There is an obscure accounting battle bubbling up around the world that has broad implications for how to run a business. The battle begins when a company starts to implement "lean manufacturing," a practice that pits costs against productivity.
This week's column examines the implications of the way lean philosophy asks companies to rethink their businesses starting with basic principles.
Lean, in the simplified form, involves three fundamental concepts: flow, pull and continuous improvement. The idea of flow is that manufacturing processes should operate as a continuous flow with as few interruptions as possible. In lean parlance, flow processes are called value streams and they run counter to the departmental and functional silos that dominate the org charts of most companies. The generalization of lean has taken this paradigm and applied it to processes outside of manufacturing such as health care, financial services and construction.
The idea of pull is that manufacturing should occur in response to actual demand, not predictions about inventory. A pull system is used to organize functions when the flow process is initiated. Instead of making products based on predictions and forecasts, you make them when an order is received.
The idea of continuous improvement is that there should be a constant and never-ending effort to reduce waste and improve productivity. Individual employees in an organization must be encouraged and made responsible for finding improvements and empowered to implement changes.
So in a lean process, the demand signals pull the materials through the flow processes and the right number of products is created with as little waste as possible. When all the suppliers of materials are also making their processes lean, the result is that the entire supply chain is extremely responsive and efficient. One of the biggest benefits of lean is that it allows companies to dramatically reduce their cycle times, that is, the amount of time from getting the order to delivering the product. This happens when the flow processes are redesigned to eliminate delays. Implementing lean also usually means a company can make significant reductions in inventory.
Here's where the accounting fun begins.
If I have $100 of inventory and I reduce it by $80, everyone should be happy, right? The company now has less money tied up in inventory and that money can be used for other purposes. But unless you understand the big picture, when you start to implement lean practices, it looks like they cost you money. Why? An $80 reduction in inventory is a loss from the financial perspective if you handle it as a write off and profits go down. You did have a higher level of inventory and now you have a lower level. That $80 reduces your shareholder's equity, although it is really a benefit. (Note to accounting experts: This is a simplistic case that represents the problem people are having in the field. We could argue all day about different ways to approach accounting for this inventory.)
Unless the accountants understand the way that lean works, in the worst case it seems to them that lean produces losses, not efficiencies. In a typical case, they cannot see the cost advantages. This is the source of many of the arguments I found out about at the Lean Enterprise Summit, a gathering of companies sponsored by
SAP, Seal Consulting, Demand Point and several other lean-focused vendors.
The people attending the summit, those who were fighting to introduce lean into their companies, reported over and over again that finding a way to reconcile accounting the way lean does it and standard cost accounting was proving to be much harder than it should be.
Lean practitioners think of accounting in cash terms. Lean is against creating data and reports for their own sake. That would be considered another form of waste. In general, lean advocates have a jaundiced view of enterprise software and any general-purpose automation tools. The lean approach measures how well your value stream is working.
One presenter at the summit used weight loss as an analogy. When dieting, standard cost accounting would advise you to weigh yourself once a week to see if you're losing weight. Lean accounting would measure your calorie intake and your exercise and then attempt to adjust them until you achieve the desired outcome. While this analogy is oversimplified, it does get to the core difference between lean and standard cost accounting. Lean accounting attempts to find measures that predict success. Standard cost accounting measures results after the fact.
But even when the accounting types and the lean practitioners start to understand each other, problems remain. How can we reconcile the kind of data collection and accounting that lean demands and the standard cost accounting? Duplicated data collection and reporting is indeed a form of waste.
Value stream accounting was suggested by Bruce Baggaley of BMA as a way out. The company's revenues and costs are reported weekly for each of the value streams. The costs reported do not include allocations or standard costs, just the costs that actually occurred within the value stream last week. This produces reports that are easy to understand and are used for cost control; they also monitor the cost reductions or profit increases coming from the company's lean improvements. This report also gives the information needed for making routine business decisions. In some cases it is possible to implement value stream accounting using profitability and cost management systems that allow advanced modeling of costs in a way that still connects everything to the chart of accounts and shared cost allocations used in standard cost accounting.
One presenter explained that when financial cost-focused accounting was adopted in the U.S. about 100 years ago, its promoters warned that it would not be a good tool for operational management. A growing body of experience at companies implementing lean accounting is showing that they were right. Too many vital decisions are based on standard cost accounting, which obscures the true operational picture.