Mark C. DeLuzio, CMAPresidentLean Horizons ConsultingGlastonbury, CTemail: firstname.lastname@example.org
There is a lot of confusion in the lean world today over the role that the accounting function must play in order to facilitate a successful lean transformation. There are two schools of thought: Applying lean concepts to drive waste out of the accounting function itself (known as Lean Accounting); and modifying the accounting process to properly promote lean behaviors (known as Accounting for Lean). This article addresses the latter, as it's more relevant to those managing a lean transformation. Please note, however, that the two go hand in hand. Without taking out the waste in the accounting process, accountants will find that a majority of their time will be spent on non-value-added activities, and they will be viewed as historians. Accountants need to be proactive, and play the role of navigator.
Traditional management accounting practices were developed by accountants to accommodate a batchand-queue environment. Batch-and-queue environments are characterized by non-lean practices such as functional scheduling, push inventorymanagement systems, amortization of long setup times, and maximization of overhead absorption variances. Although management accounting covers many areas, some areas of traditional accounting practices promote dysfunctional lean behaviors.
Just consider: standard costs are estimates of what you think a product will cost to manufacture, based on projections and forecasts. Typically, standard costs are established annually, in concert with the annual budgeting cycle. One could argue that standards are wrong from the moment when they are developed. Typical cost-management systems then use these standards, and compare them to actual costs, which generate a variance to the standard. Variance analysis many times leads to decisions that are counter to lean-thinking philosophies.
Examples of traditional variance analysis, and their contribution toward dysfunctional decisions, are as follows:
The key dysfunctional behavior associated with measuring and rewarding purchasing professionals on Purchase Price Variance (PPV) centers around the subject of volume discounts. One way to avoid unfavorable variances is to buy in high volumes, which would yield quantity discounts, thus lowering the unit cost for each item. This practice, however, promotes the building of excess (and eventually obsolete) inventory balances.
Another danger with using PPV as a performance tool is the risk that the purchasing group may source their parts from the lowest-priced vendor, while ignoring critical attributes such as supplier quality, service and delivery, lead times, etc. This approach has the potential to negatively impact an organization's service to their customers, as well as becoming a source of additional costs driven by quality and warranty issues in the marketplace.
Volume (absorption) variances reflect variances in fixed manufacturing costs (overhead) that arise when the actual production level (volume) differs from the expected level used in computing predetermined fixed overhead rates for product-costing purposes. Using an absorption variance as a measure of manufacturing performance supports the notion of producing as much as possible, regardless of customer demand. In fact, the smart production manager learns quickly, (after being beaten up for unfavorable absorption variances), that certain products provide more absorption credit than others. Eventually, these products are produced regardless of demand requirements. Soon, customer service levels slip, while the inventories of these high-absorption products increase. Clearly, the use of absorption variances as a control device sends the wrong signals.
One of the fundamental Lean philosophies is the notion of kaizen, or continuous improvement. Traditional variance analysis, however, does not support this notion. Table 1 shows four months of variance tracking for a particular product. Using traditional standard-cost variance analysis, it would appear that for the first three months, we have registered favorable results, because we beat the standard. But upon further inspection, we find that each month our actual costs have increased. Despite the fact that we are favorable to standard, results show an unfavorable trend. In the spirit of continuous improvement, these results are strictly unfavorable, regardless of the fact that our variances are favorable for the first three months. If you believe in kaizen, you must subscribe to the notion that favorable trends are measures of success. Clearly, variance analysis can be misleading.
Traditional cost accounting defines direct labor as the labor cost of those workers who are actually engaged in the physical manufacturing of a product. All other labor costs are classified as indirect labor, and treated as a part of factory overhead costs. To accumulate these different labor classifications, a labor-reporting system is required. The use of time cards as a labor-collection device is common in a traditional environment. Once data are recorded, a whole host of activities is required by the accounting department to properly segregate, classify, and report this labor information. Additionally, a staff of Industrial Engineers is required to study and administer the detailed routings throughout the shop. The functions performed by the IE's and accountants who track this data represent waste and should be eliminated.
In a lean environment, the focus needs to be on multi-skilled operators who can work within several different labor classifications. Factory employees are expected to perform activities that are classified as direct and indirect labor by traditional cost accounting definitions. For example, in addition to working directly on the manufacture of a product, a multiskilled operator will be expected to perform tool changes, complete setups, maintain equipment, clean the workplace, take part in kaizen activities, etc. These tasks, by traditional definition, are indirect in nature.
As we try to develop our multiskilled workforce, it's critical that we don't discourage their growth. Traditional measures such as the ratio of direct labor to total labor and direct labor efficiency will encourage shop supervisors to circumvent the work not considered to be direct labor. The result is an unfavorable operating situation despite favorable financial performance.
Considering total cost, labor amounts to less than 20% in many manufacturing companies. Other items, such as direct material and other overhead expenses, should be the focus of continuous improvement. Yet many traditional cost accounting systems dedicate a majority of their resources to the collection and reporting of labor information. Because the significance and classification of labor is less important in a Lean environment, cumbersome labor-data collection systems should be discontinued. Labor should be treated as an overhead expense item, and charged to the appropriate value stream.
Traditional capital budgeting methods have taught us that a capital acquisition should provide a targeted payback, or rate of return, if it is to be considered a financially sound investment. If the capital investment did not satisfy this hurdle rate, it would be better to invest the same funds in some other financial instrument (e.g., bonds, stocks, etc.). These ground rules forced the manufacturing group to financially justify all capital requirements in terms of net present value (NPV), return on investment (ROI), or some other payback method.
Although financial considerations should not be ignored in a capital budgeting decision, in a lean environment there are other considerations that need to be taken into account:
Traditional batch-and-queue accounting focuses on maximizing the utilization of equipment. This measure promotes the building of unnecessary inventory, and discourages the equipment changeovers required to meet customer demand.
As companies move toward a lean business model, they typically reorganize their operations around value streams. A value stream is defined as all of the value added and non-value-added activities required to bring a product or service through the main material and information flows. Value streams cut across functions, and the ultimate goal of value stream analysis is to eliminate waste from the process, with the net result of producing shorter lead times, lower costs, and higher quality. The value stream map shown displays material flow along the bottom of the map, and information flow across the top.
The main idea behind value-stream accounting rests with the concept of control and accountability. Typically, an entire value stream is managed by a value-stream manager. This manager is responsible for all of the activities that occur within the value stream. So, it follows that our accounting methodologies should follow this line of thinking. Value stream accounting has the following characteristics:
Focusing on the entire value stream encourages managers to maximize the performance of that value stream, not just specific functions or departments. Performance metrics (financial and nonfinancial) are developed which promote controlling one's destiny as well as accountability.
Working capital and fixed assets are more effectively managed within the value stream. For example, excess capital within a value stream will have an adverse impact on the value stream's profitability. Building excess inventory will directly affect the inventory and balance-sheet position of the value stream.
All of the traditional batch-and-queue accounting practices are discarded when moving toward value-stream accounting. For example, variance analysis to standard costs is not utilized. Instead, the focus is on actual costs and continuousimprovement trends.
Moving away from traditional accounting methodologies requires the support and understanding of senior management. The accounting system must be changed within the context of the lean transformation. As accountants become more efficient in satisfying their fiduciary requirements (payroll, accounts payable and receivables, corporate financial reporting, SEC and IRS requirements), they can transition toward becoming navigators and business partners to value stream leaders. Historically, accounting has stymied and even killed off many lean transformations by insisting on batch-and-queue measurements that supported dysfunctional behaviors. These measurements have provided the wrong signals to management as to the success of moving toward a lean culture. It's imperative that the accounting community become educated in lean through hands-on involvement. Only then can the accountant successfully lead the revolution that must take place in the accounting function.
This article was first published in the December 2006 edition of Manufacturing Engineering magazine.