Traditional Accounting Systems -- They Don't Properly Value Time

Lean advocates have long been critical of the fact that traditional accounting systems motivate over-production and promote building inventory. In her book, The Monetary Value of Time: Why Traditional Accounting Systems Make Customers Wait, the author, Joyce Warnacut, discusses the fact that traditional accounting systems don’t properly value time. I asked her directly: "How is this different from the Lean perspective?" and here is her complete response:

Lean objections are based on the fact that absorption costing requires overhead allocation. The cost per unit is driven down by making more and spreading the cost over a larger number of units. H. Thomas Johnson (Professor of Business Administration, Portland State University) wrote the following in his article Work Lean to Control Costs: “Producing more and more output to reduce average unit costs is a time-honored pathway to excess, delay, and abnormal variation – prime drivers of higher total cost.”

These concerns are valid, and yet the total impact of traditional accounting goes far beyond overhead allocation. The matching principle, one of the foundations of traditional accounting, requires matching of production cost to revenue. This means that if you spend $1,000 making a product this month, but don’t sell it until next month (or next year), the matching principle requires you to stash $1,000 away in inventory. This puts the $1,000 on your balance sheet as an asset and keeps $1,000 in production costs off your profit and loss. The $1,000 will be recorded as a cost of sales at the time the product sells (i.e., the cost will be “matched” to the revenue).

Note that the $1,000 cost – and the resulting profit from the transaction – is exactly the same whether the product sells today or several months from today. Is this true? Inventory costs (storage, handling, carrying costs, planning, expediting, moving, counting, potential obsolescence, etc.) are allocated in some fashion over production. The allocation may be as simple as units or hours (volume-based allocations are by far the most common) or a more complex allocation formula.

But no matter what formula is used, the cost recorded for that particular product is the same whether the product is sold immediately or held in inventory for months. Intuitively, most people would think that product sold directly off the production line contributes more to the bottom line than product that is carried on the books for a month or more. From an accounting perspective, however, this is generally not the case.

Resources that are invested in inventory are valued no differently than resources invested in product that can be converted to cash immediately. What if our accounting methods put a value on time? What if product cost increased for every day the product was held in inventory? What if our shop floor operations were evaluated based on how quickly they turn orders into cash? What different motivations might this create? What changes would be made in how we allocate resources?

Although accountants recognize the time value of money when comparing investment alternatives, the same principles are not applied in how we value inventory, how we allocate resources, nor in how we evaluate the profitability of our products. 

What do you think of Joyce Warnacut's perspective here? Does your organization function under a traditional accounting system? Have this system undercut the true value of your Lean initiative?

Chief Financial Officer (CFO) = Lean Architect

Nick Katko recently published a book titled The Lean CFO: Architect of the Lean Management System, and it fully explains why chief financial officers (CFOs) must rethink their traditional management accounting systems. During a recent conversation, I explicitly asked him: "What are the basic reasons why a CFO, who works for a company engaged in a Lean Initiative, must become a Lean CFO?" Here is his complete reply: 

Lean is a money-making business strategy. Companies that adopt a Lean business strategy are successful because they accomplish two tasks very effectively. First, they employ Lean practices everyday, everywhere, all the time. On a daily basis, the Lean company focuses on three tasks: delivering value to its customers, flowing all business processes, and relentlessly eliminating waste. Second, the leadership of the company clearly understands exactly how Lean makes money and communicates the link between Lean practices and more profits to every employee in the business. They understand the economics of Lean. 

The economics of Lean can be explained in basic terms of supply and demand. Let’s look at demand first. By focusing on creating and delivering customer value, the demand for your company’s products or services increase and you command better prices. Financially, this means the growth rate of your revenue should increase compared to your historical growth rate and should be better than industry averages. 

The supply side of the equation focuses on your supply of resources. Your supply of people, machines, and facilities are responsible for creating and delivering customer value. By focusing on creating flow and continuous improvement, the productivity of your resources will improve dramatically. Using Lean practices to create flow means that resources will maintain productivity levels regardless of short-term fluctuations in demand. Continuous improvement practices mean that the productivity of your resources will achieve consistent annual improvements in productivity of 10% to 20%. 

The financial impact of maintaining and improving your resources’ productivity is that the rate of increase in the cost of those resources (i.e. your operating expenses) will slow down and be less than the growth rate of your revenue. The difference in growth rates between revenue and costs means your company will make tons of money with lean. 

So where does the CFO fit into all of this? As CFO, you chart the financial strategy of your company. Whatever the business strategy, you need to project the financial impact of the proper execution of the strategy. You also have oversight of the management accounting system: the measures and methods that are used internally to measure how well a company is performing at any time. How you present the financial benefits of Lean and how you determine how to measure it will be the determining factor of whether a company adopts Lean as the business strategy or thinks of lean as “part” of a business strategy. 

As the Lean CFO, you need to understand the economics of lean so that you can align the financial strategy with how Lean makes a company money. You must make the necessary changes to financial measurement and reporting systems to measure the execution of the Lean business strategy. I believe this is the single most important factor that prevents companies from realizing the true financial potential of Lean. Your ability to translate the language of lean into the language of money will make it clear to everyone in your business why the proper implementation and daily execution of lean practices are necessary. 

As the CFO, you are the resident expert (and owner) of the measurements. It is very important for you to change the financial and operational measurement system so that the measures drive Lean behaviors. Traditional measures, of course, will drive traditional behaviors. That is what they are designed to do. But these traditional measures will obscure and undermine the vital changes required by the economics of Lean. 

If you change to a Lean business strategy, you cannot account, control, and measure it using the old methods. The most important contribution of the CFO is to lead these changes. To go Lean, you must understand how the principles of Lean create the economics of Lean. 

What do you think of Nick's perspective? How does your company measure its manufacturing practices? In your company, has the CFO directly supported or unknowingly hindered the the Lean initiative?