Lean Accounting and Traditional Accounting Compared – Financial Reporting

06-Meeting_PeopleOne of the most important tasks for Lean Accounting is to provide useful financial reporting for people within the company. The purpose of this information is to enable value stream leaders to control their costs and profits, and to improve their costs and profits.

What would this reporting look like in a lean organization?

  1. Timely information. If we have to wait until several days after a month-end to get this important information – this is not lean. In lean accounting we usually report about once per week.
  2. Clear & understandable information. If you have financial reports that use arcane accounting language & concepts like Gross Margin, Variance Analysis, and Overhead Absorption then (almost) nobody in the company will understand them. Lean companies use “plain English” financial reports that are immediately understandable to everyone.
  3. Information that Enables Financial Control. One of the primary reasons for financial reporting is to create appropriate control of the company’s income, spending, profits, and capital. Lean Accounting achieves this by five things:
    1. Simple reports that people understand.
    2. Reports that come very frequently so that the information being reviewed is current.
    3. The reports are shown on a single sheet of paper; not a 50 page analysis. The detail is, of course, accessible when needed.
    4. There is Leaders’ Standard Work in place so that the key people within the value stream come together frequently and go through the information in an orderly and standard way. Their task is to bring the spending and profits under control, and then to improve them.
    5. The value stream manager and NOT the financial team is responsible for the financial information.

These financial reports are also useful for decision-making. The value stream team needs to make all kinds of decisions including pricing, quoting, accepting orders, make/buy, purchasing, prioritizing improvement tasks, capital equipment, labor requirements, etc. etc.. If they use a standard cost to make these decisions, they will be lead in the wrong direction.

I recognize that most of you do not just blindly follow the standard costs. You are smarter and more experienced than that. But I have found that greater than 90% of the companies we work with make poor decisions for these frequent and routine issues. They turn down orders they should take. They take orders they should not. They under price and give money away. They over price and loose lucrative orders. They outsource things they should be making in house and vice versa. They do lean improvement events to get cost “savings” and then argue with the financial guys who cannot find the cost savings.

Often this is due to “policy” and often it is due to misunderstanding their cost structure. Standard costs – with all their allocations and variances – have nothing to say when it comes to making business decisions. And when they do have something to say …… it’s just cold, steely-eyed lying 🙂

I will let a couple of our own customers make the case. They found they had to change and change fast. Here’s what they had to say:

Ed Grinde, Controller at Watlow (Hannibal MO) said in an Industry Week article  “ … that implementation of Lean Accounting was a necessary step, as the company needed a simpler accounting methodology to reflect the dramatic shop-floor changes that were taking place as a result of its lean manufacturing initiatives.”   Read the entire Watlow article click here

Another company, Buck Knives, increased their ability to serve their most important customers effectively, reduce costs, and see their way clear to further opportunities which (according the CEO C.J. Buck) “ … would have remained hidden had the company not converted to … lean-accounting practices.”  In the article he goes on to discuss how figuring out the company’s  true costs  helped the company make decisions that would have gone against the grain according to traditional accounting principles that dictated a large-batch operation.  Buck Knives instead chose an option that favored flexibility over batch production; they were able to save money, serve their customers better and improve the bottom line.  Read the entire Buck Knives article click here.

Here’s the Point:  Cost information is critically important to lean manufacturing; you need much better ways to understand cost and spending. And also income and profits.

Value stream financial reports display the results of operations for each of the value streams within a plant. Unlike reports prepared by traditional financial methods based on standard cost accounting, lean reports provide a clearer picture of the performance of the value stream during the period. And they provide a timely basis for taking action.

Value Stream financial statements use “plain-English” to communicate financial results from operations in a way that non-financial people can use.

Have a look at the following traditional financial statement:

02 TradFinReptPic

It’s an example of a typical (not plain-English) financial report that you can imagine would be presented to senior management. Of course, the statement is accurate from an accounting point of view, but it doesn’t communicate what is most relevant to managers, namely: “Why were the profits for Period 2 $99,723?” The answer is no doubt buried somewhere in the numbers and the variances, but where? And how?  This requires an accountant to decompose the numbers and “explain” the variances. Even the Gross Profit seems to have very little meaning.  Revenues less standard cost of goods sold (COGS). What does that mean? I think it is meaningless.

You have probably sat in meetings where this sort of thing was discussed. There are a number of basic questions that cannot be answered from this statement. Among them:

  • How much profit was derived from which side of the business? We can see the revenue, but which product line contributed more to the bottom line?
  • What are the components of cost of goods sold? (labor, material and overhead) And what does this actually mean?
  • What do all the “Adjustments” mean? Why did we pay less for products during the period than standard, and is that a good thing? (purchase price variance) Why did we use more materials during the period than standard, and what was the cause? (material usage variance) Why did we pay less for labor to make the product and is that a good thing? (labor variance) Why did we absorb less overhead than we should have and is that a bad thing? (overhead absorption variance). And what is absorption anyway?
  • The accountant knows that all the “adjustments” are required to transform cost of goods sold at standard cost to what was actually paid during the period. Moreover, the accountant knows the standard costs were developed the prior year during the creation of the annual budget. But who knows whether a deviation from a standard, in either direction, is either good or bad? Beyond that, the “adjustments” are calculated based upon abstract conventions of accounting known only to accountants and are expressed in accounting jargon that has little relevance in common usage. Sure, the accountant can explain them, but is that how we want to spend our time in a meeting?

Using Lean Accounting and weekly Value Stream financial statements is the answers to these questions and issues.

Next is an example of a useful value stream financial statement:

02 PlainEngFinStmt

From this example, anyone could answer the question about the decrease in profit: “Why were the profits for Period 2 $99,723?”  Anyone can see where the numbers come from and where they have changed. The huge jump on the “Inventory Adjustment” line tells the tale. And, to a Lean Manufacturing manager, it should be clear that this company shipped lots of inventory while keeping costs down. They eliminated the waste of inventory while increasing their production costs modestly. This little company is doing good lean things, as any value stream manager should be able to explain.

It is this kind of straight-forward, timely, and actionable information that enables the value stream team to stay on top of their financial performance and make the right decisions on what they need to change.

Here is a real-life example of a lean style value stream income statement:

06_Plain-Eng_Page_2The difference between the two approaches is clear.


Next blog, I’ll focus on external reporting, and the particular issues this entails. I’ll be making the case for why Lean Accounting is much better suited to external financial reporting than any of the full absorption accounting methods around, and why it gives a more accurate understanding of what we are actually doing.  I’ll hope to clear up some of the “GAAM’s” — Generally Accepted Accounting Misconceptions – that are floating around.

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