Why a Lean Quoting Process – Part 3

This is an excerpt from Ed Grinde’s new book Leveraging Lean with Lean Quoting, now available on amazon.com.

This is the third and final article on developing a new lean quoting process.  In the first two articles I discussed (1) the need for a lean quoting process and (2) the part of the process that moves most quotes quickly through to completion.  This last article talks about what happens to the few that fail a filter and must go to the daily opportunity review process.  Those are the orange boxes below.

As shown in the flow chart above, any quote that fails a filter due to capability, capacity, material content, or strategic direction will go to the daily opportunity review boards.  This is a meeting at a location set up to have all functions of the value stream come together to discuss these quote opportunities that will drive the sales, and profits, of the value stream to a higher level by using lean accounting to take advantage of the gains you have made with your lean improvements.  

This meeting needs to be a priority for all concerned, and this is not a meeting for just the quote team.  You want to have people representing the plant floor, the quote team, value stream engineering, the value stream leader, accounting, sales representatives, and occasional visits from the general manager, marketing, and continuous improvement.  At this meeting key and/or large quoting opportunities will be discussed as a team and the decisions made will be by the team.  

The purpose for this cross-functional team is 3-fold.  First is that when it comes to these key quotes you want to hear all functions concerns/issues, if any, about the quote.  Next, with all functions regularly attending these meetings you can get most answers right there at the meeting that the quote team would previously have to wait hours if not days/weeks to get an answer. Lastly, this is a great learning opportunity for all attendees.  They will learn more about the overall business and will make better decisions in the future with what they learn at this meeting.  

What this standup meeting setup could look like is shown below.

The key reason for a stand-up meeting is that you want the meeting to be fast and focused.  If you allow folks to sit down it will make it easier for people to have side conversations and become a distraction to the meeting.

Note that there are 4 boards.  They are the Current Opportunities, Financial Impact, Key Opportunities Quoted Status, and the Opportunity Gap Board.  Also, of interest is that this should be a stand-up meeting, ADA considerations notwithstanding.  At the start it will be best if the value stream leader runs the meeting, but after everyone is comfortable with the process you should encourage others to take turns running the meeting.  

How the boards work is as follows:

  • The Current Opportunities Board will have all quotes that failed a filter and the final disposition has not been made.  There will be key data about the job being quoted, action items assigned with due dates, and any other pertinent comments.  After deciding to quote or not quote, you take the opportunity off the board.
  • The Financial Impact Board is where you will review how large opportunities will impact the value stream profits using lean accounting.  It will contain the lean P&L for the value stream in question, other value streams, and the plant P&L.  It will also show non-financial data to consider such as impact to inventory, is there a quality concern, and will it affect your value stream capacity.
  • The Key Opportunities Quoted Board will be used to track the jobs you decided to quote and will stay there until the job is won or lost.  Once a job is either won or lost you take it off this board.
  • The Opportunity Gap Board is where you will document jobs you passed on because you were lacking either the capability or capacity to do the job.  You will use this board in your annual or semi-annual value stream assessment to see where you can expand your core competencies and what the potential sales level could be.  It also helps marketing see where new opportunities may lie.

The first few meetings will be a bit awkward because most of these participants are not used to be asked their thoughts and opinions on future business opportunities.  But as you continue with these daily meetings, and encourage active participation, they will become more comfortable with the process and start interjecting their thoughts and opinions.  

Why a Lean Quoting Process – Part 2

This is an excerpt from Ed Grinde’s new book Leveraging Lean with Lean Quoting, now available on amazon.com.

In my previous article I said I will discuss a unique quoting process that will allow you to quote faster and free up quoting manpower to spend the appropriate amount of effort on the few key quotes that can drive your profits higher.  This article will highlight that process.  This new process is designed to run through 95+% of all quotes quickly and get back to the customer faster than the competition.  It also frees up the time for your value stream quoting team to spend the appropriate amount of time on the handful of large and/or special quotes that will truly drive the profits of your company.  

The basis of this new process is to develop filters around key criteria that are pass/fail in nature.  Properly developed, 95% or more of your quotes should go quickly through this process and get to the customer in a day’s time.  The quotes that fail any of the filters will go to the daily meeting for these failed quotes.  This daily meeting I call the Opportunity Review meeting.  Here the quote that failed a filter will get the appropriate level of discussion necessary to determine if you will quote the business.  And if you choose not to, how to capture the data for future consideration.  

Figure 1 shows the high level process.

In order to get through the “Yes” lane, there are 4 key filters that have to be passed.  

Filter #1 = The first is the capability filter.  This is a detailed listing/matrix that has what you are able to do on the plant floor.  It will be segmented into green (easy things or things that you do well with common material content), yellow (processes and/or material that you don’t do a lot or have some difficulty with), and red (processes/material that you can’t do or don’t work with.)  Below is an example of a capability filter. 

Filter #2 – Capacity.  Can your value stream handle the volume a given quote would bring to the value stream.  If you are working with a lean boxcsore then you can look to the capacity section of the boxscore to see if you have enough capacity to take on the work. Another way to look at the opportunity is the size being quoted.  This can be in either units or dollars.  Units are a better volume determinant for small parts, but for large products it is better to use dollars.  What you would do is create a filter that states if the opportunity you are quoting is over a given number of units or a given $$ size, then it fails the filter and goes to the daily opportunity review meeting.  

Filter #3 – Material content.  This filter is determined by the material cost as a percent of the target price.  (Target price being what the customer is willing to pay for the product.  Remember, the cost to manufacture the product has no bearing on the price the customer is willing to pay.  More on this in my soon to be released book “Leveraging Lean with Lean Quoting”)  In order to have this filter you need to segment your products into distinct grouping by volume, complexity (high/medium/low) and by product class.  Keep all of these criteria as high a level as possible.  Below is an example of a material content filter.  

You get these percentages through analysis of your sales data and see where you are successful.  From there you make the determination as to what level of material content is deemed acceptable for the smaller orders.  A subset of this is how to handle this filter if you have a target price or if you don’t have a target price.  If you have a target price then you just divide the material cost into the target price and if the material content percentage is lower than the above matrix, it passes.  If it is higher than the material content listed it fails and you either no-quote or you quote at a higher price that passes the filter.  If you don’t have a target price, you can simply divide the material cost by the reciprocal of the maximum acceptable material content based on the matrix above (material cost/(1-max matl content %) and that becomes your minimum target price.  You can always submit a higher price, but this is the lowest price.

Filter #4 – Does this job support your strategic direction?  There is no template for this.  To be able to make this decision you need a close working relationship with your marketing team or whatever function drives this direction.  You don’t want to be taking on jobs that don’t support your strategic direction.  You need to understand what your area of strategic attention is, what is being cash-cowed, and what areas are you avoiding.  Depending on which area the opportunity falls in will determine how you proceed with the quote.  

If the quote makes it through all the filters successfully, then the business is quoted, and you go to the next quote.  This part of the process will drive additional sales merely by being able to successfully complete more quotes and those quotes will get back to the customer faster.  How many quotes for new business have you lost because you either couldn’t complete them in time or they were so close to the deadline that the customer had already made up their mind as to who was getting the business.

If the opportunity fails any of the filters, the quote goes to the daily opportunity review meeting.  This is where the real growth will come from.  Because you have saved the quote team so much time from the above listed process, they will have time to participate in this new daily meeting.  And this meeting will focus its attention on the large or strategic opportunities that will drive exceptional growth.  In my next and last article I will discuss this daily meeting.

Why a Lean Quoting Process – Part 1

This is an excerpt from Ed Grinde’s new book Leveraging Lean with Lean Quoting, now available on amazon.com.

Have you implemented lean within the four walls of your facility and you are wondering, “We have made all of these improvements: faster flow, better quality, improved employee engagement, and increased on-time delivery.  Why don’t the results show up on the Profit and Loss statement?”  This is a common question within companies early (and sometimes later) in their lean journey.  

You may have realized some minor cost improvements using attrition to assimilate the excess employees.  But you are not seeing the large-scale profit improvements.  There is a simple reason for that.  A true lean transformation is not a cost cutting exercise, but rather it is a culture change first and foremost.  It is respect for your employees so they are not worried about their jobs disappearing, and they are challenged to be the best they can be.  After that, it is really a growth strategy.  You need to use that freed up capacity to GROW the business systematically and strategically.  The true benefit to the P&L of lean is to allow you to sell more with the same manpower and equipment.  

What are your biggest expenses?  Usually it is materials, depreciation, labor and fringe benefits, utilities, and supplies.  The only real variable costs are material content and a few supplies.  Your depreciation does not change just because you have improved flow time by 75%.  You might see a reduction in overtime each month from efficiency gains; otherwise, your labor will only change if you reduce the employees you redeploy due to productivity gain.  But doing that will stifle your lean deployment.  If there is attrition, you can avoid hiring by utilizing the redeployed employees.  But again, these are not huge savings.  Most of your utility expense is for either heating or cooling the facility.   Therefore, the only utility savings comes from running equipment less which is minimal from a financial impact. 

Also, your lean activities pull capitalized labor and overhead from the balance sheet to the income statement as your customers realize that you are delivering product faster.  While this is good, they will realize that they do not have to order so far in advance nor keep as much inventory on hand.  You may see a short-term sales drop because your customers will start depleting their excess inventories without reordering because they know you can deliver faster.  

In Exhibit 1-A you can see the impact to the value stream income statement.  This explains why top management might not be able to understand all the excitement on the floor about the improvements from all the lean efforts.  

If this were all you had to look at, you would not want to go any further with lean.  Sales have stayed the same.  Your profits actually decreased in dollars and as a % of sales.  Even if you removed the impact of pulling into the quarter the capitalized labor and overhead from prior quarters that were sitting in your inventory, Exhibit 1-B shows that the impact is minimally favorable.  Here you see that we only added $65,250, or 0.4%, to the bottom line for all our effort.  

Let’s look at the income statement where instead of reducing the labor to sell the same amount of product, we use the freed-up capacity to strategically sell more product.  That impact is shown in Exhibit 1-C.

This is the real power of lean as a strategy!  We improved our profit margin by 1.6% points and $729,600.  In our analysis you will note that we acknowledged we could selectively and strategically go after business in a more aggressive fashion.  A slightly lower selling price will create a higher material content percentage (35% to 45%).  Because we utilized our excess manpower capacity to sell more with the same number of employees, we were able to make a significant improvement in our profits. Using lean as a growth strategy, using your freed-up capacity, is the most effective way to take advantage of your lean improvements. 

Thus far, the discussion has been around the strategic issues as they relate to the Profit and Loss statement.  Another area in which lean impacts the financial statements is on the balance sheet and the statements of cash flow.  For the balance sheet you will see a lowering of all three components of inventory – raw material (RM), work-in-process (WIP) and finished goods (FG).  You will see a decrease in FGs because you will need less in stock since you can replenish your FG inventory much faster.  You will also see a lowering of WIP inventory because your product is moving through the plant much faster and not sitting nearly as long.  This is partly because it is flowing faster but also because you should have instituted Standard WIP (SWIP) which controls the amount of inventory allowed on the floor between successive operations.  Finally, you will need less raw material in stock because you can schedule the receipt of the raw material in smaller quantities and more frequently due to the speed of product flow.

Because you will have less money invested in your inventory, the line of credit you utilize to manage your business will require less money, thereby reducing your interest expense.  Finally, you will have an improved cash flow as you sell more product and tie up less money in inventory.  This outcome is critical to a growth strategy since now you have more cash available for capital expenditures, if needed, or for other investment opportunities.  

Even with all these balance sheet and cash flow benefits that are important, we find that too many managers/general managers/presidents fixate on the impact to the income statement.  As noted earlier, until you properly utilize your excess capacity to build and sell more product, the benefit to the income statement is minimal at best.  So why are customers not flocking to you with new business?  You are delivering faster and with better quality.  They get their product on time and can reduce their in-house inventory.  You would think that you would be flooded with new opportunities and you would win many more quotes.  

So far, your lean activities have attacked the plant floor but not the quoting process.  How do you change the whole quoting process to be nimbler, thereby allowing the company to process and win more quotes at the margins desired?  You simply cannot continue to use standard cost thinking, silo activities, and linear processes to accomplish the growth that lean promises.  Just like leaning out the factory floor, you must lean out your quoting processes to utilize the capacity gains your other lean efforts have garnered.  In a subsequent article I will discuss a unique quoting process that will allow you to quote faster and free up quoting manpower to spend the appropriate amount of effort on the few key quotes that can drive your profits higher.

Value stream management in emergency management

NICK KATKO, RICCARDO PAVANATO, GIANANDREA CAPO

This free article appeared in the Harvard Business Review – Italy as part of a free series of articles published to help companies deal with the consequences of the COVID-19 pandemic.

Companies go bankrupt. This is the naked truth that even Jeff Bezos pointed out stating that every single company is intended to fail sooner or later.  In fact, if we look at the numbers, the average life of Italian companies is just 12 year[GC1] s. The goal of people working in the organizations and of those who manage them is to postpone that moment as much as possible. This can happen if a company is dedicated to continuously improve its processes, defining and deploying efficiently its strategies, focusing on constantly reviewing customers’ needs and designing value streams that can fulfill those needs.

But organizations are social entities that are goal-directed, are designed as deliberately structured and coordinated activity systems, and are linked to their external environment (R. L. Daft 2017). To survive, a company must not only interact with external environment, it also has to manage and organize its internal relations, thus including all the people that cooperate and are connected with external environment. One of the most common ways to manage organization is to create compartments of people that share similar tasks, centralizing decisions and promoting the establishing of hierarchical control. Without a doubt this kind of functional organization has the merit of facilitating vertical coordination and relations between people that works in the same process steps, improving their efficiency.

Evidence is clear that in the last few years markets shows more and more volatility, and customers’ needs are in fast and continuous evolution, but never as drastic as it happened with the actual pandemic, where some companies abruptly had no more market and other, on the contrary, had to face high demand peaks.

In the first quarter 2020 the balance in startup and closed companies is -30.000; to find such a negative trend we need to look at 2013 crisis (Unioncamere Movimprese 17/04/2020). A Cerved Rating Agency study shows that, in case the pandemic would have ended by June 2020, the number of companies with a very low rating (high risk of default) in Italy would have increased of 8 percentage points. If the pandemic would continue till the end of the year, this number could increase to 26 percentage points because of the shocks created on Italian market.[GC2] 

Being able to create compartments in a company in this context could become particularly useful, as it could be necessary to close a portion of the organization due to deep markets changes or because of some infection cases. For a functional organization structure it could be easy to create as well physical compartments as often such organization correspond to a similar structure of offices and space; this could offer the company a chance to close only a portion of the business, maintaining a partial functionality.

Is this organizational model useful to reduce the risks and to face the actual situation? Only partially. In fact, a company that had to face a market fall in a particular product line won’t be able to just “turn off” one of these compartments, as well as it won’t be able to close the purchase office for a reduction in the supply chain workload, or to close the order entry office because there has been an infection case. Doing so would result in the paralysis of the entire organization also affecting the part of the business that is still working. How is it possible to face these extreme events reducing the risk of being wiped out?

An organization based on value streams

The best way is to change the organizational model is to switch to a value stream organization. Sometimes big companies adopt a divisional organization, which is similar, because it divides the company by business units, which can make it easier to close or convert those business units that are not profitable anymore or are not useful to satisfy a specific customer’s need. This is something that can be adopted also in smaller environment, creating compartments that don’t put together people that do the same job but, on the contrary, put together all the people that work in the same value stream.

Once you identify your value streams, you can create a team of people that work in different offices or departments, from the order receipt to the production, order fulfillment and shipping. This team won’t report to a functional manager but to a value stream manager, someone who will be accountable for the performance of the entire process. The basic principle is to organize and manage the company as if it were made of many micro-companies, each of them is responsible for everything needed to satisfy a customer. This way the organization is more agile, quicker to react to change because closing or converting a value stream has little impact on the rest of the company. 

To adopt such a model efficiently you need to adopt a different managerial style, where value stream managers have an entrepreneurial role as they are accountable for the profit of the entire value stream. Like entrepreneurs who manage and control a company through a set of KPI and financial reports, a value stream manager is in need of a set of tools that can lead to better decision making to manage and improve the value stream and is also aligned with the strategies defined by the company.

At the same time, these tools are needed to align people that do totally different jobs in the same value stream and that usually, in a traditional organizations, report to different offices or departments. These functional areas have often different KPIs, different objectives and often they are even in contrast among each other. Having a common set of KPI and report is useful to create a common view over the ultimate goals and therefore, using techniques such as lean accounting is mandatory to create these tools.

The relevance of indicators of performance

The first consideration is that the main generators of profit in a company are, as a matter of fact, the value streams. Hence, management accounting and every internal report must be focused on measuring and monitoring such objects.

Defining and implementing a set of operational KPIs is the first step to create alignment among the people working in a specific value stream towards a common objective. These KPIs must measure the relevant performance dimension for a process, that are: velocity, delivery, quality, productivity, flow, and continuous improvement culture. The value stream manager must learn to understand the relationship between the operational measures and the financial performance generated, so that the best possible decisions can be taken to continuously improve the process. 

Management accounting has the important role to build a reporting tool that can show the resources that are used by the process (materials, men, machines, etc.) and the output value generated (product or services delivered to the customer) so that it is possible to link a financial impact with the decision that generated it.

Implementing the value stream management, supporting it with a management accounting system based on lean principles, is a key element to build a lean organization, efficient and responsive to the abrupt market changes we have recently seen that could undermine the company stability and in some cases even endanger its survivability.

Nick Katko , President of BMA, organization worldwide for the lean accounting and author of “The Lean CFO”, (ed. Guerini Next). 

Riccardo Pavanato , CEO auxiell. 

Gianandrea Capo , Value Delivery Manager auxiell.   


 [GC1]Italian data, we should present it as it is or find same information regarding US companies?

 [GC2]Italian data on companies, we should present it as it is or find similar data on US companies?

Myth-Busting: Time Drives Costs

A few years ago I was working with a software company its lean transformation.  During a training session someone made the statement that they must charge higher prices to their new clients for training because their training costs are higher. I opened up a discussion on that statement and the general consensus was “it takes us longer to train our new clients on our software that the competition.”

I raised the point that the software company’s  training costs are fixed – based on the number of trainers they have on staff. I  then facilitated a quick “5-Why” exercise and the primary root cause of why their training takes longer was the complexity of their software.

The thinking inside this software company was the longer it takes to perform the training, the higher the costs for the software company. This is the same thinking that exists in manufacturing – the longer it takes to produce a product, the higher its costs.

The root cause of this thinking is based on traditional cost allocation methods, whether it be allocating training costs to a software implementation project, to a complex tax return in an accounting firm or to a product being manufactured.

Under this thinking, each business would seek to reduce the time it takes to process the products/services to “reduce” costs. Or prices would be adjusted to “cover” the additional costs.

In Lean Accounting, we want to stop allocating costs based on time because it just isn’t really an accurate way to understand costs. In order to make this transition, financial thinking in an organization needs to change.

  1. Processing time creates value: Lean companies recognize that the time to produce a product or service is based on the value-added processing time (e.g. cycle time). Typically, the more value that needs to be created, the more time it will take resources (people and/or machines) to create the product or deliver the service.
  2. Waste adds to costs: any of the 7 wastes of lean adds costs to the business as well as increasing lead times to produce products or services. Some costs may be direct,  such as poor quality in manufacturing increases material costs. Other costs are less direct – a company hires more people than necessary because waste exists in the processes. 
  3. Lean companies also recognize that the cost of the resources, to the business, is typically fixed. This means the business will incur these costs on a regular basis regardless of time spent of individual products or services. Lean companies make cost decisions based on long-term trends rather than which work must get completed today. 

Lean Financial Thinking – Labor Costs

Labor costs are fixed based on how many people are employed. Companies hire more people based on total demand projections. Full-time, hourly employees work a 40-hour week, regardless of demand. Yes, a company may have temporary or part-time workers that they can bring in or send home based on demand, but usually these are not the primary workforce.

Measuring the waste in a process and understanding the capacity of a process is what will control labor costs. Employment of continuous improvement and other lean practices eliminates waste, improves capacity and creates time. This time is then applied to value-added activities, which improves productivity and prevents lean organizations from having to hire additional people.

Lean organizations consider their employees to be their most important asset, which is counter to how employee cost is shown on the financial statements – as an operating expense. The second most important asset of a lean organization is time, which does not appear anywhere on financial statements.

Lean organizations develop employees’ thinking so on a daily basis they become experts in the difference between value added activities and waste and have the skills to eliminate the waste on a daily basis. This work is done through observation and daily performance measurements. 

Cost allocation systems, which are primarily used by managers, really work in direct conflict with daily improvement activities and measures. It’s important for the financial leadership of every lean organization to eliminate the use of cost allocation methods. 

An Accountant’s Guide to Understanding Lean Accounting

I think one of the difficulties accountants face in understanding Lean Accounting is because we are trained to be “doers” of accounting. Our training & education is about how to perform accounting tasks & functions, from learning the basics of journal entries in Accounting 101 to how to close the month in the company we work at. We want to master how to execute, and the better we are at executing, the better accountants we are.

To understand Lean Accounting, accountants need to adjust their perspective from “doing” to “practicing”. And the first step to begin practicing Lean Accounting is the change the way we think as accountants. 

Lean Accounting is like Lean – it is a journey towards a destination. Our journey is practicing Lean Accounting and the destination is organization improvement. Our 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 about us (the accounting function) it’s about the organization as a whole and the customers the organization serves. 

The second change in perspective for accountants is the understanding & 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 we think about the processes we “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 & 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.

“Practice makes perfect” is an old wise saying, and applies to Lean Accounting. The first step to practicing anything new is always mental, whether it be a musical instrument, a sport or a new skill. Once someone opens up their mind, it becomes easier to learn how to do something through regular practicing. If you are new to Lean Accounting, spend time opening up your mind, before diving into the “how to do” of Lean Accounting.

Lean Accounting is applicable to any company, in any industry, that commits to a Lean strategy.

I like to define Lean Accounting this way:

  • Lean Financial Accounting – applying lean practices to accounting processes
  • A Lean Management Accounting System to support any business that is Lean.

I’ve also heard Lean Accounting experts such as Jean Cunningham, Jerry Solomon, Brian Maskell & Orie Fiume explain it this way:  Lean Financial Accounting as “Lean for Accounting” and a Lean Management Accounting System as “Accounting for Lean.” 

It doesn’t really matter exactly what terms or phrases are used, what is important is to understand the distinctions. Let’s look at both in more detail.

Lean Financial Accounting is applying lean practices in all accounting processes to improve productivity, delivery, quality & service. Eliminate waste in accounting processes. A simple example is applying lean practices to eliminate waste in the month-end close process to have a shorter close cycle. 

Any accounting department can begin applying lean practices to its accounting processes, even if your company has not yet committed to beginning its lean journey.

Applying lean practices to accounting processes in no way compromises meeting financial reporting requirements, maintaining compliance with tax laws or other regulations or the internal controls to maintain compliance. In fact, from a lean point of view, maintaining compliance is the quality standard of accounting processes.

Management accounting systems are used by management to control & measure the operations of a business and provide a decision-making framework for all types of business decisions. Management accounting systems are for inside the business and not intended to external stakeholders. What we are really talking about here is financial analysis, operational analysis, measurements & other information required to run the business. Management accounting systems do not have to comply with any external regulations.

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 criteria 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 disconnect between Lean practices and the information management will be receiving to understand how well the Lean business is running. 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.

Lean Accounting and 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: Aligning Financial Management Practices

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.

Lean Accounting: Alignment of Financial Statements

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.