A Critical Analysis Of Lean Accounting And The Important Role It Plays Accounting Essay

Category: Accounting

A critical analysis of lean accounting and the important role it plays for companies in today's world while traditional accounting methods become obsolete.

INTRODUCTION

As the industries and markets evolve with the continuously increasing demand for goods and services, companies face new challenges to fulfill those needs while staying ahead of the competition. According to "The Goal" by Goldratt, three areas must be improved to achieve every company's goal of making profits and surviving. The first area is to decrease the inventory level while the second is to decrease the overhead cost. The third objective is to increase throughput. Lean philosophy is based on the idea that no product or service will be produced until it has been ordered. Lean thinking tends to minimize inventory while improving operational effectiveness and in the same time improving quality and capacity with reducing cost and lead time (Sheriff). The full implementation of lean philosophy relies on the integration of lean manufacturing supported by lean accounting. Although many believe that lean accounting will not become the mainstream method and companies will continue to use and support traditional accounting practices. Others believe that going lean will eventually replace the traditional accounting methods and spread worldwide. In today's business environment, lean manufacturing is the key to success but in order for it to help a company achieve what they want to attain, it must be supported by lean accounting. Implementing both lean manufacturing and lean accounting practices simultaneously is the only way to survive in this era. If employed correctly there are many benefits to going lean, such as decreasing inventory levels, speeding up processes, and cutting recording costs. As more and more companies are starting to become lean, the need for lean accounting is increasing as well. Three key issues define the lean philosophy: the elimination of wasted resources, the involvements of staff and the drive for continuous improvement. The traditional manufacturing era based on mass production is starting to fade and fading with it the traditional accounting practices.

WHAT IS LEAN ACCOUNTING?

Lean accounting came to support this new manufacturing system, known as lean manufacturing, or as Brian H. Maskel defined it "lean accounting is the general term used for the changes required to a company's accounting, control, measurement, and management processes to support lean manufacturing and lean thinking" (Maskel). Lean accounting is a collection of ideas which group methods such as the adaption of just-in-time, identification of constraints, value stream mapping and many others. This compilation of tools is used by companies to help them asses things like the true cost of what was produced and help them make decisions based on reliable data. Lean philosophy requires not only the combination of the tools and processes but also people to make it work. Most important to keep in mind is that lean accounting, is at its core, a cultural and people-oriented initiative. The key to making the transition to a Lean organization lies in the fundamental change in corporate culture that must be made. It is also the use and adoption of lean beyond one department such as manufacturing production control that make a lean initiative most effective (Infor).

THE RISE OF LEAN ACCOUNTING

To understand the need and origins of "lean accounting", knowing what "lean manufacturing" is will help to have a better idea of what purpose it serves. Toyota was the first to come up with a breakthrough philosophy called lean manufacturing which is a set of principles and methods that they adapted in their plants. These principles led them to become the leader in their industry when it comes to reducing lead time and cost while improving quality. Toyota, Becoming a large profitable company, was set as an example of success and many companies followed their steps by applying lean manufacturing. It was only a matter of time before they realized that their standard accounting methods were not the right approach when applying lean manufacturing because it led to no results. Old accounting and management methods were at odds with lean manufacturing and the creation of new "leaner" methods to comply with it was inevitable. Even though accounting has been around for a long time, it was not until the past few decades that we witnessed great evolution in the practice. The creation and adaptation of new methods and tools to produce more accurate and reliable financial statement for the stakeholders has become crucial for company's' success. That is why a new way of thinking has risen and it was called "lean accounting." Lean accounting was necessary when applying lean manufacturing.

Those who support lean accounting argue that lean manufacturing cannot be measured in the same as standard manufacturing by using traditional accounting methods. In today's world, companies are moving away from the economy of scale ideology that focuses on high volume production runs that fully absorb overhead and build work-in-process and finished-goods inventory (Drickhamer). Using the traditional accounting methods can lead to decisions based on inaccurate numbers in relation to product cost that can be tragic to the company while making pricing decisions. "At heart, the lean accounting approach takes a simpler look at what goes on between the inputs and outputs of a production process, tracking costs in less-minute detail, expensing material as soon as it's pulled into production, and eliminating work orders, the tracking of transactions and the reporting of variances altogether" (Drickhamer). Many plant managers rely on the activities above to track and monitor inventory value but this could be inefficient if the productions operations are not lean enough and organized by value streams.

THINKING LEAN

According to Frances Kennedy author of "Lean Accounting: What It Is All About?" there are four major steps when it comes to adopting lean thinking. The first step is to find out the value that the customers view in a product or service. The second step is to identify the value streams that add value into a product. The third step is to make the Value Stream Flow. It necessitates a migration from mass production that leads to inefficient accumulation of inventory, rework, and waste to "cellular work arrangements that pull together people and equipment from physically separated and functionally specialized departments." Multiple processes and equipment are put together in a way that copies the steps of the manufacturing process, hence producing a continuous flow. The fourth and final step is to implement a pull system where customer demand defines how much product needed is to be produced. (Kennedy)

WHAT LEAN ACCOUNTING HAS TO OFFER

In today's world we are moving toward real time information and only those businesses that possess the fastest and most reliable data have an advantage over their competition. More demand equals more services to offer and products to make. More information about production runs and product costs are needed and lean accounting can provide them faster than traditional accounting methods. Lean accounting seeks to replace traditional accounting by providing timelier and more relevant management information. Thomas Johnson provides a well composed explanation of what lean should do for managers regarding timeliness of information "lean is about viewing operations in the present moment, not with delay, and in a specific, concrete place, not in an abstract context removed from the site of the actual work" (H. T. Johnson). Dan Woods also support what Johnson has said when it described that lean accounting attempts to find measures that predict success while standard cost accounting measures results after the fact (Woods).

Beside the advantage of providing information faster than standard accounting methods, lean accounting helps simplify the accounting operations needed to record information related to products such as inventory levels. Lean accounting applies the lean philosophy to the finance process, radically stripping out transactions and complexities (Maynard).

More benefits are described in Brian Maskell article "what is lean accounting?" when implementing lean accounting. According to Maskell the benefits include increases in sales, money savings, cost reduction, and a better understanding of financial impacts of lean improvements (Maskel). These benefits are all a result of more "accurate" and "understandable" financial information which leads to improved decision making. The box score below in table 1 represents a real case of how lean improvements helped freed-up resources such as physical space, machine time and people's time to be assigned to other tasks. Regarding operational measurement improvements, it shows the future inventory turns that will increase as well as sales per person and the decrease in lead time.

Table 1. Box score of a company showing improvements in mainly both operational and capacity measurements

Another example of a successful implementation of lean accounting would be Watlow Electric Manufacturing Co.'s Hannibal, Mo. Lean accounting has given Watlow-Hannibal a better understanding of its cost structure, condensed front-end processing time, broken down functional silos, provided real-time data and driven the business unit to focus on the value to the customer (Cable). The implementation of lean accounting was necessary for the company since it needed a simplified accounting method to reflect the cost changes related to the adoption of lean manufacturing. Watlow-Hannibal understood lean accounting and viewed it as a significant part that affected every process and aspect of the company.

Regarding statements such as those related to product cost, John Cable in his article "Lean Accounting's Quest for Acceptance", mentioned how clearer lean accounting statements were. Switching from traditional statement about cost of products to plain-English P&L (Accounting Plain Language statements) statements led to more interactions among the departments' heads during presentations. The new statement made the product costing table easier to read and understand which helped those present to better understand them without requiring much accounting knowledge. The Lean Accounting Plain Language statements can be constructed to comply with GAAP with the simple addition of a line at the bottom reflecting the transfer of expenses to the balance sheet in the form of inventory. Firms managing with Lean Accounting typically perform very simple allocations of overheads for GAAP purposes since the sole purpose of allocation is to comply with GAAP (Waddell). Traditional financial statements are still required to satisfy auditors and reporting requirements. The financial statements are not meant to be used to manage the business but merely to serve as reports. The ultimate result of having lean accounting is to make the accountants more than "traffic cops" and allow them to provide reports that are practical for decision-making and straight forward rather than only checking for accuracy (Drickhamer).

In an article by Ross Maybard it has been determined, by doing a follow up on companies that switched to lean, that to operate in a lean environment requires lean accounting. "Only by producing financial and performance reports at the value stream level can you drive continuous improvement in the long term and exploit the full effectiveness of lean as a business growth strategy. The box score and value stream profit and loss report are the key tools of this transformation." (Maynard). Table 2 reflects the results of an Italian company that went lean and provides information about how it improved on many levels after just three years.

Return on assets

78% improvement

Return on sales

74% improvement

On-time delivery

Improved to 95%

Reduction in freight expediting costs

100% reduction

Scrap rate

51% reduction

Average days of inventory

41% improvement to 16 days

Productivity

15% improvement

Table 2. Italian company improvements results after being lean for three years.

Figure 1 represents a summary of the principles, practices, and tools of lean accounting (Maskel)

Figure 1. Principles, practices, and tools of lean accounting

APPLYING LEAN TO EXTREME

Lean accounting should be used in moderation because if overused and carried too far it will negatively affect the operations of any company. In order for lean accounting to work, the company must think and act lean because just as lean can lead to a more profitable business, it could also lead to its loss. Implementing it successfully depends of the integration process and the company's culture. Applying lean ideas will lead to more profit and better management of resource, but if one part fails or is not applied then using lean accounting will be disadvantageous. The application of lean tools, new technologies, and new business processes to a traditional silo-oriented culture did not prove to work (Infor). It led to many mistakes such as incorrect product costing, higher or lower level of inventory than needed, and more overhead cut than required. Companies can also fail while adopting lean accounting when they rely on suppliers that have long lead time or just deal with one supplier.

As a way to cut cost, the faster and easiest way is to dismiss employees. This method may cut cost for the short term but it can backfire when a large order with short deadline is received. In this case the company finds itself short on staff and without capacity to deliver on time. The company will be forced to hire temporary employees which will increase cost or lose the deal to a competitor. It may also happen that a certain employee with valuable knowledge has been terminated but who happened to be the only employee that could operate certain machinery or provide certain services (Coldwell). This would result in having a company unable to serve its customers resulting in loss of business. There should be a healthy balance between cutting cost and affecting responsiveness to fulfill large orders.

To be lean also means that your supplier has to be flexible when it comes to delivering materials for a company so that they can fulfill customers' need. In "Taking Lean to Extreme" by Roy Coldwell, the author warns companies on working with suppliers with long lead time and calls to measure their performance and ensure their creditworthiness. He also warns companies about using a single supplier which might give favorable rates and other rewards but also puts the company at risk if it faces troubles or goes bankrupt.

Coldwell also advises on the inventory level that a company should have if uncommon orders are received. Companies, especially in the manufacturing industry, take lean to extreme by cutting down their inventory to low levels. Sudden fluctuation in demand may put a company in a difficult position where they cannot fulfill all of their order. To solve the problem, Coldwell suggests increased flexibility from the company when it comes to inventory level by evaluating its dependencies. He also suggested that "value stream mapping exercises to identify areas of waste resources will also put companies in better shape to deal with an economic upturn or downturn" (Coldwell).

RESISTANCE TO USE LEAN ACCOUNTING

Lean accounting is not widely used mainly because there is resistance to adopt a new system. Replacing what managers and chief accountants have been working with for many years is hard to achieve. Switching to another method translates for them to more training of personnel and hence more cost added to the confusion of adapting to new methods different from what they have been used to. Managers are accustomed to looking at operations through quantitative data analyzed by computer, mainly because of their tendency to see operations through abstract models. It is one of the factors that explain why most businesses have little success when attempting to adopt and execute lean practices. Managers are not motivated to see the world concretely. Lean principles require the conduction of operations and the use of accounting principles and tools in the actual manner they occur, not through abstract models (T. H. Johnson). This is very important for decision makers since it will help them manage their resources better and lead them to correct any mistake before problems arise. Also those against the use of lean accounting believe that it introduction would lead to rethink most of the regulations already in place and to the creation of new loopholes and problems.

Other reasons exist on why lean accounting is still not used in many companies while they adopt lean manufacturing. One of the reasons is that traditional accounting systems reward overproduction, and overproduction is a common way for manufacturers to make their results appear better than they really are. Another reason is that lean accounting divulges bad business practices that companies do not want to show and that whereas standard cost accounting hides what is really happening, lean accounting shines a light on it (Cable).

FAILURES OF STANDARD ACCOUNTING

Standard accounting systems fails to meet companies' true needs. Perhaps the most important is the need to have a real time snapshot of the current status of the company. Johnson and Kaplan claim that traditional cost systems have become irrelevant and concluded that the typical 1980s cost accounting system is not helpful in determining product cost or operation cost. The information traditional cost systems provide are not useful for cost management, the existence of such systems are only for periodic use such as in monthly financial reports prepared for senior management (Aranoff).

Supporter of the standard costing method argue that because it is the most widely used method in the world it should be the right method. Attia Marie author of "Is Standard Costing Still Relevant?" states that 86% and 73% of companies in United Kingdom and Japan respectively still use these methods. Attia Marie went on to say that most managers are pleased with these methods when it comes to decision making (Marie). Most companies just reconfigured their system to meet their requirements and did not take into account what their competition is up to. The author ignored the fact that these managers do not want to replace a system that they have gotten used to over the years. The article presented Dubai as an example of a booming economy that uses standard accounting methods and that they are successful. The table below presents the percentage of industrial and service companies in Dubai that use standard accounting methods.

Dubai

Industrial %

Service %

Yes

77

39

No

23

61

Total

100

100

Table 3. Use of traditional accounting system in Dubai

Table 3 above does not prove that standard accounting is not obsolete. Lean accounting methods have just been introduced to support lean manufacturing few decades ago. Having 23% of the industrial companies and 61% of the service companies that do not use standard accounting methods lead to think that it is slowly vanishing.

The article states that "Dubai industries have become more international in their operations and hence are facing greater competition in global markets. Thus one would expect these companies to review their costing standards frequently to cope with a changing environment where new products are introduced daily." (Marie). Becoming more global does not necessarily means that a company's' methods used are being successful. A state like Dubai is only becoming more competitive because of the huge capital invested in it and the interest of the west in its resources.

Another statement in the article proves that lean accounting is neither known nor the preferred method when it mentioned that "the majority of chief cost accountants in Dubai earned diplomas from schools in developed countries". This could explain that these chief cost accountants have not heard of the lean accounting term since to reach that position meant that they should have gotten their degrees more than a decade ago when lean accounting was still developing and unheard of.

LEAN FOR THE UNDERDEVELOPED

Many underdeveloped countries, such as Malaysia and Nigeria, have started to move toward lean thinking by adopting the tools that led to the prosperity of many big companies. Businesses in these countries felt that the economic down run in the developed nations affects them the most and decided to adopt what could help them thrive and avoid future economic problems. Also wanting to take share of the world market and wanting a faster industrial growth to support their populations directed them to learn and adopt from what many successful companies have used which is lean manufacturing and accounting. Toki Mabogunje+ & Co, which is a Nigerian a consulting firm that provides business development services, strongly believe that to bring small to medium enterprises into the modern business world lean thinking must be applied with the support of lean accounting.

CONCLUSION

Lean accounting is a new innovative practice and just as other practices before it, it will have supporters and many who oppose it. Regardless of that fact, lean accounting is important if companies want to remain competitive because there is much to be gained when lean practices are implemented. As mentioned throughout this critical analysis it is crucial to realize that lean manufacturing is not effective if lean accounting is not implemented along with it. Lean accounting will eventually replace traditional accounting as more and more companies begin to implement "lean practices" and moving away from traditional accounting. Still many have not heard of this new method and what it has to offer. Because lean accounting is relatively new there is a need for spreading the word of the advantages that it can bring to a company. One way to increase awareness is to introduce it to accounting students through their business classes. These students represent the future members of the profession and the ones that will determine which accounting method will be used in the future.