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Tuesday, April 23, 2013

On Lean Accounting

I thought it might interest a few of my dear readers to see what we academics talk about during our rare serious moments.  Here is an exchange of ideas from such a time.
The question:
  • Alexandra Mutiu  
  • Duncan McDougall

 Dear Professor,
 I remember you mentioned maybe two years ago about lean accounting and its potential. Do you remember it? If you did, can you tell me why you were so  thrilled about it?
Thank you
Here is my reply:

Dear Professor Muţiu,

As you know, my business background was largely in manufacturing, my doctorate is in production and operations management, and my academic interests have been largely focused on management accounting, specifically on the measurement of manufacturing performance.  These experiences combine to explain my belief in the importance of the (rather old) set of ideas that is now being called "lean accounting."

I attach my paper "Operating at the Rate of Consumption."   In its Exhibit 1-1, you will see graphs of the downward trend of Inventory Turnover (CGS/Average Inventory) in major American manufacturing companies between 1950 and 1975.  I believe that trend to have been caused in large part by the widespread use of standard costing with a full absorption costing approach.  The use of those approaches to inventory valuation provided a strong incentive to management to operate their factories at high levels of utilization.  Whenever demand for their products was less than their higher-than-demand operating rate, the result was increased inventory.  The role played by standard costing was seen in their income statements.  Operating at above planned (index, or standard) levels of capacity utilization under a standard costing system led to more fixed overhead cost being assigned to inventory than was actually being incurred during the relevant fiscal period.   Under the GAAPs, it was necessary to adjust income before taxes to recognize the fact that the company had, in its costs of goods sold at standard, overstated its fixed costs, thus understating its profits.   Hence, a period-end adjusting entry was necessary to reverse the error.  This entry affected the manufacturing overhead (a temporary account in which the incurred overheads are collected as debits, and to which overhead applied to inventory is credited), and the cost of goods sold, which is a debit-balance account.   When overhead has been over-applied to inventory, as in the case at hand, manufacturing overhead ends the period with a credit balance, so the adjusting entry is to debit manufacturing overhead for the amount of over-applied overhead, and to credit cost of goods sold, in the same amount.

Thus, a company (or manufacturing segment of a firm) that has operated at above-standard levels gets to decrease its reported cost of goods sold at year-end.  The happy surprise is that year-end profit proves greater than the sum of the quarterly profits, before this adjustment.

But, woe to the manager who comes to bat after that inventory-builder gets promoted, for if she chooses to reduce the operating rate below that of demand in order to get the inventory down to a reasonable level, she is required to expense not only that period's full amount of incurred fixed cost, but also the prior period's fixed costs that have been stored in the inventory values of the beginning inventory she inherited, and sold.

Old idea:

The concept of variable costing has long been taught by management accounting professors as an internal control system that removes from the score-keeping system the incentive to build inventory.  But, since it is in conflict with the accounting principle that holds all costs incurred in the manufacturing function to be part of "product cost," only a small percentage of American firms use it.

Lean movement:

The lean movement has been driven by the realization that, as some Japanese managers have said, "Inventory is the root of all evil."  Inventory has, since about 1980, come to be understood as wasteful.  It represents cash invested that is not earning anything.  Its existence as WIP slows the throughput of orders through factories.  It can hide process problems.  It is muda!  Working to reduce lot sizes by shortening set-up times, and by using a pull system to signal the need for more production at each successive stage of manufacturing, has been proven to facilitate process tuning to prevent defects, to speed the introduction of new products, etc.  Those principles of lean manufacturing, formerly called JIT or "world-class manufacturing," have proven both highly effective operationally, and highly problematic organizationally.  Why the latter?  Because the managers who implement the huge inventory reduction that these techniques bring about do not get the benefit of "the over-absorption fiddle."  (That is my nickname for the managerial game that I described above: using an inventory build-up to protect or expand reported margins.)

To the extent that the "lean accounting" concept can get public accountants and corporate managers at high levels to see the over-absorption fiddle as the unethical act of mismanagement that it is, then I am quite enthusiastic about it. 

In my opinion, the concepts of lean accouning must be included in our MBA course, Accounting for Managers.

Thank you for asking. 

With respect,

P.S. When we discussed this subject before, I believe that I was reading Solomon, Jerrold M. Who's Counting? A Lean Accounting Business Novel, and laughing about it.  It is not as powerful as The Goal, by Goldratt, but it does depict well the challenges facing an accountant who attempts to bring his company's accounting practices into line with its progressive operations.

Wasn't that fun?  Accounting always is!!!

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