Lean Accounting for the Lean Enterprise 2-Day Workshop Ross Maynard BMA Europe Ltd

Objectives of this Workshop Understand why traditional accounting, control & measurement methods need to change as the company continues the lean transformation Overview the primary methods of Lean Accounting that will be important to the company Develop a ‘Go Forward’ plan for your organization

A Brief History of Lean Management 1911-1915 Henry Ford influenced by Frederick Winslow Taylor’s ‘Principles of Scientific Management’ Ford introduces mass production 1926 1979 Taiichi Ohno develops ‘The Toyota Production System’ (TPS) based on Ford’s principles of 1926 Today… 1945 on… 1934 on… Toyota develop ‘Pull Production’ (producing only for actual sales) in response to resource shortages. This was inspired by a visit to a US supermarket chain Toyota starts producing vehicles, developing Kaizen teams in 1936 3

The Toyota Production System The idea of pull production (producing only for actual sales) was inspired by a visit to a US supermarket chain - ‘Piggly Wiggly’- shortly after WWII Levels of demand in the Post-War economy of Japan were low and the focus of mass production on lowest cost per item via economies of scale had little relevance TPS is a whole management system - it is not just about production

The Philosophy of Lean Maximize competitive advantage through operational excellence A time-based strategy – flexibility & speed of response to the customer & speed through the production/ service delivery process Why would you perform any activity that the customer is not willing to pay for? Improve the flow and you improve profitability

The Five Principles of Lean Production Make value flow at the pull of the customer Identify the value stream & eliminate waste Involve & empower employees Specify value in the eyes of the customer Continuously improve in the pursuit of perfection 6

Traditional thinking and lean thinking are in conflict Traditional Standard Costing Lean Thinking ASSUMPTIONS ASSUMPTIONS Profit comes from full utilization of resources Direct labor is the most important conversion cost Control the business thru detailed tracking All excess capacity is bad Profit from maximizing flow on pull from customers. Waste is resources impeding the flow Control thru continuous attention to flow & waste Excess capacity provides flexibility

Why Lean Accounting? Traditional Standard Costing was developed for mass production The philosophy is that profitability is maximized when labor and machine utilization are maximized The focus of Standard costing is on lowest cost per item through economies of scale This does not apply in a high variability, multi-product environment Here profitability is maximized when the rate of flow is maximized

What’s the problem? Traditional management systems: Actively work against Lean Manufacturing & other lean improvements. Are expensive and wasteful. Provide misleading, wrong, and harmful information. Motivate people to do the wrong things. Are complex and confusing to people. Here’s a Few Simple Examples

Actively work against lean manufacturing Drill on CNC Machine Inspect & Pack Batch 2500 1 minute 4 minutes Machine on Lathe Grind 6 minutes 4 minutes Total labor time: 15 minutes Labor cost: $5.00 Overhead cost: $15.00 Material Cost $1.50 TOTAL COST: $21.50 Lead Time: 6 weeks Inventory 25 days Batch size 2500 (10 days) On-Time delivery = 82%

Lean manufacturing changes Create a cell. Use an drilling machine with quick change over. Reduce the batch size. Reduce the lead time. Reduce inventory. Almost perfect delivery. Created additional capacity on the CNC machine.

Drill on Drilling Machine Lean improvements Machine on Lathe Drill on Drilling Machine 4 minutes 4 minutes Lean Cell Grind Inspect & Pack 6 minutes 4 minutes Total labor time: 18 minutes Labor cost: $6.00 Overhead cost: $18.00 Material Cost $1.50 TOTAL COST: $25.50 Lead Time: 2 days Inventory 5 days Batch size 250 (1 day) On-Time delivery = 98%

The problem We have made great improvement. BUT…. the product cost has gone up and the project is cancelled. In fact, the changes were highly beneficial both operationally and financially. It is the standard costing that is leading us in the wrong direction.

Traditional income statement What does Gross Profit mean? Why have the earnings fallen so much in period 2? How would you explain this someone in production? The first statement illustrates the confusion created with the traditional statements: It requires the intimate knowledge of the cost system possessed by and horded by accountants. How were standards determined? At what capacity levels? Sometimes based on how well you can negotiate with your cost accountant Let’s look at these statements: Gross Margin went down but was that because the standards were increased to reflect lower expected volumes? Was it because the material standards are frozen for network procurement? Total Adjustments went up. Is that good or bad? Did it go up due to purchase price variances and over absorption of overheads. What does that mean? Absorption of the expenses Let’s look at another way of presenting the income statement that we call the lean way. Same data, just presented differently Volume decreases from one year to the next. How did spending fare with those decreases? This statement shows what was spent on those elements during the year. In lean you would expect the relationship to be close to the current sales What about the change in inventory? They reduced it both years and had they kept it at the same level without continuing to reduce it, they could have duplicated the ROS. But they did some good lean things and it hurt 16 16

“Plain English” Income statement What does Gross Profit mean? Why have the earnings fallen so much in period 2? How would you explain this someone in production? The first statement illustrates the confusion created with the traditional statements: It requires the intimate knowledge of the cost system possessed by and horded by accountants. How were standards determined? At what capacity levels? Sometimes based on how well you can negotiate with your cost accountant Let’s look at these statements: Gross Margin went down but was that because the standards were increased to reflect lower expected volumes? Was it because the material standards are frozen for network procurement? Total Adjustments went up. Is that good or bad? Did it go up due to purchase price variances and over absorption of overheads. What does that mean? Absorption of the expenses Let’s look at another way of presenting the income statement that we call the lean way. Same data, just presented differently Volume decreases from one year to the next. How did spending fare with those decreases? This statement shows what was spent on those elements during the year. In lean you would expect the relationship to be close to the current sales What about the change in inventory? They reduced it both years and had they kept it at the same level without continuing to reduce it, they could have duplicated the ROS. But they did some good lean things and it hurt 19 19

Misleading cost information Prepare for Mounting Align & Secure Inspect & Pack 6 minutes Product B Output 10 per hour 3 minutes 4 minutes Product A Mount Components Actual Production Cost = $580 per hour Material cost = $42 per item Product Cost = ?

Misleading cost information Product A Product B Standard Cost = $90.06 Material $42 Labor 17 mins @ $24.23/hr = $6.87 Overhead 600% = $41.19 Actual Cost = $100 Production $580/10 = $58 Standard Cost too low Standard Cost = $109.85 Material = $42 Labor 24m @ $25/hr = $9.69 Overhead 600% = $58.18 Actual Cost = $100 Material $42 Production $580/10 = $58 Standard Cost too high

Poor decision making: Outsourcing product B Traditional Approach Actual Impact Standard Cost = $109.85 Outsourced Cost = $85.00 “Savings” of $24.85 per unit New Material Cost = $ 85 Old Material Cost = $ 42 Increase in Actual Material Cost = $ 43 Actual production cost per hour = $ 580 because no resources were eliminated Actual costs increase due to outsourcing

There is no “Standard” Cost! In a lean environment, the cost of the product is related to flow… Waste affects cost so that there is no one ‘standard’ cost of a product Cost varies with production, FPY, scrap, mix, quality, downtime etc If you control the flow, you control the cost By improving flow through the Value Stream we improve capacity = flexibility 25

Performance Measurements Traditional accounting performance measurements motivate non-lean actions. Measuring labor efficiency, machine utilization, and overhead absorption leads to large batches and high inventory.

Sales policies mismatch with lean capability Week 1 2 3 4 Sales Orders & Shipments Level Schedule Value Stream Suppliers Pull System Single Piece Flow Result: High inventory Late deliveries Higher costs Confusion Conflict

Transaction-based control systems cost too much Entering and administering transactions is wasteful and time-consuming. EXAMPLE: A production plant with 150 people, 120 products, and revenue of $15M required over 4,000,000 transactions per year. Job costing, procurement, inventory control, accounts payable, accounts receivable: 38 equivalent heads spent processing and using the transactions. 12.7% of revenue

Two Aspects of Lean Accounting Applying Lean Thinking & Methods to the Company’s Accounting Processes Accounting for Lean & Supporting the Lean Transformation Cost accounting, labor reporting, production reporting & work orders Purchasing & accounts payable Inventory tracking & valuation General ledger simplification Month-end close, etc Reporting & decision-making to support lean manufacturing & other lean processes Financial reporting that is immediately understandable & useable to everyone Single lean accounting system for management accounting & external reporting Accounting processes focused on customer value, value streams, pull, empowerment, & continuous improvement

All of this requires Trust Lean is a People Process The aim of lean is a production system that highlights problems and a human system that produces people who are willing and able to identify and solve them Eliminating waste is done by people using rigorous problem-solving methods Behaviours that focus on improvement & problem-solving Involving people in lean is at least as important as lean tools. Lean is a set of collaborative and inquisitive behaviours that result in a culture of continuous improvement. All of this requires Trust 30

Lean Accounting has Seven Aims Performance measures that motivate lean–cell & value stream measures Support relevant, accurate & timely decision making using contribution costing Elimination of unnecessary accounting transactions Drive the growth of the business by increasing customer value using Target Costing Value Stream Costing, replacing Standard Costing = Value Stream Profit & Loss Account Highlighting impact of lean improvements – eliminate waste, improve capacity, improve flow Motivate lean behaviour in the planning process – SOFP 31

Box Score - Financial Impact 34

Example: Italian Client

Value Stream Profit and Loss Account THE VALUE STREAMS MUST MAKE A MINIMUM OF 46% 43

Italian Client Value Stream Profit and Loss Account

Summary - Lean Accounting Primary method of lean control for meeting customer needs & driving continuous improvement Performance Measurement Simple, direct, & accurate way to create financial reports. Very few transactions Save time, money, & confusion by radical elimination of wasteful transactions Value Stream Costing Transaction Elimination Lean Decision Making Financial Impact of Lean Improvement Manage the business by value streams with accountability for growth, profitability & continuous improvement Understand the financial impact of lean improvement & create a money-making strategy Target Costing Drive the business from the customer value – not the cost

What Will Lean Accounting Do For Us? Increase sales & reduce costs through better decision-making information Clearly identify the potential financial benefits of lean programs Reduce costs through eliminating wasteful transactions & systems Motivate long-term lean improvement through lean-focused information & measurement Eliminate the problems caused by traditional costing methods

Why Lean Accounting ? It’s all about flow … 51

It’s all about flow … In a lean environment, profitability is related to the rate of flow through the Value Stream. By measuring and managing the flow, we manage the cost. By improving the flow, we reduce cost, and increase capacity. By increasing the capacity of the Value Stream, we increase its profitability. 52

The Heart of Lean Accounting A defined Value Stream Agreed Performance Measures Direct Value Stream costs Revenue/ customer value Material costs People costs (including direct support) Machine costs Space and energy costs Capacity Box Score

Watlow Controls, Winona MN Jan Brosnahan, Controller Why Lean Accounting?

Action Plan Goal: to implement lean accounting at your site Lean performance measures linked to plant goals Defined Value Streams Value Stream direct costing Box Scores used for control, decision making, planning and improvement Identify the Obstacles to implementation What are the Causes of those obstacles What Actions will you take to eliminate the causes and implement lean accounting ?

Agenda day 1 Value Stream Management Defining the Value Stream Box Score Day 1 Performance Measurements Value Stream Costing Value Stream Costing Exercise Day 2 Value Stream Capacity Value Stream Capacity Exercise

Day One Wrap-up 61

Agenda day 2 Decision Making Decision Making Exercises Financial Benefits of Lean Day 1 Month End Close & GAAP Transaction Elimination Warm Up Day 2 Transaction Elimination SOFP Implementing Lean Accounting

Day Two Wrap-up