Author: nkatko@maskell.com

One of the most critical responsibilities accounting must assume, in a lean manufacturing company using a standard costing system, is to explain the financial impact of reducing inventory.

Most manufacturing companies begin their lean journey with high levels of inventory. Through the deployment of lean practices and methods, inventory will be reduced. One of the most basic lean manufacturing practices is make-to-order. A pull system is designed to pull customer orders through the production process as orders occur. This means products will not be manufactured unless there is an order to ship. No more building inventory without an order.

What happens at the beginning of a lean journey is orders will be filled first from existing finished goods, and finished goods will not be replenished. This will continue until the proper level of WIP & finished goods are achieved for lean operations to maintain flow.

The design of a lean pull system does have levels of WIP and/or finished goods built into it as a buffer against the variability of demand and differences in production cycle times. When designing a pull system, lean practitioners can usually figure out exactly what quantity of raw material, WIP & finished goods is necessary. Inventory quantities will continually decline until the desired level is reached.

In financial accounting this means the overhead capitalized into inventory through production of product will be consistently less than the overhead portion of cost of goods sold. In standard costing terminology, overhead absorption will be consistently “under absorbed” as inventory is reduced.

As a result, profitability will be lower than in periods of overabsorption. And people who don’t understand this will think “lean is not working.”

Accounting can take a leadership role in this issue by modeling the financial impact of inventory reduction.

Implementation of lean practices to create a pull system is very methodical and disciplined, so inventory reduction will not happen suddenly. Early in the Lean journey, accounting needs to develop a relationship with the lean practitioners to understand the plans to reduce inventory.

Discussing days of inventory (or inventory turns) is the common language between lean operations and accounting. Inventory days is one of the basic lean performance measures used to understand how well lean is working. Accounting can use projected days of inventory as a basis to model the financial impact of inventory reduction.

• Expected overall rate of improvement in days of inventory (or inventory turns)
• Breaking down this overall rate by raw materials, finished goods and work-in-process
• Target rates of days of inventory/inventory turns

Armed with these numbers, it is not difficult to develop simple monthly/annual financial forecasts to model  the financial impact. Accounting’s leadership role is to use these projections to explain to all levels of management what is going to happen financially as lean practices reduce inventory levels.

Accounting’s message to the company must be: Lean is working!

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.

Accounting professionals are trained to be “doers” of accounting. Accounting training and education is about how to perform accounting tasks, from learning the basics of journal entries in Accounting 101 to how to close the month and report regulatory compliant financial statements.

Looking at this thinking from a lean viewpoint, the readers and users of a company’s financial statements are the customers, and they value quality, delivery and speed. These customers are served by the financial accounting system of a company.

The accounting function has another set of customers – internal customers who need relevant financial and operational information to understand the relationships between operating performance and financial performance, along with the ability to make financial decisions consistent with company strategy. These internal customers are served by the management accounting system of a company.

To understand lean accounting, accountants need to adjust their perspective from “doing” financial accounting to “practicing” lean management accounting. The first step to begin practicing lean accounting is to change thinking in the accounting function by breaking away from thinking of all of their work on a “month-to-month” basis of producing financial statements.

Lean accounting is like lean – it is a never-ending journey. The journey is practicing lean accounting and the destination is continuous financial organization improvement. This journey never ends because the destination is not final. This is the first change in perspective for accountants– changing the way we think about accounting in a lean organization. It’s not just about the technical ability of accounting to produce financial statements, it’s also about the organization as an internal customer.

Management accounting is more of a continuous process that is practiced throughout the organization on a daily, weekly, monthly and annual basis. The needs of the users of management accounting are more dynamic based on business conditions. A successful lean strategy is based on relevant, accurate and timely financial and nonfinancial information, which is supplied by a management accounting system.

The second change in perspective for accountants is the understanding and accepting continuous improvement. All business processes can improve in a lean organization, including accounting processes. It’s not that the accounting processes are bad, it’s simply that they can get better. It’s important for accountants to change the way they think about the processes they “own.” Accounting is not exempt from improvement.

The final change in perspective for accountants is creating value for your internal customers. Accountants are very good at understanding and delivering value to external customers because the quality of our work is based on GAAP/IFRS, tax laws and other regulations. Internal customers in lean organizations value specific, relevant, timely, actionable information & data which support lean practices. Accountants need to listen to what their internal customers value and deliver on that value by making the necessary adjustments to accounting processes to deliver the exact value desired.

Lean is first and foremost a business strategy based on 5 principles: creating customer value; organizing the business around its value streams; creating flow and pull; empowering employees and continuous improvement. The impact of these principles creates change throughout the organization, and the entire business must be aligned to execute the strategy.

Companies use their management accounting system is to align company strategy with its business model of operating practices by providing relevant data to all levels of management for decision-making and financial analysis.

Lean Accounting is the management accounting system for a lean organization. It provides the relevant financial and nonfinancial information necessary to execute the lean strategy and drive financial success.

This blog series will explain how and why Lean Accounting creates strategic and operational alignment in 5 areas of a lean organization:

• Alignment with Lean Strategy
• Alignment of the accounting function
• Alignment of performance measurements
• Alignment of financial information
• Alignment with financial management practices

Alignment with the Lean Strategy

Lean is a multi-faceted business strategy, with a primary focus on employees and learning. Through the use of various lean tools, practices and methods, employees learn to master their work, solve the right problems and help an organization learn how to doing things tomorrow it cannot do today. That’s why we should always talk about “lean thinking” as opposed to “doing lean”.

Lean also changes the way an organization thinks about making money. The financial impact of a lean strategy is well known – all we need to do is look at the many companies that have been successful in their transformations. We know that focusing an organization on customer value will result in revenue growth, and that the deployment of lean tools and techniques that create flow and eliminate waste will result in improved cost management. These are the economics of lean.

But before any of that appears, a fundamental shift must occur in what and how an organization measures itself operationally and financially. Financial management must be aligned with the economics of lean, and that’s what lean accounting is all about.

To achieve success, a lean organization must develop an effective and efficient accounting function that complements its financial accounting system to provide a knowledge base for effectively making decisions about the future (this is critical because the focus of financial accounting is on past activity). Lean accounting makes relevant information available to decision makers on a timely basis.

In a broader context, lean accounting is a financial learning system for the entire organization, not just the accounting function. Because the economics of lean changes the relationships between operations and financial numbers, the whole business must learn the new relationships and incorporate the dynamic context of these relationships in their financial analysis.

Now, here’s the challenge: the financial impact of lean is neither direct nor immediate, which is counter to traditional short-term business financial thinking. A lean organization considers employees and time to be its two most important assets. Helping employees to learn how to better use an organization’s time to deliver value to customers is a long-term strategy. This is accomplished though continuous improvement, which focuses the employees’ attention on maximizing value-added activities and eliminating non-value activities. Lean accounting uses this information to calculate value stream capacity and incorporate the impact of capacity into all financial analyses.

Internal financial management in a lean organization must be focused around the flow of money, rather than externally-reported financial results. External financial results can be impacted by compliance with accounting reporting requirements, which most people in a business do not understand. By focusing financial analysis around the flow of money, all functions in an organization can perform consistent, reliable financial analyses that will result in long-term financial growth.

All functions in a lean company must learn and understand the impact of their particular financial decisions based around the correlations between lean operational performance, resource capacity and financial numbers.

A REAL-LIFE EXAMPLE

Here is a simple real-life example of the benefits of using lean accounting practices for financial management and analysis. It is the story of an Italian company auxiell & BMA have been supporting since March 2017. We started by creating box scores in one value stream (heating elements), which they then began  to use for financial analysis.

A customer recently requested a quote for a custom heating element product. The price the customer wanted was less than the standard cost of the product. In the past, the sales team would have not accepted this order because the product would “lose money” on a standard cost perspective after about one week’s worth of e-mail discussion between business functions.

Instead, the Corporate Controller assembled a cross-functional team of people from operations, engineering, purchasing, sales and finance to look at this opportunity using the box score. First, the sales representative explained the opportunity – the sales volume, the specific component parts required and the sales price. The total revenue of this opportunity was calculated by finance.

Next, the engineering representative discussed the functionality of the component parts and it was determined that the customer’s product specifications would be achieved. A bill of material was created. Purchasing then derived the cost of the new components from the bill of material, and total material cost was calculated by finance.

Operations asked sales many questions about the total volume of the order over the expected timeframe of delivery and it was determined that they had available capacity to produce the order. Because capacity was available, there was no additional labor or machine costs associated with this order.

Finance calculated the actual profitability of the order: the total revenue less the total material cost, and the consensus of the team was the order should be accepted at the price the customer desired.

This is a very simple example of using lean accounting information and lean financial management practices to evaluate business decisions in alignment with a lean strategy. The long-term benefit of this alignment is unlocking the financial potential of lean though better financial analysis and decision-making.

In the first cost reduction blog I explained cost reduction is lean organizations is different than traditional cost reduction practices because of method and measurement. In this blog, I want to dive deeper into material cost and machine cost to explain how lean organizations measure these cost reduction and the methods used to achieve it.

As a reminder:

Effective Measurement: Actual cost as a % sales

Goal: reduce cost as a % of sales over time

Alternative measurement for material cost: actual gross margin as a % sales

Goal: increase gross margin as a % of sales over time

Material Cost

To achieve material cost reduction a lean organization breaks down material cost into its components to study, learn and improve: price X quantity = cost. Let’s look at each.

Purchase price of parts

Lean organizations usually don’t seek out the lowest price suppliers because price is a function of value. Lean organizations want more out of their suppliers than the lowest price, they want their suppliers to be partners in improving material flow. Lean organizations seek suppliers who deliver the highest value in terms of quality, delivery and lead time, at the lowest price.In many lean organizations, supplier certification programs are present where suppliers must continually meet agreed upon performance requirements.

To decrease the purchase price of an individual part one of three events must occur. The part used in a product must actually change, which usually requires some form of engineering change or overall product redesign. Negotiating a lower price with the current supplier is successful or a new supplier is selected that offers the same part at a lower price (but not in exchange for bulk purchases that increase inventory!)

Once one of these 3 events occur, the difference in unit price is known. The direct cost savings for purchase price decrease is best expressed on an annual basis because material is constantly being moved through operations.

Here is calculation for direct cost savings:

• Purchase price reduction X annual part usage = annual cost savings

Supplier certification programs have the ability to lower the overall cost of the purchasing function. Poor supplier performance leads to nonvalue added purchasing activities such as expediting, reworking purchase orders and continually fixing recurring problems. Certifying suppliers will reduce these nonvalue added activities,  increase the capacity of purchasing and avoid future cost increases. As a result, purchasing expenses as a percentage of sales should decrease over time.

Quantity of material

The quantity of parts purchased is function of what I call the 3 outcomes: ship, scrap or stock. Using purchased material to ship more products to customers is the desired outcome. Scrap and stocking materials are both waste.

Scrap

I like to think improving quality has a multiplier effect when it comes to improvement. Improving quality reduces scrap and also improves productivity, flow and delivery.

Most manufacturing companies measure scrap expense, and sometimes it is a separate line item on an income statement. The direct cost savings of improving quality is not difficult to calculate using the improvement in the quality measure.

Here is an example of how to calculate the cost savings using the quality measure of first time through.

Current State

Annual scrap cost = $50,000

First time through rate = 70%

Future State

1. First time through rate improves = 80%
2. Calculate the percentage increase in first time through: 10%/70% = 14.3%
3. Multiply percentage increase in first time through rate by annual scrap cost to calculate actual cost savings:
   • 3% X $50,000 = $7150 annual actual cost savings

Inventory

The financial impact of reducing inventory through lean practices is on the balance sheet– decrease inventory and increase cash.  If your company happens to be  using an internal value stream income statement material purchases will be reduced.

Here is an example of how to calculate the cost savings, using days of inventory as the performance measure.

Current State

Average materials inventory = $1,000,000

Days of Inventory = 60

Future State

1. Days of Inventory improves to = 45 days
2. Calculate the percentage improvement in days of inventory: 15 / 60 = 25%
3. Multiply percentage improvement in days of inventory by average materials inventory to calculate cost savings:

25% X $1,000,000 = $250,000

Cost reduction of inventory management activities

Inventory is considered waste in lean organizations and it also creates a great deal of nonvalue added activities related to the receiving, inspection, movement, tracking and management of inventory.

These nonvalue added activities are performed by employees.  Reducing or eliminating  these activities as a result of less inventory will create capacity.

Over time these costs as a percentage of sales should decrease. Don’t overlook these cost reductions!

Machine  & Equipment Costs

Lean improvement activities for machine & equipment focus around increasing the uptime or availability of a machine. For those who may not be that experienced with lean practices, this is different than utilization, which is about maximizing the amount of time a machine is used to produce parts and usually results in inventory.

Lean problem solving focuses on identifying the root causes of unavailability of a machine, which fall into two broad categories of downtime and change over time. Improvement activities related to reducing downtime are commonly referred to as total preventative maintenance (TPM) programs. Improvement activities related to change over time focus on reducing change over time and also standardizing the change-over process.

Increasing machine availability is another way to describe increasing the capacity of a machine and this will avoid increasing future costs of operating the machine.

In addition, eliminating these wastes has the added benefit of increasing the capacity for the operators of the machine (who perform change overs) and the employees that perform maintenance activities.

Some direct cost savings can also be identified, such as:

• Reducing overtime of machine operators, if machine runs overtime
• Reduction in replacement parts due to TPM
• Reduction in maintenance expense from suppliers who do maintenance work

Wrap Up

This wraps up this blog series on cost reduction in lean organizations. The key points to take away from these blogs:

1. A lean business strategy does reduce costs over time
2. Measuring cost reduction in learn organizations is a combination of identifying actual cost savings and identifying how improvements avoid future cost increases
3. Develop lean-focused cost reduction measures and analyses and avoid using conventional cost reduction

In the previous blog I explained cost reduction in lean organizations is different than traditional cost reduction practices because of method and measurement. In this blog, I want to dive deeper into labor cost to explain how lean organizations measure labor cost reduction and the methods used to achieve it.

Effective Measurement: Labor Cost as a % sales

Goal: reduce labor cost as a % of sales over time

Lean organizations consider their employees to be their most important asset, because they create the value, solve problems and improve the organization.

In lean organizations, the cost of labor is how much the company is paying for a level of capacity to perform work in value streams and other business processes. The amount of capacity needed in any process  function of the demand on the process and how much waste is in the process. The more waste in a process, the higher the labor costs.

Lean organizations look at their full-time employees as permanent capacity. Overtime, temporary employees and contract labor is considered temporary.  To better understand how lean reduces labor cost, think of labor cost the same way:

• Fixed costs – salaries and wages of full-time employees.
• Variable costs – overtime, temporary employees, contract labor.

Improvement activities result in creating available capacity. The “first choice” is to use the available capacity to meet demand. If excess available capacity still exists, it can be re-deployed in the organization or eliminated.

Eliminating excess available capacity is first done to the temporary capacity– overtime, temporary employees and contract labor.  This results in actual cost savings that is reflected on the income statement.

To deal with available capacity of full-time employees, lean organizations develop strategic methods to utilize the capacity. These methods have the financial impact of avoiding increased costs in the future.  Over time, these methods reduce labor cost as a percentage of sales.

Here are some examples:

• Attrition – not replacing employees who leave the organization
• Redeploy resources to other value-added activities
• Fill open positions internally
• Promote from within and backfill lower paying positions
• Insource previously outsourced operations
• Cross-training to create flexible capacity to move between operations or value streams
• Temporary strategic assignments: assign employees to continuous improvement activities or other strategic initiatives

In order to achieve a reduction in labor costs (as measured by labor as a percentage of sales), it is very important for an organization to be proactive in creating and executing  a comprehensive plan to address the capacity that will be created due to improvement activities across the entire organization, not just operations.

Here is a simple example of using some numbers. If lean organizational improvement activities achieve annual 20 % improvement in productivity, this means 20% capacity will be created annually. If revenue is not increasing 20% annually, then the organization will be faced with excess available capacity.

Labor happens to be an expense on the financial statements and conventional practices to reduce labor costs usually don’t work very well in lean organizations. As you begin your lean transformation journey, closely examine your current practices regarding managing labor costs and make the necessary modifications to align them with the lean strategy.

In the next blog we will look at both material and machine costs.

Does lean reduce costs? – Yes! Tiiachi Ohno stated this very clearly: “costs do not exist to be calculated, they exist to be reduced.”

In my career at BMA I’ve been fortunate to have worked in many different companies of different sizes and in different industries. Some have been further down the lean transformation journey than others. One common theme I have recognized in all companies I’ve worked with is a desire to better understand and control costs. What I’ve also learned is there sometimes is a disconnection between the financial analysis of cost reduction, which is usually based on conventional practices, and what a lean strategy achieves operationally.

This led me to write this blog series to explain how and why a lean strategy can achieve cost reduction and make some attempts to connect lean practices with cost reduction analyses.

Today’s blog will focus on lean cost reduction methods, measures and thinking. The following  blogs will focus on specific costs, such as labor and material costs, where we will look more deeply into exactly how lean practices achieve cost reduction.

A lean organization’s goal is to deliver value with the highest quality with the lowest costs possible. Lean organizations understand price is set by the market, and in some cases a company’s ability to  influence market demand may be difficult. This means in the “profit equation”: Price – Cost = Profit, the only part of that equation a lean organization can totally control is cost. Let’s now look at a general framework of how lean organizations approach cost reduction.

Method

The five principles of lean form the basis for lean organizations to become learningorganizations through lean problem solving, which is summarized in the chart below. The root causes of costs are pretty much the same as root causes of poor process performance. I explain this to finance people by suggesting if they want to better understand costs, go to the Gemba and observe.

The better a lean organization is at problem solving, the better it will be at reducing costs. But getting good at lean problem solving takes time because the organization as a whole must learn, which means cost reduction will also take time.

This long-term approach to cost reduction is counter to conventional cost reduction practices which usually focus on achieving a level of cost reduction over a short time period through top-down management decisions and actions.

Measurement

Lean organizations seek to reduce costs over time. Lean organizations understand that lean problem solving will reduce costs in two ways:

Actual Cost Savings– actions taken that lower current spending, investment or debt levels and the savings are tangibly reflected in the financial statements. Through continuous improvement activities specific, actual costs can be identified and can be eliminated once improvements are sustained with new standard work.  I’ve heard financial people call this type of cost reduction called “hard savings.”

Cost Avoidance– actions taken that avoidhaving to incur costs in the future. Potential cost increases are avoided through continuous improvement efforts and are never reflected in the financial statements. I’ve heard financial people this type of cost reduction called “soft savings.” How continuous improvement avoids costs requires a more detailed explanation.

A primary result of many improvement efforts is the creation of capacity (see chart below). Another way to think about this is the elimination of wasteful activities creates available time for the resources of a lean organization.

Lean organizations must decide what to do with this available capacity: enhance the deliver value to customers or re-deployed throughout the organization. In most cases, using the available capacity will avoid having to buy more capacity in the future.

Cost reduction in lean organizations is a combination of identifying specific, actual cost savings which are the result of improvement activities and measuring the potential future costs that will not occur in the future.

A cost reduction measurement which I think is very effective to use in lean organizations is cost as a percentage of sales. Cost can be one specific expense line item or a group of costs. I think this is a good measure because it captures actual cost savings, cost avoidance, and considers lean cost reduction takes time.

Financial A-3 Thinking

I believe the key to understanding and measuring cost reduction in lean organizations is matter of changing thinking habits. There are many established, conventional methods to analyze costs, some of which don’t work well in lean organizations because they either rely solely on identifying only actual cost savings or use other methods to “show” savings that never materialize. It’s often said “lean changes everything” and this also applies to measuring cost reduction.

I like to use the term Financial A-3 Thinking. If you are trying to understand the financial impact of a specific improvement activity, or a group of activities, think operationally first, then financially.

• Current State – does the operational problem being studied have any actual direct costs associated with it?
• Root Cause Analysis – would eliminating a root cause impact the actual direct cost?
• Future State – if the future state is achieved, will actual cost savings occur? Will achieving the future state avoid future cost increases? Will a combination of both occur?

It is very important to be clear and specific if any cost savings will appear on the external financial statements or not. If your company uses value stream income statements internally, the same holds true. Use real, actual numbers. Avoid using any estimate or rate.

In the next few blogs, I will look at specific costs and explain how lean achieves cost reduction.