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Background

As you begin your migration to a lean enterprise, you will inevitably run squarely into the question of whether the standard cost based financial statements provide information that is useful, informative and actionable? You don’t have to go far into the lean journey before these questions become relevant. Why?

Standard cost based financial statements are an outgrowth of the mass production era. Just pick up any cost accounting text and review the history of standard costing. Better yet, pick up "Relevance Lost" by H. Thomas Johnson and Robert S. Kaplan. When I read it, I was surprised to find that the standard cost concepts were all in place by 1925. They were an outgrowth of the Frederick Taylor, "one best way to produce" scientific era. In fact, cost accounts for material, labor, and overhead; budgets for cash, income, and capital; flexible budgets, sales forecasts, transfer prices, and divisional performance measures were all set in place by that time.

Since then, not much has changed. Some believe there was little incentive to develop other accounting methods since corporate organizations and manufacturing approaches used during those early years continue to be the model to this day.

Others point to quite a lot of change related to product offerings, additional services, quality improvement, and the complexity of design, manufacture, & distribution. They pointed out that in the early 1900s, products and processes were relatively simple. Later in the century, customers began demanding more and with that came the growth in overhead as more and more knowledge workers were hired to address these product variety and complexity issues. However, accounting information stayed as it was. Accountants and managers were still using standard costing approaches with single unit drivers (direct labor or machine hours) to absorb overhead, still measuring efficiency and utilization and hammering the workforce for more output to drive the unit costs down.

Johnson and Kaplan pointed out those shortcomings in "Relevance Lost" when they claimed that:

Management reports are of little help to operating managers as they attempt to reduce costs and improve productivity. Today’s management accounting systems provide a misleading target for managerial attention and fail to provide the relevant set of measures that appropriately reflect the technology, the products, the processes, and the competitive environment in which the organization operates. Financial managers, relying exclusively on periodic financial statements for their view of the firm, become isolated from the real value creating operations of the organization and fail to recognize when the accounting numbers are no longer providing relevant or appropriate measures of the organization’s operations. Management accounting systems can and should be designed to support the operations and the strategy of the organization.

A rather harsh wake up call, but it worked. It was soon followed by a number of responses that seemed to solve the problem. Kaplan and Cooper plunged into activity based costing and provided a new path with new tools. But the excitement and interest was short lived as those tools only added complexity to the accounting functions.

Standard Cost Based Financial Statement

How does this all play out? Look at the typical standard cost based financial statements create in Figure 1 (below). It looks simple enough with just 5 categories. But that’s where it ends. Most users, quite frankly, don’t understand this document but if you are using it in your company and have used it for some time, be careful. You may be labeled a heretic if you try to abandon it.


The Categories Are Not Intuitively Obvious

Since the categories are not intuitively obvious, we need a short definition of each. Sales represents shipments for the period net of any returns and warranty claims. Cost of sales is the standard product cost of all the items sold during the period and, as a result, is subject to all the vagaries of the standard costing process. While we could fill pages about how standard costs are developed through time studies, endless meetings and the negotiations between the cost accountant and the manufacturing manager that occur over a few beers, suffice it to say that standard costs are nothing more than estimates of what we think is going to happen during the period. All variances from this meticulously prepared standard are included in the total adjustments line. So this category becomes the dumping ground for purchase price and usage variances, labor rate and efficiency variances, overhead spending and volume variances, inventory and scrap adjustments and the not to be forgotten changes to the ending inventory to apply the variances. Little wonder how this statement can confuse and often intimidate.

SG&A (Sales, General & Administrative Expenses) and Other expenses need no explanation so we’ll move to reviewing the changes from one period to the next.

The Review is Not An Easy Task


Based on the statements, you can readily see the results have slipped substantially. Earnings before tax went from 20.1% to an anemic 12.7% while the sales increased to $3.5 million over the previous period. How can that be? Sales increased over 16% but earnings are down nearly one quarter over the prior period!

Examining the details of the statement does not provide any insight. For example: Gross margin was 34.3% in period 1 but slipped to 32.6% in period 2. Was this decline due to higher standard costs because more excess capacity was included in the standard overhead rate? Or was it due to higher material costs, wages or overhead increases? Or, was it because our frail and tiny cost accountant was "convinced" by our large and muscular Production Manager to increase the standards this year?

Getting no satisfaction out of reviewing the first categories, let’s look at the manufacturing adjustments line. This is the largest single contributor to the decline. Wouldn’t you know it? This category contains almost everything that goes on in the shop floor and the direct support functions. All variances, inventory changes, and on and on are contained here, which makes you wonder: Who is responsible? Who should address these questions?

I think you get the point. Reviewing the traditional financial statements and arriving at reasons for the changes in performance from one period to the other is not an easy task. Likewise, once you find the answers, how do you use this information to improve the results? What do you do with an efficiency variance that happened 3 weeks ago?

The Behaviors Are Hardly Lean

As the saying goes: "Tell me how you will measure me, and I’ll tell you how I will behave." What behaviors does standard costing encourage?

bullet Build inventory for absorption.
bullet "Cherry pick" products to earn hours to improve efficiency measures.
bullet Run parts on machines to increase utilization.
bullet Run large batches to avoid set ups.
bullet Buy in large lots to secure favorable purchase prices.
bullet Ignore what the customer wants or needs


These are hardly lean behaviors. In fact, they are the exact opposite of the types of lean behaviors you are trying to create


A "Plain English" Income Statement

Now, let’s look at the same numbers but recast in a different way. I like to think of this approach as one that complements, not contradicts lean.


The Categories Are Clear

While there are as many categories, they are simple, unambiguous and clear. Jeffrey Liker in his recent book, The Toyota Way defined lean as:

A way of thinking that focuses on making the product flow through value added processes without interruption (one-piece flow), a pull system that cascades back from customer demand by replenishing only what the next operation takes away at short intervals, and a culture in which everyone is striving continuously to improve.

Taiichi Ohno, founder of TPS (the Toyota Production System), said it even more succinctly: All we are doing is looking at the time line from the moment a customer gives us an order to the point when we collect the cash. And we are reducing that time by removing the non-value-added wastes.


What better way is there to report costs than in the same sequence in which they are incurred? We buy the material, convert it and ship it to the customer. Why not report the costs in the same order: procurement, conversion, and distribution? Wouldn’t this provide some better insights than the traditional statement? Think of a company that out sources a major part of their production. You would expect procurement costs to be proportionately higher as more of their sales dollar would be consumed in buying materials and subcomponents from suppliers and subcontractors. Likewise you would expect them to employ a greater number of supply chain managers. Our example, on the other hand, shows a much higher portion in conversion costs. You would expect, and be right, that a greater portion of their sales dollar is invested in a fairly sizable design and process engineering staff that is engaged in producing a highly engineered product for their markets.

Now that you know what it costs to acquire the materials and convert them into finished product, you can turn to what it costs to get the product to the customer. Distribution captures those costs, which include the costs of the physical logistics (warehousing, transportation, invoicing, etc.) and the costs of selling and marketing the products. Think of the difference that must exist in this category between Dell and its competitors, as Dell became the leader in the direct selling model. They are now using that low cost advantage to capture market share.

Our next category is support costs. They represent the business sustaining costs (operating unit manager’s and their staffs) which are allocated to the unit. Capturing these costs separately helps see the organization structure the unit is using to support the value added activities. Higher costs usually mean a steeper pyramid.

There are two below the line adjustments; External Overheads and Inventory Change. External Overheads are those costs that arrive from Corporate like bad news every month. There is usually no logic to these corporate charges; they may be allocated as a percentage of sales, for example. There is really no need to do this random allocation of corporate overheads, but many companies cannot break out of the habit.

The last component on the statement is the change in inventory that needs a little explaining. The concept under lean is to shorten the time from the customer order to the time of delivery. Theoretically, the expenses incurred in that accounting period should be related to the sales of that same period and there should be very little, if any, inventory. Consider a Trim Master Inc. plant that supplies seats to Toyota’s Georgetown, Ky. plant. Their inventory turns 135 times a month. Yes, 135 times a month! That translates to an inventory amount that would be less than ¾ of one percent of the monthly costs. It’s hardly significant and, in this case, recording ending inventory can be ignored. Most companies – even very lean companies – cannot achieve inventories as low as Trim Master, and we need to show the effect of period-end inventory.

In our example in Figure 2, we have recorded the ending inventory. However, by showing the inventory change separately, it’s pretty easy to tell when inventory is increasing or decreasing. Whether it increases to level production for seasonal demand or increasing just to improve results, the effect on operating earnings for that period is unambiguously clear. Likewise, as you move to lean and reduce inventory, the charge to earnings would be equally evident. You just can’t find this change in the traditional earnings statement! Perhaps that is an overstatement. Any CPA with an advanced degree in accounting can find it, if given enough time.

Companies that are serious about lean manufacturing reduce their inventories significantly. This does not usually happen quickly; it is a consistent decline in inventory value as continuous improvement steadily eliminates the need for it. It is important to be able to readily see the effect of this inventory reduction on earnings.

The Review is Simple

As shown in figure 2, the largest portion of the change in Return-on-Sales (ROS) is the change in inventory. The reason? A customer postponed a shipment in period 1 to a later period. Explanations become that simple.

The Behaviors Complement Lean

"Tell me how I’m measured and I’ll tell you how I’ll behave" are still the watchwords. What behaviors do you think this type of statement influences and are those behaviors aligned with lean?

bullet Purchasing only buys what’s needed, when needed. If the purchasing group is able to negotiate a discount for a large volume buy and all is delivered, procurement costs will be out of whack. Sure, inventory will increase by an equal amount but this is a clear signal that we purchased and paid for materials that were not needed. Now you have to move it, to store it and to treat it as a royal guest in your ‘parts hotel’ until you are ready to use it. That costs money and is muda.
bullet Level scheduling so that the products produced are sold in the same period. If you’re not doing this the conversion costs will be out of proportion to the sales for the period and the capacities (people and machines) not planned appropriately.
bullet Inventory builds and declines are visible and controlled. It’s no secret that companies expand and contract their inventory to make their numbers. Will this approach stop that behavior? Probably not. However, two things will become clear. The first is how much you have added to inventory in a particular period. That begs the question: why has inventory increased? If your answer is to smooth production, fine. On the other hand, if it is to manage earnings, then there is a problem. While you have ‘made your numbers’, employees will know by your actions that you speak lean but don’t do lean.

The second thing that becomes clear is how much inventory has decreased and the effect on earnings for that decrease. As you move to lean, inventory decreases will reduce earnings. Traditional managers are apt to comment, "this lean thing isn’t working!!" and abandon the lean effort. Clearly showing this effect on earnings may not get them completely on board, but it will certainly go a long way towards gaining an understanding of the financial effects of lean changes.

Conclusion

Nothing is as easy as it sounds, and this is no exception. If this lean statement resonates with you—as it has with many of the operational and financial folks that have seen it—then try it. Wiremold Corporation uses this type of financial reporting and the way they introduced it was to run it alongside the traditional statements and see which one the users preferred. It didn’t take long before they moved to the lean statement exclusively and trashed the traditional.

What you will also find is the data is much easier to gather than you might think. It’s there; you just have to go get it. As a first step, map the traditional ledger accounts and departments into these new categories. The only category that is a little tricky is the inventory change. What you need to do is identify all those changes and then put them into the following categories:

bullet Procurement includes all the material purchases and subcontracting costs and come from accounts payable.
bullet Conversion includes direct labor and overheads incurred that come from payrolls and department costs, respectively.
bullet Other inventory changes that include absorption, cost of sales, and inventory adjustments that come from the respective ledger accounts.


As you mature with lean, you will find it easier to just expense these costs during the period and to determine and record the inventory change at the end of the period.

One way to think about this is that in the traditional system, you record the charges (material purchases, direct labor earned and overhead absorbed) to an asset account and track it until it is sold. Inventory is in the system so long that you have to cycle count it, reconcile it, and provide reserves against it for slow moving and obsolete parts. All of these steps are necessary to ensure inventory is properly valued.

In lean, parts move swiftly through the plant and there is just not much inventory on hand. As a result, you can expense all the charges when incurred and set up the inventory at the end of the period. Usually, you take a physical and use that to value the inventory. It is simple, straightforward and quick.

Returning to our question, "Do we need to Simplify Financial Reporting?" If you want a statement that is simple to prepare; easy to understand; easy to drill down to find underlying causes; easy to assign responsibility; easy to drive improvements, and one that is aligned with your lean strategy, then your answer is "yes". Is this the right statement? If not, it is a good start and goes a long way in the right direction.

NOTES
1. "Relevance Lost; the Rise & Fall of Management Accounting" by H. Thomas Johnson and Robert S. Kaplan, Harvard Business School Press, Boston, 1987.
2."The Toyota Way" by Jeffery K. Liker, McGraw Hill, New York 2004
3."The Toyota Way", page 217.
4."Real Numbers" by Orest Fiume and Jean Cunningham


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