The management accounting community is currently wrestling with controversy - conflicts and ambiguities caused by competing forms of managerial accounting for organizations embracing lean management techniques and principles. The controversy does not involve financial accounting for external reporting. Its purpose is historical reporting for external and regulatory entities; with recent reforms regarding fair value, one can say its purpose is financial valuation. In contrast, the purpose of managerial accounting is for economic value creation through better internal decision-making.
Part of the problem is that proposed accounting methods for a lean management environment, which typically focus on short-term decisions, assume a steady state. That is, they assume most expenses remain unchanged - fixed - except for those affected by a localized operational improvement. In contrast, longer-term decisions are strategic - such as pricing, investments, new product selection or rationalization, and marketing - and assume resource capacity and its expenses are adjustable - variable.
Related to this problem is the fact that lean management principles advocate simplicity. Because the vast majority of employees who make decisions are only responsible for the day-to-day operations of their portion of their organization, any simpler and more relevant costing technique for them is appealing. However, for the minority who make less frequent but more important strategic decisions, which may each have the impact of hundreds of day-to-day decisions, an enterprise view is needed to understand long-term economic consequences. This minority may not win the popular vote to choose their organizations cost accounting method, but their knowledge about costs and profits may generate the vast majority of their organizations bottom-line financial impact. The result is a debate between lean management practitioners proposing alternative management accounting methods and mainstream accountants.
What is Lean Management?
Lean management can be described as a systematic approach to identifying and eliminating waste and errors, including nonvalue-adding (NVA) work activities. Productivity increases are accomplished through continuous improvement of processes to accelerate the throughput time of products or services. Increasingly, lean management techniques are merging with Six Sigma quality and just-in-time (JIT) initiatives.
Nonmonetary process data is foundational to lean management, quality and continuous improvement projects. Employees are trained to use tools such as process flow charts, check sheets, fishbone charts, Pareto diagrams, process control charts, histograms and scattergrams. In addition, they measure movement of products or transactions, such as flow times and distances, as well as unplanned events like product rework and errors.
Value Stream Mapping
A popular method to visualize and measure processes is value stream mapping. A value stream consists of all the activities to create customer value for a product family or service offering.1 It removes the barriers of functional or department silos to aid improvement teams with better communications and decision-making. A simplified value stream is similar to a process flow chart.
Each value stream may have multiple performance measures, such as for safety, quality, time, delivery and cost. The last metric, cost, has spawned a relatively new cost accounting method referred to as lean accounting or, more appropriately, management accounting for a lean management environment.
How Does One Calculate Accounting For Lean Costs?
Accounting for lean is based, in part, on the concept that time is money. For example, a nights stay at a hotel might be 11cents per minute. Attending a music concert may be 63 cents per hour. A meeting with 10 employees may be $6.50 per minute. Any value streams cost-per-minute rate can be calculated as a ratio of its annual expenses (e.g., wages, supplies, depreciation, etc.), divided by the total annual minutes that all of the resources worked, excluding holidays and a percent factor for coffee breaks, illness, etc. This cost rate exists independent of whether the work produced any outputs. Think of it as an input cost rate - the rate of resource expenses supplied.
Another key concept is to quantify NVA costs from a customers view. For any value stream, the calculated time of work (for a time period, such as a month or year) to make error-free products or deliver error-free services is based on that product or service offerings average unit processing time (e.g., a bank tellers 4.26 minutes per customer). This is the rate of resource expenses used. This rate is then multiplied by the volume of units processed or delivered during the time period and the value streams input cost rate per minute. This total production cost is subtracted from the total value stream expenses, and the difference can be classified as the NVA costs for that time period.
The NVA cost is a total amount with little or no detail and visibility. There is only a single lump sum of the total value stream expense and a lump sum of the NVA cost. It can calculate an aggregate financial figure that the traditional accounting spending, standard cost accounting or income statement cannot report.
What Caused Interest in Accounting for Lean Costs?
Accounting for lean developed as a result of frustrations managers and employee teams in operations have with traditional standard cost accountings inability to evaluate lean projects for cost savings potential or measure improvements after they are completed. In addition, operations personnel question if their daily efforts to collect transactional data are worth it, given that many operations people have found little use for actual-to-standard cost variance reporting. This frustration is understandable considering what is now generally understood about deficiencies with traditional standard costing.
Accounting for lean attempts to solve some of operations immediate financial measurement problems, because as they make improvements (e.g., eliminate NVA costs, reduce resources and increase the rate of throughput in processes), they can financially measure productivity increases that show up on the bottom line of the companys income statement.
Controversy Among the Accountants
There are three areas of conflict:
One conflict that mainstream accountants have with accounting for lean is that it ignores or distorts product costing. It is one thing to calculate each value streams cost as a total, but another to calculate product costs (the costs of each value streams consuming outputs). The source of the problem is that accounting for lean suggests not bothering with calculating product costs. If product costs are required by someone, then it applies very broad averages (e.g., the number of total processed units) to compute a unit cost resulting in no differentiated costs. Additionally, it typically excludes applicable indirect expenses that support value streams, like an equipment maintenance department. The disturbing result is that reported costs are different from cost tracing methods that mainstream accountants are familiar with, such as activity-based costing (ABC). ABC resolves the deficiencies with the traditional standard costing methods.
This conflict arises because driver-based and consumption-based costing methods, like ABC, comply with a universal accounting principle - the principle of causality. The causality principle states that a cost should proportionately reflect the consumption of its inputs - with a cause-and-effect relationship. In contrast, accounting for lean follows a flow-path principle as its guiding principle behind monetary management information.2 Lean management guidelines include simplifying, hence the appeal of removing transactional paperwork.
A second conflict involves accounting for leans disconnect from supporting strategic decisions. Enterprise performance management stresses the importance of strategy formulation and execution that relies on fact-based information. Accounting for lean appears to have no link to supporting strategy formulation (e.g., which products or customers are more or less profitable). Further, there appears to be no link for modeling the monetary impact of what-if scenarios (e.g., a make-versus-buy decisions) or rolling financial forecasts to test and validate strategic alternatives. It has no driver quantity data for these calculations.
A third conflict involves economic analysis of future outcomes. Mainstream management accountants project incremental changes in expenses - not with the assumption that the level of resource capacity is fixed as volume changes (a lean management assumption), but that capacity is adjustable within relatively short-term planning horizons. In addition, mainstream accountants use customer and product demand-driven volume driver quantities with causal consumption rates to project economic outcomes. This is key information that accounting for lean advocates suggest abandoning. Finally, mainstream accounting now traces the non-product-related, cost-to-serve expenses like selling, distribution and marketing to different types of customer microsegments to measure and manage customer profitability, which accounting for lean single value stream is not structured to enable.
Because of these shortcomings, mainstream accountants ask if lean accounting advocates are deluding themselves. How can strategic decisions be made if you eliminate the required parameters - activity driver cost rates and product costs - for predictive planning or ignore measuring cost-to-serve expenses and computing profitability for high or low-maintenance customers? They question what the transformational potential of lean accounting has, other than identifying productivity improvement opportunities, compared to other emerging managerial accounting advances.
How Will The Debate End?
Accounting for leans violation of the accounting principle of causality raises the question, Is accounting for lean a viable replacement for, complement to, and/or supplement for current and evolving management accounting approaches such as activity-based costing? Another way of asking this question is, Should there be two different coexisting cost reporting methods that report dissimilar numbers? One cost for operations that is tactical, used for short-term decisions, and another cost that is strategic used for longer-term decisions such as for planning, marketing, pricing and sales analysts to evaluate profit margins.
There will be debates, but eventually some form of consensus will triumph. My opinion is that the criticisms that lean management advocates have on standard cost accounting, though valid, are misplaced. Some of their criticisms set up the straw man of traditional standard costing as the target for their call to action; this creates an artificially wide gap (and ignores that ABC has already resolved the problem). Their real argument is with the inappropriate ways that many companies use information generated by standard costing systems and the potential inappropriate actions that may result.
There is a deeper problem: cost accounting system information is not the same thing as cost information, which should be used for decision-making. The majority of value from cost information for decision-making is not in historical reports. Its primary value is in planning the future, such as product and customer rationalization, marginal cost analysis for one-off decisions or trade-off analysis between two or more alternatives. Therefore, key tests for accounting for lean will be:
- How does it handle economic projections?
- Does it classify resource expenses as variable, semivariable, fixed, unavoidable or avoidable (i.e., allowing for capacity adjustment decisions)?
- Does it isolate unused/idle capacity expenses?
The good news is that organizations are challenging traditional accounting, so in the end any accounting treatments that yield better decision-making should prevail. The coexistence of two or more costing approaches may cause confusion over which one reports the correct cost, but that is a different problem. What matters is that organizations are seeking better ways to apply managerial accounting techniques to make better decisions.
- Institute of Management Accountants. Lean Enterprise Fundamental. Institute of Management Accountants Statement of Management Accounting, 2008.
- Kennedy F. and Huntzinger J. Lean Accounting for Operations. Target: Innovation at Work, 2005.
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