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!