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Ask Art: What sets lean accounting apart from traditional accounting?

by Art Byrne
November 15, 2016

Ask Art: What sets lean accounting apart from traditional accounting?

by Art Byrne
November 15, 2016 | Comments (5)

This is a great question because you can’t really become a lean enterprise without making the shift from traditional standard-cost accounting to lean (i.e. plain English) accounting.

There are several powerful reasons for this. First of all, the traditional standard-cost accounting system doesn’t provide good information—in fact, the information it does provide is often misleading. This makes it very difficult for management to make good decisions. More importantly, standard cost encourages many of the things you are trying to eliminate with lean, which is why I like to call it the anti-lean. On top of all that, running a standard-cost accounting system is much more expensive.

Let's start with poor information. The standard cost system expresses results in the form of a long list of variances:

  • Purchase price variance;
  • Material usage variance;
  • Labor efficiency variance;
  • Labor rate variance;
  • Overhead volume variance;
  • Overhead spending variance

Etc., etc. These are all variances from the assumptions made during the budgeting process, which was itself just a guess in the first place. As a result, when there is a problem, no one can really tell if this problem is actually in operations, or shows up as a result of flawed assumptions made while putting the budget together. In many cases, the finance guys don’t understand what is going on - and even if they do, they have a hard time explaining it to humans.

The traditional standard-cost company believes in having a product cost for each product, in detail, out to four digits. Every one of these is based on various assumptions and estimates that get so complicated that in the end no one outside of finance believes they are accurate. Even so, finance insists that product pricing be set on these inaccurate costs. This leads to either overpricing certain products, or underpricing them and leaving money on the table. After all, the price for any product is really set in the marketplace and not by an arbitrary cost estimate that the finance department comes up with…at great expense, I might add.

There are many ways standard cost accounting is anti-lean; one of the worst is that it incentivizes the building of inventory. Of course in lean, inventory is seen as the root of all evil because it hides waste. With lean a major thrust is to reduce inventory to eliminate waste; not build it. The standard-cost absorption approach, on the other hand, allows you to defer a certain amount of the overhead costs into inventory and thus a future period as long as inventory stays the same or goes up. The more inventory you build, the more costs you can defer and the better this month's results will look. In fact, many standard-cost companies keep a keen eye on the number of absorption hours created during the month as they see this as a key measure of how they will do vs. the budget at the end of the month. If they are running behind after, say, the third week, the various functional managers will switch to making the products in their areas that have the highest absorption hours, even if there is no demand for them, as they know this will make the month look better and no one is going to bother them about building a little extra inventory.

Another benefit of the lean accounting approach is that it will help you gain visibility on your costs at a higher level. As you organize into cells, you will develop a clear idea of the labor and material for the products being made in each cell. Then at the product family or value stream level you will also see the overhead for all the products in the family. It will only be down to the gross margin line as a family, as trying to allocate all your overhead on a product-by-product basis is an exercise in futility. Even so it will be a more accurate view of profitability than you have now. In fact, the production cells will know which particular products are causing problems and as a result the people will work to remove the waste from them long before any standard-cost system will identify the problem (if in fact it ever does). You can set your prices based on the market.

Don’t expect that making the transition will be easy, as your finance team will likely fight the change. At Wiremold, we helped a number of companies get started down the lean path. Many of them called us a year later and asked if they could send their CFO and a couple of their staff to spend a week with us to understand lean accounting. Their resistance was one of the biggest obstacles these companies faced in making the transition to lean. You will want to run the lean P&L in parallel with the standard-cost system, but before you know it, no one will want to look at the standard-cost numbers anymore. Then you will know you are on the right track.

Got a question for Art to answer in his Ask Art column? Please share with us at leanpost@lean.org. Art will give copies of his new book, The Lean Turnaround Action Guide, to the first five people who share questions with us. 

The views expressed in this post do not necessarily represent the views or policies of The Lean Enterprise Institute.
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5 Comments | Post a Comment
Daphne King November 23, 2016

Thank you for posting this article. I have been anxiously awaiting someone to point out the "waste" factor in traditional cost accounting. I am currently trying to persuade my director that the way we are accounting for our cost is not the most accurate, and hopefully this article will help. 



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art byrne November 25, 2016

Daphne, thanks for your comment. I hope this article helps solve your problem. Not only is traditional accounting less accurate than lean accounting it is also much more expensive. What is the value of having detailed cost estimates for every product out to four digets if no one believes they are accurate. Regards, Art.



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Owen Berkeley-Hill November 28, 2016

Thank you Art!

I do have a concern that your article and thinking is part of a very small minority, perhaps tiny even in the Lean community and that your thoughts will be drowned by the cacophony from traditional accountants and those in the Lean community who cannot see past Toyota’s tool box.

I remember being told, many years back, about the market place determining the price and that:

the traditional thinking of Cost + Profit = Price should be replaced by PriceProfit = Cost.

I remember stories of accountants coming down to the shop floor (something they avoided like the plague) and accusing the Lean team of destroying value as we reduced inventory.

But has anything changed?  I see this call to question accounting going the same way as Lean has, being relegated to some irrelevant side show slightly less important than synchronised swimming or tiddlywinks.  And for this, LEI and the Lean movement should take some of the rap for not being more rigorous when challenging the b-schools.

It’s been over a quarter of a century since the term Lean was coined by academics, but I cannot think of one university or b-school which has based its lucrative cash cow, the MBA, on a Lean foundation so that the next generation of leaders start their careers thinking Lean.  Yes, there are a few institutes which have developed post-graduate courses, but these are MScs and have the “specialist” mark of Cain which will be avoided by those wanting to climb right to the top. (And before you think it, I’d agree that the way management education should be taught is by following the 70/20/10 distribution because Lean or good leadership cannot be taught just in the classroom.)

A great article, Art, but I’m afraid you are preaching to the choir, some of whom I suspect cannot read your music or don’t want to.

 



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art byrne November 29, 2016

Owen, thanks for your nice comments. I'm glad you enjoyed the Post. Your right that getting traditional accountants or management to switch to lean accounting is a tough slog. In fact getting most traditional management to think about lean as anything but a cost reduction program or a bunch of tools that you can pick at random is also very difficult. It needs to be seen as a strategy, a way to run your business. We may get there eventually but your right that progress has been very slow. As for the business schools, some do teach some lean concepts but to do it right there needs to be a hands on element. This requires building a network of nearby companies that will allow the students to come and do kaizen work as well as provide summer jobs in their Kaizen Promotion Offices. This is difficult to put together but both the companies and students could benefit a lot from such a network. Regards, Art.



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Robert Porter Lynch October 02, 2017

Thanks for your great insights Art. We have found that Lean is really a method of generating ideas for improvement using "collaborative innovation." The emphasis on collaboration is critical. Our experience shows that in companies where trust is low, lean fails to take hold, and innovation stalls. What are your thought on measuring trust factors and innovation flow in the new accounting?

Robert



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