The Lowdown on Lean Accounting A new way of looking at the numbers. JOURNAL OF ACCOUNTANCY JULY 2004 EXECUTIVE SUMMARY 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 years. Source: Lean Advisors, Ontario, Canada, www.leanadvisors.com . WHAT LEAN MEANS 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 information. 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. STANDARD COST ACCOUNTING DOESN’T FIT 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 NOT STANDARD COSTING, THEN WHAT? 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. A PANACEA? 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 discrepancy. 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.” PRACTICAL TIPS TO REMEMBER 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. WHAT ACCOUNTANTS THINK 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.” IMPLEMENTING LEAN ACCOUNTING 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 Fiume. 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.