Lean Accounting and Generally Accepted Accounting Principles

In the context of applying Lean Accounting in manufacturing companies, there have been some arguments that Lean Accounting practices do not comply with Generally Accepted Accounting Principles (GAAP). I decided to write this blog to try to explain from a GAAP perspective, how and why Lean Accounting does comply.

This is a long blog. I considered splitting this up into a series of blogs, but decided otherwise.

The arguments as to why Lean Accounting doesn’t comply with GAAP usually are made around the methods used in Lean Accounting to value inventory and cost of goods sold and how different these methods are from conventional practices.

Conventional inventory valuation is usually done using an ERP system. Here is a simple explanation of how this works. ERP production reporting systems track the movement of materials from receipt, through the production process and finally to shipment. These ERP systems allow for a cost to be assigned to each item in a company’s inventory item master. When costs are assigned, the inventory movement transactions also values inventory and cost of goods sold.

Most of the time a “standard cost” is assigned to each item in inventory, which is why this type of inventory valuation is simply called “standard costing.” And for the sake of simplicity, I’m going to use the term “standard costing” when referring to these conventional inventory valuation systems.

Lean companies using Lean Accounting take a different approach to inventory valuation. Lean Accounting is concerned primarily with the total value of inventory on the balance sheet, rather than the specific value of each individual item held in inventory. Lean Accounting simply employs the “leanest” method possible to value inventory.

Let’s first look at what accounting principles require in regards to inventory valuation, then we will discuss how Lean Accounting complies with all accounting principles.

The valuation of inventory and cost of goods sold is one of most important issues for financial reporting because it is material to the proper determination of income. Inventory valuation is one of most unique components of accounting because GAAP requires companies that carry inventory to capitalize a portion of production costs into inventory to determine the proper reporting of income.

Here is what US GAAP states (note: International Financial Reporting Standards basically say the same thing): “Inventory has significance because revenues may be obtained from its sale. Normally such revenues arise in a continuous repetitive process of cycle of operations in which goods are acquired, created and sold, and further goods are acquired for additional sales. Thus, inventory at any given date is the balance of costs applicable to goods on hand remaining after the matching of absorbed costs with concurrent revenues. In practice, this balance is determined by the process of pricing articles included in inventory.”

What this means in layman’s terms is that a portion of a company’s expenses are moved from the income statement to the balance sheet. Expenses are reduced and this increases profits. So it’s easy to understand how important inventory valuation is for financial reporting.

GAAP Requirements

There are two issues related to inventory valuation – the value of inventory on the balance sheet and the determination of cost of goods sold.

GAAP states that inventory must be valued at cost, which is the same as all other assets on a balance sheet. Cost is defined as the actual expenses incurred to get goods (products that are sold) in condition for sale. These expenses are the actual cost of materials plus a portion of the actual costs of production. GAAP also recognizes the inherent complexity of inventory valuation: “it is understood to mean acquisition costs and production cost, and its determination involves many considerations.”

Proper valuation of cost of goods sold is related to the matching principle, which states that all expenses recognized in any period should be the expenses incurred to generate the revenues recognized. Because cost of sales is often times the largest expense on the income statement of a manufacturing company, it is material to the proper determination of income. GAAP states this as follows: “A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues.”

The issues in a manufacturing company in determining cost of goods sold are related to continuous nature of manufacturing. Products produced in one period may not be sold until a subsequent period. The prices paid for purchased items may change. And finally, actual production costs change over time. This makes matching the specific, actual production costs to the revenue reported quite difficult.

GAAP recognizes that calculating the exact, specific cost of an item in inventory and cost of goods sold really cannot be done because of the timing issues of good produced and sold, material costs changes and determining the exact manufacturing costs incurred for goods in inventory. ASC 330 states: “although the principles for the determination of inventory costs may be easily stated, their application, particularly to such inventory items as work in process and finished goods, is difficult because of the variety of considerations in the allocation of costs and charges.”

To overcome this problem, GAAP allows companies to use a cost flow assumption to value inventory and cost of goods sold in a consistent and systematic manner that best reflects income.

Companies must use a consistent method over time, which means a company can’t simple switch cost flow assumptions year-to-year. If a company changes its cost flow assumption it is considered a change in accounting method and must be disclosed in audit reports.

 

There are 4 cost flow assumptions that can be used: FIFO, LIFO, average cost or specific identification. FIFO (First-in-First Out) means the most recent costs are assigned to ending inventory. LIFO (Last-in-First Out) means most recent costs are assigned to cost of good sold, which usually results in less income reported than under FIFO. Average cost means that inventory and cost of goods sold are valued at the average costs of all goods available for sale. Specific Identification means a company can accumulate the exact, specific costs of each item in inventory, which is rare but possible if a company doesn’t have many different types of products it sells. (Note: IFRS does not allow the use of LIFO, which is one of the most significant differences between it and US GAAP. There are currently discussions going on about how to basically merge US GAAP with IFRS and have one worldwide set of accounting standards.)

 

By consistently applying a cost flow assumption to value inventory, it will also mean that cost of goods sold is also properly stated.

This is because cost of goods sold is really the difference between goods available for sale (beginning inventory + purchases) and ending inventory. Here is the method to determine cost of goods sold, based on the following equation:

 

Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold

 

  1. Beginning inventory in any period is known, and would be properly valued using the cost flow assumption.

 

  1. Purchases in any period are known and it’s easy to determine the value of purchases in any period.

 

  1. Ending inventory based on the cost flow assumption. The capitalization of production costs between the balance sheet and income statement is adjusted at the end of each period based on the change in inventory quantities during the period

 

  1. Cost of goods sold is then considered correct because the other 3 components of the equation are correct

 

What the accounting principles mean in practice is that as long as a company’s method of inventory valuation approximates cost, and is applied in a consistent manner, the company’s financial statements are compliant with GAAP. Determining if inventory approximates cost and is applied in a consistent manner is usually determined by the company’s outside auditors, who will issue an unqualified opinion on the financial statements.

 

During the audit, the auditors will test company’s inventory valuation methodology to determine if it approximates cost. If it “passes” the audit tests, inventory is considered properly valued. If the tests are “not passed” the auditors will tell the company what adjustments need to be made to “pass” the test.

 

How Lean Accounting Complies with GAAP

Lean Accounting uses the cost flow assumption of average cost to value inventory and cost of goods sold. Accounting principles require inventory to be valued at cost, which is composed of the cost of material and a portion of the production costs. Let’s look at how Lean Accounting calculates average material costs and average production costs.

 

Calculating average material cost is dependent on three factors: the number of purchased items, price stability and rate of flow of materials.

 

For a company with thousands of items calculating the average material cost per unit should be done at either the individual item level or by common product families. A company with few items of purchased raw material or components can do an overall average material cost.

 

For stable material prices, the average cost may be calculated less frequently (annually or semi-annually). In cases where material prices are highly volatile, the average cost may have to be calculated more frequently, such as monthly.

 

The final factor in calculating average material cost is the rate of flow of materials, which is typically measured in days of inventory. The rate of flow helps determine which costs to average. For example, a company has 30 days of inventory on hand this means, on average, the inventory was purchased in the last 30 days, and average cost would be calculated based on cost changes over the last 30 days.

 

The actual mechanics of calculating the material value of inventory is usually dependent on the number of purchased items a company has in its inventory item master. For companies that have hundreds or thousands of purchased items, it’s probably easiest to maintain the quantities of these items in your ERP system. In the cost field for each item the average cost will be entered, rather than a standard cost that remains frozen for one year.

 

For companies with few purchased items a simpler method could be employed.

 

  1. All purchases are recorded as expenses in the period (to cost of goods sold).
  2. At the end of each period, the ending inventory value of material would be calculated as follows:

 

Finished Goods = quantity on hand X average cost per unit

Work in Process = quantity on hand X average cost per unit X average % complete.

  1. Adjust material value on the balance sheet to ending inventory using a journal entry

 

The capitalization of production costs can be done at a macro level, in total using a journal entry, rather than item-by-item, regardless of the number of items of inventory.

  1. Average cost per unit for the month is calculated using the actual production costs (all costs but material) from the value stream income statement divided by the actual units produced.
  2. The amount of production costs that need to be capitalized as ending inventory is calculated as follows:

Finished Goods = quantity on hand X average cost per unit

Work in Process = quantity on hand X average cost per unit X average % complete

  1. Adjust inventory production cost value on the balance sheet to ending inventory value calculated in #2 above using a journal entry.

 

As stated earlier, determination of a “consistent method” that “properly reflects income” is really up to the company and its auditors. As long as the auditors are OK with the inventory valuation methodology, it meets GAAP requirements. The key is to understand what type of cost flow assumption is being used.

 

Benefits of Lean Accounting Inventory Valuation

 

The process of inventory valuation is simpler, easier and much waste is eliminated under Lean Accounting compared to conventional product costing methods.

 

There is much less maintenance of costs in Lean Accounting as compared to other methods. The average material cost is relatively simple to calculate and probably doesn’t need to be updated too often unless the material is a commodity. The process of calculating standards and analyzing actual to standards can be eliminated.

 

In standard costing systems, production costs are gathered item by item using labor and overhead rates. Every time a finished good is completed, its labor an overhead costs are capitalized into inventory. And when a finished good is sold, its cost is transferred from inventory to cost of goods sold. Since Lean Accounting calculates capitalized production costs at a macro level all labor and overhead rates can be set to zero, as they are no longer needed.

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The Best Performance Measure for the Manufacturing CEO

If you are a CEO of a manufacturing company with many value streams, it’s impractical to think that you have the time to review all the performance measures of every value stream in your company. Yet you need to know the operational impact of Lean on your entire organization.

The traditional solution to this issue is to roll-up or aggregate measures so the CEO sees just a few numbers to get a pulse of performance. However, rolling up value stream measures doesn’t work because the aggregation of value stream measures really doesn’t mean anything. Each value stream is really a separate business unit with different products, customers and operational issues. Because each value stream is an independent business unit, performance should be measured against future state targets, which may be different for each value stream.

What I tell manufacturing CEO’s and executive a management team is to focus one measure – Flow, as measured by inventory days or inventory turns. I believe this is the best indicator to let the CEO the effectiveness of deploying and using lean practices, tools and methods.

When a company commits to a lean business strategy, it means that Pull Systems will be used to manage inventory from suppliers, through production to the customer. Traditional companies employ many methods to “manage” inventory. Lean companies employ Pull Systems to minimize inventory throughout the business. If your company does replace traditional inventory management methods with Pull Systems, Inventory Days will go down significantly.

What I’ve seen in many companies is that they are selective in how they apply Pull Systems in their business. The initial focus is usually reducing work-in-process inventory in production. From a lean viewpoint, this is not too difficult to do. But many companies stop here and claim “victory” over inventory. But you as the CEO see that total inventory days for your company is not going down.

The real inventory problems in many larger companies are raw materials and finished goods. And I think the primary root cause of these problems is functional silo thinking in companies. Let me explain.

Purchasing or Supply Chain typically controls Raw Materials inventory. In a functional environment, Supply Chain leadership may focus their performance measures solely on their function. This is why many larger companies still use Purchase Price Variance as a performance measure. The focus on PPV is simple – the job of Supply Chain is to reduce material cost. The result is a Supply Chain function that is disconnected from Operations. In a Lean company, Operations is the customer and Supply Chain is the supplier. Supply Chain’s job in a Lean company is to create Pull Systems from suppliers to operations and minimize raw materials inventories.

Marketing and/or Sales typically control finished goods warehouses. In many larger companies, these warehouses are regional distribution centers that are supplied finished goods by many factories (which in fact may be very Lean). In a functional environment, Marketing/Sales is concerned about availability of finished goods, so it plans finished goods levels based on sales forecasts. These sales forecasts end up driving production in the Lean factories because the distribution center places orders to factories. The result is high levels of finished goods.

There is not one solution to reducing finished goods in warehouses controlled by Sales & Marketing. Creating a Pull System from finished goods warehouses back to Operations one step. As orders are filled from a warehouse, it should send a signal back to operations to replenish the warehouse. Orders should not be placed based in forecasts.

 

Another step in reducing finished goods is changing the way Sales & Marketing plan finished good levels. Finished good requirements should not simply be based on a sales forecast, because that is simply an estimate of what the company wants sales to be. Lean companies plan finished goods inventory levels based on a combination of forecasts, lead times and safety stock.

 

The final step to reducing finished goods is what I mentioned a few paragraphs earlier – create effective Pull Systems from your suppliers through Operations to your warehouses. The faster you flow materials, the less inventory you will need.

 

If you are a CEO of a Lean manufacturing company, you should see significant reduction in Inventory Days. Figure it takes about one year to introduce Lean to a small company, or a division of a larger company. In first year, there is focus on training, education and getting Pull Systems in place. After the first year, you should start to see reductions in Inventory Days of 20% or more per year. This means by year 3 or 4 your inventory should be about 50% less than what it was when you began the Lean journey. If you are not seeing this, your company is not employing lean practices they way they were meant to.

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Audit Costs Bleeding You Dry? Can Lean Help?

By Richard B. Palanzi

First a note from Brian Maskell: I’d like to welcome a new Guest Blogger. Mr. Richard B Palanzi is a lean expert, black belt, experienced finance professional, and a consultant with Mindfulness Management. Richard’s view of auditing is innovative and refreshing. Please give us your comments and ideas.

Wealthy Senior Man Upset by Tax BillNobody likes audits. They are costly, involve a lot of work, don’t add value for the customers. Yet all companies have to do them. From a Lean point of view, we think of them as “necessary waste.” Even if we cannot eliminate them entirely, what if companies could figure out ways to cut this waste and minimize audit costs?

Consider the potential bottom line impact of the value-added projects these internal resources could otherwise be supporting if the external audits were completed with greater speed.

Here’s Some Background

External audits are expensive and their costs are rising annually. In October of 2014, FEI (Financial Executives International www.financialexecutives.org ) released the findings of its annual “Audit Fee Survey.” Here is an excerpt from this report:

Public and private companies which responded, as well as non-profits, saw an overall increase in their audit fees in 2013 over the previous year. Public companies paid on average $7.1 million in audit fees. The number of audit hours required for a public audit averaged 17,525; which is estimated to be an average of $249 per hour. Privately-held company respondents in 2013 averaged $174,858. The number of audit hours required for a private company averaged 2,927 hours, estimated to be $179 per hour.

Complex business processes and related transactions are one driver of external audit costs. Ask yourself, how and why is this case?

  • Certain steps in processes will create business transactions. Some classes of transactions are processes in and of themselves, such as the Purchase to Payables process. Manual, automated, and everywhere in between, these processes may be completely internal to an organization, exist between separate entities of an enterprise or involve external parties. Many of these business transactions result in one and often many accounting transactions.
  • Accounting transactions and related accounting processes are what external auditors have to examine. The goal of internal management oversight, internal audit and external audit activities is to prevent, identify or correct any material misstatement possibilities as a result of transactions or accounting practices which might be wrong, missing, or incomplete – whether made so deliberately or accidentally.
  • External auditors employ sampling techniques, whereby they may evaluate less than 100% of the items within an account or class of transactions as a way to understand the nature of the entire account or class of transactions. Auditors will pull a random sample of a specific type of transaction, examine those, and draw conclusions about the quality of the information and controls. In performing an audit, auditors must be able to drill down to the source of each piece of data generated by a transaction (the audit trail). This process can be very time-consuming for external auditors and for internal accounting and business staff as well.

Here’s Where Lean Comes In

Lean initiatives often result in processes with fewer steps, thus fewer transactions.

If, as a result of a successful Lean initiative, the number of business transactions is reduced, it follows that the number of accounting transactions will be reduced. This happens because Lean visual controls work better and naturally improve control while cutting transactions. Kanbans that control inventory movement are an example of this.

When transactions are reduced, the samples which external auditors draw from certain accounts or classes of transactions to be audited will also be reduced. This results in reduced external audit cost.

In addition, internal accounting and business operations resources are allocated to the audit process. Not having to dedicate so many hours of internal resources to audits means you can use this resource differently.

Perhaps reduction in external audit costs alone would not be the impetus driving enterprise wide Lean implementation. But I believe this potential cost reduction just scratches the surface. I believe there are other potential benefits and opportunities to be realized when Finance and Accounting teams prioritize continuous improvement of their processes as an important component of any Lean initiative.

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