During my days as a working CFO, my #1 job was financial review and analysis. I had to explain my company’s financial results to all those reading our financial statements. Like all CFO’s, I had to understand the company’s costs, their trends and identify opportunities. I don’t think there is any CFO anywhere who wouldn’t like to reduce costs.
Our years of professional training and CFO experience teach us that cost analysis for financial accounting has to align with your financial statements, SEC reporting (if applicable) and industry standards. Most all companies do a good job in this area.
That’s not what this blog is about.
Instead, I’m going to look at how a truly Lean company analyzes its costs internally. I maintain this is not a case where you can be “right, wrong, or indifferent.” In fact, I strongly believe that how you, the CFO, analyze costs will have a crucial influence on the success and sustainability of Lean in your company.
Let’s get to it.
I’ll start with my experience (and probably yours) using what I’ll call “traditional” cost management methods.
Traditional Cost Management
The name of the game here is to establish rigorous links between operational performance and financial results. Companies using traditional cost management methods will typically use a variety of tools to do this:
Annual budgets are set and actual results compared to the budget.
- Some companies create a financial forecast, which is essentially an updated budget, and do actual-to-forecast analyses.
- Manufacturing companies use production-reporting systems to track and explain operational performance to plan.
- Finally, companies use product-costing systems, such as standard costing and activity-based costing, to explain the impact of inventory on the financial statements.
These tools all share common characteristics:
- They are based on analyzing historical costs.
- They are complex and time consuming.
- They use GAAP-based financial statements.
- They rely on actual-to-plan analysis.
Analyzing historical costs – The analysis of any cost is historical. You are looking backwards to understand why a cost occurred. Sure, you can find out the reason the cost was incurred, but all you can do is explain it. You cannot change it. It’s a little like doing an archaeological dig – you do all that work to develop information that you essentially can’t act upon.
Annual budgeting – Think about how much time and effort goes into your annual budgeting process. In the end many people are skeptical of the budget and feel it’s out-of-date even as it is published. Think also about how much time goes into your monthly analysis to explain the actual to budget numbers. If you have a standard costing system, think about how much time goes into setting standards, then comparing actual to standards. At the end of the day, how many people truly believe that these systems are very effective at what they are intended to do, namely, to manage costs?
GAAP-based reporting – Non-financial people in your company often have a difficult time understanding GAAP-based financial statements. They don’t understand the accruals, reserve adjustments and inventory valuation work that must be done to create GAAP-compliant statements. Worse, they don’t understand why thinking about these, and talking about them in meetings has much of anything to do with what they are actually doing to meet customer demand and make money.
Annual budgeting – Finally, people seem to really dislike the annual budgeting process or annual standard setting process. This is usually because of all the assumptions they must make about the future, the “fuzz factors” and predictions about what might happen months down the road. If your company creates a monthly detailed expense budget by department (many do,) you are asking your managers to be fortune tellers. They had better come up with the right predictions, or there will be some explaining to do – and hard questions to answer monthly about actual-to-budget results. No one can accurately predict what business conditions will be like months in advance; if you could, you would make a lot of money doing that for a living.
Stick around. In my next blog, I will show you an alternate (and better) way for Lean companies to manage costs.
