This blog is an article Mike De Luca wrote for the LEI Lean Accounting Newsletter.
In July, Nick Katko and I presented a webinar for LEI called “How to Use Lean Accounting to Help Design Profitable Value Streams.” As part of reviewing the core concepts of lean accounting, we said that lean is not a cost-cutting method. After the webinar, we received a very thoughtful question from an attendee about what might seem to be a contradiction. The attendee asked how to reconcile our comment that lean is not a cost-cutting method with our discussion on how to improve value-stream operating profit by understanding the lean accounting thinking behind cost drivers. I always appreciate questions like this since they help me clarify my thinking and improve how I communicate it to make it clearer to the audience. I responded directly to the attendee, but this point comes up so often that I wanted to share some thoughts about it and invite a constructive discussion.
“Long-term financial improvement is an outcome of a lean strategy. Lean is not a short-term cost-cutting methodology.”
— from the book Practicing Lean Accounting by Mike De Luca and Nick Katko
In our recently published book Practicing Lean Accounting, Nick and I discuss cost improvement in the chapter on lean thinking for accounting: “Long-term financial improvement is an outcome of a lean strategy. Lean is not a short-term cost-cutting methodology. Although some companies have better financial results as an early by-product of their lean strategy, there is usually a lag between operational improvement and sustained financial improvement. This lag occurs because learning and improvement take time.”
Distinguishing Between Cost-Cutting and Cost-Improvement
First, I’d like to distinguish between my use of the terms “cost-cutting” and “cost-improvement.” I use the phrase “cost-cutting” to refer to what, in my experience, are periodic (often during the annual budget process) reductions to the cost structure that may not be strategic or sustainable long-term. Instead, such cuts are made to balance a budget or meet a short-term organizational cost-reduction imperative. Cost-cutting in isolation, even using lean approaches (and I would say that this is a misuse of lean thinking), may not be aligned with the organization’s strategic priorities. Misalignment occurs when short-term cost-cutting distracts leaders from focusing on – or undermines their ability to invest in – continuously improving customer value. In particular, cost-cutting will not align with lean principles if used as a method to make reductions in force. How can we engage everyone in the organization in driving out waste from their work – and creating capacity that can be redeployed strategically – if they risk losing their jobs in the process?
On the other hand, I use the term “cost-improvement” to refer to the methodical approach of identifying value-added and nonvalue-added activities and applying lean thinking to eliminate the waste and improve the quality, delivery, and cost of those activities. To support this work, lean accounting professionals must help the organization understand both the lean perspective on how costs behave as well as how best to measure the financial impact of our improvement efforts.
This explanation may seem like unnecessary or esoteric mincing of words. However, the point is to understand and be clear on both the intent of and approach to the work of cost management. For example, is the intention to align with the lean strategy, and is the approach to engage the people who do the work in identifying and eliminating the waste without concern for their job security?
Gaining a Clearer View of Cost-Improvement
Next, I’d like to address the statement that better financial results can be an early by-product of a lean strategy. Again, the key point here is about the company’s intent in adopting lean thinking. There are likely companies where a strategic imperative to cut costs prompted their adoption of lean management. Still, I would argue that if they’re faithful to lean principles, they improve their cost structure with a focus on – and certainly not to the detriment of – delivering customer value and modeling respect for the people who do the work.
I think it’s helpful here, especially in understanding the importance of lean accounting practices, to refer to Taiichi Ohno (industrial engineer, businessman, and father of the Toyota Production System), who is quoted as saying, “Costs do not exist to be calculated. Costs exist to be reduced.”
“Instead of being creative with accounting, Ohno advocated reducing cost by being creative in how we look at our work to find ways to make it easier, better, and faster.”
— Jon Miller
In a 2019 blog, “Not All Costs Exist To Be Reduced,” Jon Miller says, “His [Ohno’s] point was that traditional accounting can fool us into justifying inefficient operations, building up inventory, or acquiring assets because the numbers look good. Instead of being creative with accounting, Ohno advocated reducing cost by being creative in how we look at our work to find ways to make it easier, better, and faster. Today, there are lean accounting methods that allow us to reflect the reality of costs more accurately in a lean operation, where traditional cost accounting does not.” Miller goes on to say that “focusing [solely or primarily] on costs can limit opportunities for value creation.”
For me, then, an organization’s cost-improvement approach must come back to its strategy. What does the company need to accomplish or become capable of in order to grow and thrive in serving its customers? It may be cost improvement, creating capacity, improving quality or delivery, accelerating innovation, or a combination of these. At the same time, I think it’s important to remember the lean tenet of respect for people, that the lean strategy is grounded in people-centered learning and improvement. With clarity around both strategy and intent, organizations can drive meaningful, sustainable, and best-in-class improvements to financial performance.