Lean Accounting: What's It All About?

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Lean Accounting:What's It All About?Brian H. Maskell and Bruce L. BaggaleyW"hat is Lean Accounting?" is anoft-asked question. Everybodyworking seriously to implement lean thinking in their company eventually bumps up against their accounting systems. It soon becomes clear that traditionalaccounting systems are actively anti-lean:menting lean accounting are makingpoor decisions: turning down highlyprofitable work, out-sourcing products orcomponents that should be made inhouse, manufacturing overseas productsthat can be competitively manufacturedhere at home, etc. They are large, complex, wastefulprocesses requiring huge amounts ofnon-value work. They provide measurements and reportslike labor efficiency and overheadabsorption that motivate large batchproduction and high inventory levels. They have no good way to identify thefinancial impact of the lean improvements taking place throughout the company. On the contrary, the financialreports will often show that bad thingsare happening when very good leanchange is being made.While there is good understanding ofthe problems, there is not widespread understanding of the solutions. In September2005, at the Lean Accounting Summit inDetroit, co-sponsored by AME,1 a group ofthe conference presenters got together anddecided to create a definition of LeanAccounting as it stands now. We decided tosuccinctly document the Principles, Practices,and Tools of Lean Accounting.Leanaccounting has developed over the last tenyears or so and although it continues toevolve, we felt it would be helpful to docu- Very few people in the company understand the reports that emanate from theaccounting systems, and yet they areused to make important and far-reachingdecisions. They use standard product costs whichare misleading when making decisionsrelated to quoting, profitability, sourcing,make/buy, product rationalization, andso forth. Almost all companies imple-In BriefThis article reviews the framework of principles, practices, andtools of lean accounting being developed by a group of leanaccounting thought leaders as a result of the Lean AccountingSummit in September 2005. A brief overview was presented at the2005 AME annual conference. The principles are accompanied byan illustration of financial and non-financial analysis using "boxscores," one of the generic techniques being employed.35First Issue 2006

ment the current "state of the art" as seen bya group of both consultants and practitionersin this area. The purpose of this article is tobriefly describe the principles, practices, andtools of lean accounting developed thus far.Vision for Lean AccountingWe started with a vision statementand then drilled down to the practical toolsused to make the vision a reality. Our visionis that Lean Accounting will:1. Provide accurate, timely, and understandable information to motivate thelean transformation throughout theorganization, and for decision-makingleading to increased customer value,growth, profitability, and cash flow.2. Use lean tools to eliminate waste fromthe accounting processes while maintaining thorough financial control.3. Fully comply with generally acceptedaccounting principles (GAAP), externalreporting regulations, and internalreporting requirements.4. Support the lean culture by motivatinginvestment in people, providing information that is relevant and actionable, andempowering continuous improvement atevery level of the organization.Lean Accounting Principles,Practices, and ToolsThe Principles, Practices, and Tools ofLean Accounting summarized in Figure 1are separated into five principles, A-E. Thefollowing discussion amplifies them.A. Lean and Simple BusinessAccountingThis can also be stated as "applyinglean methods to the accounting processes."Some accounting processes contain mudatype 1 (waste that can not be eliminated atthe moment) but most accounting processes are muda type 2 (waste that can be eliminated). The tools of lean must be rigorously applied to our accounting, control,and measurement processes so that wasteis relentlessly driven out.36Target Volume 22, Number 1This is achieved in the same waywaste reduction is achieved anywhere else,through continuously eliminating wastefrom the transaction processes, reports,and accounting methods throughout theorganization. The tools to achieve this arethe value stream maps (current and futurestate), kaizen (lean continuous improvement), and the venerable Plan-Do-CheckAct (PDCA) problem-solving approach.These improvements can be madeearly in the transformation to lean and willopen up time for the accounting personnelto work on other Lean Accounting changes.Inevitably these early projects improveprocesses that will later be eliminated, butthey make a good start to the introductionof Lean Accounting into the business.B. Accounting Processes thatSupport the Lean TransformationLean accounting reports and methodsactively support the lean transformation.This information drives continuousimprovement. The financial and nonfinancial reporting reflects the overall valuestream flow, not individual products, jobs,or processes. Lean accounting focuses onmeasuring and understanding the valuecreated for the customers, and uses thisinformation to enhance customer relationships, product design, product pricing, andlean improvement.Visual Performance MeasurementControl of production processes (andother processes) is achieved by visual performance measurements at the shop-floorand value stream level. These measurements eliminate the need for the shop-floortracking and variance reporting favored bytraditional cost accounting systems.2Continuous ImprovementContinuous improvement (CI) is motivated and tracked using value stream performance boards. Typically these visualboards are updated weekly and used by thevalue stream CI team to identify improvement areas, initiate PDCA projects, and mon-

PRINCIPLESPRACTICESA. Lean & simplebusinessaccounting1. Continuously eliminate wastefrom the transactionsprocesses, reports, and otheraccounting methods1. Management control &continuous improvementB. Accountingprocesses thatsupport leantransformation2. Cost managementC. Clear & timelycommunicationof information3. Customer & supplier valueand cost management1. Financial reporting2. Visual reporting of financial &non-financial performancemeasurements3. Decision-makingD. Planning froma leanperspective1. Planning & budgeting2. Impact of lean improvement3. Capital planning4. Invest in peopleE. Strengtheninternalaccountingcontrol1. Internal control based on leanoperational controls2. Inventory valuationTOOLS OF LEAN ACCOUNTINGa. Value stream mapping; current & future stateb. Kaizen (lean continuous improvement)c. PDCA problem solvinga. Performance Measurement Linkage Chart; linkingmetrics for cell/process, value streams, plant &corporate reporting to the business strategy,target costs, and lean improvementb. Value stream performance boards containingbreak-through and continuous improvementprojectsc. Box scores showing value stream performancea. Value stream costingb. Value stream income statementsa. Target costinga. “Plain English” financial statementsb. Simple, largely cash-based accountinga. Primary reporting using visual performanceboards; division, plant, value stream, cell/processin production, product design, sales/marketing,administration, etc.a. Incremental cost & profitability analysis usingvalue stream costing and box scoresa. Hoshin policy deploymentb. Sales, operations, & financial planning (SOFP)a. Value stream cost and capacity analysisb. Current state & future state value stream mapsc. Box scores showing operational, financial, andcapacity changes from lean improvement. Planfor financial benefit from the lean changesa. Incremental impact of capital expenditure onvalue stream box-score. Often used with 3Papproachesa. Performance measurements tracking continuousimprovement participation, employeesatisfaction, & cross-trainingb. Profit sharinga. Transaction elimination matrixb. Process maps showing controls and SOX risksa. Simple methods to value inventory without therequirement for perpetual inventory records andproduct costs can be used when the inventory islow and under visual control.Figure 1. Principles, practices, & tools of lean accounting.itor their progress. These boards show thevalue stream performance measurements,Pareto charts (or other root cause analysis),and information about the CI projects. Theboards also show the current and futurestate maps together with the project plan tomove from current to future state. The valuestream performance boards become "mission control" for both breakthroughimprovement and CI of the value stream.37First Issue 2006

Value Stream CostingCost and profitability reporting is doneusing value stream costing, a simple summary direct costing of the value streams.The value stream costs are typically collected weekly and there is little or no allocation of "overheads." This provides financial information that can be clearly understood by everybody in the value streamwhich in turn leads to good decisions,motivation to lean improvement across theentire value stream, and clear accountability for cost and profitability. Weekly reporting also provides excellent control andmanagement of costs because they can bereviewed by the value stream managerwhile the information is still current.Target CostingTarget Costing is the tool for understanding how the company creates value forthe customer and what must be done to create more value. Target Costing is used whennew products are being designed and/orwhen the value stream team needs to understand the changes required to increase valuefor the customers. The outcome of this highly cross-functional and cooperative processis a series of initiatives to create more valuefor the customer and to bring the productcosts into line with the company's need forshort-term and long-term financial stability.These improvement initiatives encompasssales and marketing, product design, operations, logistics, and administrative processeswithin the company.C. Clear and Timely Communicationof InformationLean accounting provides financialreports that are readily understandable toanyone in the company. The income statements are in "plain English" and the information is presented in a way that is no morecomplicated than a household budget. PlainEnglish income statements are easy to usebecause they do not include misleading andconfusing data relating to standard coststogether with hosts of incomprehensiblevariance figures. When used in meetings,plain English financial statements change38Target Volume 22, Number 1the question from "What does this mean?"to, "What should we do?"Visual ManagementVisual management is a cornerstoneof lean management. Lean accountingrequires visual presentation of both financial and non-financial measurements. The"Box Score" format commonly used in leanaccounting provides a one-sheet summaryfor a value stream showing the operationalperformance, the financial performance,and how well the capacity is being used.Figure 2 shows an example of box scoreused for weekly performance reporting.Decision-Making and Box ScoresRoutine decision-making — includingquotes, profitability, make/buy, sourcing,product rationalization, and so forth — isachieved using simple yet powerful information that is readily available from thebox score. There is no need to use a standard cost again for these important decisions. Figure 3 shows a box score used topresent decision-making information related to sourcing of a new product.D. Planning and Budgeting from aLean PerspectiveLean planning starts with hoshin policydeployment and runs through to the monthlySales, Operations, and Financial Planning(SOFP) process leading to an integratedgame plan for the organization. These plansare all made at a value stream level and uselean accounting information.Hoshin Policy DeploymentHoshin policy deployment starts withthe company's business strategy. The business strategy will often look out three tofive years whereas the hoshin policydeployment establishes what must be doneduring the coming year. The top-levelhoshin plan has a handful of break-throughchanges required to support the businessstrategy together with the measurementsto monitor the achievements, and theresources needed to complete the plan.

FINANCIALCAPACITYOPERATIONALExample Box Score for Weekly Performance Reporting8/118/18Goal8/256/96/166/236/307/7Units per pment100%100%100%100%100%100%100%Dock-to-Dock Days6.006.006.006.006.005.55.5First Time Through80%80%81%85%85%87%92%Average Cost 343 337 362 338 337 325 evenue 471 485 456 490 488 526 576Material Cost 123 125 129 132 135 137 139Other Variable Costs 49 50 51 54 76 87 51Fixed Costs 120 120 118 116 116 116 108Profit 179 190 158 188 161 186 278Return on Sales38%39%35%38%33%35%48%7/147/217/288/46/2Box Score used for weekly value stream performance reporting. Note the “Goals” set from the future state value stream map.Figure 2.Example Box Score for a Sales Order Sourcing DecisionCURRENT STATEORDER USINGSTANDARD COSTStd Cost 42.44OUT SOURCE TOCHINALanded Cost 30MAKE IN HOUSE BUYADDITIONALMACHINES 29,789 29,789 33,647 33,647On-Time-Shipment95%95%90%95%Dock-to-Dock Days16.416.421.115.1First Time Through80%80%75%81% 29.95 29.95 30.18 26%Available24%24%24%22%RevenueOPERATIONALSales per PersonFINANCIALCAPACITYAverage Cost 1,042,631 1,042,631 1,177,631 1,177,631Material Cost 399,772 399,772 455,513 466,909Other Variable Costs 24,991 24,991 66,000 24,844Fixed Costs 392,089 392,089 392,089 400,756Profit 225,779 225,779 264,029 285,12221.65%21.65%22.42%24.21%R e t urn o n S a l e sThis Box Score illustrates a sourcing decision for a potential new sales order. If the decision is made using a standard cost the company will turn down the orderbecause it does not have sufficient “margin.” If they buy it from China, the order is profitable. If they make it in-house they must buy additional equipment andhire more people, but in this example, this provides the best profitability and operational performance.Figure 3.39First Issue 2006

This top-level hoshin plan is then rolled-outto the first-level executives, their first-levelmanagers, and down to the value streams.Hoshin is not the traditional commandand control plan where (often unattainable)goals are set by managers for their underlings. The hoshin process includes at eachlevel timely and detailed "catch-ball" stepswhereby the people required to achieve theresults are very much involved in the planning and goal-setting for their own areas ofresponsibility. Hoshin is a cooperative andempowering business transformationprocess. Hoshin plans are typically developed annually and reviewed monthly.Sales, Operations, and FinancialPlanning (SOFP)SOFP is typically done every monthand is a comprehensive, company-wideprocess for short- and medium-term planning. SOFP is a formal and rigorous planning process completed for each valuestream. Sales and marketing provide forecasts for the number of products that willbe sold by a value stream each month forthe next 12 months (for example). Theseare high-level forecasts of total unit sales,although sometimes it is helpful to go onelevel down and forecast by product familieswithin a value stream. The operations people provide forecasts of the value streamcapacity each month for the next 12months, and product engineering bringsthe plans for new product introductions.Through a series of formal, tightlyscheduled meetings the customer demandis matched by production capabilities. Thefinal executive SOFP meeting is chaired bythe most senior person in the organization— often the president or CEO — and a company wide game-plan is developed.Everybody in the organization can buy in tothis game plan because it has been developed cooperatively. SOFP is the planningprocess in lean companies. It provides bothshort-term updating of such things as kanbans and cell manning, and longer-termplanning such as capital equipment, andhiring or redeploying people.The financial planning outcome of the40Target Volume 22, Number 1SOFP process is to update budgets eachmonth and thereby largely eliminate thewasteful annual budgeting choreographymost companies engage in. Calculatingshort-term month-end results also decreasesthe need for month-end reporting processes.Financial Impact of Lean ImprovementThe true impact of lean improvementmust be understood at the outset of any leantransformation. Using the current state andfuture state value stream maps, leanaccounting tools are used to understand howthe changes taking place in the value streamwill affect the operational performance, thefinancial performance, and also how thecapacity usage changes within the valuestream. This analysis often shows excellentoperational improvement but little improvement in cost or bottom-line profitability.3What bridges the gap between these? Theanswer is capacity change.Most lean improvement projects eliminate waste and create available capacity inthe form of machine time, people's time,and physical space. The financial impact oflean improvements on the company's bottom-line comes from the decisions made bymanagement on how this newly freed-upcapacity will be used. Figure 4 shows areal-life example of this from a companymaking temperature and pressure gaugesused on off-shore oil rigs.One of the most difficult changesmade by senior managers when they arebeginning the process of lean transformation is to stop thinking about productionimprovements in terms of short-term costreductions. This is very much mass-production, standard cost thinking. This thinking will limit the progress the company canmake with lean manufacturing and otherlean initiatives. We need to start thinkingabout customer value and business growth.This does not mean that cost information isunimportant; cost is very important. Soimportant, in fact, that we need much better tools to show the cost information: toolslike value stream costing and box scores.By understanding this true nature oflean, we change our question from, "How

FINANCIALCAPACITYOPERATIONALBox Score Showing the Assessment of Financial Benefit from Lean ImprovementC u r r en t S t a teB efore Lea nDec ‘02Future State LeanStep Tw oDec 2003Future StateLonger Termincluding NewPro duc tsSales per Person 224,833.00 224,833.00 277,031.00Inventory Turns6.51520Average Cost per Unit 3 1 .3 2 2 9 . 88 24 .25First Pass Yield81 %95 %95 %Lead t ime in Days2552.5Productive55 %52 %79 %Non-Productive42 %12 %12 %Available3%36 %9%Revenue 4,062,000 4,062,000 5,686,000Material Costs 1,164,184 1,109,327 1,552,839Conversion Costs 1,483,416 1,483,416 1,657,500Value Stream Profit 1,414,400 1,469,257 2,475,661Value Stream Return on Sales35 %36 %44 %Hurdle Rate Variance (40%)-5%-4%4%As the company moves from the current state to the future state the operational measurements improved, but there was little financial improvement. The realchange is that available capacity and cash (from inventory reduction) was freed up. Tangible financial benefit comes when the company introduces new productsthat use that newly-freed up capacity.Figure 4.large a cost will we save?" to, "How can weuse our newly-created capacity to increasecustomer value and make more money?" Itis important to ask this question every timea future state value stream map is developed because the answer gives us the truefinancial impact of lean changes, bothshort term and longer term.etc. 3P also requires the team to evaluateeach alternative using an extensive checklist of lean attributes, most of which arenon-financial. The financial impact of eachalternative is presented on a box score as apart of the decision process. Figure 5 showsa box score used for capital planning.Investment in PeopleCapi

is that Lean Accounting will: 1. Provide accurate, timely, and under-standable information to motivate the lean transformation throughout the organization, and for decision-making leading to increased customer value, growth, profitability, and cash flow. 2. Use lean tools to eliminate waste f

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