Lean Decision Making Framework Guidelines

Lean Decision Making Framework: General Guidelines

In this blog, I’d like to explain 3 general guidelines accounting should follow for creating an effective lean decision framework for your lean manufacturing company.

#1- Financial Impact on Value Stream Profitability

The general rule for lean decision making is to understand the financial impact of any decision is based on the impact on total value stream profitability. Hence, the necessity for value stream income statements in a lean manufacturing company. This is a departure for most accounting professionals in manufacturing, as many financial analyses get broken down by specific product, product family, business unit, etc.

The change in actual value stream profitability will accurately reflect the economics of lean, as described in an early blog. Another advantage of using actual value stream profitability is that the profitability impact will be realized because the analysis is based on actual revenue and actual costs.

#2 – Stop using Cost Allocations

Most cost allocations have a level of subjectivity in them (such as all rates in a standard costing system). And many cost allocations are an attempt to make a fix cost variable by linking it to units produced. Using rates in financial analysis is dangerous because they can make it appear that costs are decreasing, when in reality actual costs are not changing.

Here is an example in manufacturing – direct labor costs. Standard costing systems assigns direct labor based on a direct labor rate & volume produced. If a manufacturing business was considering eliminating a product or product line, the financial analysis would show a “direct labor savings”, because direct labor is assumed to be variable.

The reality in most companies is your full-time employees come to work every day and get paid a full day’s pay whether they produce 100 products per day or 500 products per day. If a company were to eliminate a product, these employees would still be full-time employees, which the actual labor cost for the company does not change. Actual labor would decrease only if fewer employees were employed.

Accounting’s responsibility is to begin to understand how costs change in a lean manufacturing company, without using cost allocations. If cost allocations are commonly used in your company in financial analysis, it’s time to begin migrating away from them by introducing the value stream income statement.

#3 – Lean Improvements create Capacity

This is a fact of Lean: eliminating waste creates time – the time spent on waste is now available to spend on creating value. This is also described as creating capacity.

This fact of lean must be incorporated into your lean decision framework. The creation of time has no financial impact, but how the business uses that time does have a financial impact. The majority of the time, a lean manufacturing company will use this newly created capacity to build & ship more products, and the financial impact will be increasing revenue.

In your lean decision making framework, it’s essential to be able to incorporate the amount of time being created so accounting can properly project revenue that can be realized.

In the next blog, we will begin to look at lean cost analysis in more detail.

Removing Standard Costs from the Income Statement

Creating value stream income statements is the second part of a lean decision making framework that is not based on a standard costing system. The value stream income statement is an essential element of lean decision making due to how lean practices & methods impact profitability. It’s important for accountants to understand the “lean logic” behind a value stream income statement, as follows:

Value Streams – the lean definition of value streams is the sequence of activities from order receipt to shipment that are necessary to create the product to ship to the customer. Lean manufacturing companies organize, manage & control by value stream. The accounting definition of value streams is they are your company’s profit centers.Therefore, internally we will want to look at value stream profitability.

Flow – the lean definition of flow is to move all orders as fast as possible through a value stream from receipt to shipment by employing lean practices and eliminating waste.  From an accounting viewpoint, maximizing flow maximizes value stream profit. Improving flow impacts both value stream revenue and costs. The faster the flow, the more revenue will grow. Eliminating wastes controls total value stream costs.

The first step to creating a value stream income statement is to understand your company’s value streams. I recommend accounting sit down with your company’s lean leaders to look at your value stream maps & discuss the value stream organization. Value stream maps show the flow of products through each value stream and identifies the process steps required in each value stream. The value stream organization is the actual people, machines & resources that work in each value stream.

From this discussion, it should not be difficult for accounting to assign the actual direct costs to each value stream, such a labor, facility and machine costs. All these costs are in your general ledger and usually assigned to departments or cost centers. I recommend accounting do a reconciliation between the departments/cost centers in the general ledger and the value streams. This reconciliation will serve as a template to create most of the value stream costs.

Material costs are most difficult to assign to a value stream. The general rule is to use the actual cost of material consumed during a period, which may not match exactly with the products sold. It is important for accountants to remember that a value stream income statement is for internal use only and needs to reflect actual costs.

What is important for accounting to remember is it is not trying to assign every manufacturing cost to a value stream, only the actual costs the value stream can control. In a value stream income statement, we don’t want to use cost allocations. I like to think of this cost assignment as putting costs where the spending decision is made.

When creating a value stream income statement, think of your customers – lean operations and management. What they value is knowing exactly how profitable each value stream really is based on actual revenue & actual costs, not based on artificial standard costs.

In the next blog, we will look at how to use the value stream income statement to make lean business decisions.

Removing Standard Costing from Financial Analysis

Using standard product costs in business decision-making works well in traditional manufacturing companies, because standard costing systems were designed for traditional manufacturing. In lean manufacturing companies, continuing to use standard costing for business decision-making will create conflict and confusion throughout the organization. One of two outcomes can occur when standard costs are used in business decision analysis in Lean companies. Either the wrong decision is made, or traditional manufacturing practices creep back into operations to support the financial analysis.

Accounting’s role is quite simple, lead the company through the process of eliminating standard costing in business decision making. The actual task of making this happen can be quite complex & may take some time depending on how ingrained standard costing is in your company’s decision making process and how fast your company can develop lean-focused decision making methodologies.

Fortunately for accounting, it doesn’t have to start from scratch. Standard lean accounting practices present a plan for how to get from where you are to where you need to be. This blog and the next few blogs will explain how to get your lean manufacturing company into “lean decision making.”

Manufacturing companies typically have long-held methods for doing internal financial analysis and making business decisions. If a manufacturing company uses a standard costing system, standard cost information is usually used in understanding the financial impact of business decisions. These decisions are made in all parts of the company: sales, marketing, purchasing, engineering, operations, senior leadership and accounting. And the people who are actually making the decisions are comfortable and confident in the current methods.

Accounting’s challenge is getting acceptance by the people making the decisions that a lean decision making methodology is better for the company. It’s more about winning over hearts & minds rather than simply creating a new methodology.

Accounting’s first step is to develop a lean-based decision making framework not based around standard costing. A lean-based decision making framework should be based on what I like to call the “economics of lean.” The rate of growth of revenue consistently exceeds the rate of growth of costs, which results in increasing profitability.

The overall goal of becoming a lean company is to become more profitable, primarily through improving the delivery of value to your customers, which drives revenue growth. If a lean manufacturing company really does improve flow, reduce inventories and improve on-time delivery, it should realize revenue growth greater than its historical averages.

The other aspect of the economics of lean is cost control. Please note I did not say cost reduction, because lean is not a methodology to dramatically reduce costs (we will get into this more a bit later). Operationally, lean practices improve productivity which means output increases at a greater rate than the resources needed to produce the output. This occurs because eliminating waste increases resource capacity (or creates time) rather than hiring more people or buying more machines.

As a CFO of a manufacturing company in the 1990’s, my company’s lean transformation resulted in the average sales growth rate increasing from 7% to 20% and profits increasing 66%. We didn’t lower prices or change our product mix. We dramatically changed operations by delivering on-time 95%, without finished goods inventory and an average order lead time of 3 days. This is how I learned about the economics of lean.

I’m going to stop writing here because I it’s important to think about the economics of lean and your company before we start moving into the “how to” phase of a lean decision making framework.

  • How well are the economics of lean understood in your company’s accounting function?
  • In other parts of the organization?

Talk these questions over with your colleagues and I would be interested in reading your comments.

Lean Accounting & 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!

Lean Accounting & Standard Costing Variances

A standard costing system generates rate & volume variances by design. Standards are entered into the system, actual is reported into the system and variances are created. Because standards are used to value inventory and cost of goods sold, actual variances are reported on the income statement to bring the financial statements back to actual. In a “traditional” manufacturing company these variances are often used as performance measures by operations itself, senior management and/or accounting. The definition of a performance measure being “to measure and manage operations.”

A standard costing system is also designed to maintain GAAP/IFRS compliance regarding inventory valuation. GAAP/IFRS states a portion of manufacturing production costs must be capitalized on the balance sheet as inventory in a consistent manner. A standard costing system within an ERP system automates this process. This process creates overhead absorption on the income statement, which can be favorable (increasing profits) or unfavorable (decreasing profits). Overhead absorption is also often used as a performance measurement.

Because variances and absorption both appear on an income statement, the accounting function of a manufacturing company must be able to understand, analyze and explain these numbers to perform the necessary function of financial analysis.

When a manufacturing company begins its Lean journey, the entire infrastructure built to support the standard costing system & related analysis must also adapt to Lean. Here is how the accounting function can lead this process.

Variances as Performance Measurements

Using variances as performance measurements in a lean manufacturing company will not work. Variances are designed to drive mass production manufacturing behavior – building inventory, long production runs and buying lots of raw material to get a lower price. Lean practices totally opposite of this.

Accounting must accept & understand this, and must explain this to any other part of the organization that believes differently. Accounting must also get behind 100% on deploying lean performance measures. Accounting may not have to do the actual deployment, as many experienced lean practitioners can do this. At a minimum accounting needs to participate in the development of the measures, actively support their operational uses and learn how to integrate these measures into their financial analysis.

Variances on the Income Statement

It’s easy to “stop” using variances as performance measures and replace them with lean performance measures. But the standard costing system is still being used and variances will appear on the income statement. The good news is that accounting has the opportunity to lead in modifying the standard costing system to potentially eliminate some or many of the variances on the income statement.

The first step for accounting is to team up with some IT and manufacturing people to study exactly how your ERP system calculates variances. Determine if it is possible to change ERP settings to “turn off” variance calculations.

Next, learn exactly what “actual” information the ERP system uses to do its calculation (every variance is simply actual to standard). Study the manufacturing floor to learn how that information gets into your ERP system. Get IT to set up a test database of your company and practice not entering actual transactions and look at the impact on your income statement. Here are some examples of what to try:

  • Stop reporting actual labor and machine time to work orders
  • Stop reporting differences in material SKU’s used to work orders
  • Implement back flushing reporting

After learning how the ERP system reacts to changes, you can make the necessary changes in your live database and shop floor reporting to eliminate variances.

Based on personal experience, I am confident you will find some ways to eliminate variances on the income statement if you make an investment in time to learn specifically how the ERP system works.

It’s important for accounting in a lean manufacturing company to address standard costing variances early in the Lean & Lean accounting journey. Educate the company on why standard costing variances will not work in a Lean manufacturing company. Support & assist Lean operations in developing and maintaining lean performance measures. Finally, dive into your ERP system and make the necessary changes in the system. You will be pleased with the results.

Lean Accounting and Standard Costing: An Introduction

If you are in the accounting department in a lean manufacturing company, and your company uses a standard costing system, it is inevitable that the accounting department will be faced with confronting how its standard costing system is being used.

I stress the term inevitable,because based on my own experience both as a CFO and a consultant, I have seen it happen consistently. Sometimes the confrontation will occur early in the lean journey, sometimes later, but it is going to happen.

My advice to the accounting people in accounting departments of lean manufacturing companies is to lead rather than react. Be the leaders of proactively evaluating how the standard costing system is being used as your lean journey begins and come up with a plan.

Coming up with a plan is not difficult, as long as you understand the issues. Fortunately, these issues happen to be very common across lean manufacturing companies that use standard costing systems. For the next few blogs, I am going to write in detail about the issues, look into exactly why these issues occur and lay out solutions.

I see 6 issues that accounting will have to deal with in a lean manufacturing company:

  1. The financial & operational impact of variances and overhead absorption
  2. The financial impact of inventory reduction
  3. Internal financial analysis & business decision making
  4. Inventory valuation
  5. Maintaining GAAP/IFRS compliance
  6. Other – such as transfer pricing or maintaining local regulatory compliance

Before we get into the issues, I think it’s important to get some background on why standard costing even becomes an issue in lean manufacturing companies.

The Root Cause

The primary root cause of why accounting will have to deal with standard costing is twofold. Accounting needs standard costing to value inventory but lean operations does not need, nor have any use for, the performance measurement & financial analysis aspects of a standard costing system.

Conflict between accounting and lean operations occurs when each side doesn’t understand each other’s reasoning.

Lean operations people don’t like the performance measurement & financial aspects of a standard costing system because standard costing systems are based on mass-production manufacturing practices and lean operational practices are 100% opposite of mass-production practices.

It’s important for accounting to recognize this and not try to force lean operations to use standard costing information to measure or manage lean operations.

Accounting needs standard costing to value inventory for GAAP/IFRS compliance. In most manufacturing companies with high inventory and many SKU’s, this is the simplest and easiest way to value inventory. And ERP systems are set up to do this, which automates the process. Accounting has another obligation, which is being able to explain the financial impact of the financial information a standard costing system produces, such as variances, absorption and margin.

It’s important for lean operations to understand accounting responsibility for maintaining GAAP/IFRS compliance and “stop using standard costing” is not a simple to do.

First Steps in Leadership

I mentioned earlier that accounting should lead the discussion on using a standard costing system in a lean manufacturing company. Here are 4 initial leadership steps accounting can take.

  • It’s a company problem not an accounting problem. Accept that your lean manufacturing company will have to deal with standard costing. Information from standard costing systems are used in all parts of a manufacturing business, and for many different reasons. The entire company will have to be part of the solution.
  • It’s a long journey not a short destination. It’s going to take time to adapt, improvise & overcome a standard costing system. Just like a Lean journey, there will be successes, and adjustments along the way. The larger to company, the longer it will take.
  • Begin communication of the issues. The CFO needs to begin talking to senior management. The controller needs to engage lean operations management. The entire accounting function needs a continuing dialogue on this topic. Begin laying out the specific issues your company is going to face over the long run.
  • Lean accounting practices & methods do provide a path & solution to resolving these issues in your lean manufacturing company. Learn about Lean Accounting.

In the next blog, we will begin discussing the issues in detail.

Time for Leadership – How Standard Costs Impact Company Behavior

There are many things wrong with using standard costing in an Lean company, but perhaps the most dangerous is when standard costing actually drives a company’s behavior in a way that makes Lean unworkable.  Here is an example:

Recently, I was working with a company on implementing Lean Accounting. The company manufactures products at one location, and sells those products in its stores. The stores also provide service on the products.  Manufacturing operations has been practicing Lean for about 3 years. They all work internally was on a Pull System and they were performing regular kaizen events. The company currently uses a standard costing system.

pushmiI was reminded of Dr. Doolittle’s pushmi-pullyu, a strange animal that had two heads at opposite ends of its body. When it tried to move at all it was stuck; both heads tried to go in opposite directions.

In this company’s case, both ends of the company seemed to be at cross- purposes.  The stores view themselves as the “profit centers” of the business and they see manufacturing as a cost center.  The stores need a standard cost for every product so each store can calculate its profitability. The conversation between stores and manufacturing typically revolves around manufacturing lowering its costs to improve store (and company) profitability.

After further discussion, I discovered that the store managers and the sales force are being compensated based on store gross margin (revenue less standard cost of goods sold) – no wonder lowering  manufacturing costs was such an important issue!   Because of this compensation policy, there was strong resistance on the part of the stores to defining the true value streams of the company. Doing so would have to include manufacturing and would involve calculating value stream profitability (rather than store profitability.)

As of the writing of this blog, this issue is still under discussion within this company. It has delayed the roll out of lean accounting.

What can you learn from this story?

It’s essential to understand why people within a company are pulling in a given direction. You have to keep asking “Why?”   In this company’s case they were using a standard costing system to determine people’s pay. This is what has stymied their Lean Accounting roll out.

In order to get everyone pulling together, management had to take the lead. They had to create an action plan to move the company off using standard costing for compensation.  Seems simple, but the key was understanding the impact of standard costing, so they could work through the related issues and clear the way forward.

It’s About Spending, Not Costs – Part 1

During my days as a working CFO, my #1 job was financial review and analysis. I had to explain my company’s financial results to all those reading our financial statements.  Like all CFO’s, I had to understand the company’s costs, their trends and identify opportunities. I don’t think there is any CFO anywhere who wouldn’t like to reduce costs.

Our years of professional training and CFO experience teach us that cost analysis for financial accounting has to align with your financial statements, SEC reporting (if applicable) and industry standards.  Most all companies do a good job in this area.

That’s not what this blog is about.

Instead, I’m going to look at how a truly Lean company analyzes its costs internally. I maintain this is not a case where you can be “right, wrong, or indifferent.”  In fact, I strongly believe that how you, the CFO, analyze costs will have a crucial influence on the success and sustainability of Lean in your company.

Let’s get to it.

I’ll start with my experience (and probably yours) using what I’ll call “traditional” cost management methods.

Traditional Cost Management

The name of the game here is to establish rigorous links between operational performance and financial results. Companies using traditional cost management methods will typically use a variety of tools to do this:

Annual budgets are set and actual results compared to the budget.

  • Some companies create a financial forecast, which is essentially an updated budget, and do actual-to-forecast analyses.
  • Manufacturing companies use production-reporting systems to track and explain operational performance to plan.
  • Finally, companies use product-costing systems, such as standard costing and activity-based costing, to explain the impact of inventory on the financial statements.

These tools all share common characteristics:

  • They are based on analyzing historical costs.
  • They are complex and time consuming.
  • They use GAAP-based financial statements.
  • They rely on actual-to-plan analysis.

Analyzing historical costs – The analysis of any cost is historical. You are looking backwards to understand why a cost occurred. Sure, you can find out the reason the cost was incurred, but all you can do is explain it. You cannot change it.  It’s a little like doing an archaeological dig – you do all that work to develop information that you essentially can’t act upon.

Annual budgeting – Think about how much time and effort goes into your annual budgeting process.  In the end many people are skeptical of the budget and feel it’s out-of-date even as it is published.  Think also about how much time goes into your monthly analysis to explain the actual to budget numbers. If you have a standard costing system, think about how much time goes into setting standards, then comparing actual to standards. At the end of the day, how many people truly believe that these systems are very effective at what they are intended to do, namely, to manage costs?

GAAP-based reporting – Non-financial people in your company often have a difficult time understanding GAAP-based financial statements. They don’t understand the accruals, reserve adjustments and inventory valuation work that must be done to create GAAP-compliant statements.  Worse, they don’t understand why thinking about these, and talking about them in meetings has much of anything to do with what they are actually doing to meet customer demand and make money.

Annual budgeting – Finally, people seem to really dislike the annual budgeting process or annual standard setting process.  This is usually because of all the assumptions they must make about the future, the “fuzz factors” and predictions about what might happen months down the road. If your company creates a monthly detailed expense budget by department (many do,) you are asking your managers to be fortune tellers. They had better come up with the right predictions, or there will be some explaining to do – and hard questions to answer monthly about actual-to-budget results.  No one can accurately predict what business conditions will be like months in advance; if you could, you would make a lot of money doing that for a living.

Stick around. In my next blog, I will show you an alternate (and better) way for Lean companies to manage costs.

How Standard Costs Impact Company Behavior

There are many things wrong with standard costing, but perhaps the most dangerous is when standard costing begins to drive company behavior. Here is an example.

I was working with a company recently on implementing lean accounting. The company manufactures products at one location, and sells those products in its stores. The stores also provide service on the products. The company uses a standard costing system.

The stores view themselves as the “profit centers” of the business and manufacturing as a cost center. A standard cost for every product is then required so each store can calculate its profitability. The conversation between stores and manufacturing typically revolves around manufacturing lowering its costs to improve store (and company) profitability

Upon further discussion it was revealed that the store managers & the sales force is being compensated on store profitability. Because of this compensation policy, there was resistance on the part of the stores to defining the true value streams of the company (which would include manufacturing) and calculating value stream profitability rather than store profitability.

As of the writing of this blog, this issue is still under discussion within this company and has delayed the roll out of lean accounting.

What can you learn from this story? It is vital to identify how a standard costing system is used within a company and what impact it is having on company behavior. Company management must create an action plan to move the company off using standard costing at the beginning of the lean accounting implementation process.