initiatives. We'll provide some fresh ideas and tips on overcoming the barriers traditional accounting creates to accurately tell the lean story. Furthermore, the approaches we offer don't mean throwing out your existing accounting system. Once you understand the issues and problems and how to bridge them, your team will better understand the impact of their lean efforts.
Lean is Different
Most lean programs concentrate on streamlining manufacturing operations and the supply chain to produce cost savings. Lean savings in the production areas result from a number of value steam mapping steps that produce lower material costs, reduce the amount of direct labor, and eliminate scrap to improve yield from the production processes. Savings are derived from increasing cycle times by reducing delivery and production lead times. Material traveling through the production cycle spends 95 percent of the time waiting in queues or being moved from one work center location to another. It is little wonder that significant savings can be derived from reducing the amount of inventory investment. After this quick overview, lets take a look at how traditional cost management impacts enterprises that adopt lean thinking.
The Impact of Lean on Cost Systems
Traditional cost management systems are not effective in measuring and accounting for lean initiatives. Much of the problem rests with the training that managers and accountants have received over the past century. The emphasis has been on the use of standard cost systems predicated on efficiency and managing variances. Traditional accounting thinking provides incentives to over produce and to purchase in quantities at the lowest cost. Placing emphasis on high labor efficiencies and low purchase price variances will often inflate the investment in inventory. The level of quality and vendor service can be adversely affected by the practice of purchasing based on price alone. In addition, generally accepted accounting principles require that overhead costs and expenses be allocated to production in the determination of cost of goods sold and in valuing inventory assets reported on the balance sheet.
Lean production is a one-piece continuous flow synchronized with the demand for products as specified by the customer. Now we have applied lean concepts to the production process by reducing the time required for set ups and changeovers, shortened travel distance, and instituted 5S housekeeping that makes sure everything is in place. Kanban signals are established to insure that material is available when it is needed either from outside suppliers or internally. The only work in process inventory is just the amount that is sufficient for the work center. Suddenly inventory investment is drastically reduced or eliminated, especially work in process inventory.
Let's look at a hypothetical situation to help understand the dramatic impact that lean can have on inventory costs and valuation. The following example presents a pre-lean inventory comprised of the three cost components:
Now we adopt a lean program that reduces the amount invested in material and labor by 50 percent. The overhead rate used to allocate overhead was 200 percent of labor before the lean initiative. The overhead rate increased to 222 percent because manufacturing overhead remained constant and labor cost was reduced. This caused a reduction in the amount of overhead in inventory creating an adverse adjusting journal entry. The example is shown below:
The lean savings in direct cost totaled $3,000.000 since we slashed material and labor by 50 percent. The inventory reduction was $4,777,778 after adjusting overhead in inventory by $1,777,778. Lets assume interest expense was reduced by $300,000 as a result of the eliminating $3,000,0000 of direct cost from inventory. The impact of cutting direct cost by $3,000,000 and inventory by almost $5,000,000 only produced a $1,000,000 improvement in GAAP net income after taxes. The critical issue is that generally accepted accounting principles forced us to take a major hit because of the reduction in the amount of overhead in inventory and distorts the perceived benefit from the lean effort.
This situation is presented to help launch us into a discussion of how to utilize the cost accounting system to accurately monitor and measure the benefits accruing from lean thinking programs. We need to realize that inventory using GAAP and a standard cost system will lead to confusion and inaccurate calculation of lean savings. We also see that a standard cost system will hinder our understanding of the savings and monitoring the continued benefits. The distortion in this situation is straightforward because we limited the variables. Imagine what can happen with multiple variables and a failure to baseline the starting point. No wonder companies struggle to understand lean savings.
Overcoming the Obstacles to Accounting and Measurement
The above example is typical when lean thinking is applied in a traditional accounting environment. Lets spell out the obstacles and understand how to overcome them using the existing accounting system. The big issue is that generally accepted accounting principles fail to provide appropriate rewards for reducing inventory investment. Along with GAAP, most companies are using some form of standard costing with their ERP system. These systems rely on standards for both material and labor that are updated annually at year-end. Overhead rates used to value inventory, which are also locked into changes that are updated annually. Since the interim financial results are driven using this data, savings from lean programs will not impact inventory valuations until revisions are made.
Lean is all about speed and eliminating waste. Our first step is to take overhead out of the determination of lean savings. We realize that GAAP requires an overhead component for asset valuation, but the impact on the income statement should be isolated as an extraordinary item so the true cash savings resulting from the acceleration of synchronized flow through the production process can be clearly identified. Now we need to deal with the problems stemming from the standard cost accounting system.
The first step in overcoming the hurdle of standard costing is to realize that continuous change will occur so quickly that standard costs will quickly become outdated. The purpose of using standards is also driven by outdated cost management concepts that utilize variances and efficiencies, which are no longer valid metrics in a lean world. The suggested measurement method should utilize direct costing so that evaluation includes only those costs that are affected by lean thinking. In these instances it makes sense to adopt an actual average costing approach. If standards are used then just apply them to material. This will allow continued use of your ERP system since most of them can accommodate actual average costing. You can still utilize bills of material and routings. Many systems will accommodate cellular work centers that will allow the utilization of multi-trained workers. The accelerated speed will necessitate showing costs in the period incurred. Direct costing employing the approaches discussed above will provide a focus on measuring:
A standard cost system will not be able to keep pace with the rate of changes that will occur in the cost structure. A direct costing system based on actual average costs will not only provide better measurement of the lean initiative, but is better suited for target costing. Target costing will be applied to set selling prices that will increase the level of throughput. With an abundance of excess capacity, it is critical to make every effort to maximize throughput. This will fully utilize the benefits from lean thinking and avoid the risk of losing the investment in our cross-trained work force.
A Profit Focused Accounting Approach
All lean initiatives should start with an assessment and a baseline starting point. If these steps are not followed it becomes difficult to know how far the lean program has come and where it is going. These are critical steps to measuring program progress and sustaining its momentum. A direct costing or Throughput Accounting is what I call Profit Focused Accounting. This approach takes advantage of the attributes of The Theory of Constraints but allows for greater acceptance since traditional accountants can more readily understand the terminology and make a paradigm shift to the lean accounting process.
The initial shock of making an inventory adjustment has to be overcome. The reality lean companies need to face is that inventory levels will not return to the bloated state that existed prior to the lean initiative. It is a simple calculation to check overhead levels in inventory and should not reoccur after the initial adjustment. Profit Focused Accounting profit and loss statements should report the variable contribution from operations so that a more accurate understanding of how well lean is performing can be seen on a month to month basis. By using actual average costs, companies will gain a better understanding of what is occurring. Accordingly, the localized measurement occurring at the cell level will be more in tune with the profit and loss statement.
A Profit Focused Accounting approach provides a throughput focus to the financial numbers. The impact of capacity will be much more evident than when the numbers are masked with overhead in inventory. Also, the overhead or standby expense will be much more visible so that lean thinking can be applied to the commercial and office processes in addition to the factory floor. When the effect of capacity is revealed on the profit and loss statement, it becomes a call for action. Since the cost data is narrowed down to actual leaner costs, target costing can be applied to opportunities for increasing throughput.
Taking the Next Steps
Lets summarize these lean accounting approaches. Using actual average costs and avoiding standard costs achieves better accuracy of lean programs. Measuring profit on a direct costing basis within the existing accounting system, managers will now be able to visualize the contribution from their effort. This will require restructuring the reporting format of the income statement, but will be well worth the effort. Extraordinary adjustments such as overhead in inventory adjustments and other related factors such as depreciation and amortization should also be shown separately. In effect, accountants need to report an accurate picture driven by the program using a throughput focus to ensure the maximum lean benefits.
ABOUT THE AUTHOR
C. Lynn Northrup is the principal of C. Lynn Northrup, CPA based in Wilmington, N.C. In addition to his CPA and consulting practice, he creates and teaches continuing professional education programs. Among his programs is an 8-hour workshop entitled Accounting for Lean Six Sigma. His new book, Dynamics of Profit Focused Accounting will be available from J. Ross Publishing in June. Details regarding the new book and training programs are available on Lynn's web site (http://www.northrupcpa.com/).
Lynn was previously with McGladrey & Pullen's national manufacturing consulting practice where his specialty was conducting operational and workflow assessments focused on business process improvement and performance measurement utilizing ERP systems. He also worked on the application of strategic cost management and analysis concepts.
After starting his career in public accounting with Price Waterhouse Coopers, he was the Controller at Schlegel Corporation in Rochester, N.Y. Schlegel, a complex multinational manufacturing company grew rapidly from $10 million in sales to $300 million from 1965 to 1984. Lynn developed and implemented the cost accounting, financial, and budget forecasting systems for this company on a worldwide basis, which included over 35 profit centers located in 17 different countries.
In addition to creating his own CPA and advisory practice, Lynn has held various management and executive positions in industry including Controller and Vice President of Finance. His experience included working with a wide variety of manufacturing companies in diverse industries plus construction, service industries including CPA firms, mail order, hospitality, real estate, and non-profit organizations.
Lynn received a B.B.A. from Clarkson University in 1960 and was certified in production and inventory management (CPIM) with (APICS) in 1999. He is licensed as a Certified Public Accountant in New York, North Carolina and Oregon and is member of the American Institute of Certified Public Accountants and the North Carolina Association of CPAs. He is also an active member of APICS. Lynn can be reached at 910-686-2135 and by e-mail at firstname.lastname@example.org.