To sustain a lean transformation, top executive and financial managers must know how to transform traditional accounting practices to a new system that not only is lean itself but also supports lean practices. The lean accounting movement seeks a change from such traditional cost accounting practices to ones that are more understandable, accurate, and effective in measuring and motivating companies implementing lean management principles.
Five thought leaders of the movement recently held a special conversation about what lean accounting is and isn’t, why it is vital to sustaining a culture of continuous improvement, how it relates to GAAP, and why it provides a truer picture of how your company is performing.
Listen to the full conversation here:
As long-time lean accounting practitioners, they also liberally share practical, real-world examples of how traditional accounting can mislead and misinform decision-makers.
- Art Byrne, author, former CEO Wiremold, and columnist for the Lean Post
- Jean Cunningham, author and executive chair, LEI
- Mike De Luca: lean management practitioner and coach
- Jim Huntzinger, president and founder of Lean Frontiers, which runs the Lean Accounting Summit
- Nick Katko: lean management practitioner and coach
Josh: Why don’t we begin our conversation providing a simple definition for the uninformed, of which I will count myself among that group: what is lean accounting? Maybe I could ask LEI’s executive chair, Jean Cunningham, to provide us with a simple definition for lean accounting to get this conversation started.
Jean: So lean accounting is a term that actually I think we could probably credit to Jim Huntzinger who’s on the panel, but I’m not exactly sure who decided to call it lean accounting. It’s a way of thinking about how accounting and financial information fits in an organization that has adopted lean management. It has in my view, two main points. One is what does accounting do to help support the lean transformation of an organization — the changes in the information, the way they engage with the organization. The second part is how can an accounting function and a finance function benefit from lean thinking.
In both those parts are about focusing on the customer, whether it be an internal or external customer, about simplification, and about using language that our customers understand, not complicated accounting units. That would be my simple definition.
Nick: I typically describe lean accounting primarily about a management accounting system in a lean organization that provides the relevant, reliable information at all levels to drive the lean strategy forward. The other piece is practicing lean inside the accounting department.
Josh: Excellent. I guess the natural follow-on question is why is lean accounting needed?
Jim: A lot of organizations going through the operational changes and physical changes of a lean transformation, run into impediments in accounting. It could be the accountants — but I don’t want to pick on them. It could just be the systems that they have in accounting, which would direct what they’re doing or trying to do in the wrong direction, or not give adequate information.
Art: I think we need lean accounting because the traditional accounting, in my opinion, incentivizes all the things we’re trying to get rid of with lean. It causes management to make some terrible decisions. We’ve seen a lot of companies over time in the private equity world talk about how they’re doing lean and everything’s great. Then you say, “Yeah, but you’re only turning inventory three times.” When you dig into that a little bit, what you find out is that the finance guy is looking for absorption. He’s looking for absorption hours and making the operations make inventory and run equipment that they don’t need to run.
At Wiremold we helped a lot of companies get started with lean, and about a year or so later they would call us up and say, “Hey, can we send our finance team to see you for about a week?” I’d say, “Why do you need to do that?” They’d say, “Well, because they’re driving us nuts. We’re doing a good job on lean, and we can’t get them to go along with it.”
If you have a situation where management is strategically trying to implement lean, and its finance team is fighting it tooth and nail all the time because the numbers look terrible as you drop inventory, then it becomes very difficult to implement lean using the old approach.
Jim: If I could add onto what Art’s saying, this is actually the way I got into it. Again, I’m an engineer, not an accountant but many, many years ago, we were doing an ROI analysis on the lean changes we were making, which got me involved in the managerial accounting system and the standard costing system we used. As I crunched through those numbers to calculate our internal product cost, I found out that the information it was giving us was utterly wrong. That was very disturbing to me because as a Fortune 500 company, we made every corporate decision based on this information, and it was wrong. It was just outright wrong.
That bothered me because I knew we were not making the right business decisions. Make or buy, capital equipment purchases or capital allocation, all those things were not going to be appropriate because we just simply had wrong information as the foundation to our decision making.
Jean: When I first got exposed to lean, I was a finance person for our company, responsible for all the financial and accounting things. It became clear to me so quickly that the information we were using in accounting was not helpful because people didn’t understand it, but worse, was driving the wrong answers. There’s a couple of reasons for that.
One is that basic standard cost accounting, which most manufacturers use and generally accepted accounting principles (GAAP) reward you for building up inventory and punish you for reducing inventory. Literally, the very things that we’re trying to do with the reduction of lead time and reduction of batch size, which results in reduced inventory, the accounting system was punishing us for. It was so invisible in a standard cost system that you couldn’t even tell what was going on.
The other thing that it does is treat all manufacturing costs as costs that vary with volume. We know that most of the costs in manufacturing do not vary with volume, but the system treats people costs as varying with volume, and just completely dehumanizes the environment. Of course, with lean thinking, we’re becoming a very human environment, engaging people, respecting people, and we had an accounting system that did none of that.
Jim: It makes accounting significantly simpler along with being significantly more accurate. We just had a deeper, more intimate knowledge of what those actual costs were, so even the stratification of it allowed us to make even in between decisions much better. We finally had a clear vision or picture of how things were instead of some aggregate blob that we really didn’t have a grasp on. They thought they did originally but didn’t really have any grasp on.
Art: I’ve always thought that standard cost accounting is something that can’t be explained to humans, and in general most of the finance people don’t really understand it either.
If you’re working at a P&L, and it’s a variance to this and a variance to that, and this kind of variance, that kind of variance, seven or eight kinds of variances. If you ask, “What are these variances to?” You find out well, they’re variances to a budget that we created last fall. They’re not real, they’re just a variance to a budget, and that budget has so many assumptions built on top of it that the whole thing makes no sense, to begin with. Yet we’re trying to make business decisions based on something that we made up last fall and that doesn’t relate to anything. I just never could understand it.
Jean: I think the other thing that I think that Nick and his organization has really brought to life in lean accounting is that not all the information about your business needs to be in your accounting system. I think a lot of organizations assume that if it’s not in the accounting system, it’s not real information.
Yet, Nick, you’ve done such amazing work in helping people see that key measures are right there at the shop floor, right there in the sales department — wherever it may be –that we can bring to life. They help people know what’s going on, and then they take more responsibility, are more empowered for how they can influence future business results. I think your work, Nick, has been really amazing.
Nick: What I try to tell finance people is that it’s your responsibility to learn how lean works operationally. As you collaborate with operations learn the relationships between the operational performance measures and financial outcomes. Because the operational performance measures will pretty much drive root cause analysis to why you’re not achieving the financial results you want. If you’re an accountant or a CFO, you’re not going to get to root cause analysis by sitting in front of your computer and creating a spreadsheet. The only way you get to root cause analysis is to understand what’s going on in operations.
Mike: All of what you’re saying holds true in a service industry like healthcare. I’m passionate about not just why lean accounting is nice to have in a lean organization but is a must-have. We as accounting and financial professionals can do so much to not just enable the lean transformation of the organization — enable the effective adoption of lean thinking — but enhance and accelerate that. The lean organization is about the continuous improvement of value to the customer in whatever industry we’re in.
If we think about a lot of what we do in finance, we inform the clear understanding of current performance and we inform decision making. If operations are after improving customer value, and operations is our customer in finance and accounting, what are we doing? What can we do? What must we do to really clarify the information they’re using to make these decisions?
Art, I think it was you who was talking about making decisions based on fully burdened costs, and not really understanding what informs an incremental business decision. In a lean organization, we have to do exactly what you said, Nick. We have to get out there and understand what in the world is operations doing from a lean perspective and how does that get reflected? What do we do in finance and accounting to drive the improvement or support how the organization’s driving improvement of customer value? It’s that constant PDCA cycle; how will you check if you don’t understand what the financial and operational measures mean?
Nick: I was working at a company this week, a very traditional manufacturing company with standard costing deeply embedded in the organization. One thing I mentioned is they were talking about how senior leadership was not pleased with the results in 2018 at about this time of year, so they told operations, “You got to make things better.” Guess what operations did by the way? What do you think they did?
Jean: They built inventory.
Nick: They built inventory. Then in December, guess what senior leadership was worried about?
Jean: Cash flow.
Nick: Yeah, cash flow and inventories, but I said to them, “It’s this financial engineering view where the finance people can look at numbers and dictate what has to happen with no interaction. That’s what gets organizations in trouble.”
Jean: This is one of the challenges for lean accounting; [traditional accounting] is very deeply embedded in our educational system. It’s deeply embedded in reward systems. It’s deeply embedded in how we think about generally accepted accounting principles. But the good news is that everything we talk about with lean accounting can comply with generally accepted accounting principles. We are not talking about going off and doing some crazy reporting that won’t last. We are talking about reformatting and reconfiguring and refocusing the work that we do as finance and accounting departments within the constructs of what’s required for GAAP, but much more focused on the customer and your internal customer needs.
A lot of people have been afraid that they can’t do lean accounting because auditors won’t let them. I’ll tell you, our auditors were never a problem. They completely supported everything we did. In fact, what most people don’t know in manufacturing is that standard cost accounting does not comply with generally accepted accounting principles. It’s just something that is not well understood. There are these artificial barriers to people’s thinking about how we could look at the business differently, and the role that finance and accounting can play as partners, as contributors, as value creators in our organizations.
Josh: When getting folks in the accounting group or the finance group to go and see, to go learn what operations is doing, what are some of the tips that you give or some of the advice or exercises that help them?
Art: Because we started lean at Wiremold — the first three or four kaizen teams that we had — I wanted to make sure that my management team members were on these kaizens. So, I assigned them and when it came to my finance guy, Orry Fiume, who is one of the smarter guys that I know, I said, “You’ve got to be on this setup reduction team.” He said, “But Art, I’m the finance guy. I don’t know anything about setup reduction. We’re closing the books this week, and blah-blah-blah.” He had about 10 excuses, he didn’t want to be on the kaizen team.
I said, “Orry, I’m not listening to any of this stuff, just get out there and get on the kaizen team.” He said, “Okay, all right, all right.” He’s on this team and during the week they reduce setup from 90 minutes to five minutes. Of course, Orry, ever the finance guy, kept track of how much it costs to do this because the mentality in traditional accounting is that if you want to get productivity, you must spend a lot of capital money. He kept track, very detailed track of how much it cost us during the week to go from a 90-minute setup to five minutes. Total cost was $150, and at the end of that week, I had my best advocate for lean in the whole company.
Mike: In the way we approached kaizen events, there was a finance person who was shoulder-to-shoulder with the operations folks for the preparation before the kaizen, attended the entire event, and was an integral part of developing the measurement plan coming out of the event.
Because those of us in finance tend to understand and work Excel a lot better than other folks, we were integral in helping the operations folks come up with really easy ways to find the data, do the reporting — and like you all have said — it was largely operational data and not financial data.
Everyone on my team was assigned a primary operational area. They would attend on a regularly scheduled basis the huddles for that operation’s team. They would see what day-to-day issues the team is dealing with, whether it’s planning their work or responding to issues that are coming up, or problem solving at different levels.
This idea that when we learn to see, operations learns to see their processes from a lens that’s very thoughtful and critical, not in a negative way but just in a critical thinking way. Then when finance learns to see those same processes, and you bring those two perspectives together, you will more deeply understand not just what’s going on in the process but how it contributes to results and the outcomes.
Jean: I really feel there are two parts to this deep understanding and engagement with the work. One is the head, and the other’s the heart. The head means that as leaders we must understand that going and seeing what’s going on in our companies is real work. If we think it’s just extra or something you do when you have time, it will never happen. You must truly think that it is real work to go and learn, as Art said. To go to a kaizen event, to go as Mike said, to go participate in a huddle. If you don’t see that as real work, there will always be an excuse, and you will never learn.
The heart, on the other hand, means that you must have the heart that says every single person in the organization can contribute and that they too can learn by having an opportunity and time to see what’s really going on upstream, downstream, or in an area completely unrelated. If your head isn’t right and your heart isn’t right, you’ll always find a barrier to deeply understanding what’s going on in your company. That’s fundamental not just to lean accounting, it’s fundamental to product development, it’s fundamental to customer service, it’s fundamental to making a product, it’s fundamental to serving in a hospital. It is the head and the heart combined that really creates the kind of environment where transforming all our work actually happens.
Art: I think one of the key things here is that when you talk about trying to remove waste, which is what we’re really trying to do with lean, the people that do the work will always come up with the best ideas for how to remove the waste. Doesn’t matter whether they’re an operator on the shop floor or they’re someone in accounting or they’re someone in marketing or sales or product development. The people who do the work know where the waste is, and we’ve never really listened to them before. Certainly, on the shop floor, people have given ideas and suggestions for a long, long time and no one listened to them.
Jean: In accounting, while we know that the person who does the job is the one who can see the waste, I think we have an added barrier. A lot of people within accounting know that there are certain rules and regulations that you’re supposed to adhere to. Often, they see a very small slice of the work. There’s a sense of: I must do it this way, this is the way the job is defined.
There’s a special burden to break down that thinking. One of the things that aligns so well with learning to see and asking questions, is to have people really understand what the purpose of your work is. Maybe we call that value add, but what is the purpose of this job? If you don’t understand the purpose of someone’s work — and this happens a lot in accounting — then it’s very hard to know how to improve it and eliminate waste. Understanding that core purpose — what is value add, what is the purpose of this — can really unleash people who work in accounting to look at their own work and make it better, as well as getting them to see how their work interacts with other people’s work.
Josh: Why should owners and executives care about the accounting practices in their company, care about lean accounting? Why should they care?
Mike: How are they making decisions?
Nick: The way I describe it is very similar. I put one word in front of decisions, and it’s making “quality” decisions. Quality decisions aligned with lean strategy, whether it’s looking at lean strategically or operationally, you want to make quality decisions. What is the relevant and reliable information that all internal customers need to be able to do that on a consistent basis?
Art: I think if you look at the traditional standard cost accounting with variance to this, variance to that, variance to everything, you don’t have enough information to really make good decisions. A lot of what you think is good information is not. Every time I give a speech someplace, I always ask for a show of hands as to how many people believe that the standard cost of every product in their company is correct? No one ever, ever puts their hand up. You’re spending huge amounts of money trying to get product costing down to four decimal points when it’s always wrong, and nobody in your company believes it. What’s the point of doing that?
Lean on the other hand is going to give you very accurate, very up to date information that you can make decisions on, and on top of that, it costs you a whole lot less to do lean accounting than it costs you to do traditional accounting. We got rid of move tickets, routings, and labor tickets and all this kind of stuff that was very expensive to collect. We didn’t have to do that anymore. Not only do you get better information to make decisions on, but it costs you less to do it.
Jean: There’s a couple of reasons why executives need to care about lean accounting. First, if the information isn’t accurate it isn’t driving good decision making and it’s very expensive as we’ve all talked about. Also, it means we have people doing work that nobody uses. Every person and every function of every part of the company needs to be focusing on doing work that actually matters so that if we can root out work that doesn’t really matter, we are freeing up capacity in people who can do work that is greater value. I think this is really, really important.
An even bigger reason is respect for people. To me, when accounting puts out information that the people who receive it don’t understand or don’t believe, it’s disrespectful. Speaking in [accounting] language no one understands and expecting people to learn is disrespectful. Providing information that rewards the behavior we’re trying to stop is disrespectful. Giving people work that has no meaning and expecting them to do it to the fourth decimal is disrespectful. Respect is a core component of the type of companies we are when we really become lean companies.
Mike: We had one particular problem that showed up on our claims side, and claims was almost $2 billion a year of our $4 billion business. It was a significant chunk that my team was doing financial planning and analysis on. Claims lag is months and months before you have a sense from a reporting perspective when your completion factors are all full and you’ve got enough information. Saying, this is what it cost us last July; how helpful is that? Out of respect for the end-user of the information and the great skill of the finance team, we came up with a great set of current and leading indicators and discovered a multi-hundred-million-dollar problem as it was emerging. We had countermeasures in place before it turned into really a serious financial situation. This ability to sense and respond in real-time is very important.
Jean: I was helping a company that had 50-some plants, and they started their lean efforts in a third of those plants, implementing pull systems and eliminating a huge amount of work-in-process inventory and finished goods inventory. Well, if you understand your cost system you know that from an accounting point of view, you’re going to take a really terrible hit to your income statement even though your cash flow is great.
This company had too much capacity, so they knew they were going to be closing a plant. They closed one of the plants that had made huge inventory reduction, became much more efficient, and where people had all been trained. They left open a plant that had not been involved with lean and had built inventory. These are not just casual decisions that companies make. These are serious life-changing mistakes that companies can make just because the information is too hard to understand, not simple, and not real.
Sometimes I think we’re a little afraid to talk about finance and accounting; we’ll seem anti-people in some way. But money is the language of business. It really is motivating and helpful for us to see the feedback of how we’re impacting the outcomes of the business. We’re going to talk about this thing that we’re calling the Lean Profit Model, and give people the ability to tell their lean stories related to the Lean Profit Model.
Mike: For those of us who are bringing lean thinking into our own professional practice and into our organizations, we’re lifelong learners. That’s what we want to do. I’ve learned so many really valuable things and made such great connections in prior Lean Accounting Summits. I go every year to hear the case studies across various industries and what practitioners and thought leaders are doing and learning. I always get an enormous amount out of going to the summit and enjoy it every year.
Art: I’m really pleased to see the Lean Accounting Summit not only continue but grow because I think without it, we can’t have any lean enterprises.
Jean: You can’t do lean if you’re stuck with the old ways of measuring and evaluating the performance of your company. This is why I wanted to come to LEI; I saw it as a way to get our message elevated. I invite each of you, please, let’s work together, let’s help each other, and let’s bring this to something beyond what we’ve achieved so far, which is good, but it can be great. I’m really committed to that.
Interested in Learning More?
- Increase your professional value while learning how lean accounting sustains a lean transformation. Register today for the Lean Accounting Summit, where Jean, Nick, Jim, and Mike will present!