Lean Financial Management: Material Cost Analysis
In the world of Lean Accounting, you will hear that a value stream income statement needs to show “actual material cost”, and is typically defined as actual material purchased. This confuses accounting professionals because it appears to be in conflict with the matching principle of accounting. So here is my attempt to clear up this confusion.
If a lean manufacturing company has about 30 days of inventory, then actual material cost will be what is purchased in the period. But in many cases, especially early in the lean journey, manufacturing companies have more than 30 day of inventory. In this case, material purchased is much different than the material cost of goods sold. This is the reason accountants think a value stream income statement is not compliant with GAAP.
What is important for accountants to remember is a value stream income statement for internal use only. The purpose of a value stream income statement is to explain the financial impact of lean progress. The accuracy & precision of a value stream income statement is not based on GAAP but on how it represents the current state of lean progress.
So, I’d like to clarify the definition of actual material cost, based on where a company is in its lean journey.
I believe a good starting point in creating a value stream income statement is to define actual material cost as “actual material consumed” by each value stream. This would be the actual cost of material released into the value stream.
I use this definition because there are three operational stages for material after it enters a value stream:
- Sold – material can be processed through the value stream and sold
- Scrapped – material is defective and scrapped during operations
- Stored – material can be stored as inventory, and subsequently either sold or scrapped
At the beginning of the lean journey, material in most value streams will likely be in all 3 stages. Then as quality & flow improves, the quantity of material scrapped & stored will reduce. Eventually if a company can reach 30 days of inventory, actual material cost will be what is purchased & sold within period.
Accounting’s responsibility is to financially analyze material cost its impact on value stream profitability based on what happens to the material as if flows through a value stream. Let’s look at this in more detail.
Obviously, any financial analysis involving changing sales volume would have a corresponding change in material cost.
As lean manufacturing operations improves quality, value stream material cost will decrease because less material is being consumed. Using a standard lean performance measure such as First Time Through or scrap rate, it’s not difficult for accounting to calculate the financial impact of better quality.
As lean manufacturing operations improves flow, it will also lead less material being consumed. Using a standard lean performance measure such as inventory days or inventory turns, accounting can calculate the financial impact. This is very important to show on a value stream income statement, because the external financial statements will not show this as reducing inventory only has a balance sheet impact – improving cash.
One financial analysis accounting needs to move away from in a lean manufacturing company is simply analyzing material price. Don’t get me wrong – the logic of lowering material prices does have a positive impact of profits. But in lean manufacturing operations, material price is balanced with supplier quality, delivery & lead time.
The price of anything is a reflection of value. Lean manufacturing operations values short lead times, high quality and on time delivery from its suppliers because this type of supplier performance will increase flow, and thus increase revenue. Suppliers that provides the best overall performance with lowest price usually become preferred suppliers.
The danger of focusing financial analysis simply on lowering material prices is the only short term solution is large volume purchases from suppliers that offer volume price discounts. But this is “anti-lean” because it increases inventory.
Accounting’s financial analysis of material costs based on “actual material consumed” will provide real time financial information to management to clearly show the impact of lean operations on material costs.