Lean Accounting & Traditional Accounting Compared – COST ACCOUNTING

Today’s blog is Number TWO in a series that will take a deep look at how and why Lean Accounting differs radically from traditional accounting.  Once again, I’ll show how each approach does or does not support Lean Principles.  (Click the following link to view a mind map on BMA’s web site showing the five principles of Lean:   Five Principles of Lean ) I’m going on the assumption that if we support the five principles of Lean Thinking, then we will be supporting Lean throughout the company; operations, product development, sales and marketing, and administration.

Let’s get started.

I’m going to start with some definitions.

Cost Center Accounting is a method of keeping track of the costs with a “cost center”. The company is set up into a large series of independent cost centers that are budgeted annually and the actual expenses tracked and compared to budget. In traditional companies a cost center will generally equate to a department. The department manager is responsible for the costs within the cost center and has no need to understand anything about revenues and profitability. There is a “disconnect” between cost and revenue, and between process improvement and the impact on costs and revenues. The financial controls are fragmented and disintegrated, and the value to the customer is out of sight to all but a few people. Bottom line, this means that what it takes to serve the customer, improve the process flow, and prosper the company is broken down in a way that makes it difficult (I would say impossible) to figure out where the responsibility really lies.

To make it worse, cost centers are often broken down into additional lower-level cost centers. For example, an assembly line could be a cost center, but within it each major machine may have its own cost center that is used to create allocation rates to feed the standard costing system. I think about this as “excessive granularity” by which I mean: large amounts of detailed cost data are accumulated and reported but this gives very little or no benefit to the people trying to control and improve the process. And none of this information relates to how value is created for the customers. This leads to waste upon waste and more waste. In lean terminology: MUDA.

The cost accounting reports in these traditional companies are not clearly understood because they use standard costs and “actual costs”. This requires the use of arcane and (largely incomprehensible) concepts like Gross Margin and Variance Analysis. This confusion coupled with the need to “explain” the financial results often leads to enmity between the operations people and the accountants.

Value Stream Accounting is a method of providing clear cut, up-to-date, and meaningful financial information. This includes the actual, real costs within the value stream this week; the actual value stream revenues this week; and the profitability and cash flow generated by the value stream. Once the value streams are defined, then this revenue and cost information can be readily produced in the form of a value stream P&L on a single sheet of paper.

Using this “plain English” reporting approach (see the example below) there is a clear line-of-sight between the revenues earned and the money spent. The accountability for revenues, costs, and cash lies clearly with the value stream manager. There is an obvious understanding of the relationship between cost, revenue, and cash-flow, and – more importantly – the changes needed to improve customer value and eliminate waste are clear. This sets the foundation for radical lean improvement of the value stream processes that leads to more capacity, more sales and much more cash.

The work required to create these very meaningful and lean-driving financial reports is very low. There is no need for detailed labor reporting, work orders, inventory movements, and other wasteful and complicated data tracking. The operational and financial information is collected and reported at a value stream level. In a later blog, I’ll be detailing out what data gathering for this involves.

This elimination of wasteful work frees up the operations people, the financial people, the engineers, planners, and managers so that they can spend more of their time on serving the customers, improving the processes, and making more money. Plus the operations and financial people work together with common goals and accountability.  Simply put:  they are all on the same page, speaking the same clear language.

Example of the Problem

The income statement shown below is a simplified version of a traditional income statement.

There are revenues shown at the top and a “cost of goods sold (COGS)” shown next. This COGS is the cost of the products sold calculated using the standard costs of all the items sold. This leads to a Gross Profit (Revenue – COGS.)

Below the Gross Profit is a panoply of variance analyses. In this example I have only included a few of them. But these variances are supposed to show the reason why the real profit is not the same as the gross profit. At the bottom there is a (spurious) allocation of other company costs called “sales, general, and administrative” costs, leading to a bottom line Net Profit.

While this is a simplified example, it shows the kind of financial reporting most manufacturing companies use in one form or another.

A couple of questions about this come to my mind.

What does the Gross Profit mean?  You perhaps can recall meetings where operations and financial people spent a bunch of time trying to figure out what really happened and what caused the results you see above.  I believe Gross Profit in this case means nothing. I have asked 1,000’s of people about this over the years, and I have not heard a satisfactory explanation of what it means. Many can define it (as I did above), but no one I know can say what it means.

The second question is why is the net profit for the two months so radically different when the revenues are about the same?  Again, no satisfactory answer is available from these numbers. A management accountant can, of course, deconstruct the variances and get to the causes of these kinds of issues. But these variances are a complete mystery to most people. And scary too …. because they have to “explain” them each month.

My next example is an income statement (again simplified,) called a “plain English” statement. You will see the same revenue information, but the cost information shows the real, actual cost of the value stream for that month. This statement gives important and understandable information that can be used to improve the value stream’s processes.

Now the Gross Profit is meaningful. It is the amount of money the value stream has brought into the company this week (give or take some equipment depreciation.) There are no incomprehensible variances – just plain, straightforward, and useful information. Imagine yourself in a meeting discussing these results.  Would you have trouble understanding  where money was spent?

Why is This Important?

In a Lean focused company, Value Stream cost accounting provides the best information available for managers to make decisions, reduce costs, eliminate waste, and become more productive. And, it does this quickly with less waste, and in a format that lends itself to providing value to the company’s customers and making more money.   Lean companies are constantly striving for simplicity and transparency. The complexity and transaction-heaviness of a standard cost accounting system creates waste and doesn’t add much to the Lean conversation.

For more information about Value Stream Cost Accounting, take a look at our “Why Lean Accounting?” PowerPoint® presentation.  Click here and select the “Why Lean Accounting” button below  under resources for understanding Lean Accounting.

Coming up next time:  I plan to shift from “pure” accounting, to the subject of lean performance measurements.  I’ll be exploring why traditional measurement systems are just plain wrong for lean, and making suggestions for what type of measurements work hand-in-hand with Lean.