LEAN ACCOUNTING By John Darlington & Kate Mackle

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“How much are we saving from our lean activities?” Have you ever been asked that question? How easy did you find it to answer?

“You’re telling me we’re doing all the right things, but why isn’t it showing through on the bottom line?” Ever struggled to justify that your improvements have had a real effect on business financial performance?

“Why should we continue this lean programme because I’m not convinced the results are worth it?” Are you being challenged to prove that your lean implementation is the right thing for the needs of the business?

However uncomfortable those questions make you feel you can rest assured that you are not alone. In fact, there is a growing trend for senior managers to question that lean implementation is delivering the hard bottom-line results that they anticipated.

We see two main causes for this.

The first is simply that a lot of lean implementation activities are well-intentioned but naïve applications of tools and techniques which do nothing to fundamentally alter the capability of the business to sell more, with less inventory and lower operating expenses. After all, that is the only way to make more money.

We’re firmly on the side of managers who question such approaches: a lot of what passes for “lean” today is certainly not what Taiichi Ohno had in mind when he described the Toyota Production System as “profit-making industrial engineering”. Misapplication of lean tools does no-one any favours and gets lean a bad name.

The second cause is more serious and harder to correct. Many lean implementations falter when a major contradiction raises its head. The system is performing better: on-time delivery performance is higher, quality has improved, productivity is better and manufacturing lead time has fallen with a consequent reduction in inventory. But the profit looks worse. How can that be?

The reason why conventional accounting systems will show a loss when inventory reduces are well-documented – if not always well-understood (look at Box 1 if you want to know more about this). Management teams who know of this effect will plan for the “bad news” and take the longer view, looking forward to the service and operating expense benefits of short-lead time manufacturing (see Box 2 for more details).

However, even enlightened managers are not well-served by conventional accounting systems when it comes to the question of how much better the financial performance is after lean implementation or when trying to prioritise improvement activity for the greatest financial gain. In fact traditional accounting systems based on standard costing principles will frequently provide misleading information leading to poor decision-making. Let’s look at a few typical examples.

• Producing in smaller batches to match production with demand and reduce lead time to the customer will make the product cost appear to go up

• The need to changeover a non-bottleneck machine more often in order to better match the mix required by the customer will reduce its utilisation and appear to increase production costs.

• Reduction of operating losses will often be focussed on a machine where we find the biggest losses even if this is on a non-bottleneck machine despite the

LEAN ACCOUNTING

fact that targeting a smaller loss on the bottleneck will have a greater effect on the whole system.

Hard to believe? Not when you understand that the purpose of “lean” for many organisations has been narrowed down to the elimination of waste in the belief that this will equate to cost reduction. In contrast, successful businesses focus on protecting and increasing real sales to the customer, so that their improvement activities are determined by a pursuit of value. This is the essence of the Toyota Production System and explains the meaning of the importance of flow.

In this context, flow means far more than the physical movement of product. What it means is to produce to real customer demand so that capacity and materials are being converted into product which will be sold and generate cash. This is a basic lean principle and if this is how we want to operate our business, we need a way to account for money in the business which is consistent with this view. In contrast, traditional accounting systems work on the “value-added” principle, by which anything which is produced contributes to increased value in the accounts. In reality, we know that anything which has been produced which we cannot yet sell has absorbed money which will not be returned until we sell the product.

A further flaw in the traditional accounting methods is that overhead costs are allocated in relation to the amount of direct work carried out on the product. In the dim and distant past of mass production and labour intensive manufacturing, this principle may have been valid. However, in today’s environment the principle leads to inappropriate allocation of costs and subsequent poor data on which to make operational improvement decisions.

Much intellectual effort has been applied to develop alternatives to traditional cost accounting, such as activity-based costing. But no system has yet been developed which reflects the basic fact that most operating expense is attracted to products whilst they are NOT being manufactured, whilst they are in work-in-progress, being inspected, moved and stored. Think about it! This is what Ohno’s 7 Wastes was actually telling us!

Rather than build up a complex system of transactions and allocations to attribute cost in relation to activity, all effort which makes no material difference to the actual capability of the system to deliver value to the customer, why not take a pragmatic approach? No manufacturing company is going to take lightly the complete overhaul of its traditional accounting system, not least because it’s part of the business environment which they can’t change independently: the parent group, the shareholders, Companies House, the stock exchange all expect traditional accounting disciplines to be maintained.

Equally there is little value to be gained from spending a lot of improvement effort in reducing the transactions required by traditional accounting systems. We believe this is a dead-end into which so-called “lean accounting” has drifted, prompted again by prioritising “waste elimination” over “value creation”.

Instead, we advocate developing a parallel system of financial information which can better support operational decision making and be used to quantify the real money effects of lean improvement: we call this flow accounting.

What is flow accounting? Simply a new way of looking at financial measurement that will tell you the real cash consequences of operating a lean system and allow you to monitor performance trends in order to focus improvement activities where you will get the greatest financial impact. Flow accounting does not mean throwing out your current financial systems with all the valid concerns that might bring. What is does mean is involving your finance team as key players in your business improvement programme. Their role is to enable your commercial and operational managers to

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make better decisions by providing them with financial information which is not distorted by variances from standard costs and under-recoveries.

And let’s face it, what manager anywhere has ever found that sort of information a help when faced with hard choices about how to improve performance? More likely, they spend time away from valuable work trying to explain the reasons for figures which bear little resemblance to their understanding of the real world. Armed with flow accounting information, managers are freed from these frustrations and can do what they’re there to do: direct and manage performance improvement for their area of responsibility. And because the numbers they are using describe what they really control, they can be truly held accountable for financial performance.

So, if you want to know how much your lean activities are contributing financially or to want to make sure that all that good lean work is being directed where it is really going to count on the bottom line, you need flow accounting. Like many pioneering businesses in this field, you’ll find you can make a step change from “doing lean” to using a lean approach to create a more profitable business. That way, we’ll really do justice to the legacy that Taiichi Ohno left us.

Kate Mackle & John Darlington

Thinkflow Limited

212 Piccadilly

London W1J 9HG

Tel: 020 78 30 96 77

For more information email us at:- flowaccounting@thinkflow.co.uk

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Box 1 Standard cost based accounting systems interpret the value adding principle by the phrase “each time I make something I add value to the business”.

This manifests itself by double entry book-keeping, a fundamental building block of accounting, through an addition or debit to inflate the value of inventory and a corresponding credit to the profit and loss account.

We must have two entries for the books to “balance”.

As inventory is considered an asset (and who could argue that the right inventory in the right place at the right time is an asset) then we increase our assets each time we make.

But we need to take a credit now for our books to balance and this is to the profit and loss account. These accounts we “credit” are often called recovery accounts.

Ever heard the phrase “we haven’t recovered enough overhead?”

Well now you know what it means, it means we haven’t made enough.

Hang on a moment though!

What if we have made sufficient for our customers?

What happens if we are trying to embrace flow and pull systems?

What happens if we are trying to teach precision manufacturing, reduced lead times and schedule adherence?

Sorry the accounting system needs more recoveries! Even though we know this is not real money just a feature of a double entry book keeping system, we need more real money in the form of material, labour and machine capacity spent on inflating the inventory!!!

Of course we could just change the value added principle to “each time I sell something I add value to the business”. Then all this silliness would go away.

Go on ask your accountant, they know how to do it!! And if they don’t………

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Box 2

INTERNAL • Date: 20-02-2007 • Page: 19 © Thinkflow Limited

July End Inventory of £146.1 million.

Working Capital Relationships Current State

Inventory Pipeline in Days

Raw WIP Fin Gds

22 34 12

•

Finance Days

58

Payables Days

60

Debtor Days

50

Check out your own current state in the manner depicted above and ask yourself, not your accountant, why do we have such a big queue of work in progress?

If it was shorter how would it influence: -

Quality?

Engineering change?

Investment?

Overtime?

Due date performance?

Finished goods?

Don’t see the link?

Still think to reduce the lead time is a “one off” gain?

There’s a career for you in the standard cost accounting community.

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