LEAN ACCOUNTING FAD OR FASHION?

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1 LEAN ACCOUNTING FAD OR FASHION? Richard E. Crandall, College of Business, Appalachian State University, Boone, NC 28608, , Karen Main, University Business Systems, Appalachian State University, Boone, NC 28608, , ABSTRACT Lean manufacturing, or lean production, is a continuous improvement program that has become popular in the business press in recent years. A number of recognized companies have adopted lean practices. As a corollary, some management accountant advocates have developed a new management accounting method called lean accounting. This paper is a preliminary exploration of how lean accounting differs from existing management accounting techniques, what benefits it offers, what issues are associated with its adoption, and speculates on its future. An Exploratory Look at Lean Accounting Lean manufacturing, or lean production, is a term that first became popular in the early 1990s as a result of a study sponsored by the International Motor Vehicle Program (IMVP). The group studied automobile assembly throughout the world to assess the productivity and quality of some 90 locations. The study was described in a book entitled The Machine That Changed the World, The Story of Lean Production and prepared by James P. Womack, Daniel T. Jones and Daniel Roos (1990). The term lean accounting has come into the business literature more recently. Brian Maskell and Bruce Baggaley published a book entitled Practical Lean Accounting, A Proven System for Measuring and Managing the Lean Enterprise in A few authors have published a number of additional articles in the past five years or so, primarily in Strategic Finance and Cost Management. While there is a growing awareness, the movement is not yet of major impact. What is lean accounting? Lean production is a philosophy of production that emphasizes the minimization of the amount of all the resources (including time) used in the various activities of the enterprise. It involves identifying and eliminating non-value-adding activities in design, production, supply chain management, and dealing with customers. Lean producers employ teams of multiskilled workers at all levels of the organization and use highly flexible, increasingly automated machines to produce volumes of products in potentially enormous variety. It contains a set of principles and practices to reduce cost through the relentless removal of waste and through the simplification of all manufacturing and support processes. Syn: lean, lean manufacturing. (Blackstone and Cox 2005) Based on the above definition, what is lean accounting? Is it an accounting system to interpret the results in lean manufacturing operations, or is it an accounting system that is, in itself, lean, or with all nonvalue-adding activities removed? The answer is Yes to both questions.

2 Brian Maskell says Lean management accounting aims to provide information useful to the people in production plants who are actively implementing and sustaining lean manufacturing. He goes on to say, In lean accounting, the accounting systems must themselves be lean. Transactions are to lean accounting what inventory is to lean manufacturing. All transactions are waste. (Maskell 2000) Jerry Solomon points out that Lean accounting is an accounting system that minimizes the consumption of resources that add no value to a product or service in the eyes of the customer by utilizing the Lean tool kit. He then defines accounting for lean as An accounting system that provides accurate, timely and understandable information to motivate and support the Lean transformation throughout the organization and improves decision making leading to increased customer value, growth, profitability and cash flow. (Solomon 2006) The conclusion is that while, lean accounting was designed to support a lean manufacturing environment, it can and should become lean by using the same techniques that drive lean manufacturing. Another point to make. This paper is about management accounting, or accounting that is useful in the management of a business, as distinguished from financial accounting, the accounting necessary to satisfy external requirements of a business and that conform to FASB requirements. What are the drivers of lean accounting? Why is it necessary to invent a new management accounting system for lean manufacturing? Why are the existing accounting systems inadequate? The change to lean manufacturing requires a change from the batch and queue methods of the past to a flow along the value stream approach. It also requires a change from a transaction orientation to a process orientation. Because of these changes in the manufacturing processes, two major problems result. The transition to lean manufacturing results in a reduction of inventories. To increase the flow of goods along the value stream, much of the inventory that clogs that flow under the old batch and queue system has to be eliminated. Under absorption accounting, a reduction in inventory causes a reduction in income because the additional flow of overhead costs (which had been stored in inventory) now must be included as added costs in the income statement. This reduction in income leads many to conclude that lean manufacturing is ly increasing costs, not reducing it as expected. Some executives have stopped the transition to lean as a result, because the financial accounting results convey an unfavorable message to their stakeholders. Another problem occurs when the lean manufacturing process results in greater productivity and a reduced requirement for employees and an excess of equipment capacity. Because lean manufacturing usually involves the participation of employees in the improvement efforts, such as in kaizen blitzes, companies often promise that no layoffs will result from the improvements. Thus, Increased productivity, which would mean fewer employees, is stymied by the commitment not to reduce the workforce. The same is true if excess capacity is reported as a negative, as it is in some accounting systems. The operations manager, in trying to implement a valuable new improvement process, appears to be doing just the opposite. The answer is that the excess capacity, both employees and equipment, need additional volume of work to capitalize on the increased capability. Otherwise, there is no true improvement and no real reduction in costs. While a lean accounting system does not change the results described above, it attempts to highlight them to show that they are anomalies of the transition that must be worked through until a new equilibrium is established no further reduction in inventory and the utilization of the excess capacity.

3 How is lean accounting different from other accounting methods? How does a lean accounting system attempt to handle the problems outlined above? How does it do this differently from other accounting systems? Figure 1 shows a comparison of several different account systems. The diagram is necessarily simplistic, and is intended only to capture the major characteristics of each system. Theory of constraints accounting A cost and managerial accounting system that accumulates costs and revenues into three areas throughput, inventory, and operating expense. It does not create incentives (through allocation of overhead) to build up inventory. The system is considered to provide a truer reflection of revenues and costs that traditional cost accounting. It is closer to a cash flow concept of income than is traditional accounting. The theory of constraints (TOC) accounting provides a simplified and more accurate form of direct costing that subtracts true variable costs (those costs that vary with throughput quantity). Unlike traditional cost accounting systems in which the focus is generally placed on reducing costs in all the various accounts, the primary focus of TOC accounting is on aggressively exploiting the constraint(s) to make more money for the firm (Blackstone and Cox 2005). (variable) costing An inventory valuation method in which only variable production costs are applied to the product; fixed factory overhead is not assigned to the product. Traditionally, variable production costs are direct labor, direct material, and variable overhead costs. Variable costing can be helpful for internal management analysis but is not widely accepted for external financial reporting. For inventory order quantity purposes, however, the unit costs must include both the variable and allocated fixed costs to be compatible with the other terms in the order quantity formula. For make-or-buy decisions, variable costing should be used rather than full absorption costing (Blackstone and Cox 2005). Standard cost accounting A cost accounting system that uses cost units determined before production for estimating the cost of an order or product. For management control purposes, the standards are compared to costs, and variances are computed (Blackstone and Cox 2005). Absorption costing An approach to inventory valuation in which variable costs and a portion of fixed costs are assigned to each unit of production. The fixed costs are usually allocated to units of output on the basis of direct labor hours, machine hours, or material costs (Blackstone and Cox 2005). Activity-based cost accounting (ABC) A cost accounting system that accumulates costs based on activities performed and then uses cost drivers to allocate these costs to products or other bases, such as customer markets, or projects. It is an attempt to allocate overhead costs on a more realistic basis than direct labor or machine hours (Blackstone and Cox 2005). Resource consumption accounting (RCA) A dynamic, integrated, and comprehensive cost management system that combines German cost management principles with activity based costing (ABC). RCA is dynamic in that changes in the environment are reflected in the cost model in a timely manner. RCA is integrated with all relevant organization systems. RCA is comprehensive in that it focuses on resources but readily includes ABC, ABM, variable costing, absorption costing, costs, standard costs (set in a formal process), a complete set of segmented income statements, activity based resource planning, primary costs, secondary costs and more. RCA is typically applied as part of an enterprise resource planning (ERP) system effort to achieve the best combination of cost management principles implemented in an integrated fashion. (Clinton and Keys 2007)

4 Lean accounting An accounting system designed for lean manufacturing. The traditional accounting systems were designed for mass production, and lean thinking violates these rules. Lean accounting addresses these needs: (1) replaces traditional measurements with few and focused lean performance measurements that motivate lean behavior at all levels of the organization, (2) Identifies the financial impact of lean improvements and establishes a strategy to maximize these benefits, (3) implements better ways to understand product costs and value stream costs, and use this cost information to drive improvement, make better business decisions, and enhance profitability, (4) Save money by eliminating large amounts of waste from the accounting, control, and measurements systems, (5) frees up time of finance people to work on strategic issues, lean improvement, and to become change agents within the organization, and (6) focuses the business around the value created for customers (Maskell and Baggaley 2004). Each of the systems, except the traditional absorption costing system, presumes to operate under the banner of management accounting, or an aid to management. Each does it in a somewhat different way and with somewhat different objectives. What are the benefits of lean accounting? Lean accounting advocates list a number of benefits to using a lean accounting system. The first is that it shadows the lean manufacturing process so that it reports accurately what is happening on the shop floor. This is a valid claim, but only for those companies who have, or are, implementing lean manufacturing, a minority, at the present time. Closely allied to the first benefit is the design of the lean accounting system to collect information by value stream segment. Most other accounting systems collect cost information by department, and those departments have usually been functional entities. If the departments were organized by value stream, presumably other accounting system would be able to collect cost information accordingly. Lean accounting highlights the two problems described earlier the negative effects of inventory reduction and the availability of excess capacity. Although this could be done with other accounting systems, at least as an exception reporting, it is a primary feature of the lean accounting system. The claim that a lean accounting system makes accounting reports more meaningful to non-accountants echoes a claim that all management accountants make. When have management accountants not been trying to make their reports more meaningful? Perhaps the answer is to educate the non-accountants to understand accounting reports better. Lean accountants also claim to provide more current information to managers, presumably by reporting more frequently. This also suggests that more frequent reporting is available to any accounting system that wants to do it. The dilemma is that, no matter how quickly accounting provides feedback, it always lags results. Lean accountants make use of key performance indicators (KPI) that include physical measures that are more meaningful to managers hours and pieces instead of dollars. This capability is also available to other accounting systems. Maskell indicates that lean manufacturers need performance measurements at (at least) three different levels of the business: production cell measurements, value stream measurements, and company or plant level measurements (Maskell and Baggaley 2004).

5 Finally, lean accounting systems should reduce the need for reporting and analyzing measures of little value. This implies that, as operations become leaner, variances (not standard cost variances) in the product, the process, the employee, the equipment, and the demand are reduced. As a result, the results from the input of known quantities of materials and labor will result in a known output of goods and services. Control, often incorrectly attributed to accounting systems, is exercised at the point of expenditure, not after the analysis of accounting reports. As a result, lean accounting systems become themselves lean, or have a reduced content of non-value-added activities. Even some who support the need to change warn that management accounting sometimes make exaggerated claims. One author cautions that there are at least three claims that are not valid: (1) accounting is the problem (this comes from comparing lean accounting with absorption costing, a known liability in management reporting), (2) all conversion costs are fixed (the Theory of Constraints claimed this some time ago and even before that, direct costing advocates tried to distinguish between fixed and variable overhead costs), and (3) lean accounting can transform external reporting, too (this has not been established and besides, what would be the motive?) (van der Merwe 2007) What are the barriers to implementing lean accounting? Lean accounting systems face many of the same barriers that other management accounting systems have faced the infringement on the financial accounting turf! While it is easy to say that managers need better information with which to manage their operations, it is not so easy to gain acceptance that it should come at the cost of changing the traditional accounting systems that have withstood many attacks over the years. This carries with it the additional burden of overcoming the following requirements of the financial accounting system: Need to gain acceptance by FASB and other regulatory agencies Cost to change the accounting system Acceptance by the investing public, especially for public companies, if the changes are transparent In addition, there are a number of other requirements for internal acceptance. They include the following. The changes may not be meaningful, or even appropriate, to businesses who have not implemented lean manufacturing. Accountants must learn lean manufacturing, a major requirement for professionals who are already strained to keep up with changes within their field. There is a need, at least in the short term, for both internal and external reporting systems, despite those who favor a cold turkey approach in the transition. The ROI for changing the accounting system may be lower than for other projects; consequently, it may lag and create a dysfunctional situation. There will be a need to change the organization structure and culture in the move from a transaction orientation to a process orientation. Accountants will need to change from a control mentality to become enablers who help managers to understand the accounting implications of their actions. Accounting will lose some control over the planning, budgeting and evaluation process and will become co-participants in the management process with operating managers. The academic curriculum is slow to change their curricula and instructors may be loathe to change. The reverse could be true where academics could be a driver of change. The burden of overcoming these barriers to achieve limited benefits raises the question of Why bother? a question we will address at the end of this paper.

6 What is the likely future of lean accounting? Lean accounting is in the early stages of its life cycle and it is difficult to see if it will survive as a viable management program. It may not even be prominent enough to be considered a fad; certainly, it is a long way from being a fashion. Granted, it is in the early stages of being promoted and it is possible that it will gain wider acceptance by those companies who have, or are, implementing lean manufacturing. It does not appear likely that lean accounting will be a driver of change for companies to adopt lean manufacturing methods. Other accounting methods will continue in use at those companies, at least in the near term. Consequently, it is also not likely that lean accounting will revolutionize the management accounting field. While it has some worthwhile features, these are features that other management accounting systems can adopt. Two basic questions will become more apparent in the future. 1. Should accountants try to develop an all-encompassing management accounting system that provides all the benefits of existing management accounting systems and which integrates with the financial accounting requirements? 2. Should accountants leave the financial accounting system alone and develop a parallel system for use in planning, performance measurement, pricing and improvement that doesn t have to integrate with the financial accounting system? The Resource Consumption Accounting (RCA) model described briefly earlier may be an attempt to design the master combined management accounting and financial accounting system that is all things to all people. One challenge is how to design and implement such a system. Surely, it will have features built into the system that will not be needed by all businesses, creating in itself an excess capacity problem. The second challenge will be the implementation costs and time requirements, as well as the need to change organization structures and cultures. The third challenge will be how to use the system in an effective way. Will it be so complex that accountants will again face the problem of making it understandable to non-accountants? One of the early advocates of activity-based costing (ABC), F. Thomas Johnson, now says that an answer to the wrong question. The efforts should be directed to reducing or eliminating the overhead expense items, not measuring them more precisely. He now says that lean accounting faces a similar test. He reports that Toyota s long term financial results emerge from countless nonlinear feedback loops in a complex, self-adaptive, and self-corrective living system. This suggests that chaos and complexity theory are needed to adequately cope with the information management systems. He suggests that the emphasis should be on improving operations and that measuring and reporting results can be done with other approaches. The titles of a couple of his articles suggest his emphasis: Lean Accounting: To Become Lean, Shed Accounting (2006a) and Managing a Living System, Not a Ledger (2006). Johnson raises a valid point. Operating managers have long survived and even prospered without accounting systems as their primary source of knowledge. They have moved from the black book days when every supervisor kept a record of the KPIs that mattered, to today s more elaborate reporting systems. The progress to date may favor the second alternative listed above and reduce the pressure to discover the ultimate accounting system.

7 Management Accounting Methods Theory of Constraints Costs Standard Costs Activitybased costs Absorption costs Resource consumption accounting Lean accounting VS1 VS2 VS3 Costs included in Cost of Goods Sold labor - Variable overhead standard Variance labor - labor - labor - labor - standard Variance Overhead 1 Overhead A Variable and Overhead 2 Overhead B fixed Overhead 3 Variable and Overhead C overhead - Overhead 4 fixed Overhead D standard Overhead 5 overhead Overhead E Overhead 6 Overhead F Variance Overhead 7 Variance Procurement Conversion Distribution Support Inventory adj Overhead allocation basis labor labor labor Overhead assignment basis Cost driver Resource unit Process step Uses Product pricing - full Product pricing - incremental Value inventory Budgeting - financial Budgeting - operations Performance measurement Analysis and improvement Complies with FASB Figure 1. Comparison of Accounting Methods

8 References 1. Blackstone, John H. and James F. Cox, APICS Dictionary (11E), APICS, Alexandria, VA, Johnson, H. Thomas, Manage a living system, not a ledger, Manufacturing Engineering, 137, 6, 73, Johnson, H. Thomas, Lean accounting: To become lean, shed accounting, Cost Management, 20, 1, 6, 2006a. 4. Maskell, Brian H. and Frances A. Kennedy, Why do we need lean accounting and how does it work? The Journal of Corporate Accounting & Finance, 18, 3, 59, Maskell, Brian and Bruce Baggaley, Practical Lean Accounting, A Proven System for Measuring and Managing the Lean Enterprise, Productivity Press, New York, Maskell, Brian H., Lean accounting for lean manufacturers, Manufacturing Engineering, 125, 6, 46, van der Merwe, Anton and Jeffrey Thomson, The lowdown on lean accounting, Strategic Finance, 88, 8, 26, van der Merwe, Anton and David E. Keys, The case for resource consumption accounting, Strategic Finance, 83, 10, 30, Womack, James P., Daniel T. Jones, and Daniel Roos, The Machine That Changed the World, The Story of Lean Production, Rawson Associates, Macmillan Publishing, New York, 1990.