Before any meaningful discussion of the Lean’s effect to the accounting, accountants, and chief financial officer (CFO) in a lean business can take place, we need to come to a common understanding about what lean “is”. Lean is not a manufacturing tactic. Lean is not a cost-reduction program. Lean is a business strategy. The reason for focusing most of the initial attention on manufacturing processes is that is where most of value-added activities that need to be liberated take place. Cost savings are achieved over time, but that takes place in the context of implementing lean as a business strategy.
Lean Strategy Results
Toyota’s market capitalization today is greater than the combined value of the next seven largest automotive companies in the world. Lean creates value. And it does that by creating competitive advantages that better satisfy the customer.
What Does It Take To Implement A Lean Strategy?
Much has been written about Toyota and the principles, practices, and tools of lean. However, very little has been written about the pillar of its strategy that Toyota considers most important. It has been expressed as “respect for people” and it recognizes that, in the end, it’s all about the people. At its core, any company is just a collection of people trying to satisfy another collection of people [the customer] better than those other collections of people [the competitors]. And in the end, the best, most motivated, and focused collection of people wins. Therefore, successfully implementing a lean strategy requires that people change the culture of their companies so that they think and behave lean. How is this accomplished? In fact, what is culture? There have been different ways of defining culture, but the one that makes the most sense to me is this:
The people in a company hold a set of values and beliefs that causes them to behave in certain ways. When they behave in accordance with their values and beliefs and get the results they expect, they reinforce the validity of those values and beliefs in their minds. This self-reinforcing cycle of values and beliefs driving behavior, behavior yielding expected results, and results driving values and beliefs is what we call culture.
How do people change the culture of their company? Some companies attempt to force a new set of values and beliefs on people with such mandates as, “We are now going to be customer focused”. If the company has always been internally focused, this statement will have little effect because leadership cannot externally impose new values and beliefs on people. That is an internal, personal change process!.
The alternative? The key to changing values and beliefs, and thereby culture, is to require people to behave differently so that they can experience a set of results that are better than what they have experienced in the past. As this happens over and over again, they evolve to a new set of values and beliefs (thinking lean) that drives new behaviors (acting lean) yielding better results (being lean).
Who is responsible for changing culture? There is only three correct answers: the CEO, CFO and their accountants. Since implementing strategy is the primary responsibility of the CEO, since lean is a strategy, and since implementing this lean strategy requires a change in culture, the CEO must take personal responsibility for this cultural change.
But since this post is proposed for the financial and accounting people, then in this post I would rather talks more about the accountants and CFO roles.
The Association for Manufacturing Excellence (AME) recognizes this principle. In its “Cultural Leadership Program”, it states that the CEO must “lead the change to a new culture.”
Lean Affects Accounting Too
Since lean is a business strategy, it affects everything the company does, including accounting. In their 1987 book, Relevance Lost: The Rise and Fall of Management Accounting, Tom Johnson and Bob Kaplan state that “corporate management accounting systems are inadequate for today’s environment”. Brian Maskell has done work in the area of accounting in a lean business environment, and he makes the observation that all of the essentials of modern management accounting were established by 1930, without any significant change since then.
What are Maskell, Johnson, and Kaplan talking about? In the early part of the twentieth century, the typical American manufacturer had a product cost structure of about 30 percent material content, about 60 percent touch labor content, and about 10 percent overhead content. Today, the typical American manufacturer has a product cost structure of about 60 percent material content, about 10 percent touch labor content, and about 30 percent overhead content. The standard cost accounting system that we use today was created to support the “yesterday” environment when a small amount of overhead was allocated to products on the basis of their touch labor. That environment doesn’t exist anymore, but we are still using its accounting system.
Companies beginning to implement a lean strategy often complain that they do good things in operations, such as increase productivity and reduce inventory, but it shows up as a negative in the company’s financial statements. To borrow a medical term, this phenomenon is a false negative and is the result of the mechanics of the standard cost-absorption accounting model.
Many accountants have been frustrated by the meaningless information generated by a standard cost system, but their efforts to change to something more meaningful are thwarted by many obstacles. One of those obstacles is the complexity of our existing systems driven by the incredible number of transactions that companies process in an attempt to capture data at the smallest increment possible.
CFO and controller occasionally supervised a series of manufacturing simulations that illustrate the benefits of lean production methods versus batch and queue methods. During those 20-minute simulations, the participants produce two products through six operations. In addition to making the products, participants have to complete all of the transactions normally found in a Class A, MRP environment such as purchase orders, move tickets, and labor tickets. Usually, between 200 and 220 transactions are generated during the simulations. Extrapolate that to a real-world company with thousands of products, hundreds or thousands of operations, and thousands of minutes in a week.
Companies are processing millions of transactions through their business systems. Since those transactions are a significant source of information for the financial statements, accountants want to ensure that they are processed in a way that is complete [we have them all] and accurate. That many transactions cannot be processed with those objectives without the use of very complex processes. All of this is driven by the combination of MRP systems and standard cost accounting systems.
The end result? Standard cost/variance profit-and-loss statements those are virtually unusable!.
The other significant obstacle is the traditional emphasis within the accounting community on compliance rather than improvement. While one of the major responsibilities of the accountant is to make sure that proper internal control exists and is being followed, the way that accountants go about fulfilling that responsibility has put them at odds with the rest of the organization.
A number of years ago, Financial Executives International’s research arm, the Financial Executives Research Foundation, did a study on what operating people thought about their financial peers. More than 50 percent of the respondents described them in what could loosely be called “corporate cops”. If my peers perceive me this way, how willing are they going to be to seek my help solving their problems?
This situation has been exacerbated by the compliance requirements of Sarbanes-Oxley. Like many laws, it started off with good intentions (addressing accounting abuses), but it got lost along its way to implementation. Let’s face it—accountants have been given a nuclear weapon, figuratively speaking. We can stop any change that we do not like in its tracks just by invoking the phrase “Sarbanes-Oxley” or “the auditors won’t sign off on that”. If we use it this way, we are guilty of misusing our professional authority.
What Is The Accountant’s Role In The Emerging Lean Environment?
The transformation from a traditional to a lean workplace begins with a keen understanding of the power of the intrinsically motivated workforce and a good idea of what it takes to develop an enterprise culture that supports innovation and empowerment. The five tenets of lean measurement support the transformation by providing guidelines to ensure the development of appropriate lean measures.
Now, what is the accountant’s role in this emerging lean environment?
Lean accountants can help build an organizational culture of intrinsic commitment by promoting five enterprise-wide behaviors:
Role#1. Lean accountants enable process ownership.
They do this by providing timely information that is actionable and easily understood by nonfinancial coworkers. The accounting traditional enterprise language that uses terms like absorption costing, variances, over-applied overhead, and month-end close is useless to employees who lack accounting training and who need to make decisions in the moment rather than after the month-end close. Lean accountants also encourage process ownership by developing performance measures that link each employee’s actions to a unifying set of lean strategic objectives that support overall enterprise success. Accountants should participate fully as value stream teams establish performance metrics and develop the data collection processes.
Role#2. Lean accountants build a lean culture by thinking and talking sustainable growth first.
Rather than obsessing with the expense side of the income statement and targeting employee layoffs, lean accountants recognize that net income can also be increased through sustainable sales growth. Using re-deployable human resources to alleviate constraints and grow the business increases employee commitment to the organization. Accountants can help in this change of focus by identifying growth opportunities as people, machines, and space become available.
For example, traditional accounting is compelled to allocate 100 percent of occupancy costs to products. Lean accounting allocates only the costs associated with the space utilized by enterprise value streams. This process highlights two key benefits:
The value stream is motivated to continually reduce their footprint, including any idle inventory storage.
The space and the cost of unutilized resources are made visible to decision makers whose task it becomes to grow the business—either increase sales or develop new markets.
Role#3. Lean accountants embrace a long-term perspective when analyzing enterprise performance.
Obviously, pressures from Wall Street to meet the analyst’s quarterly earnings forecasts is a non-negotiable fact of life in a world dominated by traditional thinking. Nonetheless, lean accountants can strike a better balance between the short-run and long-run views of the enterprise.
For example, inventory levels usually drop substantially during a lean transformation, which in turn causes a drop in absorption net income. The accountants can react to this artifact of the financial accounting process by either seeking to assess blame or proactively managing the expectations of senior managers by giving them an advance warning of the short term “hit” to earnings. Lean accountants can also champion a longer-term view by emphasizing nonfinancial lean performance measures that drive future financial performance.
Role#4. Lean accountants build internal commitment by becoming business partners with their nonfinancial coworkers.
Creating a culture of cooperation is better than maintaining arm’s length relationships with those who supposedly need to be monitored and controlled. Lean accountants seek to learn from their operational business partners who possess process knowledge not only because it improves the quality of the cross-functional, team-based decision making process, but also because it builds the self-esteem of those doing the educating. Similarly, lean accountants seek to build a shared commitment to common enterprise goals by participating in Kaizen events across the organization.
A controller at Germaine Industries decided to employ value stream mapping with the original intention of demonstrating to the owners that there was a need to hire another person. What he found was that by mapping current and future states, his accounting personnel were able to identify enough redundancies and non-value-added tasks that the new person was not necessary to meet normal reporting needs. However, the controller learned so much about the potential of the lean way of thinking that he was able to present a case for a new position that interfaced with and supported the value stream teams.
Streamlining the labor time consumed by financial reporting requirements and Sarbanes-Oxley compliance frees up time for accountants to actually do contributive managerial accounting.
What is The CFO’s Role in Implementing a Lean Business Strategy?
So what is the CFO’s role in implementing a lean business strategy? Naturally, the CFO is responsible for all of the traditional accounting, financial, and treasury activities of the company. But the role is bigger that this. Someone once described the CFO as the CEO’s copilot. In this way, the CFO must be concerned with all of the things that the CEO is concerned with, plus more.
Role#1. Learn Lean by Doing Lean
As previously discussed, most of the real learning about lean comes from hands-on implementation. Accordingly, CFOs and their professional staffs must participate in lean improvement events (Kaizens). This has several benefits. First, it provides firsthand knowledge of the magnitude of the gains that can be achieved. Second, it frustrates them that they personally create these gains but can’t find them in the current financial reports. And third, they learn that the principles and problem-solving tools of lean are transferable when they start working on improving the business systems. It is easier to learn these principles and tools in a production environment, where everything is more physical, than in a business process, where the output is represented by pieces of paper or information on a computer screen.
Role#2. Change Metrics
Since accounting is generally the “keeper of the keys” when it come to performance measurement, accounting must be the primary source of information for the CEO in determining which metrics to change. The CFO must have a clear understanding of the behavior required for the new culture. The CEO and CFO must lead an analysis of company metrics to determine which ones should be discontinued, which should be modified, and which new ones should be introduced.
There has been considerable discussion recently about using the “Balanced Scorecard” as a tool to drive improvement. But the Balanced Scorecard is only as good as the metrics it contains. If it contains metrics that drive anti-lean behavior, what good is it?
Role#3. Understand the Difference between Efficiency and Productivity
The very first slide of the very first presentation that a CFO gave to employees when he/she attempting to implement lean business strategy is:
Productivity = Wealth
This simple concept became one of the cornerstones of our philosophy. At a recent conference, one of the presenters stated, “I’ve been at my company for 20 years, and if we had achieved all of the productivity gains that we said we had, we would have no employees left.” After a chuckle from the audience, and upon reflection, it became obvious that this speaker’s company did not know how to measure productivity properly. If it did measure productivity properly, one could not come to this conclusion, since the company still had thousands of employees.
Productivity is the relationship between the quantity of output versus the quantity of resources consumed in creating that output. People get confused about how to measure productivity because they are trained to think in terms of dollars, whereas productivity deals only with quantities. But every time we see a dollar amount, we can break it down into its elements of quantity and price:
Sales $ = Quantity × Price
Material $ = Quantity × Price
Labor $ = Quantity × Price
Overhead $ = Quantity × Price
It is the relationship of the “Qs” that represents productivity. No amount of financial engineering will ever create one iota of productivity gain. Productivity measures must focus on the quantities being consumed versus the output being achieved, and if people want to improve productivity, they must focus on improving that relationship.
Furthermore, productivity improvement does not come without physical change:
- Physically group product by value stream
- Physically change process layout to facilitate flow
- Physically eliminate work in process storage
- Physically store inventory at point of use
- Physically reduce set up time at least 95 percent
- Physically co-locate marketing and product development functions
- Physically combine production control and purchasing, move to operations
- Physically co-locate credit and customer service, while maintaining internal control
Because productivity is a physical concept, most lean metrics must be nonfinancial and process oriented. These metrics help ensure that when a company focuses on doing the right thing, the desired results will come—that leap of faith discussed earlier.
This discussion does not mean to imply that the “Ps” in the equation are unimportant. They are important, but are called “price recovery”. For example: if material prices increase, can we get it back in selling prices? If not, we have to offset that increase by a productivity gain or price reductions of other resources consumed; otherwise, profit will suffer. The number of people in any organization who can affect the “Ps” is small compared to those who can affect the “Qs.” Everyone affects the “Qs”.
Efficiency is the relationship between two inputs, usually standard and actual. Therefore, labor efficiency is the relationship between the standard labor hours “required” to produce something and the number of hours actually incurred.
The problem with the efficiency metric is that it presumes that the standard is correct. What is the incentive to improve if a unit happens to achieve 100 percent efficiency? The way to ensure continuous improvement is to focus on productivity because it always deals with actual results compared over time.
Role#4. Make Business Processes Lean
Because lean is not confined to manufacturing operations, but affects everything a company does, apply lean principles to the business support processes. As companies reorganize around value streams, they need to change business processes to reflect the simplicity that is being created. Most companies find that more that 90 percent of the time it takes to do anything in its business processes is non-value-added time. Eliminating that time drives the lean transformation forward even faster.
Role#5. Provide Information that Non-accountants Can Use
Most people (and probably most accountants) don’t understand a standard cost profit and loss financial statement (P&L). It starts with the presumption that standard costs are accurate and calculates arcane variances from those standards. But, let us look at how standards are derived. Below is a description of the method used to set material, labor, and overhead standard costs. The underlinned words in italics represent estimates:
Material: Quantity × Unit Cost:
- Quantity based on engineering standard, modified for yield
- Unit Cost based on current average, quotes, or ???
Labor: Hours × Hourly Labor Rate:
- Labor Hours based on engineering studies
- Labor Rates based on average rate for the department or plant
Overhead: Labor Hours × Overhead Rate per Hour:
- Labor Hours based on engineering studies
- Overhead Rate based on Budgeted Overhead divided by Budgeted Labor Hours
So this thing called “standard cost”, which is usually calculated out to three or four decimal places and is given an enormous degree of credibility, is really made up of a series of estimates and assumptions.
Even though sales are up, gross profit in dollars is flat and, as a percentage of sales, is actually down. In attempting to explain what has happened, the standard cost statement gives no meaningful information. We could go line by line, but would have no better understanding when we finished than before we started. This is the position that most accountants are in when they sit at the monthly management meeting and try to explain what happened. We revert to speaking accountese, everyone else thinks “I’m glad someone understands” and eyes glaze over.
Even though operations management knows that they have achieved some good results, the financial performance information does not support that conclusion. In a lean business, one of the responsibilities of the accounting function is to provide financial information that reflects reality and can be understood by those who do not have degrees in accounting (which happens to be most of the other people in the company).
Role#6. Avoid the Two Big Surprises
The phenomenon just described is a natural result of GAAP. Though it always comes as a surprise, it is totally predictable. Ask the operations people how much they are going to reduce inventory and over what periods of time, and one can calculate how much the P&L is going to suffer because of this. Management needs to understand this to properly assess what is happening. Accountants somehow make them understand the positive cash flow results of reducing inventory but not the negative P&L results, which always comes as a surprise and in a standard cost environment is generally explained as unabsorbed overhead due to insufficient “earned” labor hours. This in turn puts pressure on operations to increase earned labor hours, thereby increasing inventory and defeating the lean efforts.
The second surprise reflects an even more fundamental lack of understanding about lean. Although people do Kaizens week after week and talk about achieving double-digit productivity gains at the wrap-up meetings, when the financial statements are issued and management doesn’t see an increase in profit, they say, “Where’s the money?” It’s always a surprise that Kaizen results do not translate into immediate profit improvement.
This reflects the misunderstanding that lean is a cost-reduction program and sometimes even manifests through a new management requirement that the “benefit” of each Kaizen event be calculated and “delivered.”
How does a company actualize productivity gains? The best way is to sell more products because it can do so without adding people. In effect, the productivity gain represents improved capacity.
In most cases, the added cost of those additional sales is just the material content because the company already has the people, machines, and support staff. The profit leverage that this represents is significant. Since most companies can create productivity gains greater and faster than they can increase sales, there are other things that can be done to actualize those gains, such as reduce overtime. Make it very difficult to incur overtime.
As productivity increases, hold on to attrition. Even though companies give people the assurance that they will not lose employment as a result of productivity gains, they do not guarantee a fixed level of employment. Make it virtually impossible to replace people who leave for any reason. Look for in-sourcing opportunities. If the company sends something to a vendor that it is capable of doing in-house, in-sourcing represents a wonderful opportunity to improve profitability by transferring that value added from the vendor’s P&L back into the company’s.
Whose responsibility is it to actualize productivity gains? Again, there is only one answer: management. Employees create productivity gains, and it is management’s responsibility to convert those gains into improved profits.
Role#7. Don’t Forget Control, but in the Context of Lean Processes
The earlier discussion of the obstacles to implementing lean accounting addressed the compliance mentality and Sarbanes-Oxley. Unfortunately, the big accounting firms charged with reporting on a company’s internal control systems have taken a “belt and suspenders” approach to compliance. This is unfortunate and has caused companies to spend millions of dollars needlessly. And so people ask, “How can I implement lean accounting and comply with Sarbanes-Oxley?” This question implies that controls disappear as lean is implemented.
Nothing could be further from the truth, as lean actually enhances the ability to have good controls. The intent of Sarbanes-Oxley is to ensure that CEOs and CFOs know that their company policies and procedures are being followed. In effect, they have to know what is happening and can’t use the excuse “I didn’t know” when something significant goes wrong. The application of lean principles to business processes makes them simpler and more transparent. When processes are simpler and more transparent, they are easier to control. Therefore, adopting a lean strategy actually enhances a company’s ability to comply with both the spirit and letter of Sarbanes-Oxley.
Role#8. Communicate, Communicate, Communicate
It is generally accepted that people are afraid of change. In reality, people are afraid of the unknown. People are not afraid of change if they understand and believe that the change will benefit them. When this happens, they adopt change so fast that it can make one’s head spin. Once again, the problem lies not with the people but with management. Managers are often lousy communicators in terms of explaining how the lean transformation process will benefit any of the company’s stakeholders. The art of being a good manager is not being able to “motivate” people to do what you want, but to lead them in doing it. People follow leaders voluntarily because they believe it benefits them to do so, not because they have to. Each of the company’s stakeholders (shareholders, boards of directors, employees at all levels, unions, banks, auditors, suppliers, and customers) need to have a communication plan to help them understand how they will benefit from a lean business strategy. The CFO is in a perfect spot to help shape these communication plans and to help lead the company in its lean transformation.
Many books have been written over the years about the latest management fad. Many programs, some with sophisticated names, have come and gone. Many CEOs have been touted as having discovered the magic formula for success. But ask anyone about the fad, program, or CEO that was at the top of the list five years ago and you will probably get a blank stare. Then ask anyone who has been the most successful automobile company consistently at the top of the customer satisfaction surveys for the past three or more decades and you will probably get “Toyota” as an answer.
Toyota has not achieved this status by following the latest management fad. It has relentlessly pursued a business strategy that we have come to know as lean. Whatever we call it, it is a way of doing business that increases customer satisfaction by leading everyone in the company to focus on creating value for the customer, which in turn creates value for its stakeholders. Other very different companies, that have emulated the lean way of doing business, have demonstrated that lean successes are not unique to Toyota. They apply to any business endeavor that chooses to adopt and truly integrate lean principles. But adopting and integrating lean principles is not easy because it requires people to “unlearn” many bad habits, and that happens only through a true understanding of lean, and leadership from the company’s principal strategic leaders: the CEO and the CFO and their accountants.
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