How Lean Accounting aligns Lean with the accounting function

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

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

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

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

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

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

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

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

Lean Accounting: Aligning the Lean Organization

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

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

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

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

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

Alignment with the Lean Strategy

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

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

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

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

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

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

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

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

A REAL-LIFE EXAMPLE

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

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

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

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

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

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

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

Material & Machine Cost Reduction (Part 3 of 3)

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

As a reminder:

Effective Measurement: Actual cost as a % sales

Goal: reduce cost as a % of sales over time

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

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

Material Cost

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

Purchase price of parts

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

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

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

Here is calculation for direct cost savings:

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

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

Quantity of material

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

Scrap

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

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

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

Current State

Annual scrap cost = $50,000

First time through rate = 70%

Future State

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

Inventory

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

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

Current State

Average materials inventory = $1,000,000

Days of Inventory = 60

Future State

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

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

Cost reduction of inventory management activities

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

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

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

Machine  & Equipment Costs

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

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

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

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

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

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

Wrap Up

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

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

Labor Cost Reduction (Part 2 of 3)

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

Effective Measurement: Labor Cost as a % sales

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

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

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

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

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

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

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

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

Here are some examples:

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

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

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

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

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

Cost Reduction in Lean Organizations Part 1 of 3

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

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

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

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

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

Method

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

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

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

Measurement

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

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

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

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

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

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

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

Financial A-3 Thinking

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

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

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

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

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

The Fundamentals of Value Stream Costing – Part 3 of 3

Shared Value Stream Costs

Shared value stream costs exist because resources or consumption of goods & services may be shared by value streams. Shared value stream costs are operational in nature and each value stream can influence the total cost through operational practices and decisions, however the actual spending decisions and management of the costs are outside of any one value stream.

Shared value stream costs are typically assigned to value streams when creating a value stream income statement in order to understand value stream profitability. Assigning shared costs to value streams should be done using the simplest method possible, based on how the value stream influences the shared cost.

The 3 primary types of shared value stream costs are facilities & warehouse; production monuments and operational support functions. Let’s look at each in detail.

Facility & Warehouse Costs

Facility and warehouse costs consist of the rent, interest, utilities, repairs, maintenance and depreciation. Value streams can influence total facility and warehouse costs by reducing the amount of space needed. Therefore, assigning facility and warehouse costs to value streams is best done based on space (square feet or meters).

Production Monument Costs

A production monument is a value-added process step shared by value streams.  Production monument costs consist of the direct costs of labor, material, machine and other costs. Value streams can influence production monument costs based on demand for the parts the monument must produce. Therefore, product monument costs should be assigned to value streams based on percentage of parts produced for each value stream.

Operational Support Costs

Operational support functions consist of purchasing, planning, engineering, quality, maintenance, receiving and material management. In the early stages of a lean transformation, operational support functions may exist as separate departments, which would mean these costs need to be assigned in some fashion to value stream income statements.

In the middle stages of a lean transformation, you may see some operational support work move into value streams, either by moving operational support people directly into specific value streams or moving the work into the value streams to use available capacity. The result is more direct value stream costs and less shared costs.

This process will continue as the lean transformation matures and the organizational structure moves towards more of a value stream organization, at which point there would be minimal shared costs.

Determining how to assign operational support costs to value streams can create a lot of interesting discussion, so it is best to go back to the standard explained earlier: Assigning shared costs to value streams should be done using the simplest method possible, based on how the value stream influences the shared cost.

For operational support functions that consist of primarily labor costs, it’s best to assign costs based on ratio of full-time equivalent operational support employees that work in each value stream to total employees in the function (whole numbers only). Don’t overthink this or attempt to create a complex tracking system in an attempt to be “precise.”

For example, use the 80/20 rule to determine “full-time equivalent”: If on average a certain number of employees in an operational support function spend 80% of their time in one value stream, use this number as full-time equivalent. And if this cannot be done simply and easily, don’t try to assign the costs because over time, it may get easier due to the maturity patch of shared operational support costs.

The Fundamentals of Value Stream Costing – Part 2 of 3

Value Stream Costing Categories

In value stream costing, we like to categorize value stream costs either as direct costs; shared costs or business support costs.

Direct value stream costs are the costs that a value stream controls through operational activities and decisions. Direct value stream costs are rather easy to identify once value streams have been identified and mapped. From an accounting perspective, value stream direct costs can easily be charged to one value stream when posting to the general ledger. The cause – the spending decision and the effect – the expense posted to the general ledger, are quite clear, direct and natural. The 4 primary types of direct value stream costs are material, labor, machine/equipment costs and other direct costs. Each of these will be discussed in detail later.

Shared value stream costs exist because resources or consumption of goods & services may be shared by value streams. Shared value stream costs are operational in nature and each value stream can influence the total cost through operational practices and decisions, however the actual spending decisions and management of the costs are outside of any one value stream. The 3 primary types of shared value stream costs are facilities & warehouse; production monuments and operational support functions. Each of these will be discussed in detail later.

Business support costs are all the other traditional organizational costs that would be considered selling, general and administrative costs. These costs are typically not assigned or allocated to value streams.

In manufacturing organizations, there could possibly be a 4thcategory of costs – product development. Lean manufacturing organizations consider product development a separate value stream, beginning with product concept and ending with product launch and there would be applicable direct value stream costs for the product development value stream.

Material

Value stream material cost is the actual cost of material consumed by a value stream, and can be identified either at the point of purchase or the point of issuance. Purchased material is used when the 100% of the material goes into one value stream.

If purchased material is shared by multiple value streams, then the material cost would be based on material issued to a specific value stream.

Using material consumed to establish direct cause and effect relationships between material entering a value stream and the 3 operational outcomes – produce and sell (which is the desired outcome); scrap or stock.

Labor

Value stream labor cost is based on the employees assigned to work in specific value streams. Through the process of value stream organization, value streams become the primary unit of operational organization, replacing operational departments.

Once these employees have been identified, the simplest method to assign the costs are through a company’s payroll system. Payroll systems have fields such as cost centers or departments, and this allows companies to assign employees and auto post labor costs to the general ledger. Auto posting of labor costs to value streams can be accomplished by modifying the proper field in your payroll system.

If this level of detail poses an issue due to the confidential nature of salaries, it is possible to assign labor costs based on ratio of full-time equivalent employees in a value stream to total employees in all value streams. If this method is preferred, it is recommended to only use whole numbers of full-time equivalent employees and avoid fractions or percentages.

Machine & Other Costs

Value stream machine/equipment costs consist of the depreciation, repairs/maintenance, tooling and utility costs. Value stream maps identify the specific machines in each value stream, and actual costs can be recorded into the general ledger through accounts payable process.

Any other cost which can naturally be charged in the general ledger to one specific value stream can be considered a direct value stream cost. Avoid creating allocation systems in accounting to try to be precise. It’s also important to consider the materiality of any other costs because in most cases labor, machine and material costs make up the majority of direct value stream costs.

In the next blog we will look at shared value stream costs.

The Fundamentals of Value Stream Costing – Part 1 of 3

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

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

Deeply rooted paradigms exist about understanding and managing costs, usually based upon traditional financial management practices, industry practices or external financial reporting requirements. Many of these paradigms conflict with lean thinking, and if these paradigms are not changed, then eventually there will be conflict between the lean strategy and cost management & analysis practices.

The solution to this problem is value stream costing, which is a set of new paradigms based on the true cause & effect relationships between lean operating practices and costs. In this series of blogs, you will learn:

  • The lean thinking cost paradigms which must be established in lean organizations
  • The difference between direct value stream costs and shared value stream costs
  • How lean organizations define fixed and variable costs
  • Examples of typical value stream direct & shared costs

Lean Thinking Cost Paradigms

Value stream costing makes a lot of sense if it is viewed through the lens of lean thinking cost paradigms, so this is the first step toward establishing value stream costing in a lean organization. As you read through the following paradigm comparison, ask yourself 3 questions:

  • Which traditional cost paradigms are present in my organization?
  • At what organizational levels are these traditional cost paradigms entrenched?
  • What level of discussion should be established to begin changing thinking towards lean cost paradigms?

Labor

For financial reporting, labor is an expense and because of this reporting requirement, it has created traditional thinking paradigms that conflict with lean thinking. Traditional financial thinking says expenses must be managed & controlled and possibly reduced due to business conditions. This leads to managing headcount, controlling salaries and when necessary reducing the number of employees in an organization.

Lean thinking organizations view people as their most important asset. Through the use of various lean tools, practices and methods, employees learn to master their work, solve the right problems and help an organization learn how to doing things tomorrow it cannot do today. That’s the idea behind the phrase “lean thinking”. Continuously improving productivity is what matters the most to a lean organization, and as a result labor expense will be controlled.

Time & Costs

Another traditional cost management paradigm is the perceived relationship between processing time and costs: the longer it takes to produce a product or deliver a service, the higher the costs. The genesis of this paradigm is based on the desire to understand the cost of individual products or services.

Lean thinking organizations view time as their second most important asset and develop a deep understanding of value-added activities and non-value added activities. The never-ending goal is to eliminate non-value added activities (“eliminate waste”), free up capacity (time) and apply this capacity to value-added activities. The cause-effect relationship is between revenue and value-added activities: the more time resources (people and/or machines) spend on value-added activities, the more revenue will increase. Sure, eliminating waste may achieve some direct cost savings, but it will not be to the degree that revenue will increase.

Cost Analysis

Traditional cost analyses are usually based upon complex allocation schemes in order to understand costs from many aspects, such as product/service costs, business unit costs and the cost of serving customers. The primary issue with cost allocation schemes is they try to allocate as many costs as possible and the allocation bases can be quite subjective.

Cost, or an expense on an income statement is an outcome, due to operating practices or managerial decisions. Lean organizations apply “lean problem-solving methodology” to cost analysis through understanding the dynamic relationships between operating practices and spending decisions, which results in preventing costs from being incurred.

Cost Management Objectives

The two primary traditional methods to manage costs are “actual-to-budget” analysis and requiring costs to be reduced. Both are “top-down” methods where the organization sets the goals and the rest of the organization must “make it happen”.

Contrary to what some people think, lean organizations are very concerned about costs. The general goal is to reduce costs over time through:

  • Continuous improvement
  • Clearly understanding the dynamic cause-effect relationships between operating performance, capacity requirements and actual costs.

Fixed & Variable Costs

Traditional definitions of fixed and variable costs are usually based on conventional cost accounting systems in manufacturing, where labor, material and overhead are assigned to products. In this environment, direct labor is often considered variable and in some systems a portion of overhead is considered variable.

Lean organizations tend to shy away from using these traditional definitions of fixed and variable costs. Variable costs are defined as costs that vary with volume in the short term. Fixed costs do not vary with volume in the short term and are typically influenced by management decisions.

In the next blog we will look in detail at value stream costing.

Lean Financial Management: Production Cost Analysis

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 accounting function in a lean manufacturing company 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 / resources to produce the output. The output numerator is usually related to revenue. The resource denominator is usually based on number of people, actual hours worked by people or machines.

The primary root cause of low productivity is 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.

Labor and machine costs increase when additional capacity is needed.

Machine maintenance costs can be understood better by understanding the root causes of downtime. Reducing downtime will reduce these costs, as well as increasing productivity.

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. Accounting should concentrate all efforts understand the root causes of these 3 costs using lean performance measures to create value-added financial analysis.

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.