The Lowdown on Lean Accounting by zhangyun


									The Lowdown on Lean Accounting
A new way of looking at the numbers.


    LEAN MANUFACTURING PRINCIPLES FOCUS on eliminating waste and producing only to meet
  customer demand. They also typically require a company to move from a functional division of work to
  work cells where all of the processes needed to manufacture a product or line occur next to each other
  in sequence.
    AS COMPANIES IMPLEMENT A LEAN APPROACH to manufacturing, CPAs have begun to realize
  many standard cost accounting practices no longer make sense. A growing number of businesses are
  implementing lean accounting concepts to better capture the performance of their operations.

    SINCE STANDARD COST ACCOUNTING DOESN’T work in a lean operation, adherents propose a
  new way of looking at the numbers. Rather than categorizing costs by department, they organize them
  by value stream, which includes everything done to create value for a customer the company can
  reasonably associate with a product or product line.

   WHILE USING ALTERNATIVE ACCOUNTING CONCEPTS solves some problems, it is not a
  panacea. CPAs may have difficulty accurately pricing products and determining profitability when they
  analyze performance by value stream rather than by individual product. The approach also may
  emphasize speed and quality almost to the exclusion of cost concerns.

    WHEN MOVING TO LEAN ACCOUNTING, CPAs may want to supplement the company’s standard
  financial statements with additional information that captures the resulting improvements. Most CPAs
  will find the cost information they need to prepare lean financial statements already is available in the
  company accounting systems.

  KAREN M. KROLL is a freelance business writer in Minnetonka, Minnesota.

        s with many companies that implemented what are referred to as “lean” processes in their
 manufacturing operations, Landscape Structures Inc. has seen significant benefits. Manufacturing lead
 times dropped 90%, inventory turnover jumped 50% and production capacity was freed up by about 25%
 each year. According to CFO Fred Caslavka, CPA, the privately held manufacturer of playground
 equipment in Delano, Minnesota, has “had some big successes” from applying lean manufacturing
 processes to its business.

 In contrast to traditional mass-production operations, a lean company emphasizes eliminating waste,
 boosting inventory turnover and reducing inventory levels. The focus is on achieving the shortest possible
 production cycle and producing only to meet customer demand. The benefits generally are lower costs,
 higher product quality and shorter lead times.

 As a company implements this approach to doing business, its financial statements often show a
 temporary hit to the bottom line as deferred labor and overhead move from the inventory account on the
 balance sheet to the expense section of the income statement, lowering profits. (See the glossary for
 definitions of key terms.) This means a company’s financial statements may not reflect the true financial
 benefits of lean manufacturing. This dichotomy in actual vs. reported performance presents a challenge to
 CPAs seeking to accurately account for a lean company’s finances. As a result, CPAs, operations
personnel and consultants have begun to question the role of standard cost accounting. This article
explains the basics of lean manufacturing and why CPAs may need to use alternative accounting
practices to help companies better understand the benefits the process brings to their operations.

 Can’t Argue With “Lean” Results
  Gorton’s says it more than met its original goal of lowering inventories by 40% to 50%.

  Xantrex Technology Inc. says in one area it managed to reduce lead times from eight weeks to one
 day and improve productivity 100%.

  Whirlpool Inc. says its Oklahoma plant had a quality improvement of more than 40% over the past two

 Source: Lean Advisors, Ontario, Canada, .

Although lean concepts can apply to all aspects of a company’s business, to date they’ve been
implemented mostly on plant floors. Adherents range from Pratt & Whitney, a division of $31 billion United
Technologies Corp., a maker of building systems and aerospace products, to Lantech Inc., a $70 million
Louisville, Kentucky-based manufacturer of packaging equipment.

Lean manufacturing principles differ from mass production in several key ways. For starters, the latter
typically concentrates on efficiency and machine utilization, which can lead to long run times and bloated
inventory levels. “With lean, however, it’s all about reducing waste,” says Alex Tawse, CPA, CFO of the
Kaizen Institute of America, a global management consulting company, in Austin, Texas. “The biggest sin
is to overproduce.”

Operating leanly often requires moving manufacturing processes from functional divisions of work—where
different departments stamp, mold, drill, paint and so on—to work groups or cells that together produce
similar products. Rather than having a part move from department to department, which takes time, eats
up floor space and makes tracking difficult, all of the processes needed to manufacture a product or line
occur next to each other in sequence.

Lantech Inc. shows CPAs how this can work. Before moving to a lean operation, manufacturing a
packaging machine could take up to 16 weeks, as parts moved through nearly a dozen operations. The
company kept large parts inventories, and assemblies often sat idle while they waited to move to the next
step. Not only did this waste space, it often caused extra work as the machines would need touch-up
paint, having gotten nicked and dirty while traversing the factory.

 Glossary of Terms
 Capacity. The volume of products or services a business can produce with the resources available to it.

 Deferred labor. The labor costs a company incurs to produce a product it holds in inventory. The costs
 are deferred until the company sells the inventory. At that time the costs move from the asset side of the
 balance sheet to the expense side of the income statement as cost of goods sold.

 Hurdle rate. The rate of return a company requires before it will invest in a product or operation. It
 should generally equal the company’s incremental cost of capital.

 Inventory turnover. The number of times a year a company sells its inventory. This is calculated as the
 ratio of annual sales to the average value of inventory. An equivalent measure is the fraction of a year
 an average product remains in inventory.

 Just-in-time. An approach to manufacturing whereby raw materials and supplies are delivered to a
 manufacturing operation just as they are needed to meet demand. This contrasts with batch-and-queue
 manufacturing, in which a company holds supplies and materials in inventory to manufacture in large
 quantities, even if demand for the products doesn’t meet production levels.

 Lead time. The amount of time a supplier requires to fill customer orders. Typically, the shorter the
 time, the more efficiently the supplier is operating.

 Lean accounting. Concepts designed to better reflect the financial performance of a company that has
 implemented lean manufacturing processes. These may include organizing costs by value stream,
 changing inventory valuation techniques and modifying financial statements to include nonfinancial

 Lean manufacturing. A strategy designed to achieve the shortest possible production cycle by
 eliminating waste. The goal is to reduce inventory and produce only to meet customer demand. Benefits
 include lower costs, higher quality and shorter lead times.

 Scrap rate. The percentage of products in a production run that fail to meet specifications, and thus
 can’t be sold at full price. So, if a company has to “scrap” 5 of every 150 products, its scrap rate is 3.3%.

 Value stream. The flow of activities required to transform raw materials or information into a product or
 service for customer use.

 Work cell. A group of machinery, tools and employees that produces a family of products.

Still, from its founding in 1972 until the late 1980s, Lantech’s production processes largely were protected
by patents and business grew. Then, its patents began expiring and competition and price pressure
increased. “We were having a hard time meeting customer delivery times. We would build things partway
and then put them on the shelf, hoping we would have the right modules for actual customer orders,” says
Jean Cunningham who was, until recently, the company’s CFO. “There was a lot of cash and space tied
up in inventory.” (Cunningham now is the CFO of Marshfield Door Systems in Marshfield, Wisconsin. She
says she and her colleagues at Marshfield are actively following lean accounting principles.)

To remain viable, the company went lean. Employees created work cells for each of the four machine
models it produced. Instead of having parts moving all over the factory, a cell performed all activities
needed to produce a machine in sequence in one place. Workers were cross-trained to perform various
operations, and suppliers began delivering parts on a just-in-time basis. “Within a year, we were able to
manufacture a product—from cutting the steel to shipping it—in 15 hours,” says Cunningham.

Those who have worked with lean companies contend that many standard cost accounting practices no
longer make sense. “Traditional accounting was designed to support mass production,” says Mike Kuhn,
CPA, partner with Vrakas/Bluhm, S.C., in Brookfield, Wisconsin. In addition, traditional cost accounting
reports were developed to present an accurate view of the company to outsiders. Their purpose wasn’t to
help managers run their operations better. According to Kuhn, “many of the accounting assumptions
contradict lean manufacturing.” As a result a growing number of companies are implementing “lean
accounting” concepts to better capture the performance of their operations.

Why doesn’t standard cost accounting work? Under lean manufacturing some nonfinancial measures
including lead times, scrap rates and on-time deliveries show significant improvements, yet they aren’t
captured on GAAP financial statements. On the other hand, net income usually declines—albeit
temporarily—when a company switches to lean manufacturing. That’s because as the company works
through its existing inventory, deferred labor and overhead move from the asset side of the balance sheet
to the expense section of the income statement. Even though short-lived, the decline in net income
causes concern among executives, investors and other financial statement readers.

Given these difficulties it’s not surprising executives at Lantech and other lean companies began looking
for a better way to account for performance. “As a company transforms itself from traditional mass
production to lean manufacturing, the ways you count, control and measure are different,” says Brian
Maskell, CPA, president of BMA Inc., a consulting firm in Cherry Hill, New Jersey.

What are the differences? When standard cost accounting was developed in the early 1900s, most
companies’ cost structures consisted of 60% direct labor, 30% materials and 10% overhead, says Orest J.
Fiume, a retired vice-president of finance and coauthor with Jean Cunningham of the book Real Numbers:
Management Accounting in a Lean Organization. Companies typically allocated overhead costs to
products in the same proportion as direct labor. “Overhead was so insignificant that even if the allocation
was incorrect, it wasn’t a big deal,” he adds.

Today, the percentage of direct labor in most manufacturing processes is somewhere between 5% and
15%, says David Arnsdorf, president of the Alaska Manufacturers’ Association in Anchorage. So, is direct
labor a good measure for applying overhead? Arnsdorf and other lean advocates, not surprisingly, say it
usually is not. Lean proponents also view inventory differently. “Inventory is not an asset,” says Maria
Elena Stopher, manager of the national lean initiative within the National Institute of Standards and
Technology (NIST) at the U.S. Department of Commerce, Gaithersburg, Maryland. “You have handling
costs, it takes up floor space and reduces cash flow.”

Treating inventory as an asset in traditional financial statements allows a company to match its cost
against revenue—as cost of goods sold—when it sells the product. In lean operations, where the goal is to
produce only to meet demand, this strategy reduces inventory to the point where it is negligible.

Equally important, the calculations used to value inventory usually are erroneous in today’s environment
of rapid technological change. “Historically, there’s been a bias to overvalue inventory, because you
presume it all will sell at market price,” says Jim Womack, president of the Lean Enterprise Institute in
Brookline, Massachusetts. As lean adherents point out, products stocked in inventory often become
obsolete before the company sells them. As a result they often sell for less than market value.

Lean accounting advocates point out that the columns of variances from standard costs, standard material
usage, standard labor rates and the like that show up in traditional financial statements make them nearly
impossible for most nonfinancial people to understand. “We underestimate the difficulty of interpreting
financial information,” says Caslavka of Landscape Structures.

If standard cost accounting doesn’t make sense in a lean operation, what does? Adherents propose a new
way of looking at the numbers. For starters, rather than categorizing costs by department, they organize
them by value stream. A value stream includes everything done to create value for a customer that can
reasonably be associated with a product or product line, says Maskell. Among the costs in a value stream
would be the expenses a company incurs to design, engineer, sell, market and ship a product as well as
costs related to servicing the customer, purchasing materials and collecting payments on product sales.

Value streams cut across functional departments, so that’s why one stream can include sales and
marketing, production, design and cash collection costs. Ideally, each employee is assigned to a single
value stream, rather than being split among several, as is traditional with most employees. “We define the
value stream as best we can,” says Maskell. Then, it’s a matter of gathering revenue and expenses for the
value stream to produce an income statement. While corporate overhead costs are accounted for, they’re
shown below the line on internal value stream reports, says Maskell. The reason? Employees working in
the value stream can’t control them.

Lantech’s experience shows how this scenario can play out. Previously, accounting would look at the cost
for each piece or work order and then add an overhead allocation. During her tenure as Lantech’s CFO,
Cunningham began reporting by value stream as the company moved to lean manufacturing. “We tracked
costs at the product line level. I knew the revenue for the line, the material for the line, supplies for the
line, scrap for the line,” says Cunningham. With this information, managers easily can see whether
material use, scrap rates and labor costs for a product line are moving up or down.

Inventory valuation also changes under lean accounting. Because of the focus on producing only to meet
customer demand, inventories tend to be much lower than in traditional manufacturing operations. Thus,
while the balance sheet includes a line for inventory, valuing it may take just minutes. Lantech, for
instance, completes its yearend inventory count in several hours, says Cunningham.

In addition to making changes to their financial statements, companies that adopt lean processes often
include nonfinancial data in the statements. For instance, Caslavka of Landscape Structures increased
the level of detail on sales discounts. “Previously, we viewed this as one undissected pool of money. Now,
we’re taking a stronger look at how we spend the dollars and the benefits we get.” For instance, the
reports now show the number of sales leads generated by different promotional discounts. (For a
comparison of traditional and lean financial statements see the exhibit .)
Traditional vs. Lean Financial Statements

Source: Adapted from Real Numbers: Management Accounting in a Lean Organization by Jean
Cunningham and Orest J. Fiume. Reprinted with permission.
Is it possible lean accounting concepts are too good to be true? Even adherents acknowledge some
potential shortcomings. For starters, there’s the challenge of accurately pricing individual products and
determining profitability when CPAs analyze performance by value stream, rather than by product.

One example: How would management decide whether to accept an order to make a particular product
for $10? First, accounting would look at the impact on the overall value stream and determine how much
material or labor costs would increase, says Maskell.

However, if the calculations considered only the additional direct costs needed to produce the order and
excluded support functions from outside the value stream, the company’s profitability eventually would be
undermined because it failed to consider the indirect costs. To prevent that, the company needs to
determine whether the new product will not only make money but also beat a “hurdle” rate that covers
costs both within and outside the value stream, he says. A hurdle rate refers to the return the company
requires before it will invest in a product or operation. It should generally equal the company’s incremental
cost of capital.

If practiced too rigorously, a lean approach could emphasize speed and quality almost to the exclusion of
cost concerns. For instance, machine shops that make stamped metal parts frequently have lead times of
up to several days if they haven’t applied any lean concepts. Simply by reorganizing and better scheduling
their work, employees often can cut lead times to less than an hour. From there, decreasing them to
minutes or seconds usually means investing in new machinery. Arnsdorf says: “You can’t just apply lean
blindly. You have to look at costs. Faster isn’t always better.”

Cheryl S. McWatters, PhD, CMA, dean of the faculty of extension at the University of Alberta, Canada,
offers another view. “After the fact you may want to know the norm and what you spent,” she says.
“Accounting information regarding variances to budget can be a way to control employees’ performance.”
For instance, if the company’s annual budget calls for a 10% reduction in materials expenses but actual
expenses are the same as the previous year, the manager responsible will have to account for the

Finally, one of the most significant concerns regarding lean accounting is whether its principles conform to
GAAP. Proponents say not only do lean financial reports meet GAAP requirements, but they actually more
closely follow the spirit of GAAP because they’re more easily understood. “We don’t do anything that isn’t
in compliance with GAAP,” says Cunningham. “Lean accounting is simply about doing the reporting in a
way that is simpler and easier to follow.”


  Because traditional accounting was designed to support mass production, many of its assumptions
 contradict lean manufacturing. As a result CPAs may want to recommend businesses with lean
 operations implement alternative accounting concepts to better capture their performance.

  Lean adherents suggest a new way of looking at the numbers: Rather than categorizing costs by
 department, CPAs can recommend companies organize them by value stream, which includes
 everything an entity does in creating value for a customer that it can reasonably associate with a
 product or product line.
   CPAs should encourage companies moving to lean accounting to resist the temptation to eliminate
 standard reporting entirely. Businesses should supplement their traditional financial statements with
 additional information that captures the improvements lean manufacturing brings. Instead of eliminating
 the standard reporting system overnight, companies should dismantle it piece by piece as their
 underlying operations change.

The changeover to lean business and accounting concepts hasn’t occurred without some bumps. “The
thought process was formed outside accounting, so there’s always been a bit of tension between it and
traditional accounting,” says Womack of the Lean Enterprise Institute.

In addition, many of lean’s tenets are contrary to the natural tendencies of accountants, says Daniel
Szidon, a CPA and partner in Wipfli LLP in Wausau, Wisconsin. “When CPAs work with numbers, the goal
is to fully allocate costs to precise and stable cost centers,” he says. In contrast, lean focuses on
accounting for costs in a manner that’s reasonably accurate. “The goal isn’t a perfect allocation of costs.
It’s an accurate, relative measure of them.”

As with any significant change in operations, applying new accounting concepts requires the committed
support of top management. “CEOs doing this can’t be just visionaries; they have to be doers,” says

When a company moves to lean accounting, CPAs usually will want to continue to supplement the entity’s
standard financial statements with additional information that captures the related improvements rather
than eliminating the statements outright. “You can’t turn off the standard reporting system overnight,” says
Fiume. “Instead, dismantle it piece by piece as the underlying operations change. In the meanwhile,
prepare lean format financial statements on a parallel basis” to illustrate results both ways. For a sample
of hypothetical financial statements prepared according to the traditional and lean methods, see the
exhibit .

Fortunately, most financial officers find the cost information they need to prepare lean financial statements
already is available in their company accounting systems. It’s just a matter of reformatting the data, says
Tawse of the Kaizen Institute. For instance, rather than including labor and overhead expenses in the cost
of goods sold, a lean financial statement will show materials, labor and overhead as separate line items.
That way the company will recognize labor and overhead expenses when it incurs them rather that having
them get wrapped into inventory on the balance sheet.

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