Lean Financial Management: Material Cost Analysis

In the world of Lean Accounting, you will hear that a value stream income statement needs to show “actual material cost”, and is typically defined as actual material purchased. This confuses accounting professionals because it appears to be in conflict with the matching principle of accounting. So here is my attempt to clear up this confusion.

If a lean manufacturing company has about 30 days of inventory, then actual material cost will be what is purchased in the period. But in many cases, especially early in the lean journey, manufacturing companies have more than 30 day of inventory. In this case, material purchased is much different than the material cost of goods sold. This is the reason accountants think a value stream income statement is not compliant with GAAP.

What is important for accountants to remember is a value stream income statement for internal use only. The purpose of a value stream income statement is to explain the financial impact of lean progress. The accuracy & precision of a value stream income statement is not based on GAAP but on how it represents the current state of lean progress.

So, I’d like to clarify the definition of actual material cost, based on where a company is in its lean journey.

I believe a good starting point in creating a value stream income statement is to define actual material cost as “actual material consumed” by each value stream. This would be the actual cost of material released into the value stream.

I use this definition because 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.

Accounting’s responsibility is to financially analyze material cost its impact on value stream profitability based on what happens to the material as if flows through a value stream. Let’s look at this in more detail.

Obviously, any financial analysis involving changing sales volume would have a corresponding change in material cost.

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 for accounting 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, accounting can calculate the financial impact. 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.

Accounting’s financial analysis of material costs based on “actual material consumed” will provide real time financial information to management to clearly show the impact of lean operations on material costs.

Lean Decision Making Framework Guidelines

Lean Decision Making Framework: General Guidelines

In this blog, I’d like to explain 3 general guidelines accounting should follow for creating an effective lean decision framework for your lean manufacturing company.

#1- Financial Impact on Value Stream Profitability

The general rule for lean decision making is to understand the financial impact of any decision is based on the impact on total value stream profitability. Hence, the necessity for value stream income statements in a lean manufacturing company. This is a departure for most accounting professionals in manufacturing, as many financial analyses get broken down by specific product, product family, business unit, etc.

The change in actual value stream profitability will accurately reflect the economics of lean, as described in an early blog. Another advantage of using actual value stream profitability is that the profitability impact will be realized because the analysis is based on actual revenue and actual costs.

#2 – Stop using Cost Allocations

Most cost allocations have a level of subjectivity in them (such as all rates in a standard costing system). And many cost allocations are an attempt to make a fix cost variable by linking it to units produced. Using rates in financial analysis is dangerous because they can make it appear that costs are decreasing, when in reality actual costs are not changing.

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. If a company were to eliminate a product, these employees would still be full-time employees, which the actual labor cost for the company does not change. Actual labor would decrease only if fewer employees were employed.

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

#3 – Lean Improvements create Capacity

This is a fact of Lean: eliminating waste creates time – the time spent on waste is now available to spend on creating value. This is also described as creating capacity.

This fact of lean must be incorporated into your lean decision framework. The creation of time has no financial impact, but how the business uses that time does have a financial impact. The majority of the time, a lean manufacturing company will use this newly created capacity to build & ship more products, and the financial impact will be increasing revenue.

In your lean decision making framework, it’s essential to be able to incorporate the amount of time being created so accounting can properly project revenue that can be realized.

In the next blog, we will begin to look at lean cost analysis in more detail.

Removing Standard Costs from the Income Statement

Creating value stream income statements is the second part of a lean decision making framework that is not based on a standard costing system. The value stream income statement is an essential element of lean decision making due to how lean practices & methods impact profitability. It’s important for accountants to understand the “lean logic” behind a value stream income statement, as follows:

Value Streams – the lean definition of value streams is the sequence of activities from order receipt to shipment that are necessary to create the product to ship to the customer. Lean manufacturing companies organize, manage & control by value stream. The accounting definition of value streams is they are your company’s profit centers.Therefore, internally we will want to look at value stream profitability.

Flow – the lean 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 an accounting viewpoint, maximizing flow maximizes value stream profit. Improving flow impacts both value stream revenue and costs. The faster the flow, the more revenue will grow. Eliminating wastes controls total value stream costs.

The first step to creating a value stream income statement is to understand your company’s value streams. I recommend accounting sit down with your company’s lean leaders to look at your value stream maps & discuss the value stream organization. Value stream maps show the flow of products through each value stream and identifies the process steps required in each value stream. The value stream organization is the actual people, machines & resources that work in each value stream.

From this discussion, it should not be difficult for accounting to assign the actual direct costs to each value stream, such a labor, facility and machine costs. All these costs are in your general ledger and usually assigned to departments or cost centers. I recommend accounting do a reconciliation between the departments/cost centers in the general ledger and the value streams. This reconciliation will serve as a template to create most of the value stream costs.

Material costs are most difficult to assign to a value stream. The general rule is to use the actual cost of material consumed during a period, which may not match exactly with the products sold. It is important for accountants to remember that a value stream income statement is for internal use only and needs to reflect actual costs.

What is important for accounting to remember is it is not trying to assign every manufacturing cost to a value stream, only the actual costs the value stream can control. In a value stream income statement, we don’t want to use cost allocations. I like to think of this cost assignment as putting costs where the spending decision is made.

When creating a value stream income statement, think of your customers – lean operations and management. What they value is knowing exactly how profitable each value stream really is based on actual revenue & actual costs, not based on artificial standard costs.

In the next blog, we will look at how to use the value stream income statement to make lean business decisions.

Removing Standard Costing from Financial Analysis

Using standard product costs in business decision-making works well in traditional manufacturing companies, because standard costing systems were designed for traditional manufacturing. In lean manufacturing companies, continuing to use standard costing for business decision-making will create conflict and confusion throughout the organization. One of two outcomes can occur when standard costs are used in business decision analysis in Lean companies. Either the wrong decision is made, or traditional manufacturing practices creep back into operations to support the financial analysis.

Accounting’s role is quite simple, lead the company through the process of eliminating standard costing in business decision making. The actual task of making this happen can be quite complex & may take some time depending on how ingrained standard costing is in your company’s decision making process and how fast your company can develop lean-focused decision making methodologies.

Fortunately for accounting, it doesn’t have to start from scratch. Standard lean accounting practices present a plan for how to get from where you are to where you need to be. This blog and the next few blogs will explain how to get your lean manufacturing company into “lean decision making.”

Manufacturing companies typically have long-held methods for doing internal financial analysis and making business decisions. If a manufacturing company uses a standard costing system, standard cost information is usually used in understanding the financial impact of business decisions. These decisions are made in all parts of the company: sales, marketing, purchasing, engineering, operations, senior leadership and accounting. And the people who are actually making the decisions are comfortable and confident in the current methods.

Accounting’s challenge is getting acceptance by the people making the decisions that a lean decision making methodology is better for the company. It’s more about winning over hearts & minds rather than simply creating a new methodology.

Accounting’s first step is to develop a lean-based decision making framework not based around standard costing. A lean-based decision making framework should be based on what I like to call the “economics of lean.” The rate of growth of revenue consistently exceeds the rate of growth of costs, which results in increasing profitability.

The overall goal of becoming a lean company is to become more profitable, primarily through improving the delivery of value to your customers, which drives revenue growth. If a lean manufacturing company really does improve flow, reduce inventories and improve on-time delivery, it should realize revenue growth greater than its historical averages.

The other aspect of the economics of lean is cost control. Please note I did not say cost reduction, because lean is not a methodology to dramatically reduce costs (we will get into this more a bit later). Operationally, lean practices improve productivity which means output increases at a greater rate than the resources needed to produce the output. This occurs because eliminating waste increases resource capacity (or creates time) rather than hiring more people or buying more machines.

As a CFO of a manufacturing company in the 1990’s, my company’s lean transformation resulted in the average sales growth rate increasing from 7% to 20% and profits increasing 66%. We didn’t lower prices or change our product mix. We dramatically changed operations by delivering on-time 95%, without finished goods inventory and an average order lead time of 3 days. This is how I learned about the economics of lean.

I’m going to stop writing here because I it’s important to think about the economics of lean and your company before we start moving into the “how to” phase of a lean decision making framework.

  • How well are the economics of lean understood in your company’s accounting function?
  • In other parts of the organization?

Talk these questions over with your colleagues and I would be interested in reading your comments.

Lean Accounting & Inventory Reduction

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 Accounting & Standard Costing Variances

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. Because standards are used to value inventory and cost of goods sold, actual variances are reported on the income statement to bring the financial statements back to actual. In a “traditional” manufacturing company these variances are often used as performance measures by operations itself, senior management and/or accounting. The definition of a performance measure being “to measure and manage operations.”

A standard costing system is also designed to maintain GAAP/IFRS compliance regarding inventory valuation. GAAP/IFRS states a portion of manufacturing production costs must be capitalized on the balance sheet as inventory in a consistent manner. A standard costing system within an ERP system automates this process. This process creates overhead absorption on the income statement, which can be favorable (increasing profits) or unfavorable (decreasing profits). Overhead absorption is also often used as a performance measurement.

Because variances and absorption both appear on an income statement, the accounting function of a manufacturing company must be able to understand, analyze and explain these numbers to perform the necessary function of financial analysis.

When a manufacturing company begins its Lean journey, the entire infrastructure built to support the standard costing system & related analysis must also adapt to Lean. Here is how the accounting function can lead this process.

Variances as Performance Measurements

Using variances as performance measurements in a lean manufacturing company will not work. Variances are designed to drive mass production manufacturing behavior – building inventory, long production runs and buying lots of raw material to get a lower price. Lean practices totally opposite of this.

Accounting must accept & understand this, and must explain this to any other part of the organization that believes differently. Accounting must also get behind 100% on deploying lean performance measures. Accounting may not have to do the actual deployment, as many experienced lean practitioners can do this. At a minimum accounting needs to participate in the development of the measures, actively support their operational uses and learn how to integrate these measures into their financial analysis.

Variances on the Income Statement

It’s easy to “stop” using variances as performance measures and replace them with lean performance measures. But the standard costing system is still being used and variances will appear on the income statement. The good news is that accounting has the opportunity to lead in modifying the standard costing system to potentially eliminate some or many of the variances on the income statement.

The first step for accounting is to team up with some IT and manufacturing people to study exactly how your ERP system calculates variances. Determine if it is possible to change ERP settings to “turn off” variance calculations.

Next, learn exactly what “actual” information the ERP system uses to do its calculation (every variance is simply actual to standard). Study the manufacturing floor to learn how that information gets into your ERP system. Get IT to set up a test database of your company and practice not entering actual transactions and look at the impact on your income statement. Here are some examples of what to try:

  • Stop reporting actual labor and machine time to work orders
  • Stop reporting differences in material SKU’s used to work orders
  • Implement back flushing reporting

After learning how the ERP system reacts to changes, you can make the necessary changes in your live database and shop floor reporting to eliminate variances.

Based on personal experience, I am confident you will find some ways to eliminate variances on the income statement if you make an investment in time to learn specifically how the ERP system works.

It’s important for accounting in a lean manufacturing company to address standard costing variances early in the Lean & Lean accounting journey. Educate the company on why standard costing variances will not work in a Lean manufacturing company. Support & assist Lean operations in developing and maintaining lean performance measures. Finally, dive into your ERP system and make the necessary changes in the system. You will be pleased with the results.

Lean Accounting and Standard Costing: An Introduction

If you are in the accounting department in a lean manufacturing company, and your company uses a standard costing system, it is inevitable that the accounting department will be faced with confronting how its standard costing system is being used.

I stress the term inevitable,because based on my own experience both as a CFO and a consultant, I have seen it happen consistently. Sometimes the confrontation will occur early in the lean journey, sometimes later, but it is going to happen.

My advice to the accounting people in accounting departments of lean manufacturing companies is to lead rather than react. Be the leaders of proactively evaluating how the standard costing system is being used as your lean journey begins and come up with a plan.

Coming up with a plan is not difficult, as long as you understand the issues. Fortunately, these issues happen to be very common across lean manufacturing companies that use standard costing systems. For the next few blogs, I am going to write in detail about the issues, look into exactly why these issues occur and lay out solutions.

I see 6 issues that accounting will have to deal with in a lean manufacturing company:

  1. The financial & operational impact of variances and overhead absorption
  2. The financial impact of inventory reduction
  3. Internal financial analysis & business decision making
  4. Inventory valuation
  5. Maintaining GAAP/IFRS compliance
  6. Other – such as transfer pricing or maintaining local regulatory compliance

Before we get into the issues, I think it’s important to get some background on why standard costing even becomes an issue in lean manufacturing companies.

The Root Cause

The primary root cause of why accounting will have to deal with standard costing is twofold. Accounting needs standard costing to value inventory but lean operations does not need, nor have any use for, the performance measurement & financial analysis aspects of a standard costing system.

Conflict between accounting and lean operations occurs when each side doesn’t understand each other’s reasoning.

Lean operations people don’t like the performance measurement & financial aspects of a standard costing system because standard costing systems are based on mass-production manufacturing practices and lean operational practices are 100% opposite of mass-production practices.

It’s important for accounting to recognize this and not try to force lean operations to use standard costing information to measure or manage lean operations.

Accounting needs standard costing to value inventory for GAAP/IFRS compliance. In most manufacturing companies with high inventory and many SKU’s, this is the simplest and easiest way to value inventory. And ERP systems are set up to do this, which automates the process. Accounting has another obligation, which is being able to explain the financial impact of the financial information a standard costing system produces, such as variances, absorption and margin.

It’s important for lean operations to understand accounting responsibility for maintaining GAAP/IFRS compliance and “stop using standard costing” is not a simple to do.

First Steps in Leadership

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

  • It’s a company problem not an accounting problem. Accept that your lean manufacturing company will have to deal with standard costing. Information from standard costing systems are used in all parts of a manufacturing business, and for many different reasons. The entire company will have to be part of the solution.
  • It’s a long journey not a short destination. It’s going to take time to adapt, improvise & overcome a standard costing system. Just like a Lean journey, there will be successes, and adjustments along the way. The larger to company, the longer it will take.
  • Begin communication of the issues. The CFO needs to begin talking to senior management. The controller needs to engage lean operations management. The entire accounting function needs a continuing dialogue on this topic. Begin laying out the specific issues your company is going to face over the long run.
  • Lean accounting practices & methods do provide a path & solution to resolving these issues in your lean manufacturing company. Learn about Lean Accounting.

In the next blog, we will begin discussing the issues in detail.

Lean Accounting and Generally Accepted Accounting Principles

In the context of applying Lean Accounting in manufacturing companies, there have been some arguments that Lean Accounting practices do not comply with Generally Accepted Accounting Principles (GAAP). I decided to write this blog to try to explain from a GAAP perspective, how and why Lean Accounting does comply.

This is a long blog. I considered splitting this up into a series of blogs, but decided otherwise.

The arguments as to why Lean Accounting doesn’t comply with GAAP usually are made around the methods used in Lean Accounting to value inventory and cost of goods sold and how different these methods are from conventional practices.

Conventional inventory valuation is usually done using an ERP system. Here is a simple explanation of how this works. ERP production reporting systems track the movement of materials from receipt, through the production process and finally to shipment. These ERP systems allow for a cost to be assigned to each item in a company’s inventory item master. When costs are assigned, the inventory movement transactions also values inventory and cost of goods sold.

Most of the time a “standard cost” is assigned to each item in inventory, which is why this type of inventory valuation is simply called “standard costing.” And for the sake of simplicity, I’m going to use the term “standard costing” when referring to these conventional inventory valuation systems.

Lean companies using Lean Accounting take a different approach to inventory valuation. Lean Accounting is concerned primarily with the total value of inventory on the balance sheet, rather than the specific value of each individual item held in inventory. Lean Accounting simply employs the “leanest” method possible to value inventory.

Let’s first look at what accounting principles require in regards to inventory valuation, then we will discuss how Lean Accounting complies with all accounting principles.

The valuation of inventory and cost of goods sold is one of most important issues for financial reporting because it is material to the proper determination of income. Inventory valuation is one of most unique components of accounting because GAAP requires companies that carry inventory to capitalize a portion of production costs into inventory to determine the proper reporting of income.

Here is what US GAAP states (note: International Financial Reporting Standards basically say the same thing): “Inventory has significance because revenues may be obtained from its sale. Normally such revenues arise in a continuous repetitive process of cycle of operations in which goods are acquired, created and sold, and further goods are acquired for additional sales. Thus, inventory at any given date is the balance of costs applicable to goods on hand remaining after the matching of absorbed costs with concurrent revenues. In practice, this balance is determined by the process of pricing articles included in inventory.”

What this means in layman’s terms is that a portion of a company’s expenses are moved from the income statement to the balance sheet. Expenses are reduced and this increases profits. So it’s easy to understand how important inventory valuation is for financial reporting.

GAAP Requirements

There are two issues related to inventory valuation – the value of inventory on the balance sheet and the determination of cost of goods sold.

GAAP states that inventory must be valued at cost, which is the same as all other assets on a balance sheet. Cost is defined as the actual expenses incurred to get goods (products that are sold) in condition for sale. These expenses are the actual cost of materials plus a portion of the actual costs of production. GAAP also recognizes the inherent complexity of inventory valuation: “it is understood to mean acquisition costs and production cost, and its determination involves many considerations.”

Proper valuation of cost of goods sold is related to the matching principle, which states that all expenses recognized in any period should be the expenses incurred to generate the revenues recognized. Because cost of sales is often times the largest expense on the income statement of a manufacturing company, it is material to the proper determination of income. GAAP states this as follows: “A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues.”

The issues in a manufacturing company in determining cost of goods sold are related to continuous nature of manufacturing. Products produced in one period may not be sold until a subsequent period. The prices paid for purchased items may change. And finally, actual production costs change over time. This makes matching the specific, actual production costs to the revenue reported quite difficult.

GAAP recognizes that calculating the exact, specific cost of an item in inventory and cost of goods sold really cannot be done because of the timing issues of good produced and sold, material costs changes and determining the exact manufacturing costs incurred for goods in inventory. ASC 330 states: “although the principles for the determination of inventory costs may be easily stated, their application, particularly to such inventory items as work in process and finished goods, is difficult because of the variety of considerations in the allocation of costs and charges.”

To overcome this problem, GAAP allows companies to use a cost flow assumption to value inventory and cost of goods sold in a consistent and systematic manner that best reflects income.

Companies must use a consistent method over time, which means a company can’t simple switch cost flow assumptions year-to-year. If a company changes its cost flow assumption it is considered a change in accounting method and must be disclosed in audit reports.

There are 4 cost flow assumptions that can be used: FIFO, LIFO, average cost or specific identification. FIFO (First-in-First Out) means the most recent costs are assigned to ending inventory. LIFO (Last-in-First Out) means most recent costs are assigned to cost of good sold, which usually results in less income reported than under FIFO. Average cost means that inventory and cost of goods sold are valued at the average costs of all goods available for sale. Specific Identification means a company can accumulate the exact, specific costs of each item in inventory, which is rare but possible if a company doesn’t have many different types of products it sells. (Note: IFRS does not allow the use of LIFO, which is one of the most significant differences between it and US GAAP. There are currently discussions going on about how to basically merge US GAAP with IFRS and have one worldwide set of accounting standards.)

By consistently applying a cost flow assumption to value inventory, it will also mean that cost of goods sold is also properly stated.

This is because cost of goods sold is really the difference between goods available for sale (beginning inventory + purchases) and ending inventory. Here is the method to determine cost of goods sold, based on the following equation:

Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold

  1. Beginning inventory in any period is known, and would be properly valued using the cost flow assumption.
  2. Purchases in any period are known and it’s easy to determine the value of purchases in any period.
  3. Ending inventory based on the cost flow assumption. The capitalization of production costs between the balance sheet and income statement is adjusted at the end of each period based on the change in inventory quantities during the period
  4. Cost of goods sold is then considered correct because the other 3 components of the equation are correct

What the accounting principles mean in practice is that as long as a company’s method of inventory valuation approximates cost, and is applied in a consistent manner, the company’s financial statements are compliant with GAAP. Determining if inventory approximates cost and is applied in a consistent manner is usually determined by the company’s outside auditors, who will issue an unqualified opinion on the financial statements.

During the audit, the auditors will test company’s inventory valuation methodology to determine if it approximates cost. If it “passes” the audit tests, inventory is considered properly valued. If the tests are “not passed” the auditors will tell the company what adjustments need to be made to “pass” the test.

How Lean Accounting Complies with GAAP

Lean Accounting uses the cost flow assumption of average cost to value inventory and cost of goods sold. Accounting principles require inventory to be valued at cost, which is composed of the cost of material and a portion of the production costs. Let’s look at how Lean Accounting calculates average material costs and average production costs.

Calculating average material cost is dependent on three factors: the number of purchased items, price stability and rate of flow of materials.

For a company with thousands of items calculating the average material cost per unit should be done at either the individual item level or by common product families. A company with few items of purchased raw material or components can do an overall average material cost.

For stable material prices, the average cost may be calculated less frequently (annually or semi-annually). In cases where material prices are highly volatile, the average cost may have to be calculated more frequently, such as monthly.

The final factor in calculating average material cost is the rate of flow of materials, which is typically measured in days of inventory. The rate of flow helps determine which costs to average. For example, a company has 30 days of inventory on hand this means, on average, the inventory was purchased in the last 30 days, and average cost would be calculated based on cost changes over the last 30 days.

The actual mechanics of calculating the material value of inventory is usually dependent on the number of purchased items a company has in its inventory item master. For companies that have hundreds or thousands of purchased items, it’s probably easiest to maintain the quantities of these items in your ERP system. In the cost field for each item the average cost will be entered, rather than a standard cost that remains frozen for one year.

For companies with few purchased items a simpler method could be employed.

  1. All purchases are recorded as expenses in the period (to cost of goods sold).
  2. At the end of each period, the ending inventory value of material would be calculated as follows:
    Finished Goods = quantity on hand X average cost per unit
    Work in Process = quantity on hand X average cost per unit X average % complete.
  3. Adjust material value on the balance sheet to ending inventory using a journal entry

The capitalization of production costs can be done at a macro level, in total using a journal entry, rather than item-by-item, regardless of the number of items of inventory.

  1. Average cost per unit for the month is calculated using the actual production costs (all costs but material) from the value stream income statement divided by the actual units produced.
  2. The amount of production costs that need to be capitalized as ending inventory is calculated as follows:
    Finished Goods = quantity on hand X average cost per unit
    Work in Process = quantity on hand X average cost per unit X average % complete
  3. Adjust inventory production cost value on the balance sheet to ending inventory value calculated in #2 above using a journal entry.

As stated earlier, determination of a “consistent method” that “properly reflects income” is really up to the company and its auditors. As long as the auditors are OK with the inventory valuation methodology, it meets GAAP requirements. The key is to understand what type of cost flow assumption is being used.

Benefits of Lean Accounting Inventory Valuation

The process of inventory valuation is simpler, easier and much waste is eliminated under Lean Accounting compared to conventional product costing methods.

There is much less maintenance of costs in Lean Accounting as compared to other methods. The average material cost is relatively simple to calculate and probably doesn’t need to be updated too often unless the material is a commodity. The process of calculating standards and analyzing actual to standards can be eliminated.

In standard costing systems, production costs are gathered item by item using labor and overhead rates. Every time a finished good is completed, its labor an overhead costs are capitalized into inventory. And when a finished good is sold, its cost is transferred from inventory to cost of goods sold. Since Lean Accounting calculates capitalized production costs at a macro level all labor and overhead rates can be set to zero, as they are no longer needed.

Using Value Stream Costing for Root Cause Analysis

Value Stream Costing (VSC) is often misunderstood when it’s introduced into a business.

First reactions to VSC often are based on incorrect or incomplete beliefs about VSC.  The purpose of value stream costing is to get all employees focused on the root causes “actual costs”. Because VSC is so different from analyzing product costs, employees believe falsely that a VSC-based income statement is not GAAP compliant.  This is based on the false belief that standard costing must be used for GAAP-compliant financial reports. Another typical reaction is “These numbers can’t be right!” because the numbers look different from what they are used to. The result is a lot of stress.  It’s just human nature.

So, when I am helping a company introduce VSC, I consciously make myself aware of that these reactions may occur and look for ways to reduce this stress.

In my experience, what really helps is training.  The Lean company introducing VSC will get on board faster, once they understand two key facts about VSC, namely:

  1. It’s the best way to identify the root causes of your costs.
  2. All we are doing with VSC is applying standard Lean problem solving methodology (Plan-Do-Check-Act) to managing the costs of the business.

Once I get people to understand these facts, I invariably see the lights go on in peoples’ minds and feel the stress go down.

Here’s how you can understand this:

Let’s start with a fact that binds everyone together. Every company has a goal to be a low-cost producer.  Many companies, however, struggle with reducing costs in an effective manner.  For example, we can mostly agree that a management edict like “10% across the board cuts” is not effective way. Nor is strictly adhering to an annual budget going to work, because it is impossible to predict everything in an annual budget.

Now, let’s consider how Traditional companies differ in their approach from Lean companies.

Traditional (non-Lean) companies have problems cutting costs because they are going about cost analysis in the wrong way, looking at the wrong indicators, and not understanding what’s really driving their costs.

Lean companies understand that the most effective way understand costs, is to analyze any variability using root cause analysis. Once they identify the root cause, then they take corrective action to eliminate it. Eliminate the root cause, eliminate the variability. This is how Lean companies eliminate waste from processes.

Lean companies recognize there are two primary root causes of costs in a value stream (whether it is a production value stream or an office value stream). One root cause is the amount of production capacity required (people, machines, and facilities) to meet demand. The other primary root cause is the amount of variability in the value stream processes, such as quality problems, lack of flow, too much inventory and other wastes. And these two root causes are related because the more waste that exists in a value stream creates need for more capacity.

VSC makes the path to understanding how to improve costs more direct. It puts real power in the hands of the value stream manager because he or she gets critical actual cost information faster.

I like to use the following diagram as a handy way to contrast the two approaches.


VSC reports actual spending; a value stream manager can identify the decisions or events which were the root causes of the spending. Countermeasures go into effect quicker, and costs go down.

VSC is a much easier and more direct method for managing costs than any form of product costing. The traditional product costing process requires subjective allocations of fixed costs to products. It is quite difficult for a value stream manager to understand these allocations and they are useless to get to the actual root cause of the cost.  Please note: knowing the allocation method used is not the same as knowing the root cause.

So when introducing VSC into your company, first have a discussion on these topics:

  • Is your company meeting its cost management objectives?
  • What are the weaknesses of your current cost management/analysis system?

Then you can see Value Stream Costing as a method to achieve your Lean goals.


Time for Leadership – How Standard Costs Impact Company Behavior

There are many things wrong with using standard costing in an Lean company, but perhaps the most dangerous is when standard costing actually drives a company’s behavior in a way that makes Lean unworkable.  Here is an example:

Recently, I was working with a company on implementing Lean Accounting. The company manufactures products at one location, and sells those products in its stores. The stores also provide service on the products.  Manufacturing operations has been practicing Lean for about 3 years. They all work internally was on a Pull System and they were performing regular kaizen events. The company currently uses a standard costing system.

pushmiI was reminded of Dr. Doolittle’s pushmi-pullyu, a strange animal that had two heads at opposite ends of its body. When it tried to move at all it was stuck; both heads tried to go in opposite directions.

In this company’s case, both ends of the company seemed to be at cross- purposes.  The stores view themselves as the “profit centers” of the business and they see manufacturing as a cost center.  The stores need a standard cost for every product so each store can calculate its profitability. The conversation between stores and manufacturing typically revolves around manufacturing lowering its costs to improve store (and company) profitability.

After further discussion, I discovered that the store managers and the sales force are being compensated based on store gross margin (revenue less standard cost of goods sold) – no wonder lowering  manufacturing costs was such an important issue!   Because of this compensation policy, there was strong resistance on the part of the stores to defining the true value streams of the company. Doing so would have to include manufacturing and would involve calculating value stream profitability (rather than store profitability.)

As of the writing of this blog, this issue is still under discussion within this company. It has delayed the roll out of lean accounting.

What can you learn from this story?

It’s essential to understand why people within a company are pulling in a given direction. You have to keep asking “Why?”   In this company’s case they were using a standard costing system to determine people’s pay. This is what has stymied their Lean Accounting roll out.

In order to get everyone pulling together, management had to take the lead. They had to create an action plan to move the company off using standard costing for compensation.  Seems simple, but the key was understanding the impact of standard costing, so they could work through the related issues and clear the way forward.