Real Numbers

by Orest J Fiume

  Now take the same company and rewrite their financial report as in Figure 6.2. It is a simple presentation —even elementary — but it gives a clear picture of the prime costs of the business: material, labor and overhead. The labor and overhead are segregated into processing costs and occupancy costs. This is helpful when Profit & Loss statements are produced for each product family within the business. Processing costs are assigned to the product family and occupancy costs are allocated and represent a small portion of the total costs.

  Factory salaries for management and support personnel such as manufacturing engineers and purchasing are up by five percent. As managers of this business we know what the average wage increase has been and, combined with the knowledge that some manufacturing engineers were added to facilitate process improvement, we can conclude that five percent is reasonable. Benefits are up 40 percent so we know we should talk to HR about causes and possible corrective actions.

  Services and supplies —true overhead items —are under control and the increase in depreciation appears to be reasonable in light of capital spending. Scrap is down 50 percent, indicating that quality is improving. In the area of occupancy costs, building services are up more than expected, but we also know that energy costs have increased significantly this year and represent the major cause.

  And yet, even though sales are up more that 11 percent, gross profit is flat. What would have been a mystery in the older style report is quickly identified here: the company was building inventory last year and liquidating it this year. Last year we capitalized operating costs in inventory and this year we must charge it to operating results as that inventory is sold. This presentation recognizes the fact that the balance-sheet asset that we call “inventory” is comprised of two things. The first is the material content —the real asset. The second is deferred labor and overhead. Under the matching principle discussed in Chapter 2, labor and overhead incurred to build product that is not sold in the current period must be capitalized. It is then expensed during the period in which the product is sold. In other words, in years when inventory is increased, that period’s profits are enhanced by moving costs out of the profit and loss statement and onto the balance sheet. Conversely, in years when inventory is decreased, which happens rapidly during the lean transformation, those periods are penalized by having to recognize this charge for past years’ expenses in addition to the current ones. In fact, the factory was doing the right things, reducing costs, improving inventory turns and generating cash, but the standard cost financial statements hid this.

  This is why many operating people who begin to have some success with their lean transformation might wrestle with managers who do not have a clear understanding of its implications on the financial statement and the cash-flow report. Managers who still use standard cost-based financial statements say, “I don’t know what you’re doing, but whatever it is, stop it. You’re killing profits.”

  In this example, if we assume that the factory associates received a 3 percent wage increase, then the number of hours incurred would have been reduced by approximately 7.3 percent (+3.0 percentage rate – 7.3% hours = – 4.3 percent). If we also assume that the sales increase was all volume (i.e. no price increases and no significant mix change), and that approximately 26 percent of the total sales were satisfied through inventory sell-off, then one could argue that there was a productivity loss. The total production was down approximately 37 percent as follows:

  Now, let’s keep in mind that significant productivity gains cannot be achieved without full participation of the workforce. Since people will not willingly work themselves out of a job, companies that are committed to achieving these levels of improvement must guarantee that no one will lose employment because of productivity gains. In the example given above, the reduction in hours was achieved by reduced overtime and attrition. The excess labor hours, temporarily created by the inventory reduction, were devoted to training and kaizen activities. Using layoffs to avoid this cost is not acceptable because once the inventory is reduced to the desired level, those labor hours (i.e. people) will be needed to satisfy current customer demand.

  Unfortunately, in the quest for short-term gains, companies use layoffs extensively when productivity improves. In doing, so they reduce the probability of any meaningful cooperation of the workforce to achieve significant future productivity gains.

  People just won’t willingly work themselves out of a job. Management must take a longer-term view and put meaning into the phase “our people are our most important asset.” As time goes on and productivity gains continue to be achieved, it is acceptable to ensure that, as attrition takes place, it is difficult for replacements to be hired. In this way, the productivity gains will translate into higher profits.

  We do recognize that the employment guarantee can be a difficult commitment for CEOs. But we also know this: The reluctance to ensure employment is a major barrier to successfully implementing lean, and amounts to an admission by senior managers that they cannot grow the business fast enough to absorb significant productivity gains.

  Once we have made the transition to a set of management reports that contains both financial and non-financial information in a format that non-accountants can understand, what do we do with it? The obvious conclusion is that you can make the information more widely available, since more people can understand it. In turn, as more people understand it and see the results of their efforts clearly reflected over time, a more productive and profitable behavior will be motivated. Companies that want to move to open book management, as described in Chapter 2, will have a financial tool that facilitates this.

  Changing something as fundamental as management’s financial statements is easier to say than to do. Your colleagues have spent years attempting to react to that old information, presented in a specific format. Taking that away —no matter how useless it was —may be politically difficult. Although many people may not realize it, the lower reporting levels of standard cost systems contain all of the data required to easily present a financial statement similar to the one in Figure 6.2.

  At Wiremold, management reports were switched out in a manner so straightforward, it was almost sneaky. When new reports were ready, the traditional management reports were sent out first. About a week later, Orry distributed the alternate presentation, prepared off-line in a spreadsheet, with a note attached stating, “We’re trying something new. Would love your feedback.”

  Two things happened. First, Orry’s team received some useful feedback that improved their presentation, and gave them some buy-in from colleagues making the suggestions. As time went by and they continued to distribute the older reports a week before the new one, Accounting began getting calls as soon as managers received the traditional package. They asked for the alternate presentation sooner, and in place of the traditional presentation.

  Mission accomplished.

  WHERE TO FIND THE DATA

  Even the most standard of standard cost systems contain the data required to prepare a Plain English Management Financial Statement. If we trace each line item in the statement back to its source, we discover that the information we need is in the company’s transactional systems and trial balance.

  Sales and the related items to get from gross to net are not a problem because they are reported in the same way.

  Information about purchases, services and supplies come from the accounts payable system.

  Wages and salary costs for the various categories come from the company’s payroll system. Benefit costs come from a combination of the account payable system (e.g. health insurance premiums) or accounting journal entries (e.g. accrual of pension cost).

  Depreciation comes from the fixed asset system. Scrap is derived from a shop floor system that captures the information about product that is scraped and sent to scrap recovery.

  The item that can give some difficulty is the change in inventory. At the beginning, when inventory levels are still high, the difference in
the value of the inventory as recorded in the perpetual inventory records at the beginning of the month, and the end of the month is the source of this information. As inventory levels come down, alternative methods are possible. For example, at some companies that have achieved 20 or more inventory turns, almost the entire inventory (no nuts and bolts…remember accuracy vs. precision) can be counted at the end of the month within a few hours. This allows the company to eliminate its perpetual inventory system and all related transactions.

  Operations uses kanban for its purposes and accounting uses a count for the financial statements. This inventory is valued as material content with the labor and overhead content added via journal entry using the techniques described in Chapter 5.

  Other companies use a hybrid of these two methods. They maintain a perpetual inventory system valued at material cost only, and add labor an overhead via journal entries. On a net basis, considerable waste is eliminated. Thus, even in a company that needs to continue to produce the standard cost financial statements for some period, the data exists within its financial systems to produce the Plain English Statements in parallel.

  7

  The One-Day Close

  In just about every organization, there are efforts to increase the velocity of change and speed products to the customer. E-commerce drives us toward immediate ordering and fulfillment. UPS can get a package to your door by 8 a.m. All-night access is expected at cash machines, grocery stores, gas stations. We want instant access to weather reports, stock quotes, bank balances —and we usually get it. But the poor financial statement is still in process days and even weeks after the end of the reporting period. At that point, can we even call it relevant?

  If we want the organization to respect the information we offer and value its content, we cannot give it to them days after the activity is completed. And let’s face it, in some cases that information is weeks late. In a lean environment, immediate visual feedback is available throughout the business. Anyone can walk past a cell or work group and see how many pieces have been produced, how many hours have been lost to unplanned downtime and what the customer is buying. Leadership can react to that information instantaneously. Then we show up two weeks later, offering a report of how much was shipped, what the costs were and how much money was made. Jean can recall many times that she personally delivered the financials to other executives and managers and was greeted warmly, but with distance. All of the polite words would be spoken: “How is your day? Here’s your report. Oh, thank you very much. See you later.” On leaving that office, though, she knew her report hit the round file or recycling bin quicker than the door swung shut. The problem was, she had just delivered old news. What do you do with old news? Wrap up the trash. Use it for the birdcage.

  Let’s think about the cost of a financial statement. Better yet, let’s figure the cost of a financial statement using a chart like Figure 7.1. Calculate the number of people in the accounting team who work on closing the books. Write down their names and ask them which day they start to work on closing. Call it day one or day two or whatever. Then write down the day that the financial report is published —say, day seven. Calculate the number of days per person and then add it up.

  This reveals the total days spent on creating a financial statement. Now add in your employees’ salaries. How much does it cost? You can even use an average salary and apply it to everyone. This can be a good barometer for those who chose to start cutting down days for closing. Once you see how much those reports cost, you can see the value in reducing time spent on their creation.

  Most companies would probably agree that financial statements are vital to the company. Therefore we want to rush them to our colleagues as quickly as possible. They have a short shelf life, maybe just days, so we cannot waste any time getting these perishable products to the customer. Look back at the cost of that statement. Was that more than you were willing to spend on out-of-date information?

  There are two ways to attack the problem: Reduce the number of days that each person works on financials, then reduce the number of people involved in closing. We are not suggesting a reduction in the accounting staff, although that may be possible if your systems contain more waste than average. As illustrated in the Performance Measures chapter, there is plenty of valuable work for them, once the triangles are turned upside down.

  Do not expect to cut out the number of days required for closing all at one time. Instead create and communicate a big vision: “We will achieve an Everyday Close.” Then set interim targets. The first goal might be reducing the closing time by three days in the first quarter and taking two days out of closing in quarter two. Or decide to decrease the number of people involved with closing from eight down to five in three months. WORM your goals; make them Written, Observable, Realistic and Measurable.

  Now, let’s go looking for paths to meeting the target.

  Key Components

  A key principle in lean is always the elimination of non-value added activities. In most companies it is easy to find the non-value added activities —such as moving around materials, extraneous bookkeeping, wasted motions — because non-value added can be 90 percent of the activity (Figure 7.2).

  Traditionally, businesses have focused on reducing the amount of time it takes to do the value-added work. But if you first target the elimination or reduction of non-value-added work, the overall results are better, are achieved more quickly and morale is increased. No one wants to do work that is perceived as non-value added. Reducing the amount of time it takes to do value-added work can follow.

  At Lantech, when Jean first started looking hard at the journal entries made after the end of the month, she found an amazing fact: the highest number of entries were posted to correct items from the prior month that had been coded to the wrong account. So the first transaction, which was wrong, required a second transaction to correct it, without any understanding being gleaned from the mistake. Lantech does not do that anymore. Now, when an accountant finds an incorrect entry, she does not merely correct it; she investigates why it was recorded incorrectly the first time.

  These are usually great training opportunities. Occasionally, the team discovers that the process upstream was programmed to put the entry to the wrong account. The idea is to make your clerks into detectives, searching out how to get the data entered correctly at the source.

  Another discovery at Lantech was particularly disheartening. When Jean looked at the smallest dollar items —all the nickel and dime transactions —they made up the largest number of entries on her books. About 80 percent of the entries were for just 20 percent of the total value. Sometimes that ratio was worse. Let’s face it, in just about every company, entries are sometimes made for amounts that just don’t matter. Frequently these entries are corrections of other entries, which add redundancy to irrelevancy. The rule now at Lantech is, if the amounts are small and do need to be fixed, let them be fixed in the following month. Small amounts do not influence decisions — remember the materiality principle —and so do not need to take up precious time that we need in order to rush our reports to the customer.

  Here’s another key principle for a fast close: Out of the Closing Window or, simply, Out of the Window. Let’s say a number of the non-value added steps have already been eliminated and you are left with a number of tasks that must be done, such as calculating warranty reserves and bonus reserves and creating an accrual for unpaid days worked. These essential-but-not-urgent items are sitting there, aimed at your most precious window.

  Think of the closing window as the smallest opening in your house. There are a lot of bulky items that must pass through the house, on a deadline. Why would we try to shove everything through that one small opening? Instead, find a way to do the work before the end of the month. Think of set-up reduction work on the shop floor: all activities are divided into that which can be done while the machine is still running —external setup —and that which can only be done while the machine is at rest �
��the internal setup. In the monthly closing process, depreciation can be entered before the end of the month but income taxes cannot.

  There are two main methods for identifying items that can be moved out of the closing window, and most lean organizations will probably end up using both. One is to do the work as it happens, eliminating all batch activities. The other method is to look closely to see when each piece of information is available and put it in your books at the first available moment.

  At Lantech, as at about 80 percent of companies, a payroll service is used. A clerk —or an automatic system, at some companies — enters data three or four days in advance of payday. Summary reports and paychecks arrive a day before envelopes are handed out at Lantech. The summaries include dollar paid by department, taxes paid, vacation time versus regular time and overtime.