Do You Think Up & Down, or Do You Think Horizontally? It Makes All the Difference for Lean Success.

Lean management is simple to a grasp and understand, but many find it difficult to apply in their companies. I am sure there are many and various reasons, but simply put; lean requires almost everything to change, and change diametrically. In order to become a truly lean company your leaders and employees must learn to think differently.

This article is the beginning of a series that will show how to develop a truly Lean Management System.  We are starting with the fundamental Lean Thinking.  Here’s the big-picture diagram.

Lean Mgmt System Diagram-2 (1)
     I know you are looking for practical things.  And the way your leaders and peers think about their work is very much practical.  It governs their behaviors.  We must create lean behaviors so that lean things happen throughout the company.

Here’s some examples:

1. Traditional companies create vertical organizations with executives housed in distant and unapproachable offices. The hierarchy has independent specialist departments that are coordinated to support a wide range of products, processes, and services.

Lean companies organize themselves around horizontal, customer-focused value streams staffed with all the skills needed to give exceptional customer value. Executives and leaders spend much of their time at the value streams where the value is created.

2. Traditional manufacturers seek to build large batches of product so as to achieve “economies of scale” by calculating “economic order quantities”.

Lean companies strive to make products one at a time using single piece flow. Similarly, make-to-order job shops use project planning tools to achieve efficient production. Lean companies use pull systems with frequent visual planning and non-stop flow.

3. Much of the executive talk in classic western companies revolves around the stock price, and these numbers are posted in the newspapers and discussed endlessly by TV pundits.

Executives in lean companies focus their attention on the value created for the customers. This does not mean that stock price is unimportant; it just means customer value is more important.

      These different ways of thinking must be the foundation of our Lean Management System.

While lean methods are easy to understand, they require different ways of thinking. Many company leaders have gained their success and seniority using the old thinking. It would be natural for them to be hesitant. Yet to gain the astounding success lean companies achieve, we are required to think “leanly”.

These are the five fundamentals of Lean Thinking†.

Five Lean Principles for Blog

These principles are aspirational. They drive all lean change and improvement. Many companies (probably most companies) think of lean as a series of shop-floor tools and methods. Bad mistake. Lean is the outworking of these principles. We develop tools and methods to make us better at doing these five things.

A vital part of building a Lean Management System is making an about-turn in your company’s thinking. If everyone can (over time) learn to think around these lean principles, your management system will have a firm foundation.

HOW IS THIS DONE?
These kind of changes must be done by the company leaders. If they change their thinking and behaviors then everyone else will understand the change and will be able to safely follow.

A good starting point is to develop an A3-style document showing the “current state” of the company’s thinking. The “future state” will show the actions coming from lean thinking. The company leadership team will then develop the steps needed to adopt these fundamental changes. One common output of this is to write (or re-write) the company’s Values, Principles, and Behaviors. These provide tangible instructions on how to act, to relate, and to make decisions.

GET MORE INFORMATION.
1. Videos of the Five Principles.
2. Diagram of the Five Lean Principles.
3. “The Lean Turnaround: How Business Leaders Use Lean Principles to Create Value and Transform Their Company” by Art Byrne
4. Conferences: Lean Management Summit 2015, Jacksonville, FL,October 8-9, 2015

HELPFUL CHECKLIST: How Much Does Your Company Adhere to Lean Principles?

Our next post on the Lean Management System will delve further into the basic Lean Thinking needed before you get started with lean transformation.

Footnotes:
† “Lean Thinking” by Daniel Jones and James Womack. Free Press 2003

Posted in Lean Accounting, Lean Culture, Lean Management System, Management Accounting, Value Streams | Tagged , , , , , , , | Leave a comment

You Can’t Become Lean If You Only Eat Fried Food!!

Blog Scale -30126bd84aaeaecae6911662a8e2c556If you want to lose weight by eating organic, low calorie food but…. you deep-fry everything, you will not only stay overweight, you will become sick. However, most American manufacturers do just this with regard to lean. They want to become lean organizations but they do not want to change the way they manage.

Apparently 60% of American manufacturers claim to be “going lean”†. If this were true it would revolutionize our economy. Lean titan, Art Bynre†† estimates that the number of companies truly embracing lean is 5-7%. Most of the 60% are doing (as per Prof. Bob Emiliani’s term†††) “fake lean”. Emiliani defines “fake lean” as introducing lean tools and methods (the healthy food) without changing the company’s management (the same old fatty diet).

Success with lean can only be achieved by implementing lean principles through-out the entire organization. We must develop a truly Lean Management System so that every aspect of the company is working in unison around lean thinking and actions.

The diagram below is a high-level view of a Lean Management System addressing most of the important processes that must work together to create a thoroughly beneficial lean organization. Today, I will describe an overview of each aspect of the Lean Management System and in future blogs, I will explain how it all fits together.

I would value your stories and opinions. Please send comments to create a discussion around this vital issue.

Lean Mgmt System Diagram

We always start with thinking; Lean Thinking. Value to the acustomer. Organization by value stream. Faster flow of information. Materials and cash. Empowerment and respect for human accomplishment. Non-stop pursuit of the perfection.

bUnlike most companies, lean leaders establish value streams reflecting the work flow to serve the customers. The ideal value stream contains all the tasks required to serve the customers. Sales, marketing, product customization, purchasing, receiving, production, quality, inspection, and shipping; the entire flow.

cTraditional companies rely on ERP systems to control their processes. Lean emphasizes continuous process control. Frequent visual measures, standard work, fast problem solving, continuous improvement, weekly financial reports people can easily use, new ways to understand costs, profits, and decision-making. Control is built into the processes.

dLean organization do not place their first priority on stockholder value and/or cost cutting. These issues are very important, but in lean companies they are the outcomes of our work. The root causes of business success include a clear knowledge of how customer value is created, and developing processes that increase this value.

eLean organizations deeply understand the customers’ wants and needs. Before design there is research to capture knowledge. Product development is fast, focused, and frequent. Agile product design moves along effectively; often with parallel designs. Incremental product release so as to further hear the voice of the customer.

fDecisions in lean companies are made by the people closest to the issues, rather than higher level managers. Standard decision-making methods using real, relevant data are used; not standard costs and margins. Better decisions, better revenues, lower costs, and higher profits. It also frees up the senior leaders’ time.

gA hallmark of lean is continuous improvement. Everyone in the company is engaged in process improvement. There are big breakthrough changes, continuous improvement projects, and frequent, small “just-do-it” improvement, and target costing to bring revenues, costs, and profits in line with strategic needs.

hLean organizations are well planned. They recognize that to achieve effective operations and continuous improvement the value streams need to be very well planned. Good planning leads to excellent results. Good planning enables value streams to be flexible and ready to address unexpected issues.

IAdministrative work is not only very important but very time consuming. This kind of work is mostly 100% waste. The tasks are important, but add no customer value. The same lean methods of visual flow, waste elimination, and freeing up people’s time so they can work on more strategic activities are used to drive the company forward.

jTo introduce real lean across an organization requires:  Active, culture-changing leadership from senior executives. A long-range vision for the company to become truly lean. A recognition that we do not “implement” lean. Lean is long-term commitment to value, flow,waste elimination, and engaging everybody in continuous improvement.

This has been a quick overview of a Lean Management System. In future blogs we will delve deeper into this vital aspect of lean transformation that is sadly neglected in many organizations.

I welcome any comments, thoughts, and insights you may have about this. There is always more to learn and practice.

†.  North America data on 572 discrete manufacturing plants from The IndustryWeek/Manufacturing Performance Institute 2007 Census of Manufacturers; 2007 Canada Manufacturing Study, conducted by Advanced Manufacturing and the Manufacturing Performance Institute; and Estudio De Manufactura Mexico 2007, conducted by the Manufacturing Performance Institute with support of CS Events.
††. “The Lean Turnaround” by Art Byrne, McGraw Hill 2013. Page XX in the Introduction.
†††.  www.bobemiliani.com/back-story-real-vs-fake-lean/

 

Posted in Lean Accounting, Lean Culture, Lean Management System, Lean Manufacturing, Value Streams | Tagged , , , , , , , , , | Leave a comment

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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