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Orry Fiume

Orry Fiume: Rather than cost accounting, look out for cash improvement

By Orry Fiume, - Last updated: Tuesday, January 18, 2011 - Save & Share - Leave a comment

This is a question that has been asked in every Lean Accounting workshop that I have conducted over the past 10 years.

Probably the single biggest reason why we can’t see the gains in the Profit Statement is because most companies still use full absorption standard cost accounting.  In this system any deviation from standard is treated as a variance. As we implement Lean we satisfy some of our current demand from existing inventories, resulting in improving inventory turns…which is a good thing.  However, since our people are not producing product, by design, that shows up in the financial statements as unproductive labor and unabsorbed overhead…both looked upon negatively.  Companies that abandon standard cost accounting and adopt Lean Accounting begin to see their actual costs and can see the benefits as they are achieved.

So, what are those benefits and how do they show up in the financial statements? Some of these benefits show up in the financial statements relatively quickly and others, the more significant ones, over the long term.

The “benefit” that most people expect to see quickly is the result of productivity gains.  They do a 5 day kaizen event and hear of 50%, or more, of productivity increases at the Friday report-out meeting…e.g. we use to have 8 people in this area but now need only 4. And management expects to see the benefit of this in next month’s profit statement.  However, if the company is approaching the Lean transformation properly it has given all employees the assurance that no one will lose their employment as a result of improvement activities.  Thus, the four “extra” people have been redeployed somewhere else in the business and are still on the payroll resulting in no overall improved profit.  When we create productivity gains we have only created the potential for improved profitability.  And it will remain as only potential until management does something to “actualize” those gains.  Some of the things that can be done are:

–    Increase sales: this is the best way to actualize productivity gains.  It uses the freed up capacity (the four “extra” people) to satisfy the increased demand resulting in increased revenue without increased labor cost.  The benefit here tends to be in the long-term category for most companies.
–    Reduce overtime: if the company is experiencing overtime in some part of the business the four “extra” people can be redeployed to avoid this expensive form of labor cost.  This benefit is relatively immediate.
–    Hold on to attrition:  As people leave the company due to retirement, quitting or death, don’t replace them.  Depending on the natural attrition of the business the financial results of this benefit could be either short or long term.
–    In-sourcing:  If the company is out-sourcing something that it can do for itself then insourcing transfers all of the value added of the in-sourced products from the vendor’s P&L to their own.

Other Long-Term benefits:
-As we free up space we create the capacity to grow without adding new buildings.

-As we improve safety we reduce workers compensation costs.

-As we reduce movement we eliminate forklift trucks and their related operating costs.

-As we improve quality we reduce warranty expense.

-As we reduce inventory we have less working capital to finance, thus saving interest expense.

-As we become better able to produce to only actual customer demand we reduce obsolescence.

Although some of these benefits will result in actually reducing current costs, most of them are longer term in nature.  In effect, the focus on “eliminating waste” results in freeing up existing resources (i.e. freeing up capacity) so that we can grow the business without adding more resources.   We need to look at the long-term financial benefit of Lean as reducing cost as a percentage of sales. At Wiremold we were able to add 13 percentage points of gross profit over ten years. Although some of that was due to actual cost reductions, most was due to being able to grow the business without adding people or machines.

And Now The Single Largest Short-term Gain:  increased cash flow due to reducing inventories.  This happens relatively quickly but is generally ignored because we have been conditioned to focus on bottom line profit only.  Working Capital management is virtually ignored.  How many executive compensation formulas include working capital improvements?  However, it is cash flow that keeps a company alive.  A company can show an accounting “loss” for many years as long as it maintains a positive cash flow.  Always remember, profit is an opinion, but cash is a fact.

How does Lean relate to Toyota’s Cost Planning?

I can’t speak to this directly, however in the early 1990’s I participated in a study group that went to Japan to study Target Costing.  One of the companies we visited with was Toyota and they confirmed that they used Target Costing, but didn’t tell us much more than that.  Other companies were more forthcoming.  Target Costing is a cost planning tool for new products whereby a target cost is established at the beginning of the new product development process.  This is a cost that will yield a desired level of profit and it becomes an integral part of the product specification.  Thus, the product design engineers are designing for fit, form, function and cost.

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