Lean Accounting: Novel Number Crunching

Jan. 14, 2005
A few brave finance and accounting managers are changing how they track costs to support lean manufacturing and improve decision making.

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.

Origins of Lean Accounting

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 priced to accurately reflect the incremental cost of production, the internal customers would have paid less in-house than they did outside. Eventually, company executives chose to shut down the under-utilized plant. At heart, the lean accounting approach takes a simpler look at what goes on between the inputs and outputs of a production process, tracking costs in less-minute detail, expensing material as soon as it's pulled into production, and eliminating work orders, the tracking of transactions and the reporting of variances altogether.

Many manufacturing plants today rely on such activities to monitor product costs and track the value of inventory. But, lean-accounting advocates say that such procedures are inherently wasteful. Before a manufacturer can drop such activities, however, the production operation has to be far enough into lean manufacturing to be organized by value streams, a customer-centric structure that pulls together all of the fulfillment functions from order receipt to delivery.

Under a lean accounting system each value stream has its own, slightly modified, profit-and-loss statement. Traditional financial statements are still needed to satisfy auditors and reporting requirements, but these statements aren't used to run the business. The ultimate result: Accountants give up their roles as traffic cops and start providing the type of analysis and reports that make decision-making more straightforward, rather than a battle over the accuracy of the numbers.

"From a financial perspective, when you create a true value stream -- cells with all of the workcenters connected to each other -- the investment decision when you're looking at equipment is so much easier to make," says Jerry Solomon, vice president of manufacturing, Marquip Ward United, a Hunt Valley, Md., company that builds complex machinery for making corrugated paperboard.

"I'm sitting here in my office right now, and I have a value stream map hanging on the wall," Solomon says. "I know I can improve certain operations in those data boxes I have up there, but it will do me no good in getting product through the system to the customer, unless I improve this particular operation first."

Transitioning to Lean Accounting

Such constraints are invisible in a standard printout from accounting that lists how many minutes or hours are required at each operation. Solomon even wrote a business novel, "Who's Counting," that describes the transition to a lean accounting approach within a manufacturing company. The story shows, even though the concepts pique a lot of people's interest, why it's so difficult to do and why so few companies have actually made the change.

First, it's hard for managers to give up methods taught in business school and abandon the metrics that they've always used to track performance. Lean accounting also has a broad impact on the organization.

In addition to adoption by the accounting and finance departments, it requires buy-in from managers in engineering, purchasing, IT and customer service. Getting all of these people on board is difficult, if not impossible, without a mandate from the top. Those who have begun to change the way they track financials say it's worth the effort. If asked directly, few CEOs and even controllers can explain what drives all of their variances or how they are calculated. But when the numbers make intuitive sense, and business performance isn't cloaked in accounting jargon, people at all levels can make better -- and more profitable -- decisions.

"It allows the workforce to understand what they're spending -- i.e., what the input is to get a certain level of output. Then they can focus on how to do it better," Solomon says. Still, making the transition requires some convincing.

When looking at whether Southco can make an adequate profit at a certain market price, Wayne Thompson says they often put a standard operating income statement next to a modified one to prove the point that a product that might not meet a gross margin test can actually be very beneficial to the bottom line. "People know and breathe and die by standard cost," Thompson says. "They want to see it side-by-side and look at it incrementally and see where standard cost breaks down and where we can make a better decision." Plain English P&L TRADITIONAL

Sales $ 9,570,000 100.0%
Cost of Sales $ 6,364,758 66.5%
Gross Margin $ 3,205,242 33.5%
Total Adjustments $ 270,007 2.8%
Net Manufacturing Margin $ 2,935,235 30.7%
Other Operating Costs $ 738,164 7.7%
Net Operating Margin $ 2,197,072 23.0%
Total Sales Expense $ 139,358 1.5%
Net Operating Margin $ 2,057,713 21.5%
SG&A Expense $ 195,973 2.0%
Net Earnings $ 1,861,741 19.5%


Sales $ 9,570,000 100.0%
Procurement $ 910,184 9.5%
Conversion $ 6,388,710 66.8%
Distribution $ 337,509 3.5%
Support $ 762,116 8.0%
Total Costs $ 8,398,519 87.8%
Margin $ 1,171,481 12.2%
Change in Inventory $ 690,259 7.2%
Net Earnings $ 1,861,741 19.5%

Comparison of a traditional profit and loss statement (P&L) and a lean-accounting P&L. In this example, high conversion costs reflect a capital-intensive business. The top and bottom line are the same in both examples. One advantage of the lean accounting P&L is that the type of costs are broken down into recognizable categories. If the company is trying to rein in procurement costs, for example, the impact of such efforts would be readily apparent on the P&L.

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