Companies across all industries for the past 20 years have been adopting lean manufacturing as a strategy to improve performance. Lean accounting emerged soon after, and it has grown in recent years as a related strategy to align the financial side of an organization with the overall lean effort.
Historically, lean efforts have been focused, intentionally or unintentionally, on a company’s operating departments. The disconnect between operations and finance around continuous improvement strategies and goals limits the positive impact a company can realize through a lean strategy, and can cause organizational confusion around lean benefits and payback. This situation can quickly become contentious, trivializing or derailing a company’s lean efforts.
Here, we provide a general introduction to lean accounting, explain why companies need to align finance and operations to improve performance, and outline manageable steps to implement lean accounting.
Origins and Outcomes
In his 1998 book Throughput Accounting
, Thomas Corbett included detailed explanations of how accounting can support continuous improvement by adapting the Theory of Constraints continuous improvement tool outlined by Dr. Eliyahu M. Goldratt and Jeff Cox in their 1984 book, The Goal: A Process of Ongoing Improvement
. At the American Manufacturing Society’s 2005 Lean Accounting Summit, the vision and tools for lean accounting were largely outlined, and its use has been discussed at this annual conference ever since. Brian Maskell and Jean Cunningham also contributed to the acceptance of lean accounting, and both have published on the subject over the past decade.
These experts generally agree that a lean accounting strategy should support the larger lean efforts through the following outcomes:
- Provide timely information on performance.
- Provide data that everyone in the company can understand and use to make better decisions to drive performance.
- Accurately measure the performance gains realized through continuous improvement.
*Significantly reduce the number of transactions required by accounting to generate financial statements while maintaining adequate controls.
- Restructure financial statements into a simple, easy-to-read format while remaining compliant with generally accepted accounting principles.
To remain practical and focused on the manageable adoption of lean accounting, we do not recommend companies pursue the actions suggested by points four and five – changing how transactions are recorded and how financial statements are generated. These concepts do not provide enough benefit to offset the larger risks and challenges an organization would face by attempting them. Making changes to core financial functions like these would become a distraction, and the difficulty in accomplishing these can turn off an organization from adopting lean accounting in any form.
Lean accounting purists would argue that they could get CFOs, controllers, and auditors to feel comfortable with a significant reduction in transactions and changes to controls, and that banks and other investors would accept financial statements not presented in the traditional format; however, we feel that, as with any continuous improvement strategy, companies should start with the tools and methods that provide the best payback for the lowest investment and the least chance of failure. The best use of a finance team’s time and talent in adopting lean accounting is to focus on the first three outcomes in order to generate significant value to the overall lean efforts. This observation is based on decades of experience improving financial performance without requiring companies to reconfigure financial transactions and statements.
Lean’s True Purpose
To understand how the first three areas of lean accounting can best support overall lean efforts, it is necessary to briefly review the purpose of lean manufacturing itself. Lean is not a cost-reduction tool. Cost reduction is only one component. Companies approaching lean solely for cost-reduction are underserving themselves and missing out on larger returns.
Lean manufacturing is a management strategy that focuses on increasing the competitiveness of a company and leveraging new operating strengths to grow revenue. Lean efforts accomplish this by focusing on the voice of the customer, eliminating waste and non-value-added processes in the value stream, better using existing resources, and using newly created capacity within those resources to make and sell more goods. A company must have an abundance mindset to take advantage of, and realize, the value proposition of lean manufacturing.
In The Essential Drucker
, Peter F. Drucker states, “Securities analysts believe that companies make money. Companies make shoes.” Drucker does not minimize the importance of profits; rather he points out that the profit a company makes is an outcome of selling its product. More specifically, for a company to be profitable, it must offer quality products that customers want, have the products available when and where customers want them, and produce those goods at a cost less than the customers are willing to pay.
Lean strategies improve performance in all of these areas. Lean accounting provides the teams within an organization with the timely data they need to manage performance and profitability across that value stream. This requires supplemental financial and operational reporting beyond balance sheets, income statements, and cash-flow statements.
Standard financial reports provide valuable information on the financial health of a company, but the relationship between financial and operational performance is often unclear for non-financial managers. Lean accounting works to address one of the gaps that causes confusion for nonfinancial managers: timeliness of reporting.
It is common practice to distribute financials on a monthly basis. If financials are closed and reports are made available a week into the next month, the activities that generated the performance in those reports actually occurred one to five weeks in the past. In situations where cost of sales is recognized at the time products are sold, the purchasing of materials, labor costs, and the use of machines could have actually taken place months in the past.
This means that value-stream managers react to data that, on average, are two and a half weeks old – at best. Even if managers can make immediate changes to improve areas of poor performance, the poor performance has continued to occur and has already negatively affected the next round of financial results. This long lag time between operational activity and financial reporting makes it hard to conduct true root cause analysis and develop the appropriate improvements. Providing performance data on a more real-time basis, such as daily or weekly, allows managers to recognize problems and put corrective actions in place sooner. The faster operational performance issues are resolved, the quicker losses are stopped and improvements to the bottom-line financials are realized.
Aligned with Value Stream
Lean accounting also looks to share performance data that everyone in the company can understand. Few people outside of the finance department, including most leadership teams, truly understand the monthly reports they receive. A good portion of the conversation that takes place while reviewing financials is spent explaining where the numbers came from and what they mean. Discussions rarely get to the point of using the numbers to direct leaders toward the definitive actions necessary to improve the value stream. Discussions on labor and material variances are usually even more fruitless and frustrating for those in attendance.
Much of the confusion exists because nonfinancial managers do not understand the rules and mechanics of accounting, nor are they able to relate them to their day-to-day work. Value-stream managers perceive performance much differently. They have never seen an accrual on the shop floor; instead, they see things primarily from a cash perspective. After all, the operations they manage are linear progressions that convert raw material to finished goods. First, raw materials and components are purchased and received. Next, the materials are routed through a series of production steps before being added to inventory and eventually sold.
Managers either have the material, equipment, and labor to fulfill orders or they do not. Trying to effectively reconcile accrual-based reports with the actual timing and flow of value through operations is too difficult. Structuring reports by value stream helps operational managers identify cause and effect between this work flow and the financial results.
Straightforward Data Presentation
Lean accounting introduced a “box score” as a way to furnish straightforward performance data that should be understandable to everyone in the company. The box score is quicker to populate, so it can be reported more frequently to alleviate the previously discussed issues caused by untimely data. Since box scores are organized around a value stream, they directly align operational activities with their financial performance. This is an effective tool for helping managers make better and more impactful decisions on a more frequent basis. The simpler reporting structure and easily digestible content also increases the participation and accountability of employees in self-management and lean efforts.
Similar to a balanced scorecard, a box score includes the main financial data for a value stream as well as key performance measures on operations and capacity. It provides a more comprehensive view of performance rather than relying on one set of metrics. Operational metrics are reported at the top with financials below, which reinforces the concept that operations must be managed efficiently to generate the outcome of good financial results.
On-time delivery and cycle time are measures of customer service, while units per employee and product cost help to control expenses. First-pass quality tracks performance on customer need, efficiency, and profitability since higher quality rates require less rework and result in less material scrap with fewer potential delivery delays. The financial data in the box score can be thought of as a mini-income statement of the direct costs that value stream managers can control and influence.
Measurement of Lean Performance Gains
Lean accounting also uses box scores to accurately measure the performance gains realized through lean efforts. As a company begins to implement lean and make improvements to operations, there are times when common financial reporting methods fail to recognize the benefits, and can sometimes show lean improvements as negatively affecting financial results.
Corbett’s Throughput Accounting
contains examples of this disconnect. Consider an example in which a production line is consolidated into work cells and other process improvements are made. The equipment takes up less floor space, there is less stacking and moving of material between operations, material and tools are organized, and inefficient steps and delays have been removed from the process. As a result, the operators are able to produce all of the units ordered in six hours each day instead of a typical eight-hour shift. After these improvements, the box score would show higher units produced, higher on-time delivery, shorter cycle time, and less time on rework. Revenue would remain the same while labor costs per unit are reduced (six hours down from eight). Gross profit and return on sales for this value stream go up, showing positive results from the improvements.
If the extra floor space is not used, however, traditional cost accounting techniques would reallocate the overhead costs for this square footage across all products made in the facility. This effectively raises their standard cost. The higher standard cost per unit results in increased cost of sales and less profit. The loss continues to widen as volume grows until cost accounting adjusts the facility overhead rate. The operators now completing their work in six hours instead of eight are not rewarded, but rather risk facing a 25 percent reduction in staff. This highlights the problems that can arise when financial and operational measurement systems are not aligned.
Lean accounting does recognize that the staff costs are still incurred without terminations, and that rent, utilities, and property taxes are still paid for the vacant space. Not only did the improvements increase competitiveness for that specific value stream, they created an opportunity through a higher available capacity on the box score. Stepping away from strict cost-control thinking, and instead taking advantage of the newly created production time available on the work cells, operations and sales can work together to determine how to best fill that capacity. Since the facility, equipment, and labor are already being paid for, any new sales for the value stream will result in all of the new revenue dropping right to the profit line after deducting material costs.
Top Ten Benefits of Lean Accounting
There are many practical reasons to consider supplementing traditional financial accounting with lean accounting. Here are our top 10 benefits of lean accounting.
- Capturing relevant operational data on a consistent, routine, and timely basis provides a tool to improve operations.
- Operational data is more applicable and understandable to the majority of employees and managers.
- Lean accounting metrics can be used to evaluate and reward individual employee and departmental performance.
- Good data on operational efficiency, production capacity, staff and machine utilization, and shipment accuracy and timeliness will enable managers to be more effective.
- Monitoring operational performance will help improve the average cost of production.
- Managing cost of production will increase the opportunity to sell at a competitive price.
- Profitable sales growth will increase the bottom line.
- A history of sales growth and increasing profits maximizes the valuation of a business.
- An accurate scorecard of the operational performance of critical product lines and service offerings can help direct future strategic planning objectives and spending decisions.
- A combination of financial accounting and lean accounting data is more powerful than either one separately.
From real-time data to improved communication, implementing lean accounting helps transform a company’s financial reporting into a lever for growth. It can rally an entire organization in support of lean’s overall goals of improved performance, reduced waste, and increased competitiveness.
Robert E. Pozesky is a manager in the business consulting services group of RKL LLP in Lancaster. He also leads the firm’s manufacturing and distribution industry group. He can be reached at firstname.lastname@example.org.
John S. Stoner, CPA, CVA, is a partner in the business consulting services group of RKL LLP and a member of the
Pennsylvania CPA Journal Editorial Board. He can be reached at email@example.com.
Check out Pozesky and Stoner's CPA Conversations podcast on this topic for even more valuable information.