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Lean manufacturing and lean accounting go hand-in-hand

Many companies have adopted lean manufacturing to reduce costs and increase efficiency. But traditional accounting procedures don't measure up.

Many companies have adopted lean manufacturing in their plants to reduce costs and increase efficiency. Traditional accounting procedures, however, often fail to recognize the improvements and sometimes even see the changes as detrimental to a company's financial performance.

Lean manufacturing focuses on eliminating waste, defined as anything that doesn't add value. The lean culture recognizes eight kinds of waste: over production, inventory, defects, waiting, transportation, motion, over processing, and underutilizing people and skills. Although many of these wastes have a direct cost correlation, the total effect of a lean transformation can escape the notice of traditional accounting measurements. Let's look at areas where traditional accounting doesn't accurately measure the effects of lean manufacturing.

Measuring the effects of lowered inventory accurately

Lean manufacturing discourages over production -- making any more of an item than is strictly needed at the time. Small lot sizes are encouraged, and equipment utilization is not a concern. Unfortunately, traditional accounting measurements see smaller lot sizes and idle machines as detrimental. In the lean view, making more than is needed right away increases inventory and makes parts and products that may not be needed if demand changes or the product becomes obsolete. Running equipment just to keep utilization high consumes parts and materials that might be needed elsewhere and adds value to inventory that will sit, awaiting a need.

Lowered inventory is a major benefit of lean manufacturing, but the effect of the improvements can look like a decrease on the bottom line as labor and overhead previously incorporated in inventory now becomes an expense, lowering profit.

In the best of situations, the equipment and labor freed up by smarter utilization becomes available for additional production. If demand is insufficient to keep everyone and everything busy under the new lean approach, rates might have to be adjusted to fully recognize production costs based on lower expected utilization.

Overhead must be viewed correctly

In most manufacturing operations, overhead is applied as a rate per hour of labor or a rate per hour of machine time. Often, the overhead rate greatly exceeds the actual labor rate. Overhead at 150% of labor, 200% of labor, or more is not uncommon. As a result, labor is given a much more significant value in cost-of-goods than it deserves.

When a lean initiative increases efficiency and reduces labor required to make a product, overhead absorption also falls so the product cost is reduced. Therefore, these more efficiently produced products may be under-costed compared to other products and to previous estimates of product cost.

Lean manufacturing is all about doing more with the same resources, not doing the same with less. The labor saved on existing production should be applied to increased throughput without increased hiring or investment. If that doesn't occur, and less overhead is absorbed into the existing products, rates must rise and the whole valuation process has to recycle and management decisions re-evaluated in light of changed product costs.

Lean accounting principles provide the answer

Alternative accounting concepts, often called lean accounting, are evolving to meet the challenge. What is probably the most significant aspect of lean accounting is a shift from the traditional departmental view of costs to a value stream orientation. The value stream is the flow of activities required to transform materials into a product. The value stream crosses department boundaries. This allows a more defined view of costs as they are incurred for a specific product but it poses difficulties for accounting because some indirect costs may not be captured by product, so determining total cost and margin is problematic. The value stream approach works better for operations, however, because costs are tied directly to the activities and expenses that operations has control over, making operational management more aware of the financial impact of their actions.

Because of these divergent needs, companies moving to lean manufacturing supplement the company's standard financial statements with additional information, compiled using the value stream approach, to recognize improvements and give functional managers a clearer picture of operations. The cost information to support both approaches is usually available in the existing accounting system.

Even though the lean accounting approach is complete and GAAP compliant, companies are understandably reluctant to change accounting procedures and the transition away from traditional processes and reports can be difficult. Lean companies must be able to recognize the new reality of lean operations and be on guard for misleading results in traditional accounting measurements. If compiling and using two different views of financial information is required to do that, then a dual system will suffice. Appropriate application of lean accounting to management decisions must take priority, however, if a company is to see the full effect of going "lean" and make valid decisions on future lean initiatives.

Next Steps

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