A growing number of businesses are implementing lean accounting in order to gain a better understanding of how their operations are performing. But what is lean accounting? And is it something just confined to large corporate businesses or can small businesses also reap the benefits?
In this two-part series, adviser and cash flow expert Hayley Chiba explores how the concept can drive real change and efficiency within businesses. This part introduces lean accounting as an approach, and part two examines how lean accounting can bring tangible benefits to small business.
* * *
Content seriesView full content series
Lean accounting is a fundamentally different approach to producing and managing the financial information of a business.
From my experience, much of the theory is directed at large companies, especially those rolling out lean manufacturing in their organisations. However, there are some great techniques which I have lifted and applied practically into small businesses. These tools and approaches have delivered huge steps forward for these small companies.
What is lean accounting?
I first heard about lean when I worked for a multinational pharmaceutical company over 10 years ago. I was the finance manager of a £75m manufacturing site – the first stage of a multimillion-pound supply chain. Lean was introduced to try to increase the efficiency and cost base of this part of the supply chain. It was lean manufacturing that required us in the finance department to change in order to support this move.
Lean accounting is not a prescriptive way to produce our financial figures. Lean accounting, I believe, is an alternative approach to traditional management accounting. It does not seek to replace any financial accounting systems, but instead its focal point is in the provision of meaningful value-adding information to the non-financial and financial managers in the organisation.
Finance needed to change and understand that we needed to listen to our customers and ensure we delivered value back into the business.
In large organisations such as the one in which I previously worked, where complex, enterprise-level ‘ERP’ software are used, we were not able to use the ERP standard costing systems to support the lean factory.
This is because standard costing sets an internal standard for the site and measures performance against this benchmark. It uses full manufacturing costs as the benchmark for comparing all costs. Full manufacturing costs attempt to apportion out all overheads to a product. However, the more you allocate costs rather than directly cost, the less clear it is on which costs are being driven by what activity.
Furthermore, standard costing and absorption costing encourages us to always make more, so that we can absorb more of our overheads. Any stock (overproduction) is hidden away on the balance sheet as an asset. From the profit and loss point of view, all we see is the performance based on what has been sold. That’s great, but it doesn’t penalise us where we have made more than we needed and therefore have created ‘waste’.
More on waste later.
In lean accounting, we want to highlight where stock has increased with no corresponding increase in demand. In fact, to have increased demand but reduced stock would be the most preferred outcome!
We should be able to create measures to help those involved in the purchasing, project management and stores/ logistics sides of the business. They need to be shown where and how stock is not moving favourably. This is the only way to drive better stock management.
Better control and planning around stock inevitably improves cashflow.
Given that standard costing does not help us, we instead look to identify and cost out the business into its value streams.
Value stream costing
We need to show the costs of the value streams to the customer. The customer will only pay for the product and for what they value.
Value streams can be by overall process, detailed sub processes or by product.
Here are some examples of different value streams:
- By product/service type
- By process to make or deliver the product, eg manufacturing, drying, formulating, packing etc.
- By customer: Commercial, domestic, public sector etc.
Whichever way you choose to define your value stream, you will also need to be able to capture your costs in order to cost against this value stream. Note where customers demand different attributes from your service or product, this should give better visibility on what is driving your cost base.
As labour costs are often a key part of the costs, it may be useful to consider the way labour costs are currently set up. You may need to consider if they need to be set up differently in the future in order to give the most meaningful analysis of the value stream costs.
How to cost out the value stream
All costs should be directly costed to the value stream. If you are not able to directly cost any overheads associated with the value stream, then do not include these in the value stream costs. You should not be apportioning or allocating based on one or more key drivers, as this takes away the value and reliability of the data to the end user. It also adds complexity to the analysis.
Firstly, you need to categorise your costs in such a way that you can readily define their purpose. This is best explained by using the actual example of how I broke down the costs base for the pharmaceutical company I mentioned earlier.
Please note, these are my definitions and I used these to give a universal language to the site to help them more readily understand the types of costs we had in the business. We found this much easier to understand than our traditional definitions of cost of sales and overheads.
Raw material or module 1 costs
Those specific raw materials used in making the product.
Product specific costs or module 2 costs
For each value stream we have identified those costs which are specific to making the product ie we believe these costs directly produce value to the customer.
Module 4 costs
These costs/resources which are used for working on step change improvements and hence do not work on the day-to-day delivery of the product.
Module 5 Costs
Where resource/costs were incurred due to the site being a lead site for drug manufacture. These costs are specific to the site holding this status.
Module 3 costs
All other costs are termed as non-product specific costs.
The types of costs in here could be categorised further as:
- Compliance costs
- Shared non-product-aligned costs eg finance department costs, senior management team costs etc. They are non-critical to the immediate delivery of the product.
- Costs associated with delivery of global functional requirements eg safety health and environmental (SHE) management.
- Inherent waste activities
This different approach to viewing costs will enable you to understand what is driving these costs: what activities, status, setup and structure of the company is driving the costs base of the business.
In order to be a financially viable Producer, you need to be able to compete versus your Competitors based on the price and quality of your product. Hence it is important to establish what is the comparative target price of the product if manufactured by an alternative supplier.
When looking at the price we should be able to segregate the price into the costs of raw materials and conversion costs.
Conversion costs as in my above example are only those costs associated with making the product, they would not include step change improvements or Lead site costs.
By taking the conversion costs/unit and multiplying up by the volumes we will be making, this gives us an indication of what our overhead base should be.
Comparison of the components of our costs will enable us to evaluate what the cost is for us operating this way. If our competitor can produce or provide a service cheaper are they structured differently or are they carrying out their processes more efficiently.
In part two of this two-part series, I will look at how lean accounting can be applied to small businesses.