Lean Accounting: the new Frontiers of Management Control
In the last few years both scholars and managers have been asking a radical question: are traditional management accounting systems based on product standard costing still valid in an economic environment which is very different from the one in which they have been conceived?
Those systems have been conceived in the era of mass production, an era in which the number of products offered to the market was very limited and demand was likely to absorb all available production.
The absolute dogma of that era was total utilization of productive capacity.
Nowadays the situation is quite different: the number of products has enormously increased and demand is all but stable and uniform.
As a consequence production must be flexible and capable to adapt to a quite unpredictable and fluctuating demand.
In order to face this new challenge, new productive models have been conceived and applied, the most effective and widespread of which is the so called “Lean Production” , a model which, among other things, suggests to reorganize production processes creating “value streams”, i.e. processes that include all the activities (design, manufacturing, purchasing, order processing, shipping etc.) needed to bring the product to the customers or, in other words, to create value for the customer.
Strangely enough management accounting systems have remained anchored to the past with the consequence that they are unable to measure the results of the lean transformation and useless and sometimes even misleading for those who have to make important decisions.
If to all this we add that standard costing systems are complex and expensive, as is well known to all those who are familiar with them, it becomes very clear that a profound revision of management accounting is absolutely needed.
In order to adapt management accounting systems to the new requirements a new approach, called “Lean Accounting” has been developed and applied first in the U.S. and then in many other countries especially in Europe.
Lean Accounting includes principles and methods particularly useful to support management to understand the effects of the lean transformation on profit and loss, on cash flow and on non financial performances. The “pillars” of Lean Accounting are:
Value Stream Costing As a lean company is organised by “Value Streams”, costs are not charged to products but to value streams. As a consequence there is no more need to determine a unit standard cost for the individual product, which, beyond requiring a remarkable effort, provides a merely abstract and useless information because it depends on the criteria selected to allocate indirect costs and on the predicted level of demand, which by definition is variable and impossible to predict. In Lean Accounting costs are reported by value stream and as a consequence they are much more realistic and their computation far less complex.
Performance measurement Management accounting should not provide only financial information; it should also measure the performances at various levels: production cell, value stream, plant, company and these measures, in order to be really effective, must be frequent and timely. Measures like on time deliveries to customers and from suppliers, inventory turns, O.E.E., flow index etc. must become part of management accounting. The so called “variances” typical of a traditional standard costing system and normally reported after no less than a month, require a lot of work and serve no purpose at all.
Being reported over a month after they have been originated they give untimely and therefore useless information.
In addition to that they are often incomprehensible to management (We have never met a top manager who could understand the meaning of the mysterious “absorption variances”), they provide no performance measures and very often encourage anti-lean behaviours (as it happens with the so called efficiency and absorption variances which are favourable if production exceeds expectations, without any regard to the fact that the extra production can increase not sales but inventories)
Decision making Very important decisions such as that of making or buying or that of accepting or refusing an order, must never be taken based on standard costs (which are mere abstractions and can lead to wrong decisions).
A correct decision in these cases can be made only considering the real contribution of the decision to the profit and loss of the value stream as a whole.
Transaction elimination As in a lean environment controls are built into the work and are aimed at immediately identifying and correcting problems, subsequent controls based on the processing of thousands and sometimes millions of transactions are totally useless. Transactions are to Lean Accounting what inventory is to Lean Manufacturing: waste to be eliminated. Therefore every effort must be made to eliminate or reduce to a minimum costly transactions such as production work orders, detailed production programs, material movements, purchase orders, detailed recording of labour time etc. etc.
Measuring the effects of the lean transformation Traditional systems are incapable of measuring the true effects of a lean transformation. In particular they are incapable to measure the effects on the “flow”, i.e. the capability to respond flexibly and promptly to the requests of the market eliminating queues, delays, reworks, scraps and everything that can impede the flow. Furthermore they pay attention to production capacity only to brand excess capacity as mere waste.
According to lean thinking, on the contrary, to free up capacity (in terms of labour or machine utilization, space etc.) is a very sound objective to pursue because available capacity means more flexibility and the opportunity to expand the business.
Changing the budgeting process Traditionally the budgeting process is a yearly “rite” which is both complex and time consuming. In the final months of the year managers spend an enormous amount of time trying to figure out future market trends and to set goals for the new year. Finally after long discussions and sometimes bad conflicts between the various functions a budget document is approved, but what normally happens is that after two or three months actual results appear remarkably different from what is written in the budget. In an economic environment unstable and unpredictable like the present one this process appears totally inadequate and must be replaced by the so called SOFP (Sales, Operational, Financial Planning), a method based on a monthly updating of the budget.
The SOFP is a rolling budget for each value stream and for the entire company which is revised every month always looking ahead to the next twelve months. Replacing the long and costing budget ceremonies of the past, this agile integrated process normally leads the company to decrease inventories, improve customer service, increase the cash flow.
When implementing Lean Accounting it is important to follow a correct approach The already numerous experiences made in the U.S. and the still few experiences made in Italy prove that it is necessary to proceed by steps and gradually follow the lean transformation process. First of all time and effort must be spent to try and explain why traditional systems are no longer valid in a lean environment and how they should be replaced. To achieve this “cultural revolution” which involves the whole company, it is useful to start with some training sessions involving not only accountants, but also people from operations, design, marketing, purchasing, etc. At the end of the training, it is prudent not to apply lean accounting to the whole company, but to select a “pilot value stream” among those which have gone far enough on the path to lean transformation and make a first experiment of lean accounting application to that value stream involving a team of people from Accounting as well as from Operations. Within a few weeks the team defines the performance and financial information (the so called “Box Score”) needed to keep the value stream under constant control and the sources from which this information can be obtained in a fast and economical way. The box score of this pilot value stream is produced for two or three months in order to test and fine tune the system. The usual results of this experiment are that all the information (daily, weekly, monthly) is available promptly and with little effort, that standard cost is no longer used, and that the number of transactions to be processed decreases significantly. Once the pilot phase is concluded, lean accounting can be extended to other value streams and eventually to the whole company.