Of the many aspects of lean accounting, one that has proven especially useful is the principle of “cost avoidance.” Today on the Lean Post, lean accounting pioneer Jean Cunningham explains what this is and why it’s a must-know for any finance professional
What is cost avoidance?
Cost avoidance is when you avoid any kind of cost that you would normally incur, because of a purposeful action you took. So you’ve purposefully made some sort of improvement that has changed the cost structure of your business.
Can you give an example of that in practice?
Definitely. Let’s say you do an improvement project for which you’re looking at why you keep needing to expedite products to the customer at higher expense. As you look at that you’ll evaluate the situation and do some problem solving, and say you find out the root cause is that your inventory management system is inaccurate – your salespeople thought there was product ready to ship when there really wasn’t. And so, out of respect for the customer, you chose to expedite the order.
Then you fix the inventory error, Sales can now see what’s really available, orders are shipped as expected, and you’ve avoided the cost of the expediting. Now, the problem with accounting is, we only measure things that do happen. So since we’re no longer paying that expediting fee, it doesn’t show up on our cost sheet – in fact, it doesn’t show up anywhere. It’s just a cost we’ve avoided and no longer have to deal with.
That’s a direct cost avoidance; there are also indirect examples. So let’s say there’s a certain number of people in this organization with a culture of continuous improvement – that is, asking everyone to think about how they can make their jobs a little easier, safer, and more timely. Over time, nonvalue-added tasks are eliminated from the work, and thus we can possibly avoid hiring as many people as we did in the past to cover those bygone tasks. That’s an indirect cost avoidance – we can’t necessarily connect the savings with one particular action, but we can see the cost avoided in terms of fewer salaries to pay.
How does this help leadership realize the actual value of lean?
Let’s say I’m a leader and I get a financial report every month, and it shows how much I’m spending. I may not fully recognize the relationship of the size of my team to the overall costs accounted for, because I may not have a window into the revenue, or demand, side of the business. I may not realize that these improvements we’re making are the reason why I don’t need to grow the size of my cost structure at the same rate as my revenue structure. When we start learning to match cost avoidance to the demand side of the business, we may start to see relationships that we might not have seen before. And as those relationships come to light we can start seeing the cumulative value of all these individual savings add up to something remarkable.
This is certainly a radical shift in thinking for a leader more used to scrutinizing current costs, rather than previous costs. How do you recommend explaining this to them?
Great question. Let’s pretend I drive 10 miles to work every day, always the same route, for 15 years. I know that route like the back of my hand. But then one day, somebody tells me about a new route that is much easier than the one I’m used to. And all of a sudden that drive to work is eight miles, not 10. That’s a savings of two miles every time I get in the car to go to and from work. By making this change I’ve avoided that needless travel and the costs of doing so.
It’s the same thing with cost avoidance. When we find changes, and we no longer have to spend the money we once did, we have this sudden epiphany that we really are creating new value in our day, in our financial reports, and in the overall financial performance of our company. That’s my preferred way of using cost avoidance to sell leadership on the value of lean.
You’ve spoken in the past about a graphic called the profit model, which helps explain the overall financial impact of lean. Can the model be “scaled down,” if you will, to explain cost avoidance?
Absolutely. The profit model is a very simple economic model that I go over much more extensively in my workshop Capturing the Value of Lean. The model basically says that we have a certain level of resources in our organization and that we have a contribution margin from serving our customers, creating revenue and the variable costs that go with it. Where those things cross is called “breakeven.” Underlying all that is the capital we invest to support our business. So anywhere in that model where we have cost, we can think about cost avoidance.
For instance, in our expediting scenario from before, because we eliminated those expediting costs, our level of resources needed has actually gone down. Thus, it lowers our breakeven and increases our profitability. Likewise, that cost avoidance has increased our capacity creation – we’re able to ramp up production to meet demand while keeping our resources at a flat level. The profit model is a really great way to help you tell the story of all the lean improvements that are happening around your company – as well as their true value for both our customers and our company.
You’re doing a Lean Talk at the 2018 Lean Transformation Summit about lean accounting. What are you most excited to share in that?
I’m eager to share a way for finance and accounting professionals to improve their own value to the organization by focusing on things other than just plain “backward reporting.” I want to show them how to always be asking themselves, “How can I help create more value by using our financial transactions, understand the profit model, and improving the quality of our content so that it aligns better with our organizational needs?” And I should add that my talk is not just for finance professionals; it’s to help anyone get in the mindset of “How do my activities support the overall lean initiative and the financial performance of the company?”
Are you interested in learning more from Jean? She’ll deliver a Lean Talk at the 2018 Lean Transformation Summit on March 26 in Nashville, and teach her insightful and practical workshop Capturing the Value of Lean at LEI’s Seattle workshops on April 13.