It is common for financial people within companies where I go to question this proposition (sometimes vehemently!) I have also been told many times that auditors require standard costing and not Lean Accounting, or that SOX mandates it. These are common misconceptions.
Nevertheless, in some ways Lean Accounting is better suited to external reporting than is traditional accounting.
The example below shows a typical company with four value streams and some support people and costs that are outside of the value streams.
After that you will need to make some adjustments. The most significant of these for most companies is to show the change of inventory value since the last month-end. Lean Accounting has several simple methods for doing this. This is important, because it goes to the heart of the so-called GAAP issue.
Why Lean Accounting is GAAP Compliant?
All GAAP reporting must be stated at actual cost. Lean Accounting uses actual costing right the way through the process. So, there is no need of any complicated adjustments like variance applications, or other issues related to standard costing. The numbers in the chart of accounts are all real and represent actual costs. From this it is easy to format the information required for external reporting, as we see in the statement above.
How to Value Inventory?
Many of you will know that in Lean Accounting we often do NOT calculate product costs. So naturally the question arises: how do we calculate the inventory value?
Before I address this, I must emphasize that the way you value inventory is very much set by how much inventory you have. Traditional companies tend to have very high levels of inventory and this requires the detailed tracking of the inventory, and the calculation of item costs, and multiplying the quantity by the cost and so on.
But Lean companies have much lower inventories. If you have less than 90 or 60 days of inventory, there are much simpler methods of valuing inventory. The inventory valuation is not calculated for each individual item, but for the company as a whole. There are variations of the method, but basically it goes like this:
- Track your inventory on the MRP system, but switch off the “labor & overhead.” At month-end you will have the inventory value on the balance sheet, but for material content only.
- Then at month end, calculate how many days of inventory you have in WIP and Finished Goods. Let’s say we have 3 weeks of inventory in a 4 week month.
- Next, calculate how much “labor & overhead” (or conversion cost) needs to be applied to the inventory. This is done by taking – in our simple example – 75% of this month’s conversion costs and debiting to the balance sheet for “labor and overhead”. If our total monthly conversion cost is $400K, then we need to apply $300K to correctly value our inventory based on GAAP.
- Finally, post this amount using a reversing journal entry at the month-end.
What About Other Adjustments and Issues?
As you can see in the income statement shown above, there are usually a few other adjustments that need to be made to bring the P&L into line with reporting requirements and regulations. If you are a division of a larger corporation you will have to apply some corporate overheads. Exchange rate gains and losses need to be shown in most locations, although these rules can vary by country. Another common adjustment is to true-up transfer pricing from intra-company sales.
Once these adjustments (and any others you need to make) are applied, then you have the data required for your external reporting plus any internal reporting to group and corporate entities. There is no such thing as a “Lean P&L.” Every company has different ideas about what they need to see. The data is in the general ledger at actual cost, and can be formatted according to the local needs.
What If Corporate Wants a Traditional Statement with Standard Costs and Variances?
External reports do not, of course, have any standard costs and variances. But if you are a division of a larger corporation and you need to report externally for your division but still within your larger corporation, then this can be a requirement.
It is quite simple to convert the Lean Accounting statements and translate them back to the traditional statements. It takes about 5-10 journal entries to do this. I just spoke to one of the companies we work with and the controller told me it takes him about 20 minutes at month-end to complete this translation.
In my next blog we will take a look at how Lean Accounting helps your company to sustain continuous improvement throughout the organization.
And remember: In case you missed any parts of this blog series, you can get them all, click this link: https://maskell.com/?tag=compared