reflection of value. Lean manufacturing operations values short lead times, high quality and on time delivery from its suppliers because this type of supplier performance will increase flow, and thus increase revenue. Suppliers that provides the best overall performance with lowest price usually become preferred suppliers.

The danger of focusing financial analysis simply on lowering material prices is the only short-term solution is large volume purchases from suppliers that offer volume price discounts. But this is “anti-lean” because it increases inventory.

Lean Production Cost Management

The purpose of a value stream income statement is to analyze current value stream costs compared to current value stream performance measures to determine root cause analysis of current costs.

Actual production costs for any value stream include the labor costs for people that work in the value stream, costs to own, lease, operate and maintain machines in the value stream, a portion of the facility/factory costs and any other production cost that can be directly attributed to the operation of a value stream.

It’s important for the entire lean organization to learn & understand the relationships between value stream performance measures and actual production costs on a value stream income statement. Understanding the root causes of value stream performance measurements reveals direct insights into the current state of production costs and also what improvements can be made operationally to reduce and/or better control production costs. Let’s look at some examples.

The cost of labor & machines in any value stream can be explained by understanding value stream productivity. A typical lean productivity measure is output divided by the number resources to produce the output. The numerator “output” is usually related to revenue. The denominator “resources”  is usually based on number of people or actual hours worked by people or machines.

The primary root cause of low productivity is that the resources are spending too much time on wasteful activities, rather than the activities that generate revenue. Eliminating the waste frees up capacity, increasing revenue without a corresponding increase in costs.

On a typical value stream income statement, actual material, labor and machine costs will account for the overwhelming majority of value stream costs, possibly up to 80% of total costs. Concentrating all efforts understand the root causes of these 3 costs using lean performance measures will create very strong cost management practices.

Financial Impact of Continuous Improvement

A lean business strategy is a business growth strategy. How this strategy works can be best summarized as follows: lean practices, tools and methods are adapted to create a culture of continuous improvement, which reduces and eliminates wasteful activities, creating available capacity. Lean companies use this available capacity to create value for their customers, which increases sales without increasing the costs related to capacity, such as labor cost.

Calculating the financial impact of continuous improvement aligns the lean strategy and lean operating practices directly with the actual impact on profitability. The financial analysis is very dynamic in the fact that value stream operating performance, capacity and profitability must be analyzed simultaneously for every improvement event. Following is the standard work for performance such a financial analysis

The first step is to understand the specific operational impact of a lean improvement, which usually results in the creation of capacity (or time). There may be some direct cost savings, such as decrease in scrap or overtime, but the primary impact of most improvement events is the creation of capacity. The resulting financial analysis is based on determining how to use available capacity to grow revenue and/or making other decisions about the available capacity.

Revenue growth opportunities should be looked at in the classic marketing approach:
• Can we sell more existing products to existing customers?
• Can we develop new customers for our existing products?
• Can we develop new products for existing customers?
• Can we develop new products for new customers?

Here are some issues to consider when a company is reviewing options of revenue generation:
• What impact will lead time reduction have on your competitive position in existing markets?
• How can you position yourself against your competitors if you lead times are less that theirs?
• If lean principles are applied to the product development process, what impact will this have on generating revenue from new products?
• How much available capacity will be required in generating this revenue?

Based on the different scenarios of using the available capacity to increase revenue, a future state value stream income statement can be created to show the actual impact on value stream profitability based on each scenario.

After taking into account all sales opportunities, he next step is looking at capacity. In the area of capacity management, the focus should be reallocating available capacity created through improvement efforts.

Reallocating capacity:

• Cross train employees to create a more flexible workforce. A cross training program should be part of continuous improvement and progress measured by performance measurements
• Assign available employees to continuous improvement activities when productive activities are not available. A formal company-wide continuous improvement program should be created that identifies employees with available capacity and matches them to continuous improvement activities.
• Bring outsourced activities in-house. All outsourced production activities should be analyzed to determine if the company possesses the resources to perform these activities in-house. If the resources exist, bringing outsourced activities in house will reduce costs

The financial impact of reallocating capacity between value streams is to shift expenses between value streams. Transferring capacity to another value stream creates available capacity in that value stream, and sales scenarios must be modeled again.

Wrap Up

When a company commits to a lean strategy, the fundamentals of how the business operates will change as lean practices are put in place. How the business is controlled, what needs to be measured and the relevant information for business decisions will be different than “before lean.” Internal financial reports, financial analysis, measurements, data used to control the business and decision-making criteria all must support “Lean Thinking.”

Lean thinking requires the creation of a lean management accounting system. This is a journey, much like lean is a journey. Without a lean management accounting system, there is a no alignment between lean practices and the information company management will be receiving to understand how well the lean business is performing. Because management accounting systems are not externally regulated, they can be changed by companies. And changing management accounting systems in no way compromises external financial reporting.

The accounting function must assume leadership in creating a lean management accounting system. It’s vital to every lean company that this is created, maintained and improved, as it will provide all levels of management the relevant, timely financial and operational information needed to drive a lean business strategy forward to financial success.

External financial statements must comply with financial accounting regulations, which often times results in a disconnect between operational activities and financial results. Analysis of financial results is a necessary exercise to provide more detailed explanation to the readers of the financial statements  but does not provide much insight into how to change the future, which is what a lean strategy wants to accomplish.

To create alignment between value stream operations and financial results, it is necessary to create value stream income statements for internal use. Value stream income statements provide better insight into the root causes of cost behavior and can be used to create more predictive financial analysis when analyzing business decisions.

The “lean logic” behind a value stream income statement is based on two lean principles:

Value Streams – the definition of a value stream is the sequence of activities from order receipt to shipment that are necessary to create the product or service and deliver either the customer. Lean companies organize, manage & control by value stream. The lean accounting definition of a value stream is it is a profit center. Therefore, internally a company will  want to look at each value stream’s profitability, since each value stream can be considered a separate line of business.

Flow – the definition of flow is to move all orders as fast as possible through a value stream from receipt to shipment by employing lean practices and eliminating waste.  From a lean accounting viewpoint, the reducing the rate of flow maximizes value stream profit. The faster the flow, the more revenue will grow. Eliminating wastes controls total value stream costs. Improving flow impacts both value stream revenue and costs.

A value stream income statement is simply a different way to present the financial accounting information in a company’s general ledger that makes it relevant, timely and actionable to value streams.

Value stream income statements do not attempt assign every cost to a value stream, only the actual costs the value stream can control. Cost allocations or rate-based costs are avoided. Value stream income statements assign costs where the spending decision made or actual operating activity occurs. Value stream income statements avoid using any sort of expense allocation system or rate-based systems.

The value stream organization is the actual people, machines & resources that work in each value stream. Using value stream maps, it should not be difficult for to assign the actual direct costs to each value stream, such a labor, facility and machine costs. Actual value stream material cost is the cost of material consumed during a period, which may not match exactly with the products sold.

These principles of a value stream income statement create alignment between the flow of orders through a value stream, the flow of information through a value stream and the flow of money through a value stream. Improving the flow of money through a value stream will improve the reporting financial results over time.

Lean companies recognize that optimization of the entire value stream flow is the primary goal of lean operating practices, tools and methods, and this goal must take precedence against all departmental goals. When it comes to measuring operating performance, lean companies employ a different philosophy than traditional measurement systems: understand the present to change the future. This forms the basis for making improvements. Improving future performance to better serve customers will require specific actions and changes to current operational activities.

Traditional measurements have two common characteristics – they are financially based and developed around the vertical structure of the organization. Financially based measurements (any numbers with dollar signs in front of them) are automatically backward- looking. Sure, the root cause could be identified, but there’s nothing that can be done to change the outcome, because it’s already happened. In traditional manufacturing companies, performance analysis is often based around comparing the actual performance with standards set in a standard costing system. A standard costing system generates rate & volume variances by design. Standards are entered into the system, actual is reported into the system and variances are created.

Traditional operational measures are usually deployed based the vertical structure of the company. The goal of such a system is to maximize each department’s performance. This creates complexity.

First, there are usually way too many measures.  I’ve seen plants that have upwards of 50 -100 performance measures. Even if the measures are good, it is impossible for a plant location to try to maximize performance in that many areas, and it forces the plants to make trade-offs. Second, these measures are often disconnected from the real operational issues affecting a plant because they are decided upon by top management and dictated to the plant.

Existing performance measurements that are not lean-focused must be eliminated from the business; otherwise conflict will occur. Performance measures that are based solely on the vertical structure of the company must be eliminated or modified. The modification of these measures requires that the department, such as quality or supply chain, have measures on the department that focus on its ability to support the value stream.  In a traditionally structured company, the department dictates performance to operations; in a lean company, the value stream dictates performance to the department.

Lean performance measures must be simple and easy to calculate so they can be reported frequently – hourly, daily or weekly.  Simple measures which are timely and easy to understand will focus teams on identifying the root causes of poor performance.  This is fundamental to driving productivity improvements.

Basic Lean Performance Measurements

Flow – The best measure of flow is related to inventory velocity – turns or days.  Creating flow will allow more demand to flow through the value stream and will drive revenue growth. Improving flow creates more capacity to meet additional demand without increasing costs.

Quality – Poor quality interrupts flow, causes late deliveries, lowers customer satisfaction and negatively impacts productivity. Measuring defects at the source means defects will be discovered quickly, root causes will be easier to identify and continuous improvement will ultimately reduce defect rates.

Delivery – delivering on-time to the customer request date has the potential to set a company apart from the competition. Meet the customers’ needs in terms of delivery creates value, which will drive growth in revenue.

Order Fulfillment Lead Times – lead time is the total time from receipt of a customer order to delivery of the product to the customer. Lead time is an excellent performance measure precisely because it requires looking at how the value stream performs as a system, rather than just looking at the individual process steps of the value stream.  Short lead times create value for customers and creates a competitive advantage for a company.

Productivity – Lean companies define productivity as output (such as revenue) divided by input (resources required). If lean practices are in place and delivering value to customers, then demand will be increasing. Likewise, if lean practices are eliminating waste, a company will be able to sell, make, and ship more products and services without increasing the resources in the value stream.

Lean companies create and continuously improve flow in value streams. This is the basic business operational model of a lean strategy.  The lean company doesn’t need to measure everything; it just needs to measure the right things.  If the measurements are aligned with the principles of lean the expected outcomes will occur.