Lean Accounting Defined Target


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Lean Accounting Defined Target

  1. 1. Lean Accounting: What's It All About? Brian H. Maskell and Bruce L. Baggaley W quot; hat is Lean Accounting?quot; is an menting lean accounting are making oft-asked question. Everybody poor decisions: turning down highly working seriously to imple- profitable work, out-sourcing products or ment lean thinking in their company eventu- components that should be made in ally bumps up against their accounting sys- house, manufacturing overseas products tems. It soon becomes clear that traditional that can be competitively manufactured accounting systems are actively anti-lean: here at home, etc. • They are large, complex, wasteful While there is good understanding of processes requiring huge amounts of the problems, there is not widespread under- non-value work. standing of the solutions. In September • They provide measurements and reports 2005, at the Lean Accounting Summit in Detroit, co-sponsored by AME,1 a group of like labor efficiency and overhead absorption that motivate large batch the conference presenters got together and production and high inventory levels. decided to create a definition of Lean • They have no good way to identify the Accounting as it stands now. We decided to financial impact of the lean improve- succinctly document the Principles, Practices, ments taking place throughout the com- and Tools of Lean Accounting. Lean pany. On the contrary, the financial accounting has developed over the last ten reports will often show that bad things years or so and although it continues to are happening when very good lean evolve, we felt it would be helpful to docu- change is being made. • Very few people in the company under- stand the reports that emanate from the In Brief accounting systems, and yet they are This article reviews the framework of principles, practices, and used to make important and far-reaching tools of lean accounting being developed by a group of lean decisions. accounting thought leaders as a result of the Lean Accounting • They use standard product costs which Summit in September 2005. A brief overview was presented at the are misleading when making decisions 2005 AME annual conference. The principles are accompanied by related to quoting, profitability, sourcing, an illustration of financial and non-financial analysis using quot;box make/buy, product rationalization, and scores,quot; one of the generic techniques being employed. so forth. Almost all companies imple- 35 First Issue 2006
  2. 2. ment the current quot;state of the artquot; as seen by This is achieved in the same way a group of both consultants and practitioners waste reduction is achieved anywhere else, in this area. The purpose of this article is to through continuously eliminating waste briefly describe the principles, practices, and from the transaction processes, reports, tools of lean accounting developed thus far. and accounting methods throughout the organization. The tools to achieve this are Vision for Lean Accounting the value stream maps (current and future state), kaizen (lean continuous improve- We started with a vision statement ment), and the venerable Plan-Do-Check- and then drilled down to the practical tools Act (PDCA) problem-solving approach. used to make the vision a reality. Our vision These improvements can be made is that Lean Accounting will: early in the transformation to lean and will open up time for the accounting personnel 1. Provide accurate, timely, and under- to work on other Lean Accounting changes. standable information to motivate the Inevitably these early projects improve lean transformation throughout the processes that will later be eliminated, but organization, and for decision-making they make a good start to the introduction leading to increased customer value, of Lean Accounting into the business. growth, profitability, and cash flow. 2. Use lean tools to eliminate waste from B. Accounting Processes that the accounting processes while main- Support the Lean Transformation taining thorough financial control. 3. Fully comply with generally accepted Lean accounting reports and methods accounting principles (GAAP), external actively support the lean transformation. reporting regulations, and internal This information drives continuous reporting requirements. improvement. The financial and non- 4. Support the lean culture by motivating financial reporting reflects the overall value investment in people, providing informa- stream flow, not individual products, jobs, tion that is relevant and actionable, and or processes. Lean accounting focuses on empowering continuous improvement at measuring and understanding the value every level of the organization. created for the customers, and uses this information to enhance customer relation- Lean Accounting Principles, ships, product design, product pricing, and Practices, and Tools lean improvement. The Principles, Practices, and Tools of Visual Performance Measurement Lean Accounting summarized in Figure 1 are separated into five principles, A-E. The Control of production processes (and following discussion amplifies them. other processes) is achieved by visual per- formance measurements at the shop-floor A. Lean and Simple Business and value stream level. These measure- Accounting ments eliminate the need for the shop-floor tracking and variance reporting favored by This can also be stated as quot;applying traditional cost accounting systems.2 lean methods to the accounting processes.quot; Some accounting processes contain muda Continuous Improvement type 1 (waste that can not be eliminated at the moment) but most accounting process- Continuous improvement (CI) is moti- es are muda type 2 (waste that can be elim- vated and tracked using value stream per- inated). The tools of lean must be rigor- formance boards. Typically these visual ously applied to our accounting, control, boards are updated weekly and used by the and measurement processes so that waste value stream CI team to identify improve- is relentlessly driven out. ment areas, initiate PDCA projects, and mon- 36 Target Volume 22, Number 1
  3. 3. PRINCIPLES PRACTICES TOOLS OF LEAN ACCOUNTING a. Value stream mapping; current & future state 1. Continuously eliminate waste A. Lean & simple b. Kaizen (lean continuous improvement) from the transactions business c. PDCA problem solving processes, reports, and other accounting accounting methods a. Performance Measurement Linkage Chart; linking 1. Management control & B. Accounting metrics for cell/process, value streams, plant & continuous improvement processes that corporate reporting to the business strategy, support lean target costs, and lean improvement transformation b. Value stream performance boards containing break-through and continuous improvement projects c. Box scores showing value stream performance a. Value stream costing 2. Cost management b. Value stream income statements a. Target costing 3. Customer & supplier value and cost management a. “Plain English” financial statements 1. Financial reporting C. Clear & timely b. Simple, largely cash-based accounting communication a. Primary reporting using visual performance 2. Visual reporting of financial & of information boards; division, plant, value stream, cell/process non-financial performance in production, product design, sales/marketing, measurements administration, etc. a. Incremental cost & profitability analysis using 3. Decision-making value stream costing and box scores a. Hoshin policy deployment 1. Planning & budgeting D. Planning from b. Sales, operations, & financial planning (SOFP) a lean a. Value stream cost and capacity analysis 2. Impact of lean improvement perspective b. Current state & future state value stream maps c. Box scores showing operational, financial, and capacity changes from lean improvement. Plan for financial benefit from the lean changes a. Incremental impact of capital expenditure on 3. Capital planning value stream box-score. Often used with 3P approaches a. Performance measurements tracking continuous 4. Invest in people improvement participation, employee satisfaction, & cross-training b. Profit sharing a. Transaction elimination matrix 1. Internal control based on lean E. Strengthen b. Process maps showing controls and SOX risks operational controls internal accounting a. Simple methods to value inventory without the 2. Inventory valuation requirement for perpetual inventory records and control product costs can be used when the inventory is low and under visual control. Figure 1. Principles, practices, & tools of lean accounting. itor their progress. These boards show the state maps together with the project plan to value stream performance measurements, move from current to future state. The value Pareto charts (or other root cause analysis), stream performance boards become quot;mis- and information about the CI projects. The sion controlquot; for both breakthrough boards also show the current and future improvement and CI of the value stream. 37 First Issue 2006
  4. 4. the question from quot;What does this mean?quot; Value Stream Costing to, quot;What should we do?quot; Cost and profitability reporting is done using value stream costing, a simple sum- Visual Management mary direct costing of the value streams. Visual management is a cornerstone The value stream costs are typically col- of lean management. Lean accounting lected weekly and there is little or no allo- requires visual presentation of both finan- cation of quot;overheads.quot; This provides finan- cial and non-financial measurements. The cial information that can be clearly under- quot;Box Scorequot; format commonly used in lean stood by everybody in the value stream which in turn leads to good decisions, accounting provides a one-sheet summary motivation to lean improvement across the for a value stream showing the operational entire value stream, and clear accountabil- performance, the financial performance, ity for cost and profitability. Weekly report- and how well the capacity is being used. ing also provides excellent control and Figure 2 shows an example of box score management of costs because they can be used for weekly performance reporting. reviewed by the value stream manager while the information is still current. Decision-Making and Box Scores Routine decision-making — including Target Costing quotes, profitability, make/buy, sourcing, Target Costing is the tool for under- product rationalization, and so forth — is standing how the company creates value for achieved using simple yet powerful infor- the customer and what must be done to cre- mation that is readily available from the ate more value. Target Costing is used when box score. There is no need to use a stan- new products are being designed and/or dard cost again for these important deci- when the value stream team needs to under- sions. Figure 3 shows a box score used to stand the changes required to increase value present decision-making information relat- for the customers. The outcome of this high- ed to sourcing of a new product. ly cross-functional and cooperative process is a series of initiatives to create more value D. Planning and Budgeting from a for the customer and to bring the product Lean Perspective costs into line with the company's need for Lean planning starts with hoshin policy short-term and long-term financial stability. deployment and runs through to the monthly These improvement initiatives encompass Sales, Operations, and Financial Planning sales and marketing, product design, opera- (SOFP) process leading to an integrated tions, logistics, and administrative processes game plan for the organization. These plans within the company. are all made at a value stream level and use C. Clear and Timely Communication lean accounting information. of Information Hoshin Policy Deployment Lean accounting provides financial reports that are readily understandable to Hoshin policy deployment starts with anyone in the company. The income state- the company's business strategy. The busi- ments are in quot;plain Englishquot; and the infor- ness strategy will often look out three to mation is presented in a way that is no more five years whereas the hoshin policy complicated than a household budget. Plain deployment establishes what must be done English income statements are easy to use during the coming year. The top-level because they do not include misleading and hoshin plan has a handful of break-through confusing data relating to standard costs changes required to support the business together with hosts of incomprehensible strategy together with the measurements variance figures. When used in meetings, to monitor the achievements, and the plain English financial statements change resources needed to complete the plan. 38 Target Volume 22, Number 1
  5. 5. Example Box Score for Weekly Performance Reporting 6/2 6/9 6/16 6/23 6/30 7/7 7/14 7/21 7/28 8/4 8/11 8/18 8/25 Goal Units per Person 15.10 15.63 14.7 15.91 15.90 16.32 20.7 On-Time-Shipment 100% 100% 100% 100% 100% 100% 100% OPERATIONAL Dock-to-Dock Days 6.00 6.00 6.00 6.00 6.00 5.5 5.5 First Time Through 80% 80% 81% 85% 85% 87% 92% Average Cost $343 $337 $362 $338 $337 $325 $262 Productive 29% 29% 29% 28% 28% 28% 40% CAPACITY Non-Productive 54% 54% 54% 52% 52% 52% 33% Available 17% 17% 17% 20% 20% 20% 27% Revenue $471 $485 $456 $490 $488 $526 $576 Material Cost $123 $125 $129 $132 $135 $137 $139 FINANCIAL Other Variable Costs $49 $50 $51 $54 $76 $87 $51 Fixed Costs $120 $120 $118 $116 $116 $116 $108 Profit $179 $190 $158 $188 $161 $186 $278 Return on Sales 38% 39% 35% 38% 33% 35% 48% Box Score used for weekly value stream performance reporting. Note the “Goals” set from the future state value stream map. Figure 2. Example Box Score for a Sales Order Sourcing Decision ORDER USING OUT SOURCE TO MAKE IN HOUSE BUY CURRENT STATE STANDARD COST CHINA ADDITIONAL Std Cost = $42.44 Landed Cost =$30 MACHINES Sales per Person $29,789 $29,789 $33,647 $33,647 OPERATIONAL On-Time-Shipment 95% 95% 90% 95% Dock-to-Dock Days 16.4 16.4 21.1 15.1 First Time Through 80% 80% 75% 81% Average Cost $29.95 $29.95 $30.18 $29.48 Productive 48% 48% 48% 52% CAPACITY Non-Productive 28% 28% 28% 26% Available 24% 24% 24% 22% Revenue $1,042,631 $1,042,631 $1,177,631 $1,177,631 Material Cost $399,772 $399,772 $455,513 $466,909 FINANCIAL Other Variable Costs $24,991 $24,991 $66,000 $24,844 Fixed Costs $392,089 $392,089 $392,089 $400,756 Profit $225,779 $225,779 $264,029 $285,122 R e t urn o n S a l e s 21.65% 21.65% 22.42% 24.21% This Box Score illustrates a sourcing decision for a potential new sales order. If the decision is made using a standard cost the company will turn down the order because it does not have sufficient “margin.” If they buy it from China, the order is profitable. If they make it in-house they must buy additional equipment and hire more people, but in this example, this provides the best profitability and operational performance. Figure 3. 39 First Issue 2006
  6. 6. This top-level hoshin plan is then rolled-out SOFP process is to update budgets each to the first-level executives, their first-level month and thereby largely eliminate the managers, and down to the value streams. wasteful annual budgeting choreography Hoshin is not the traditional command most companies engage in. Calculating and control plan where (often unattainable) short-term month-end results also decreases goals are set by managers for their under- the need for month-end reporting processes. lings. The hoshin process includes at each level timely and detailed quot;catch-ballquot; steps Financial Impact of Lean Improvement whereby the people required to achieve the The true impact of lean improvement results are very much involved in the plan- must be understood at the outset of any lean ning and goal-setting for their own areas of transformation. Using the current state and responsibility. Hoshin is a cooperative and future state value stream maps, lean empowering business transformation accounting tools are used to understand how process. Hoshin plans are typically devel- the changes taking place in the value stream oped annually and reviewed monthly. will affect the operational performance, the financial performance, and also how the Sales, Operations, and Financial capacity usage changes within the value Planning (SOFP) stream. This analysis often shows excellent SOFP is typically done every month operational improvement but little improve- ment in cost or bottom-line profitability.3 and is a comprehensive, company-wide process for short- and medium-term plan- What bridges the gap between these? The ning. SOFP is a formal and rigorous plan- answer is capacity change. ning process completed for each value Most lean improvement projects elim- stream. Sales and marketing provide fore- inate waste and create available capacity in casts for the number of products that will the form of machine time, people's time, be sold by a value stream each month for and physical space. The financial impact of the next 12 months (for example). These lean improvements on the company's bot- are high-level forecasts of total unit sales, tom-line comes from the decisions made by although sometimes it is helpful to go one management on how this newly freed-up level down and forecast by product families capacity will be used. Figure 4 shows a within a value stream. The operations peo- real-life example of this from a company ple provide forecasts of the value stream making temperature and pressure gauges capacity each month for the next 12 used on off-shore oil rigs. months, and product engineering brings One of the most difficult changes the plans for new product introductions. made by senior managers when they are Through a series of formal, tightly- beginning the process of lean transforma- scheduled meetings the customer demand tion is to stop thinking about production is matched by production capabilities. The improvements in terms of short-term cost final executive SOFP meeting is chaired by reductions. This is very much mass-pro- the most senior person in the organization duction, standard cost thinking. This think- — often the president or CEO — and a com- ing will limit the progress the company can pany wide game-plan is developed. make with lean manufacturing and other Everybody in the organization can buy in to lean initiatives. We need to start thinking this game plan because it has been devel- about customer value and business growth. oped cooperatively. SOFP is the planning This does not mean that cost information is process in lean companies. It provides both unimportant; cost is very important. So short-term updating of such things as kan- important, in fact, that we need much bet- bans and cell manning, and longer-term ter tools to show the cost information: tools planning such as capital equipment, and like value stream costing and box scores. hiring or redeploying people. By understanding this true nature of The financial planning outcome of the lean, we change our question from, quot;How 40 Target Volume 22, Number 1
  7. 7. Box Score Showing the Assessment of Financial Benefit from Lean Improvement Future State C u r r en t S t a te Future State Lean Longer Term B efore Lea n Step Tw o including New Dec ‘02 Dec 2003 Pro duc ts Sales per Person $224,833.00 $224,833.00 $277,031.00 OPERATIONAL Inventory Turns 6.5 15 20 Average Cost per Unit $3 1 .3 2 $ 2 9 . 88 $ 24 .25 First Pass Yield 81 % 95 % 95 % Lead t ime in Days 25 5 2.5 Productive 55 % 52 % 79 % CAPACITY Non-Productive 42 % 12 % 12 % Available 3% 36 % 9% Revenue $4,062,000 $4,062,000 $5,686,000 Material Costs $1,164,184 $1,109,327 $1,552,839 FINANCIAL Conversion Costs $1,483,416 $1,483,416 $1,657,500 Value Stream Profit $1,414,400 $1,469,257 $2,475,661 Value Stream Return on Sales 35 % 36 % 44 % Hurdle Rate Variance (40%) -5% -4% 4% As the company moves from the current state to the future state the operational measurements improved, but there was little financial improvement. The real change is that available capacity and cash (from inventory reduction) was freed up. Tangible financial benefit comes when the company introduces new products that use that newly-freed up capacity. Figure 4. large a cost will we save?quot; to, quot;How can we etc. 3P also requires the team to evaluate use our newly-created capacity to increase each alternative using an extensive check- customer value and make more money?quot; It list of lean attributes, most of which are is important to ask this question every time non-financial. The financial impact of each a future state value stream map is devel- alternative is presented on a box score as a oped because the answer gives us the true part of the decision process. Figure 5 shows financial impact of lean changes, both a box score used for capital planning. short term and longer term. Investment in People Capital Planning Two issues are perilously neglected by many companies attempting the lean jour- The lean approach to capital acquisi- ney. One is the need for active senior man- tions is quite different from the traditional agement leadership and involvement. The return-on-investment calculations. When second is a focus on quot;lean toolsquot; rather than approaching a major decision relating to on people. Successful lean organizations the purchase of capital equipment a lean radically change their culture to make the organization will perform a 3P.4 The 3P training, involvement, and empowerment of team is required to develop several solu- their people of paramount importance. tions to the problem. Often they are forced Lean accounting contributes to this to quot;think outside the boxquot; because each effort by providing appropriate measure- solution must be quite different: fully auto- ments. While it is difficult to measure mated, fully manual, similar to current employee empowerment directly, such approach, opposite to current approach, 41 First Issue 2006
  8. 8. A Box Score Showing the Impact of Three Capacity Alternatives on a Value Stream THREE MANUAL SINGLE FULLY C EL L S CURRENT STATE 60% more capacity OUTSOURCE AUTOMATED CELL 42% more capacity (but only 42% sales increase) PRODUCTIVITY $0.2386 $0.2856 $0.1932 $0.1680 Conversion Cost per Sales Dollar PROCESS CAPABILITY 82% 97% 98% 97% On-Time-Shipment OPERATIONAL MATERIAL FLOW 29 12 18 21 Days of Inventory PROCESS QUALITY 18,892 4,250 15,000 10,000 Parts per Million (Internal) PRODUCT COST $3.62 $3.60 $3.16 $3.61 Average Cost Productive 48% 72% 42% 52% CAPACITY Non-Productive 28% 16% 32% 26% Available 24% 12% 26% 22% Revenue $10,677 $15,161 $15,161 $15,161 Material Cost $3,758 $4,585 $4,890 $6,393 FINANCIAL Conversion Costs $2,547 $4,330 $2,929 $2,547 P r ofit $4,372 $6,247 $7,342 $6,221 Return on Sales 40.95% 41.20% 48.43% 41.03% The box score compares three alternatives: Fully automated, a classic lean cell approach, and outsourcing. In this case, lean wins. Figure 5. measurements as the number of improve- Accounting changes are made prudently is ment suggestions implemented, the per- the Transaction Elimination Matrix. Using centage of people actively involved in con- the transaction elimination matrix we can tinuous improvement, and the level of determine what lean methods must be in cross training within the value streams are place to enable us to eliminate traditional, helpful. Annual surveys of employee satis- transaction-based processes without jeop- faction can also help to gauge the compa- ardizing financial (or operational) control. ny's management capabilities and success These decisions are made ahead of time with employee empowerment. Many lean and become a part of the overall lean trans- organizations also use a simple profit-shar- formation; in some cases driving the lean ing process that gives everyone a stake in changes and improvements. The new Sarbanes Oxley regulations5 the company's success. (SOX) are met by including SOX require- E. Strengthen Internal ments in the standardized work whenever Accounting Controls improvement projects are applied to the company's administrative processes. Accounting controls have always When process maps are drawn the SOX been important, and it is essential that risks are included and color-coded, and Lean Accounting enhance these controls, any changes required to mitigate and test and does not weaken them. It is important these risks are built into the improvement to bring the company's auditors into the project or kaizen event. Lean Accounting process at the earliest An important aspect of financial con- stages. A primary tool to ensure that Lean 42 Target Volume 22, Number 1
  9. 9. trol is the evaluation of inventory. Lean manufacturing always leads to substantial Brian Maskell, a well-known speaker, and the inventory reductions. When inventories president of BMA Inc., has written six books on are low and under good control (using pull topics related to lean accounting, and has 25 systems, single-piece flow, supplier part- years’ experience in industry. Bruce Baggaley, nerships, etc.), the valuation of inventory the senior partner of BMA Inc., is a regular pre- becomes much less complex. Lean senter of workshops on lean accounting at Accounting contains a number of methods AME events, and is co-author of a book on for valuing inventory that are simple, accu- practical lean accounting. rate, and often visual. Several of these methods do not require any inventory tracking at all. Footnotes: Conclusion 1. Other sponsors included the Society of Manufacturing Engineers (SME), the Institute of While Lean Accounting is still a work- Management Accountants (IMA), Lean Enterprise Institute (LEI), and Financial Executives in-process, there is now an agreed body of International (FEI). The Lean Accounting Summit knowledge that is becoming the standard was underwritten by FlexwareInnovation. approach to accounting, control, and 2. A quot;starter setquot; of lean performance measurement is measurement. These principles, practices, available from www.maskell.com/LeanAcctg.htm. and tools of Lean Accounting have been (free of charge). implemented in a wide range of companies 3. Often there is an improvement in cash-flow as inventory levels are reduced, and there are often at various stages on the journey to lean reductions in material costs as product quality transformation. These methods can be improves. Sometimes these kinds of cost savings readily adjusted to meet your company's can be substantial, but often the short-term affect specific needs and they rigorously maintain of lean improvement does not quot;hit the bottom line.quot; adherence to GAAP and external reporting 4. Production Preparation Process (3P) is a disciplined method for designing or redesigning a production requirements and regulations. Lean process. See Lean Lexicon by Chet Marchwinski Accounting is itself lean, low-waste, and and John Shook (LEI, Brookline, MA, 2003). visual, and frees up finance and accounting 5. The Sarbanes Oxley laws were Congress’ response people's time so they can become actively to the recent accounting scandals associated with involved in lean change instead of being such companies as Enron, Tyco, and Global Crossing. This series of regulations seeks to monitor merely quot;bean counters.quot; companies' compliance to generally accepted Companies using Lean Accounting accounting principles in relation to internal financial have better information for decision-mak- control and accuracy of external reporting. ing, have simple and timely reports that are clearly understood by everyone in the com- pany, they understand the true financial © 2006 AME® For information on reprints, contact: AME impact of lean changes, they focus the busi- Association for Manufacturing Excellence ness around the value created for the cus- www.ame.org tomers, and Lean Accounting actively drives the lean transformation. This helps the company to grow, to add more value for the customers, and to increase cash flow and value for the stock-holders and owners. 43 First Issue 2006