FINANCE & MANAGEMENT

The lean vs standard

cost accounting
conundrum
Ever felt your business decisions are based
on irrelevant or incomplete information?
Jean Cunningham uses three case studies
to illustrate how lean accounting can improve
your decisions, whatever your industry

A
study reported press. However, they were required, based on the bill
several years ago in soon told the orders would not of materials. When adding
the Harvard Business be accepted. What happened? these together, the total
Review concluded that 50% of Company A, like most manufacturing cost was
executive decisions are made others, used standard cost identified.
on intuition. Surely that is accounting. So the orders were What types of costs were put
cause for alarm. Is business submitted to the accounting in the cost per hour for each
decision-making necessarily department to be ‘costed’ for routing? They included labour,
that much of an art? Are evaluation of the profit supervision, utilities, supplies,
executives not well trained in potential of the orders. equipment depreciation,
the use of decision-making The gross margin percentage material handling,
tools? Or is it that executives for the orders based on maintenance, etc. These are all
sense that their information standard cost accounting was the costs that GAAP indicates
and data is skewed for some only 16% – less than A’s target are manufacturing costs.
reason, and so go on gut feel in margin of 25%. So the However, the reality of any
order to arrive at a controller decided to reject the new orders to utilise the new
comfortable decision? orders. The sales force was press was that the only
The following are three true deflated. Something did not resulting cost increases would
stories to show how using lean seem right and its intuition be for materials plus one
accounting, rather than was buzzing. After all, the additional direct labour
standard cost accounting, can equipment was available and employee (if, indeed, one
lead to better decisions. while the staff might have to be needed to be hired at all).
increased, the decision still A lean analysis of the impact
CASE A: A ‘MARGIN’ didn’t seem to make sense. of the new orders is shown in
MISJUDGMENT Standard cost accounting the tables overleaf, outlining:
Manufacturing company A treats all manufacturing costs 1. The ‘traditional’ decision
had purchased a large, new as variable. So in order to factors for decision-making
press. Its existing product base develop the potential cost for in this business.
would use only 10% of the these products, the accounting 2. The lean analysis of existing
capacity of the new machine, group looked at each of the business.
so the sales force was asked to routings required to 3. The lean analysis of the new
approach new customers to manufacture the product and business – whether 10,000
capture business that would estimated the amount of time units or 2,500 units.
utilise this press. After diligent required at each routing. They 4. The lean analysis of the
efforts, the sales people then applied the costing rate combined ‘old’ and ‘new’
returned to the corporate for each routing to those hours business.
office with several new to get the estimated labour
opportunities that would be and overhead cost. Then, they Should the sales team’s orders
manufactured using the new added the actual materials be pursued, the key

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considerations would be: happen in the distant future.

one additional employee This kind of thinking occurs
needed: because of the way traditional
a 50% probability of 10,000 financial analytical information
new units ordered: and is presented which drives
a 95% probability of 2,500 decision making on faulty
new units ordered. assumptions about
manufacturing a product. And,
And the lean analysis for the in this particular case, once
new orders would be as shown a decision maker announces
in Table 3 overleaf. a decision, it is often hard,
emotionally, to reverse the
FAULTY ASSUMPTIONS decision even when faced with
As shown in Table 4 overleaf evidence to the contrary.
the overall gross margin It would have been much
percentage on the new easier to pick out the relevant
business increased well beyond costs and revenues for
the 25% threshold when only decision making if only:
the actual costs (incremental the financial statement
revenue, material, labour) had been displayed with
were added to the existing the expense types clearly
book of business. listed; and
After the controller had the accounting adjustments
made the ‘thumbs down’ for GAAP inventory valuation
decision, the sales force sought had been displayed separately.
outside help to uncover what
impact these orders would A statement arranged like
really have. Then they were this is called a ‘plain English’
able to get a meeting with the or ‘lean’ financial statement.
president and the controller (Below is how a lean financial
to present a different picture statement might look.)
– the analysis shown in the
tables overleaf.
When the controller was LINE ITEMS ON A
faced with this ‘actual increase’ TYPICAL LEAN
analysis, he nevertheless STATEMENT
remained unconvinced. He Net sales
was concerned about what Material cost
would happen if ALL the Variable margin
business came in at this lower Variable margin %
gross margin percentage? People pay
What if the press reached Overtime
capacity and a second Benefits and taxes
machine was required? Supplies
This, even though the time Utilities
to reach capacity on this Facility cost
machine – even with these Equipment
new orders (and others) – was depreciation
expected to be years in the Manufacturing costs
future. The controller was Accounting adjustment
holding so tightly to standard for labour and overhead
cost thinking that he was in inventory
willing to forego near-term Total cost of sales
incremental profit and Gross margin
cashflow to avoid what ‘might’

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The lean statement

continues to follow GAAP with
RESULT – A BAD
DECISION AVERTED
The lean plant to the balance sheet.
Therefore, there were
manufacturing costs gathered Luckily, the president of had reduced unfavourable variances with
in the cost of sale section, and
inventory valuation includes
company A was not part of
the initial negative decision,
spending and labour and overhead was
not being ‘absorbed’ to the
labour and overheads. It is just and only saw the lean analysis. improved balance sheet.
presented differently.
The lean financial statement
In the end he decided to
override the controller and
cashflow Also, because the
productivity metric was based
can take many different forms. the new orders were taken. per employee was less. But on units produced instead of
But the one shown here operations staff were units shipped, the productivity
demonstrates some of the key CASE B: SHOP FLOOR concerned that this was the metric trended negative –
elements they have in GAINS BURIED BY wrong choice. because the only way to reduce
common, namely: TRADITIONAL During the preceding year inventory in times of level
The costs that truly vary REPORTING all the plant’s employees had revenue is to reduce the
with sales volume are A private equity firm B been trained in lean concepts number of units produced.
separated from those that acquired several companies in and had deployed them in So, even though the workers
either vary indirectly with related industries that small teams to make and supervisors of the plant
sales volume or not at all. collectively comprised over 50 improvements to the were hugely successful in
Each type of cost is reported manufacturing plants in the equipment set up, placement, retaining cash, reducing
rather than merged into US. This merging resulted in and maintenance. spending, reducing lead times,
‘standard cost and variances’. duplication and excess They had reduced overtime. and engaging all the employees
The accounting treatment of capacity across the plants as a They had reduced batch size in lean learning, they were
changes in labour and whole. Simultaneously, – resulting in lower finished all about to lose their jobs,
overhead in inventory is management began to adopt goods levels and faster lead and they all knew intuitively
captured on a separate line. lean concepts in one third of times. They had eliminated that ‘management’ was crazy
This treatment is especially the plants. At the end of the large amounts of WIP and or worse.
critical when the inventory first year, the plants that had finished goods. If the plant had used lean
levels are decreasing (as adopted lean concepts were As a result, the lean plant financial analysis and
happens in the early stages seeing significant decreases had achieved some reduced statements, the operations
of a lean manufacturing in work in process (WIP) and spending and significant staff would have seen the
transformation). finished goods – as is to be improvement in cashflow. actual costs becoming
expected from the initial Yet the income statement favourable. Also, the very
If A’s controller had been stages of a successful lean showed a lower gross margin positive reasons for the
used to seeing lean financial transformation. percentage and productivity unfavourable gross margin
analysis, he almost certainly As part of the original per employee was down. Why? would have shown in the
purchase plan, the private The lower margin and accounting-based inventory
If A’s controller equity firm was planning to
close a few of the plants. It was
productivity figures were a
result of the traditional income
valuation line. Instead the
reasons were buried behind
had been used now time for management to statement being used, and the variance and standards.
to seeing lean decide which plants to close.
Two of the plants selected
non-lean-centric information
presented by standard cost RESULT – THE WRONG
financial analysis, for evaluation made the same accounting. CHOICE FOR VALUE
he would have products in the same area of
the country. One had started
Lean manufacturing is
based on customer orders
CREATION
In the end, the lean plant was
approved the a lean transformation and (pull), and not on building up closed. The choice was made
new orders the other continued using
traditional manufacturing
inventory (push). Even though
revenue remained strong, the
by corporate-level decision
makers based on traditional
techniques. plant was not replacing the GAAP numbers only.
would have approved the new A decision was about to be inventory being eliminated This is a perfect example of
orders. The advantages in made to close the plant (a good thing). dramatic improvement gains
profit and margin would have undergoing the lean Because of this, the current on the shop floor being buried
been obvious, and the need to transformation because its costs – that had actually in traditional reporting
apply intuition would have gross margin for the past decreased (another good framework. From a value
been minimised – at least, twelve months was the lower thing) – were not being moved creation vantage point, it looks
relative to financial impact. of the two, and its production off the income statement like a mistake.

16 COPYRIGHT © ICAEW 2012 JUNE 2012 FINANCE & MANAGEMENT

 BUSINESS IMPROVEMENT

FINANCE AND MANAGEMENT FACULTY

This article was first published in Finance & Management,
the monthly magazine of ICAEW’s Finance & Management
Faculty. The faculty helps members in business to perform
at their best. For more information on the benefits of
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1. TRADITIONAL DECISION FACTORS

Quote price $30/unit Gross Margin % 16.67%
CASE C: MORE elements and manage them
MEANINGFUL DATA FOR accordingly, based on the
Standard cost $25/unit Gross margin target 25% SERVICE COMPANIES purpose of each cost.
For service related companies
Gross margin $5/unit Current gross margin 23%
including legal, medical, RESULT – FASTER
consulting etc, the issues PROFIT GROWTH
2. LEAN PROFIT STATEMENT related to manufacturing costs The improved categorisation,
FOR EXISTING BUSINESS don’t exist, but lean accounting presentation, and understanding
Direct ($) Shared ($) Total ($)
can still help provide more of the nature of costs resulted
meaningful information. Just in profits growing much faster
Sales 100,000 100,000 like in the manufacturing than revenue, leading to
environment, some of the cost improved margins.
Material 20,000 20,000
and revenue is truly variable,
Direct Costs 18,000 18,000 others are direct to a specific ASK YOURSELF SOME
product line, and yet others are KEY QUESTIONS
Shared 39,000 39,000 general overhead to provide These are difficult times where
support to the product lines. companies more than ever
62,000 (39,000) 23,000
As an example, consulting need to make the best decision
services company C every time. As a decision
3. ANALYSIS OF NEW ORDERS traditionally reported its maker basing decisions on
Incremental impact with Incremental impact with 2,500
financial statement based on financial analysis to support
10,000 new units ($) new units ($) the type of cost: travel, salaries, your company’s growth and
benefits, office rent, etc. success, I think it is important
Revenue 300,00 75,000
Faced with significant shifts to ask yourself the following
Material 60,000 15,000 in volume it was not sure if it set of key questions.
should decrease staff in some When faced with similar
Variable margin 240,000 60,000 areas, or add staff in other situations to those described
Direct cost 40,000 40,000
ones. Traditionally it would would you:
just have done a cost reduction Have the information and
Profit 200,000 20,000 across the board, or increased numbers that are truly relevant
Gross Margin % 67% 26% spending related to shifts in to product or structural
overall revenue, ie ‘If sales are decisions?
up 8%, every department Be prepared to put in the
4. LEAN PROFIT STATEMENT SHOWING budget is up 8%.’ additional time and effort it
OLD, NEW, AND COMBINED BUSINESS This time the company takes to overcome the
New Total New Total
decided to: misleading financial
Lean profit statement existing business with 10,000 with 2,500 realign some financial line indicators?
additional additional items to show two types of Make the correct decision?
units units
revenue for product lines:
DIRECT SHARED TOTAL ($) ($) repetitive sales versus Well, would you?
($) ($) ($)
one-time sales and any
variable costs (commissions,
Sales 100,000 100,000 400,000 175,000
bonus, travel, advertising)
associated with each;
Material 20,000 20,000 80,000 35,000
next, look at the more fixed
costs that were direct to a
Variable 80,000 80,000 320,000 140,000
margin specific product line which
ILLUSTRATION GWENDAL LE BEC

included employees salaries Jean Cunningham

Direct costs 18,000 18,000 58,000 58,000
and related benefits; and is founder of Jean
finally, separate the Cunningham Consulting:
Shared 39,000 39,000 39,000 39,000 ‘Building LEAN Beyond
remaining cost between office
cost, marketing, and owner costs. Manufacturing’
Gross Margin 62,000 (39,000) 23,000 223,000 43,000 jeancunningham
consulting.com
GM % 23% 57.5% 24.6% Now they could see the jean.cunningham@
relationships between these leanjcc.com

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