After spending much of the past several years deriding most business schools, I’ve become increasingly favorable toward MIT’s Sloan school and their publication, Sloan Management Review. In fact, it’s the only such publication I currently subscribe to, primarily because they actually attempt to investigate the real world. Or at least the world I seem to live in. I’m sure our fellow lean blog buddy Mark Graban will be happy to hear that.
This latest issue is no exception, and includes a top-notch article by my friend Brian Maskell of BMA, one of the leading proponents of lean accounting. The article, titled How to Manage Through Worse-Before-Better, tackles that well-know lean conundrum: the financial results as reported by traditional P&L and balance statements trail the operational results of lean, which can create a conflict between CFO’s and operations leaders. Unfortunately Sloan makes a big deal about the double-knot top secret copyright, so I need to be careful how much I quote.
Maskell describes the lean journey of a manufacturer of industrial sensors, and the conflicts created between operations and accounting.
During the first six months, Caspian, whose total revenues were about $225 million, achieved significant operating improvements. Product lead times to customers and on-time delivery performance were up sharply. Over the next six months, operational performance continued to show impressive gains, and the vice president of operations was pleased. Meanwhile, customer service was making significant strides as well, and with greater efficiences the company was able to reduce the number of direct labor employees involved in production. Payroll savings in a single value stream alone amounted to more than $40,000 per month – around 20%.
However, the CFO saw a radically different picture. During the same initial months, she saw no financial improvement at all: Sales were flat, and costs didn’t decline. During the second half of the year, Caspian’s revenues actually fell by 17%, and profits declined by an even bigger percentage.
Now where have we heard that story before? Anyone that has attended the Lean Accounting Summit knows what is going on. Maskell then dives into how lean accounting can augment traditional cost accounting.
Our approach involves replacing (or, at a minimum, augmenting) the traditional cost-accounting system with a new, transparent accounting system that tracks the company’s value streams, which incorporate all of the value-adding and non-value-adding activities required to bring a product or service from start to finish.
He notes how the beginning stages of a lean transformation can affect customer behavior, thereby impacting financial results.
Consider what happened at Caspian during the first three years of lean transformation. The company eliminated most of the queues in the production processes. This led to a reduction in lead time from 12 weeks to around one week. At the same time, because of improved reliability and quality, the on-time delivery percentage to customers went from the low 70s to the high 90s.
As customers come to rely on improved lead times and on-time performance, they begin to alter their buying habits, shrinking their on-site inventories. Cutting back on inventory can have a significant impact on sales. Although suppliers might see only a modest drop in revenue, their profits can drop by more.
And of course the internal factors.
Internally, there is dramatic improvement in operating performance as well. In particular, the cycle time for taking a product from raw material to finished goods shrinks. As cycle time drops, so does the need for in-process inventory. In response [to a shift from push to pull production] the need for finished goods inventory drops from months of production to days of production.
As both types of inventories drop, the "good news" is that operating cash flow improves dramatically as unneeded inventory is sold. The "bad news" is that most cost systems allocate fixed costs to products that are manufactured during the financial reporting period. When [inventory is declining], fixed costs that were previously capitalized on the balance sheet must be added back, thereby reducing profits.
The authors go on to describe value stream costing, and especially the "plain English" financial statement that clarifies profit at the value stream level. They also delve into nuances such as adjusting for productivity and right-sizing. For more on the subject, I highly recommend attending the Lean Accounting Summit; this year’s event will be held in Las Vegas this September. I hope to see you there!