Start Thinking About Your Financial Accounting System

As companies recognize the benefits of Lean Manufacturing and begin to implement lean strategies within their organization, they soon realize that their existing financial accounting systems do not effectively support a lean enterprise. Even worse, sometimes traditional standard cost-based financial accounting systems make it appear that the improvements credited to the lean program are doing nothing for the “bottom line”.

In this month’s column, I will not attempt to advise you on how to set up and manage an appropriate financial accounting system. I will leave that to qualified financial accounting professionals such as Modern Machine Shop’s own Irving Blackman, or Brian Maskell, President of BMA Inc. (www.bma.com). What I will try to do is convince you to start thinking about your current financial accounting methods and point out some areas in which they may be falling short.

Lean Manufacturing is a philosophy that employs a group of tools to eliminate or reduce waste. There are numerous wastes evident in any manufacturing company, including: overproduction (making more than can be immediately used); overprocessing (doing more to a part than the customer requires and is willing to pay for); excessive inventory (anything more than the right amount needed to complete a job); excessive product movement (transporting parts throughout a factory to get from one process to the next); excessive people movement (walking around while looking for supplies, materials, tools, equipment and paperwork); and more. As we start to reduce these wastes, we expect to see a positive financial impact, yet this is not always the case. This is because a standard cost-based financial accounting system, which is still used by many manufacturers today, focuses on earned hours of labor. Direct labor costs, such as time spent machining a part, are closely measured, while all other costs, such as setup time, are grouped together as overhead and added to (or in financial terms absorbed by) these direct labor costs. In a standard cost-based financial accounting system, the fastest way to see bottom line savings is to reduce the direct labor cost. Yet, lean directed improvements often do not reduce direct labor times (the only true value-adding times in a manufacturing process). Instead, lean initiatives tend to focus on all of the “other” time (the non-value adding time) because it represents a much larger portion of overall time spent in the organization. By some accounts, “other” time can be as much as 99 percent of the time a product spends in the factory.

So if a standard cost-based financial accounting system focuses only on the small percentage of direct labor time, how can it provide useful information related to the “other” time savings we are achieving? The short answer is that it cannot. In fact, using this type of system can even lead to wrong decisions, especially when it comes to comparing outsourcing (or offshoring) costs to in-house production costs. A standard cost-based financial accounting system can even hinder a company in its efforts to get rid of unneeded inventory (a desirable outcome of lean strategy). As all inventory is considered an asset, if some of this asset (which is doing no more than taking up valuable space) is eliminated, a company’s profit picture can actually appear to get worse. We must also keep in mind that a standard cost-based financial accounting system tends to focus on short-term cost reductions, which may run counter to a well-thought-out lean strategy.

Another thing to consider regarding your current financial accounting system is the amount of time and effort expended just to maintain the system. There are very real costs associated with processing and reviewing the many types of transactions that support the system. How much time do you spend capturing, reviewing, and explaining direct labor hours, absorption rates, inventory levels and more? How much of this time is truly value adding?

What is needed is a better financial accounting methodology to identify the financial benefits of our lean improvement efforts. We know these efforts will result in shorter leadtimes, improved on-time delivery performance, increased first pass yield rates, less scrap and rework, reduced inventory, and less unproductive machine time (creating more time to do other things). We need a financial scorecard that will account for these real improvements and show that we are not only satisfying our customers better, but truly making money doing so.