Real Numbers

by Orest J Fiume

Conservatism

  In plain language, this means that you should not over-emphasize the good news or under-emphasize the bad news. Anticipate your losses but not your gains.

  Warranty reserves are based in conservatism. In a practical sense, conservatism tells us to record all possible expenses immediately and wait to recognize revenue until the last reasonable moment. Pressure to show positive results in the organization can be very strong. One of the most important ethics the accountant brings to the table is the insistence on conservatism that will keep companies out of trouble. This doesn’t mean, of course, that all companies abide by conservatism.

  Although in relative terms the percentage of publicly owned companies that have restated earnings since 1995 is small, there has been a dramatic increase over the past three years. From 1998 to 2000, there were 464 financial restatements.4 This total was higher than that of the previous ten years combined. According to the study, the most common reason for restatement was revenue recognition.

  4 From a June 2001 study of earnings restatements published by the Financial Executives Research Foundation.

  In the year 2000, revenue recognition was the cause of eight of the top ten restatements, measured in terms of market value loss. The study concluded that one of the factors driving the increase was the “higher performance pressure on management teams” to achieve dramatically higher equity returns. In a Wall Street Journal article about the study, Philip Livingston, president and CEO of Financial Executives International said the pressure “pushed some management teams to stretch accounting rules to the breaking point, ultimately prompting restatements.” Even though the FERF study concludes that because the number of restatements is small, and therefore “the overall quality of financial reporting is high,” the increasing trend is troublesome. Since this study was published the number and magnitude of restatements has become such a significant issue that it has rocked our financial markets and prompted new legislation. This is shameful, and an indication that the companies’ last line of defense, the chief financial officer, was not able to withstand the pressure and agreed to break the rules.

  Consistency

  Consistency guides us to present facts in the same manner each time they occur. By presenting or reporting them consistently, the trends presented over time will have meaning because they are based on a common method of presenting similar facts. It is all about providing information that is helpful to interpret the situation.

  The best way to understand something is to learn it, and then be able to rely on it being the same each time you look at it. If you always put your toothpaste in the same place after you use it, you can rely on its placement. Might there be another place to put it? Sure, but knowing it is in the same place makes your routine easier. As a practical example, if you record freight as a product cost, consistency says you should keep reporting it that way, in the same account and location every time. If you make it a reduction to sales one month, then move it down to product cost the next, the information about whether sales are up or down is confusing and unreliable. Once the accounting information becomes hard to rely on or understand, the accountant has lost his value to the organization.

  Consistency seems to say, “Don’t change.” This book, on the other hand, is advocating change. So how do we justify this? Remember the goal: providing useful information to business managers. Consistency will help you do this, but only if the consistent information is useful in the first place. If you do change formats or methods, remember to disclose it when appropriate, or restate prior results consistent with the new method to help users understand the figures.

  Matching

  All costs to manufacture the goods you sell must be recognized as an expense in the month you recognize revenue. Most costs need to be recognized in the month they happen. A practical example: the materials that you bought for a product that will ship in two months will be kept as inventory on your balance sheet. It is not an expense until you ship the product. The cost of advertising that product, or any other, is recorded as an expense on the books in the month it happens. This was the genesis of a lot of standard cost accounting techniques.

  This is an important tenet from a lean manufacturing perspective because, as lead times shrink on products that are being made and shipped all in the same month, there is an opportunity to simplify accounting procedures. When products are made and shipped in the same time frame, accountants no longer need to put the manufacturing costs of people and overhead on the balance sheet as inventory. We can expense these costs directly as they occur and still match our expenses with our revenue. At Lantech, the elimination of standard cost absorption alone released one of eight accountants to begin doing other things — notably, analysis work on overall product line profitability.

  One of the most important retaining walls for accounting’s structure is not a traditional accounting tenet. If it were, the tenet would be called the company’s mission or objective. What the company is trying to achieve should be our guideline for determining what we report and what we measure. After all, we want to be in the stream moving with the business, giving information that is relevant instead of paddling against the current or jumping out of the water.

  For instance, perhaps your company’s competitive advantage is introducing new products rapidly. Information about development time to market and tracking the related cost to enhance tax incentives might be critical. Accounting should consider it a priority to have precise records of this information. Perhaps in your business, the cost of oil is one of the most critical factors, or you rely on government contracts, with pricing based on cost. Then these factors must be taken into consideration when developing the right kinds of techniques for your accounting reports in order to help ensure that the company meets or exceeds its goals.

  For Lantech, one of the most important pieces of information needed was product line profitability. Management wanted to know how competitive pricing could be, while maintaining acceptable profit levels for each product family. So accounting focused on evaluating the amount of resources it took to build a complete product family. The business focus told accounting there was no need to ascertain the cost of each individual product. The cost of individual units is not tracked and not compared, month to month. Managers need to know cost and sales trends; they also wanted to know the value of what was spent on trade shows. Accounting decided to track cost per lead, from trade shows or advertising, and the number of orders for a type of machine and how many shipped. The company’s objectives were the guide. Knowing the objectives, accounting could customize reporting in order to remain relevant. Reports could now reflect whether projects were moving in the right direction.

  The core tenet of Lean Management Accounting is a basic assumption that everyone in accounting would rather be a valued partner in the business rather than a bean counter. To become an asset, we must stop drowning in the sea of our own transactions. Grab a life raft and see where the journey leads.

  3

  Performance Measurement

  To know the true picture of a company, to ascertain whether it is improving or slipping down the wrong path, we know we must collect and keep certain performance measurements. Also, we know there should be one driving force behind which measures are selected and deselected: the company’s strategy and related goals.

  Look at it this way: If performance measures are to create an accurate picture of the company on which we can rely, then the strategy is the tool we use to guide our focus, like operating a camera. Selecting goals and measures is like building a strategy camera. Every camera takes a slightly different picture; build one badly, and the output will be shadows and distortion.

  The first and most important consideration for the lean accountant and executive is to ensure that the goals identified are critical to success. Experience teaches us that when goals are set, people will do whatever they can to achieve the target, even if it results in dysfunctional behavior. Consider the craze of the 1970s and 80s, MBO or Mana
ging By Objective. All that focus on the what part of the equation —the objective —instead of the methods for achieving the objective created loopholes that hurt a lot of businesses. In the end, MBO often created sub-optimization, with managers eagerly optimizing the one little piece of the process over which they had control, without concern for the big picture. It is a kind of natural law that people will try to meet the metrics set by the boss in order to make themselves look good, no matter the consequences.

  We know that metrics shape behavior. So we need to look for the metrics that will result in the desired behavior, and be certain that we are establishing measures that managers and associates can relate to their specific jobs. Metrics can be long-term in nature or can be created to address a more immediate, short-term problem. For instance, if energy prices spike, a metric can be created to focus employee attention on that issue for the length of time that it remains an issue.

  In one light, performance measures can be viewed as a simple roll-up of the business’ mathematics. Once a team begins to explore the many levels of the equation, however, some people might get lost —unable to see how to get to the bottom line when there are so many layers in between. We should be able to clear up much of that confusion in this chapter.

  One of the business world’s premier measures, stressed in most financial management programs and treated as the one prevailing metric, is Return on Investment or ROI. As currently practiced, ROI is an excellent example of the intent to capture many complex and interrelated events, thus creating one monster of a metric that few people can relate to their daily activities. Figure 3.1 demonstrates the complexity of this measurement. This type of illustration is rarely, if ever, used to help employees understand how they can relate to ROI. As we can see, however, most people can affect an ROI metric at a point that is five or six levels deep. But most employees believe that ROI is some esoteric financial concept that doesn’t touch them in their daily lives.

  The reality is that ROI is merely the complex reflection of all the activities of every individual on every day of the period being measured. In other words, ROI is the attempt to encompass everything in one number. It becomes clear that if we focus on measuring improvements in how people work —in bettering the process for each piece of work —those improvements will roll up into an improved ROI.

  Employees can more easily relate to processes, since every person uses some type of process every day. So we focus on improving the process by highlighting performance measures that are focused and less all-encompassing than the final ROI. If a company is constantly improving its processes, the results in the ROI will come. This focus on improving the individual elements of the process, by eliminating waste and increasing velocity, has great impact on the bottom line, but only when we are not focused exclusively on that bottom line. The winners will be companies that focus on process first, not results.

  The question now becomes, which process performance measurements should be kept and which deselected? Art Byrne, Wiremold’s CEO, says if he were forced to use just two metrics for the entire company, he would choose customer service and inventory turns. Byrne explains it this way: a company cannot have high customer service —which might be measured in part by the percentage of on-time delivery —and high inventory turns without doing a lot of things right. High inventory turns means the business has achieved high velocity and eliminated significant waste throughout the organization.

  Compare these simple measures with the one big hammer of a metric many companies use: Make The Month. There are businesses that expend tremendous amounts of energy and resources toward the end of the month in one mad scramble to live up to whatever numbers were budgeted or promised. Make-the-month might seem like a rather simple trap to avoid, but most typical results-oriented companies end up in the make-the-month category. These businesses may get results in the short term —much as fad diets get results —but in most cases, the practice creates significant waste that can seriously damage a company in the long term. How can we tell if a company has fallen into this trap? If we use the example of shipments, look at whether shipments reflect substantially more than 25 percent of monthly sales in the last week of a typical four-week month. If the answer is yes, make-the-month syndrome is at play. We have seen companies that regularly ship 50 percent to 80 percent of their monthly volume in the last week of the month. The resource implications of this are staggering. What are the resources, such as overtime, that are needed to process 80 percent of the volume in 25 percent of the time? Or, if the organization has staffed to comfortably handle that higher volume, then what amount of resources is sitting idle or involved in make-work activities the other 75 percent of the time?

  When Art Byrne joined Wiremold in 1991, the first slide of the first presentation that he made to employees was this:

  Productivity = Wealth

  Although simple in its form, this statement expresses a key economic principle. In fact, it is this principle that has been an essential element of Alan Greenspan’s campaign to fight inflation. Productivity gains allow companies to increase wages without increasing prices. This in turn keeps inflation below the wage-increase level, thereby increasing real income and the standard of living. However, productivity is a much-misunderstood concept and often misused. Simply reading a company’s financial statements won’t tell you whether that company increased productivity, slid backwards, or just stood still. If productivity improvement is such a key factor in achieving economic improvement at a national, company or individual level, then a short detour to discuss this subject is in order.

  The business environment includes both the physical and the financial. The physical side of the equation focuses on the relationship of the units of input —such as the time it takes to create a widget —to the units of output, which is the number of widgets. We can apply this basic idea to any process from making a computer to invoicing a customer. The physical equation deals only with the quantity of the input and the quantity of the output. It is the relationship between these physical factors that defines productivity. If you can get more output (widgets or invoices) with the same or less input (time) then we have a labor productivity gain. When we talk about the relationship between the price of the input —how much time costs —and the prices of the output, we are actually discussing price recovery. So, if workers’ salaries are increased by four percent but the company cannot increase selling prices by at least that much, it has suffered a price recovery loss.

  Once you multiply the quantities and prices of the inputs and outputs you are now dealing with dollars, and the relationship of the dollars of output to the dollars of input is profitability. In other words, sales dollars minus cost equals profitability. Figure 3.2 is a visual representation of these relationships. By understanding them, we can measure the two separate distinct influences on profitability. Then we can direct our efforts toward the areas that represent the greatest drain on profitability. In the lean world, we refer to these as opportunities.

  Focusing on each element of the cost of doing business will lead a team to look more clearly at each of the resources consumed.

  Thus, the discussion surrounding the productivity of materials used can lead us to consider eliminating the causes of scrap and redesigning products to use less material. Thinking about prices paid for raw materials leads one to look at consolidating vendors in order to negotiate more competitive pricing and redesigning products to substitute less expensive materials. Likewise, the productivity of labor or any overhead element can be analyzed separately from both the quantity and the price portion of the equation.

  The one thing that stands out clearly when these discussions take place is that in order to have productivity increase, there must be physical change. The change cannot be made solely in the numbers from accounting. Productivity cannot be improved through financial engineering. When we focus on physical change, we discover that the principal thrust is to eliminate waste. Thus, when we talk about kaizen or continuous improvement, we
are talking about the relentless, never-ending pursuit of eliminating waste in all of its forms. Figure 3.3 is a list of the “Seven Sins of Waste” as identified in the Toyota Production System. Each of these wastes are created within some business processes and therefore can be identified, measured, and eliminated in order to increase productivity.

  Waste elimination generally requires a new mindset. Most people don’t get up in the morning and say, “I think I’ll go to work and create waste today.” Dr. Edwards Deming, father of the modern quality movement, referred to most people as “willing workers” who were subjected to working in processes that had waste built in. Without calling it waste, most workers accept their wasteful practices as a normal routine.

  Identifying waste activities begins with separating all activities between those that add value and those that don’t. This is easy to say but in many cases, hard to do. How do we measure value? And valuable to whom? If a company is truly going to be transformed from an internal to an external (or customer) focus, then the core question is, Is it of value to the customer? If the customer would be willing to pay for it, it has value. If not, then it has no value. Unfortunately some activities that don’t have value by this definition must still be accomplished. A classic example of this is preparing tax returns. It adds no value to the product, but every business must do it. Once we have classified activities, what do we do with them? If the activity is adding value, or is required, we remove waste within the process by performing a kaizen. If there is no value or requirement, eliminate the activity.