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Articles - Publication Date 12.1.2004
Lean Accounting: Novel Number Crunching
A few brave finance and accounting managers are changing how they track costs to support lean manufacturing and improve decision making.
By David Drickhamer
As wary as executives are these days of anything that smacks of "creative" accounting, there's a quiet revolution unfolding among lean manufacturers. The idea creeping into the heads of a few radical thinkers is that the financial numbers reported should actually reflect the underlying reality of the business. Armed with more relevant information, business unit managers could then make better decisions when it came to product pricing, make-versus-buy questions, and product and customer rationalization.
Falling under the general heading of "lean accounting," the approach does not require any new math or tricky algorithms. But it does demand a fundamental change in perspective. Wayne Thompson, global finance manager for value stream analysis at Southco, a Concordville, Pa., company that makes latches, fasteners and hinges, offers an example of this approach to decision making.
A unit of his company had an opportunity to bid on a component with a market price of $3.75. The standard accounting showed it would cost $4.61 for the unit to make and sell the product.
"We took a look at it and recognized that from a traditional cost accounting standpoint, this would be a loser," says Thompson. "When in fact, if you go through lean processes and look at out-of-pocket expenses, we actually come away with a very profitable application."
Material accounted for $1 with standard cost calculations, and the remainder was for labor and overhead. But because the company had the capacity to make the product on existing equipment, and because the additional labor required to run the machine was negligible, the new product would essentially cost Southco only the price of the raw material. And the difference between the price and material cost would drop to the bottom line. Southco did successfully bid for the order, and reaped a six-figure contribution to quarterly profits.
"Standard cost tells you that for every dollar of material you bring on, you're going to have an incremental amount of labor and spending, and that's just not true," stresses Thompson. Essentially, the lean-accounting approach treats many of the costs typically regarded as variable as fixed, depending upon available capacity and the real investments in people and equipment required.
The lean accounting movement was born of frustration. Many manufacturers that have used the techniques championed by Toyota to reduce set-up times and convert from batch production methods to workcells and one-piece flow, don't immediately realize the results on the bottom line. In fact, during the transition, which can stretch over a number of years, net earnings take a hit as obsolete inventory is written down. If sales remain flat, lower production volumes caused by the reduction of excess inventory also increase the overhead burden on the remaining output.
Lean accounting proponents argue that lean production operations simply cannot be measured in the same way that traditional batch manufacturing is. Traditional accounting methods encourage high-volume production runs that fully absorb overhead and build work-in-process and finished-goods inventory. They reflect the era in which they were developed, which was characterized by less product variety and economy-of-scale thinking. What's more, using the information generated by traditional methods can lead to decisions that are not only wrongheaded, but tragic.
A manager at an IW 500 company tells the story of a plant in one division hit by a market downturn and subsequent lower sales volumes. This reduced overhead absorption, which increased the overhead and led to an increase in prices that reduced sales even further. Hastening this death spiral, rather than source products from this plant, which had plenty of available capacity, other business units within the division purchased parts from outside suppliers because of non-competitive transfer prices based upon standard cost plus 15%. If the products had been price
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