Category: Lean Accounting Learning

Chapter 1 – Practicing Lean Accounting

The Practicing Lean Accounting Blog Series are excerpts from a new book, Practicing Lean Accounting by Nick Katko and Mike De Luca. For updates on publication and purchase, please sign up for the BMA mailing list at www.maskell.com.

The way the accounting function works, and the way accountants think, is very transactional. Accounting must process transactions based on specific time-frames: enter invoices daily, pay employees bi-weekly, pay suppliers weekly, close the books each month, send out monthly reports and analyses. These work routines create thinking patterns which focus on getting the work done to meet the deadlines. There is nothing wrong with this thinking, because it creates reliable and respected accounting functions in companies, which is a good thing. 

But to grasp lean accounting, the accounting function must expand its thinking beyond transactions, and into practices. Lean accounting is about continuous improvement, which means that the process of striving to improve never ends. Continuous improvement is not transactional, but must be practiced. The old saying “practice makes perfect” is applicable to lean accounting. The more that these new practices are mastered, the better you get at lean accounting. 

Lean accounting, simply defined, is the application of lean thinking to all accounting systems and processes – all of the roles and functions we just mentioned. What is unique about lean accounting, compared to other applications of lean thinking, is how it is applied to the dual roles of accounting. 

The overriding purpose and goal of lean thinking, in any industry, is to serve customers better. In financial accounting processes, what customers want is common knowledge, such as paying invoices on-time or closing the books quickly. In lean financial accounting, it’s about how to deliver these products and services in the least wasteful way possible. Lean accounting is about paying invoices on-time without having to get last minute approvals. Lean accounting is closing the books on-time without working punishing overtime.

Management accounting, on the other hand, is responsible for providing information (products) and consultation (services) to many internal users. The value that internal users receive from management accounting is the “decision-usefulness” of its products and services. Internal users want management accounting to provide clear insight into both financial and operational performance to make decisions that help the company achieve better results. Management accounting deals with the financial management of the entire company. 

Here is a summary of the practices of lean accounting

Foundational practices – These are standard lean practices which must be learned and mastered for any lean transformation.

• Understanding Value. Accounting needs to think differently about who accounting’s customers are, what their needs are, and how accounting meets those needs.
• Identifying Waste. Accounting needs to think differently about how it performs its work. What activities are really helping accounting serve its customers? What activities get in the way or slow down serving customer? Accounting may have gotten so used to these activities that they consider them to be “normal”.
• Lean Measurement. Accounting needs to think differently about how to measure progress and results in a lean company, beyond the monthly financial statements.
• Using PDCA. Accounting needs to think differently about managing and improving day-to-day work and how to begin eliminating all the activities that don’t serve its customers.

Applied practices. This is how the foundational practices are used to transform an accounting function into a lean accounting function.

• Improving Accounting. Accounting needs to think differently in order to improve accounting processes. Accounting needs to look at its processes from a lean point of view, using all of the foundational practices, rather than simply from a technical point of view. Accounting will also have to collaborate cross-functionally, to drive long-term sustained improvement. 
• Lean Financial Management. Accounting needs to think differently about the information and analyses it provides to internal users in a lean company, again using the foundational practices to inform this change in thinking. Accounting needs to lead in terms of aligning information and analytical practices to support a lean strategy. 

Sustaining practices. This is how lean accounting can provide leadership for a company’s lean transformation. 

• Lean Financial Leadership. Accounting, and companies, both need to think differently about the role that accounting plays in a lean company, with regards to supporting and sustaining improvements, not just in accounting, but across the entire company, to realize the financial benefits from its lean strategy.

Excerpted and adapted from the upcoming book Practicing Lean Accounting by Nick Katko and Mike De Luca, to be published in early 2021.

Why does Accounting need to understand customer value?

Accounting is a highly specialized, technical function in a business. Becoming proficient in accounting requires education and practice. Accountants focus on being good accounting professionals, running an efficient accounting department, and getting work done in compliance with their company’s accounting policies and reporting requirements.

Sometimes, though, accounting can focus too heavily on compliance reporting, a very narrow definition of customer value and requirements. When that happens, it blinds accounting to what their other customers value. Accounting can be so focused on the monthly reporting cycle, along with the applicable controls and policies, that accounting assumes this information also satisfies what its other customers want. This assumption can lead to accounting appearing to be out of touch, isolated, or difficult to work with and lead to accounting having a poor reputation inside a business.

The nature of accounting’s work and interaction with others tends to create transactional relationships. In lean accounting, the goal is to put the entire customer experience first in thinking, not just the transaction. To better understand customer needs and requirements beyond the transactions, accounting may need to develop better relationships with their various customers.

Understanding customer value will also allow accounting to better determine if the quality of the information or service it provides meets its customers’ needs. This is not to say that accounting does not already have some understanding of this, which it does from a financial reporting viewpoint and typical financial transactions such as paying invoices. Diving deeper into understanding value will prevent accounting from making assumptions about the quality of the information it supplies to its internal customers.

Another important benefit to accounting in understanding customer value occurs when accounting begins to study and improve its processes. The principle of flow and pull means that accounting’s goal, like any other function, is to flow value to customers at their rate of demand. To understand if you are making progress toward achieving a goal, you must measure it. Understanding value will allow accounting to develop the proper performance measurements to know in real time if value is being created and delivered.

Making improvements is not a haphazard, random process. It’s a disciplined, continuous learning activity requiring the ability to distinguish between the process steps that create value and those that do not. When customer value is understood, it becomes possible to differentiate between process steps that create value and those that do not. Focusing more effort on the value-creating activities and eliminating or reducing nonvalue-added activities results in a better customer experience and, ultimately, increased customer satisfaction.

Customer Value for Accounting’s Customers

Accounting has a variety of customers, both internal and external. Rather than address each type of customer specifically, let’s look at the broader categories of customers based on their primary interaction with accounting, what defines quality, and what informs their experience.

Users of external reporting information

This group of accounting’s customers includes internal customers, such as senior leaders or owners; stakeholders, such as investors, shareholders, and banks; governing bodies, such as boards and trustees, government, or other regulatory agencies. These users value information that meets reporting compliance requirements and allows them to make informed decisions about a company and evaluate its performance.

As most accountants know, meeting compliance reporting requirements is one of the essential responsibilities for an accounting function. It is the fiduciary responsibility of the accounting function to a business. Accounting professionals are trained in compliance. Because compliance is so important, accounting processes, controls, and procedures are put in place to ensure compliance is achieved before the information is distributed to these customers. Unreliability – or the perception of unreliability in accuracy or timeliness – in externally reported financial information can have grave consequences for a company.

Because accounting understands value to these customers quite well, there is an opportunity  to develop a better understanding of the processes that create this value. Improving these processes through the elimination of waste will create more capacity (time), allow the work to flow faster and error-free, and possibly relieve overburdening of the employees who perform these activities.

Recipients of financial transactions

Accounting processes financial transactions between a company and other parties related to cash receipts and disbursements. The recipients of these transactions are another group of accounting’s customers and include a company’s customers, suppliers, and employees. What these customers value from accounting are  financial transactions completed “right the first time,” in a timely fashion, and for accounting to be easy to work with.

–Company’s Customers

Accounting’s primary interaction with a company’s customers is through the invoicing or billing process. A company’s customers expect all the information on the invoices they receive from accounting to be accurate. Inaccuracies become especially annoying to customers if they sent the company a purchase order specifying all terms and conditions but received an inaccurate invoice.

Although accounting doesn’t provide the product or service that the customer is purchasing, it can shape the customer’s experience and impact customer loyalty through how easy and seamless billings and payments are.

Another thing to consider when determining value is to evaluate how easy it is for a company’s customers to interact with accounts receivable. Are invoices easy to understand? Are payment methods straightforward? If a customer has a question about an invoice, does accounting have a quick response time to an inquiry, and is the resolution process simple, friendly, and customer-focused? It’s situations like this, when the quality of an invoice is in question, that understanding customer value, in the eyes of the customer, is most important. Although accounting doesn’t provide the product or service that the customer is purchasing, it can shape the customer’s experience and impact customer loyalty through how easy and seamless billings and payments are.

–Suppliers

The mirror image of a company’s relationship with its customers is its relationships with its suppliers. Many companies do everything possible to please their customers but treat their suppliers poorly. For example, under the guise of “cash management,” a company may set payment terms to suppliers beyond the standard 30 days and require their suppliers to accept these terms or not do business with the company.

Suppliers are an essential part of a company’s supply chain. A well-functioning supply chain in a lean organization is necessary to support the value streams which produce the company’s goods and services that drive revenue generation. From the suppliers’ point of view, the overall experience between suppliers and accounting must create value. Yes, suppliers must perform, and those performance criteria must be clearly spelled out. The same is true for accounting.

–Employees

The value to employees of accurate, timely paychecks and other reimbursements is well understood by accounting. Like customers and suppliers, it’s the overall experience employees have with accounting that matters. The process steps employees may have to perform to be paid or resolve a discrepancy can be cumbersome to an employee and contain unnecessary activities. These activities take up employees’ time, so developing minimal-waste lean processes for employees to record time or expenses creates value in the eyes of employees.

Users of internal reporting

One of accounting’s largest and most customer groups is the business managers (including senior leaders and owners). These managers get a combination of financial and operating information from a company’s management accounting system (of which accounting is the steward) and direct analytical support from accounting to measure performance, perform analysis and make decisions.

Management accounting is the link between a company’s strategy and its operating practices and ensures alignment between the two. Management accounting information and analytical practices also support the customer-facing value streams in a company that produces the goods and services that drive revenue growth.

The value to users of internal reporting information is that it helps them make good business decisions. For any decision-maker, information must be both relevant and reliable. Relevant information improves decision-makers’ capabilities to predict future outcomes or provide more accurate feedback on performance. For information to be relevant, it also needs to be delivered in a timely fashion. Reliable information represents reality at the time an analysis is performed, and that the quality (accuracy) and lack of bias in the analysis can be counted on.

Lean transformation changes what managers value

In any company embarking on a lean transformation, in any industry, the definition of relevant and reliable information will change in some form or fashion. A lean transformation also has an impact on the types and frequencies of analytical practices and accompanying decisions. Another way to say this is that a lean transformation changes what accounting’s internal customers value from accounting. It is very important for accounting to recognize this and be proactive about developing their lean accounting vision.

A helpful context for understanding and prioritizing what information is valuable to accounting’s internal customers is to compare value from the perspective of the company’s customers to what accounting understands to be the relevant and reliable information to its internal customers. It’s important to keep these two perspectives of value aligned so that the work accounting does to improve value to its internal customers will ultimately improve the company’s delivery of value to its customers, the ultimate purchasers of the company’s products or services.

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?

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. 

Here is a 35 minute interview I did for the Kaplan’s Financial Management Network, which answers the basic questions about Lean Accounting:

https://players.brightcove.net/2974989255001/rJ3YfAK4e_default/index.html?videoId=5851931685001

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.