Lean Performance Metrics, Lean Accounting, and Financial Controls
Performance metrics are collected and used for two principal purposes. First, they enable a better understanding and monitoring of the current system state. Second, they are used for control activities, which include external reporting as well as continuous improvement efforts. Various metrics have been devised to assist the lean practitioner. It is important to recognize that each of these metrics should help focus monitor and control efforts to better assist the attainment of improvements in system objectives regarding time, cost, quality, flexibility, sustainability, safety, and morale as noted in Chapter 1.
This chapter focuses on identifying various metrics lean practitioners use to assess firm performance and on the accounting practices that underlie the determination of some of these metrics. The content of this chapter is not to suggest a better means of accounting, but rather to identify potential shortcomings of current accounting practices, which may lead to future improvement efforts.
Lean Performance Metrics
Lean performance metrics, or key performance indicators (KPIs), may be categorized by the objective they recognize, based on time, cost, quality, flexibility, sustainability, or safety and morale. Alternatively, a KPI may be categorized by the portion of the system it monitors, ranging from a measure as small as a machine, to a complete process, to the entire organization itself. Although not meant to be an exhaustive list, frequently encountered lean metrics categorized by objective are identified in Table 10.1.
The vast majority of research demonstrates that firms commonly rely on nonfinancial information and metrics when employing lean.1 It is desirable to rely upon a variety of metrics possessing various characteristics. For instance, metrics that are visual enhance understanding and communication capabilities. Visual management techniques employed within a lean management system have the ability to convey a lot of information quickly. Furthermore, people remember information better when it is represented and learned verbally and visually. Data that is conveyed in financial terms is also better understood. People easily understand the value of a dollar.
Many of the metrics noted in Table 10.1 lack a direct financial nature. As an example, the amount of inventory (e.g., days of inventory outstanding) expresses the number of days that would be expected for demand to consume the existing number of units of inventory. However, a critical element of many business choices relates to the financial bottom line. Financial implications of strategic choices and tactical decisions can materially affect lean practices. Simply put, many common lean performance metrics may be converted into financial terms; however, they are not directly financially focused.
Table 10.1 Example lean performance metrics
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Lean metric nature |
Lean performance metric examples |
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Time based |
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Cost based |
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Quality based |
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Flexibility based |
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Sustainability based |
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Safety and morale based |
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Often the application point for the lean microscope differs, depending upon the environment. For example, in lower-volume, batch environments, the examination of connections and flows between resources is critical for waste reductions. This is true due to downstream arrival delays, given longer upstream process times of batches. Therefore, it is important for system drumbeat or takt times and pitch times to be consistent between connecting process resources. Alternatively, in higher-volume, repetitive processes, it is assumed that processes are initially designed with a common takt time across system resources. Therefore, a greater focus on the productivity of the resources themselves should be pursued. In particular, a measure such as overall equipment effectiveness (OEE) and the six big losses of equipment utilization, which focuses on equipment availability (equipment failure, setup, and adjustment), equipment speed loss (idling, minor stoppages, and reduced speeds), and output loss due to lower quality (defects and reduced yields) are useful.2 It should be evident that OEE focuses upon more than one objective. The point is, not all lean metrics or KPIs are useful for all types of transformation processes. Given their varied nature, lean practitioners should rely upon a variety of metrics, both financial and nonfinancial.
Lean Accounting
Financial accounting is commonly thought of as having an external reporting focus. As an integral business function though, accounting serves both internal and external cost-reporting purposes. Financial accounting measures and records transactions and contributes to various documents, primarily financial in nature, based upon generally accepted accounting principles (GAAPs).
Anecdotal evidence suggests financial accounting performance metrics do not always serve lean practitioners well for several reasons. First, financial accounting performance metrics provide late information. In particular, measures calculated at the end of a period such as a month may delay or prevent proactive actions. Second, financial accounting performance metrics, which are vague, such as the allocation of indirect overhead costs to a line of products, do not represent accurate system performance. Third, measures, which are primarily financial in nature (e.g., standard costs) do not relate to the customer’s perspective of value-added tasks for specific products. This confounds process improvement activities. Consequently, the term lean accounting has emerged, given the potential deficiencies current financial accounting practices may result in when attempting to assess system performance. Lean accounting attempts to rationalize the necessity to track, allocate, and monitor financial metrics at numerous, pinpoint locations within operation processes. Lean accounting recognizes that voluminous transaction processing attributable to standard costing and overhead allocation practices does not add value to well-understood, stable processes. Rather, many of the financial transactions focused on tracking, allocating, and monitoring financial metrics may be unnecessary and eliminated.
A sound understanding of financial accounting practices and financial metrics is important for lean practitioners’ comprehension of lean accounting and for choices both in the boardroom and on the factory floor. These practices and metrics may reflect data that are financial in nature or they may reflect data that concern defects due to unmet specifications including length, width, height, weight, or volume. Alternatively, the data may reflect flow interruptions due to late materials, poor machine reliability, missing tools, unavailable operators, and so on. The point is lean practitioners benefit from the knowledge of a broad set of performance assessment tools with the frequency of data collection being determined by the value of the data itself. Highly stable operations require less data collection and transaction processing.
Ideally, lean practitioners will rely upon a broad set of performance measures possessing numerous characteristics. These characteristics can include (1) financial metrics, (2) current, or real-time, system performance, (3) a depiction of the current state of the process relative to the planned or expected state, (4) engaging the individual(s) close to the process and those individuals who are responsible for maintaining and correcting the process, (5) relying, if possible, upon multiple sensory functions (e.g., coupling audio signals with visual signals) simultaneously, (6) utilization of smaller time increments between data capture points enabling issues being brought to light sooner and more easily, highlighting the introduction of assignable sources of variation, (7) use for accountability regarding investigative results, and (8) utilization of various colors in order to depict multiple-state conditions. Some of the more significant accounting practices and financial metrics topics impacting lean practitioners’ choices both in the boardroom and on the factory floor are identified in the following sections.
Cost Accounting
Cost accounting provides much of the information used for financial accounting reporting purposes. Cost accounting is used to provide information for internal decision making. Cost accounting typically collects, analyzes, and disseminates financial and nonfinancial information related to the costs of resource acquisition and consumption supporting transformation processes for both internal and external decision making.
Cost allocation is used to describe the assignment of indirect costs (e.g., lease, overhead, insurance, taxes, and quality control) to particular cost objects (e.g., individual jobs, orders, a product, department, machine, or material). The objective of allocating indirect costs to an object is to measure the underlying usage of indirect resources by objects. Cost accounting relies upon individuals within responsibility centers to provide estimates of resource usage for cost allocation purposes. Resource usage often cuts across multiple departments making accurate estimates difficult at best. Indirect costs, costs that are assumed to be related to an object such as a part, machine, or an order, cannot be directly or easily traced to it. Indirect costs are nonetheless attributed to the object despite the difficulty tracing costs.
Indirect costs can comprise a significant portion of overall costs assigned to objects. The historical practice of allocating indirect costs in this manner has been done for several reasons. First, it assumes this information is necessary for economic decision making, such as determining a selling price for a product. However, in a product’s inception, the selling price may not sufficiently cover production costs, as production volumes are commonly low relative to later periods. Leaders should always examine decisions from a systematic point of view; otherwise, some products assessed as being successful in later life cycle stages may never initially go into production. Second, full cost disclosure, even though one may be relying upon inaccurate cost estimates, can be used to motivate employees to alter designs. Various strategies, including simplicity from fewer parts, the use of standardized components, or possibly alternative materials or technologies can be followed to alter designs. Third, estimates for reasonable reimbursement rates may be required. Fourth, external information reporting is often necessary.
Unfortunately, indirect cost estimates can be wrong to a great extent, leading to poor decision making. This sometimes occurs because indirect costs are often accounted for with definitive time periods (e.g., a week or month). However, indirect costs may be incurred beyond these discreet time periods. Furthermore, indirect costs are often assumed to be incurred at a linear rate such as the incurrence of monthly rent. Yet not all months have the same number of working days. And, there may be variable (seasonal) aspects to some indirect costs, further reducing the effectiveness of estimates.
An additional cost allocation issue is whether indirect costs are controllable, minimally influenced, or uncontrollable. This issue is similar to non-value-adding activities. Most would agree that non-value-adding activities should be eliminated, as they are wasteful. Unfortunately, not all non-value-adding activities can be eliminated, as they may not be avoidable. Some costs that are allocated to objects are uncontrollable. Examples of uncontrollable costs include depreciation, workspace charges, general and administrative overhead allocations, and even direct labor during periods of low demands as the labor may not be transferred or eliminated. Uncontrollable costs should be recognized so that managers do not pursue matters beyond their immediate, direct control.
Choices about (1) the degree of detailed estimation, collection, analysis, and reporting of information; (2) product- or service-costing methods (e.g., variable or absorption costing); (3) job-costing alternatives (e.g., standard costing using sequential tracking or backflush costing); and (4) process costing can each have profound impacts on costs of goods sold and therefore financial reporting implications. These are but a few of the accounting issues confronting the lean practitioner. These ideas are discussed in the following four sections.
Activity-Based Accounting Systems
Emerging lean accounting practices seek to reduce non-value-adding transaction processing, eliminate standard costs in favor of actual costs, and eliminate cost allocations. Activity-based costing (ABC) represents a step in this direction. ABC attempts to improve upon traditional estimating approaches of indirect costs by focusing on less aggregated or more detailed transformation activities, such as actual machine setup times, design activities, or inspection activities for each specific product in order to allocate indirect costs to objects on the basis of specific activities undertaken for each product.
ABC activities may rely upon process flowcharts to more accurately trace and estimate indirect costs. Process flowcharts may provide a more finely structured mapping of transformative activities allowing a more accurate cost tracing and subsequent allocation.
ABC systems commonly use utilize a four-part cost hierarchy.3 The hierarchies are based upon different types of cost drivers or differing degrees of difficulty in determining cause-and-effect relationships for cost allocations, which may be estimated based upon a process flowcharting investigation. Four-part hierarchies, which determine how indirect costs are allocated are typically related to (1) output unit-level cost measures, (2) order- or batch-level cost measures, (3) product- or service-sustaining cost measures, and (4) facility-sustaining cost measures. Each of these hierarchies is defined in the following text.
Output unit-level cost measures assess indirect costs against resources consumed producing specific products or services. Examples of these activities include electrical consumption and machine maintenance. Costs associated with these activities are assumed to be directly proportionate with the output levels for a product or service. Indirect costs deemed related to unit output levels are allocated directly using a measure such as unit outputs. For example, assume the monthly electric bill for an organization producing 500 units of product A and 250 units of product B is $1,000. In this example, monthly electric costs allocated to product A would be $666.67 (500/750 × $1,000), while $333.33 (250/750 × $1,000) would be allocated to product B.
Order- or batch-level cost measures assess indirect costs against resources consumed producing an order or a batch of a product or a service rather than against unit output levels. Examples of these activities would include item procurement or setup activities. Costs associated with these activities are assumed to be incurred once per order or batch for a product or service. Assume the setup costs associated to produce a batch of product A are estimated to be $250. If five setups are done for product A during the month, the costs allocated for product A setups would be $1,250 (5 × $250).
Product- or service-sustaining cost measures assess indirect costs against resources consumed producing a specific product or service. This assessment does not occur on the basis of units or batches, but rather for the product or service itself. Examples of this would include vendor identification, product design, product engineering, and tooling costs. Each of these activities incurs costs, which cannot be directly traced to unit or batch volumes.
Facility-sustaining cost measures assess indirect costs against resources consumed producing all of the organization’s products and services. Examples of these costs include lease, custodial, security, information technology, and other costs. Determining cause-and-effect relationships for these cost allocations are most difficult. Therefore, some organizations deduct these costs from operating income rather than pursuing a product cost allocation approach.
Cost hierarchies used within ABC systems promote identification of cost cause-and-effect relationships. The idea of ABC systems is to promote more accurately tracing and estimating of indirect costs, which may promote efficiency improvements. The cost cause-and-effect relationships promote more accurate indirect cost tracing and estimating, which may allow for waste elimination and efficiency improvements. However, it is important to understand the effort involved in determining detailed identification of cost drivers and cost categories. Detailed ABC systems can be costly to initiate, understand, operate, and maintain. In effect, the lean practitioner must question the value added of the detailed information.
Product or Job Costing: Variable, Absorption, and Throughput Inventory Costing Choices
Reported income is a key metric in the performance evaluation of all managers. There are two historical product approaches for capturing inventoriable costs, which refer to the timing of when costs of a product (job) are incurred and reported as cost of goods sold. There are three alternative methods of product (job) costing utilized in lower-volume batch processes. There are two alternative methods process costing commonly uses in higher-volume, line flow processes.
The three alternative product-costing methods are variable, absorption, and throughput costing. Each method impacts reported income differently. It should be noted that among the product-costing methods, GAAP requires absorption costing for external financial reporting.
The first, variable costing is an inventory costing method that uses only variable manufacturing costs (both direct and indirect) as inventoriable costs. Fixed manufacturing costs (both direct and indirect) are excluded from inventoriable costs and therefore are treated as an expense in the period in which they are incurred rather than the period in which the product is sold. Variable costing does not delay reporting fixed manufacturing costs in the form of stored inventory until subsequent periods.
Absorption costing is an inventory costing method of expensing all costs associated with manufacturing a particular product. It absorbs, or includes, both variable and fixed manufacturing costs as inventoriable costs. Absorption costing uses the total direct costs and indirect overhead costs associated with manufacturing a product as the cost base. Because absorption-costing inventories fix manufacturing costs as inventoriable, relative to the variable costing method, use of absorption costing can encourage managers to produce more inventory than necessary in order to inflate income in the period. In general, if inventories increase during an accounting period, more operating income will be reported under absorption costing than variable costing. All nonmanufacturing costs are expensed in the period in which they are incurred under both variable- and absorption-costing approaches.
Some suggest that even variable costing promotes the unnecessary buildup of inventories, given a desire to promote current period financial reports. Throughput costing treats all costs, except those related to variable direct materials, as expenses of the period in which they are incurred. Namely, only variable direct costs are inventoriable costs.
Although absorption costing is the method most commonly used, there is disagreement as to the favored inventory costing approach. Lean practitioners might consider throughput costing to encourage greater efficiencies. However, throughput costing is not allowed for external reporting if its use results in materially different numbers than those reported by absorption costing. As previously noted, GAAP does not allow throughput costing to be used for external financial reporting for U.S. firms. However, GAAP is not followed globally. Furthermore, there is disagreement among accountants as to a favored product-costing approach. Some accountants suggest variable costing be used for external reporting because the fixed portion of manufacturing costs is more closely related to manufacturing capacity than to the actual production of specific units. Other accountants suggest absorption costing be used for external reporting because inventories should carry both variable and fixed cost components as both are necessary for production.
Traditional Product Costing and Backflush Inventory Costing Choices
Product costing for transformation systems assumes a sequential approach whereby accounting journal entries occur at sequential process stages such as procurement (raw materials inventory), fabrication (work-in-process inventory), final assembly (finished goods inventory), and distribution. Each one of these process stages requires recording journal entries.
An alternative to traditional job costing is backflush inventory costing. It is sometimes used in systems with short throughput times that maintain little in-process inventories or highly stable periodic inventory levels. Although it still reflects a linear process flow, backflush inventory costing often omits capturing one or more in-process accounting journal entries, effectively delaying the costing process until final assembly is completed. Costs are then “flushed” back at the end of the production run and assigned to the goods. This eliminates some of the detailed tracking of costs at intermediate production process steps, a feature common to traditional sequential costing systems. The detailed tracking of traditional sequential costing systems may simply not provide the value-added information for monitoring and control purposes.
By eliminating work-in-process accounts and journal entries, backflush costing simplifies the accounting process. However, this simplification and other deviations from traditional costing systems means that backflush costing may not always conform to GAAP. For example, work-in-process inventories may exist but would not be recognized in financial statements. This system also complicates a potential audit trail, as the ability to identify resource consumption at sequential process stages may be eliminated.
Process Costing: Weighted Average and First In, First Out
Variable and absorption product-costing methods are traditional sequential costing methods commonly used in lower-volume batch processes. Accounting in high-volume processes sometimes uses a process-costing approach for financial reporting. It is sometimes assumed that each item consumes similar resources and consequently direct material costs, direct labor costs, and indirect manufacturing costs in systems producing largely identical, mass-produced items. As a result of uniformity, a process-costing approach treats all units produced as equivalent through the adoption of an average production cost per unit to calculate unit costs of products or services.
As a result of equivalent products, rather than having separate journal entries for different products at each stage of the production process (e.g., fabrication work in process or assembly work in process) as product-costing alternatives practice, process-costing methods result in a single journal for each process stage. Process costing relies on two alternative inventory cost flow assumptions, a weighted average and a first in, first out (FIFO) method. Each results in different work-in-process and work-completed costs.
The weighted average process-costing method calculates an equivalent unit cost of work done to date, regardless of the actual period or timing in which the work was completed. It assigns this cost to both the number of equivalent units completed and transferred downstream as well as to the equivalent units transferred to work-in-process inventory at the end of the period. The weighted average cost is the total of all costs entering the work-in-process journal account (regardless of timing) divided by total equivalent units of the work done to date.
The FIFO process-costing method may be best explained as a four-step process. First, it assigns the cost of the previous period’s equivalent unit ending inventory (current period’s equivalent unit work-in-process beginning inventory) to the first units completed and transferred downstream during the current period. Second, it assigns the costs of equivalent units worked on but not finished during the period to the remaining equivalent unit work-in-process beginning inventory. Third, cost assignment proceeds to equivalent units arriving, completed, and transferred downstream during the period. Fourth, cost assignment proceeds to equivalent units arriving and remaining in work-in-process inventory.
The principal differences between these two process-costing procedures include the following observations. First, the weighted average process-costing method aggregates inherited units and costs (work done in prior periods and accounted for as current period beginning inventory) with units and costs of work done during the current period. As a result, the weighted average process-costing method tends to smooth (averages) equivalent unit costs. Second, the weighted average process-costing method is computationally simpler than the four-step FIFO process. Third, the FIFO process-costing method for equivalent unit costs are determined solely for work done during the current period. Therefore the FIFO method is more transparent with information concerning periodic cost changes, which may enhance one’s performance-monitoring ability. Fourth, costs of completed units and, therefore, operating income can be materially different under the two approaches when the direct material or transformation process costs vary greatly from period to period or when there is a dramatic change in periodic work-in-process inventory levels relative to work transferred downstream. This can influence one’s understanding of financial reports. Regardless of the method, process-costing approaches are typically used exclusively in high-volume process industries that produce similar items, given their need to determine equivalent units. Otherwise, the average production cost per unit is too broad.
Financial Controls
Beyond cost-based lean metrics, there are additional financial controls and KPIs that lean practitioners should be aware of as well. In any investment decision, various financial considerations should be assessed. Among these are example metrics such as the payback period, return on capital (ROC), discounted or net present value, as well as operating profit.
The payback period refers to the length of time it takes to recoup an initial investment from the revenue or free cash flow the investment generates. Consider this example: If a project costs $100,000 and is expected to return $20,000 annually, the payback period will be five years determined as $100,000/$20,000. This is a common investment evaluation measure, which assesses how quickly an investment such as equipment can be repaid. It is a good proxy for risk, but it ignores the time value of money, so its use is better suited for quick repayment periods. Although it is easy to accommodate nonlinear cash inflows, it also ignores cash inflows after the payback period.
ROC is commonly used to assess the rate of return a business is generating on the company’s book value. The ROC measure may be used as a hurdle to identify and select capital expenditure projects. ROC is determined as:
Net operating profit after tax
(Book value of equity + book value of debt − cash and cash equivalents)
The discounted or net present value refers to the time it takes to recoup an investment from the revenue or free cash flow it generates by using the value of those cash flows in today’s currency by discounting them using an appropriate discount rate. It is determined as
PV = FV(1+i)n and the NPV = PV’s − investment expense
where PV is present value, FV is future value, i is the assumed rate of return, n is the number of periods (e.g., years) ahead, and NPV is the net present value. As an example, assume you have the opportunity to invest a sum of money that will yield $1,000 at the end of two years. The present value of this investment opportunity if you want to achieve a 5 percent rate of return is $907.03, determined as $1,000/1.052.
Operating profit is the profit realized from carrying on the regular activities of a business or a company. It excludes gains and profits from other investment activities such as real estate and financial investments. Operating profit (operating income) is formally referred to as EBIT (earnings before interest and taxes). EBIT is calculated by subtracting the cost of depreciation and amortization from earnings before interest, taxes, depreciation, and amortization (EBITDA) expenses.
EBITDA = revenue − cost of goods sold − sales, general, and administrative costs
EBIT = EBITA − depreciation expenses − amortization expenses
It should be apparent that many variables impact the financial accounting KPIs. For instance, material costs, tooling expenditures and the consequential amortization schedule, equipment depreciation schedules, indirect overhead allocation costs, and many other variables impact operating profits. For monitoring, controlling, and improvement activities, the implications of these consequences should be well understood.
Summary
Needless to say, there is a wide array of important lean performance metrics. Some focus on various system objectives (e.g., cost or time), others examine specific system elements (e.g., machine utilization), some are not directly financial in nature (e.g., inventory turns), and others are directly financial (e.g., payback period). Emerging lean transformation system monitoring and control procedures are attempting to focus on recent system or current state performance, social controls (e.g., encouraging worker cross-training), and visualization approaches. Technology is facilitating and will continue to facilitate the identification of more costs as direct rather than as indirect costs. For example, bar code technology can identify consumption of specific parts within an exact stage of a transformation process.
It is important to understand that many variables impact lean performance metrics. This observation is not limited to the financial accounting KPI’s. Monitoring, controlling, and improving transformation processes are data driven. The focus, nature, and limitations of each metric should be understood. Lean practitioners benefit from the knowledge of a broad set of performance assessment tools.