9 myths of accounting in manufacturing

About 15 years ago Drew Locher, president of Change Management Associates, helped put on a conference that brought together accountants, CFOs, and operations personnel, mainly from large companies. He was one of several consultants who saw early on a conflict between operational changes brought about by lean manufacturing and company accountants who questioned the benefits. The annual conference, which continues to this day, has attracted several hundred people every year. It covers a concept called lean accounting.

“We told them, in a very nice way, that everything they learned in school was wrong.”

Locher said this back in March to attendees of The FABRICATOR’s Leadership Summit, held in New Orleans. Unlike the annual lean accounting conference, this summit, part of the Fabricators & Manufacturers Association Annual Meeting, drew CEOs and top operations personnel from mainly small and medium-sized custom fabricators. “For most of you, whatever you’re doing now, don’t stop. You know it’s all about cash flow.”

Most who attended Locher’s session found that they practiced at least some elements of lean accounting without even knowing it. As Locher described, that’s mainly because “small businesses try to keep things simple.”

Small businesses may not have formally defined value streams, and they may not distribute financial, operational, and capacity information to employees on a weekly or daily basis (a common lean accounting practice). But they don’t have bosses telling them to make the quarterly numbers, nor do they play games at the end of financial reporting periods. They also don’t balk at an increased cost of goods sold (COGS) after an inventory reduction. They sign the paychecks, so they know all too well that inventory doesn’t make payroll—but the cash freed from that inventory reduction does.

Locher clarified that it’s not as if financial people working at large companies don’t value cash. It’s that they’ve been taught cost accounting, a method that thrived in the days of the Ford Model T. But in the world of modern manufacturing, cost accounting can produce some misleading information.

This is where lean accounting can help. Various books have been written on the subject. Locher recommended Practical Lean Accounting: A Proven System for Measuring and Managing the Lean Enterprise, by Brian Maskell, Bruce Baggaley, and Larry Grasso.

The method essentially fixes a big irony of lean manufacturing: When a company implements lean, the financial metrics in the short term can look worse, even if the company, flush with cash, is in better financial shape than ever.

Using various tools (standard work, 5S, and the rest), lean manufacturing aims to shorten the order-to-ship cycle by concentrating on flow velocity and, ultimately, allowing a manufacturer to increase capacity and potential revenue with the same or fewer resources, including less inventory. Even without increased sales, the cash flow benefits can be profound.

While traditional cost accounting doesn’t ignore cash, it does present all sorts of ways for people to make the numbers look good, even when their employer is starved for cash and on the brink of bankruptcy.

Lean accounting, which focuses on cash flow, uses statements that resemble one’s personal finances—that is, how much cash is coming in and going out, and when—and anchors financial metrics to value streams. It then boils it all down to what’s known as a box score. This shows financial metrics like revenue, material costs, fixed and variable costs; operational metrics like raw-stock-to-dock days and on-time delivery; and basic capacity information (how much is used and available). This is distributed weekly (or even more frequently) so that everybody can know about the problems soon after they happen and not weeks or months later, when it’s too late to fix them.

As they do with lean manufacturing, company leaders often don’t see lean accounting as necessary, applicable, or even possible in their organizations. During his presentation at the summit in New Orleans, Locher grouped these perceptions into nine myths people have about accounting in general—myths that, if believed, can make problems worse, not better.

Myth No. 1: GAAP Requires Cost Accounting

Many in accounting departments, particularly at large companies, believe that they can’t move away from cost accounting because, as Locher put it, “the Generally Accepted Accounting Principles won’t let us change. That’s not true at all.”

The GAAP has four basic tenets, three of which present no problem for lean accounting and lean manufacturing. First is materiality. Accounting information is considered material when its omission would alter a person’s judgment and decision-making. “Lean is all about materiality,” Locher said. “We don’t care about the insignificant stuff.”

The second tenet is conservativism. Accounting information should be reported in a way that tends to minimize cumulative income—that is, conservatively. “Lean folks are pretty conservative,” Locher said. “We’re aligned with that.”

The third tenet is consistency. Transactions are to be treated in the same way for consecutive periods. “Lean people have no problem with that,” he said. “We’re the ‘standard work’ people, after all.”

The fourth tenet is matching. That is, accounting must match costs with revenue, and here is where challenges arise, especially in companies with low inventory turns. This requirement is a driving force behind allocation accounting, which can slow the accounting process to a crawl, especially if the date of costs (expenses for material and labor) occurs weeks or months before the customer pays for the work.

But as Locher explained, as inventory turns increase, the time between “money out” (expenses for material and labor) and “money in” (revenue) decreases, so matching becomes less of an issue.

Even with quick inventory turns and short raw-stock-to-the-shipping-dock cycles, matching still can be a problem, particularly if a fabricator deals with slow-paying customers. Lean accounting departments can overcome this issue by taking a new approach as to when financial tasks need to happen. This relates directly to myth No. 2.

Myth No. 2: We Can’t Close the Books Until ….

“Many organizations take weeks to close the books, to find out how they’re doing,” Locher said. “But if you’re depending on this information to make decisions, you need to close the books as quickly as possible. Without timely financial information, a company will forever look in the rearview mirror and see where it has been, not where it is going. The older the information, the less relevant it is. Some companies I work with do a soft close every day.”

A soft close gives a quick view of profit and losses as well as cash flow—what money was spent and what money came in during a specific period—again, as recent as possible. If a customer hasn’t paid yet for a shipped job, that’s fine; it can be accounted for at the next close, be it a day or week later.

“Time is a continuum,” Locher added. “If you take care of the days, the weeks, months, and quarters, the years will take care of themselves.”

For external reporting, the accounting department can perform a hard close, which incorporates matching. Locher emphasized, however, that the people or entities receiving those reports (the SEC, owners, investors, financial backers, banks, etc.) should determine how frequently the accounting department performs a hard close. A public company must file quarterly, but a private company—and most in metal fabrication fall into this category—may need to perform a hard close only once a year, when filing taxes.

Locher added that this can be a tough pill for many accountants to swallow. But companies usually don’t go under because they fail to precisely match revenue with expenses in every financial report. They fail because people operate in the dark for weeks or months without any current financial data, then learn about financial problems only after they’ve become insurmountable.

Myth No. 3: Inventory Is an Asset

Modern accountants play a new game using very old rules. The rules made sense a century ago, when the world was very different, but today these old rules incentivize the wrong behaviors.

From the old manufacturing world emerged the cost of goods sold (COGS) formula: COGS = Beginning inventory + Purchases – Ending inventory. The inventory numbers incorporate the material value and the total manufacturing costs, including labor. You then subtract COGS from revenue, and you get your gross profit.

The more ending inventory you have, the less your COGS, and the greater your profit. It’s one reason that financial people resist lean, which initially reduces “ending inventory” and, hence, increases the COGS and decreases profits, at least on paper.

Today, categorizing inventory as an asset can lead to a company’s downfall. Material costs today consume cash like nothing else. All manufacturers need at least some inventory to function, especially raw stock. But because it consumes cash, it’s really a liability.

Like any liability, it should be controlled, Locher explained. More isn’t better. More inventory may reduce COGS and increase profits on paper, but again, you can’t make payroll with inventory.

Myth No. 4: Direct Labor Is Consistent and Variable

As the Industrial Age ramped up in the 1920s and 1930s, decades before the onset of modern automation, direct labor costs dominated. Factories employed thousands of front-line workers; individually, workers didn’t make much, but collectively they cost 60 percent of annual revenue, on average; material cost 30 percent, and the rest was overhead and profit.

In the old manufacturing world, the more products workers churned out in less time, the more sellable inventory they produced, and the more their costs could be spread out. Because this increased the “ending inventory” in the COGS formula, it increased profits.

Holding excess finished-goods inventory wasn’t a huge cash drain, because material was only 30 percent of sales. And product life cycles were long, so odds were that inventory would eventually be sold. But employing an inefficient direct-labor workforce—which, again, ate up 60 percent of revenue—could be detrimental.

Today, thanks to modern machinery, direct labor is less than 10 percent of annual revenue, on average; material is 65 percent; and overhead is greater than 25 percent of sales.

In a quest to “make the numbers,” managers (usually at large companies) push people to produce more products that end up in inventory. And there it sits, unsold—material that costs more than 65 percent of sales—draining cash until a crisis hits. The company can’t pay its bills or make payroll. So what does it do? It lays off workers.

This made perfect sense financially in the days when direct labor cost nearly two-thirds of annual revenue. A layoff would reduce the payroll burden and free up cash, and the company could remain a going concern. Today, unfortunately, when times get tough, too many companies do what corporations did 100 years ago. They lay off people, each of whom now contributes more to the top line than ever before. And laying them off doesn’t save the company much cash.

“All that knowledge marches out the door,” Locher said. “Companies are shooting themselves in the foot.”

Meanwhile, the remaining workers continue to produce products (consuming material, the largest cash drain) that will never be sold before the company spirals into bankruptcy.

In these cases, Locher said, large manufacturers could learn something from the small, build-to-order job shops. When orders arrive, they buy material and produce. When the orders aren’t there, they stop producing, they don’t consume material, and they plug the cash drain. They may end up having to lay off people eventually, but it’s an act of last resort.

Myth No. 5: Making (or Buying) More Reduces Per-Unit Costs

Conventional wisdom says that if a manufacturer produces more products, its per-product cost goes down. This is thanks to absorption costing, which is required for external reporting to abide by GAAP (as when valuing inventory). But as Locher explained, it shouldn’t be used to guide financial decisions.

Say you produce a run of 1,000 widgets, then the next week run only 500. Per unit, direct labor (at $1 a unit) and material costs ($5 a unit) don’t change, but overhead is accounted for differently. Overhead doesn’t change directly with the order size. The 1,000-widget run absorbs $2,000 of overhead ($2 per unit) while the 500-piece order absorbs $1,700 ($3.40 per unit), derived from an overhead rate per hour, which goes up the smaller the order is. This makes the per-unit price of products in the 500-piece run expensive.

“The reality is that overhead doesn’t change much,” Locher said. “About 85 percent of it is fixed.”

Joyce Warnacut’s book, The Monetary Value of Time, describes how absorption costing penalizes improvement practices. Say you have $10 million in overhead to allocate. You produce 30,000 products in 200,000 hours. So you divide $10 million by 200,000, and you get an overhead rate of $50 an hour. Now let’s say you improve a process, increase part flow velocity, and produce the same job in 150,000 hours. This frees capacity and sets the foundation for the operation to be profitable and flush with cash.

But wait—what about the overhead absorption? To figure this, now you divide $10 million by 150,000, and you get an overhead rate per hour of $66.67. That improved job is now, to use some financial parlance, underabsorbed.

Instead of recognizing the freed capacity and increased flow velocity that the improvement project created, the accounting method penalizes the operation for its “unused” capacity and, ultimately, incentivizes the factory to produce more—because under this absorb-the-overhead logic, producing more costs less per unit. Some may even attempt to produce so much that they increase labor costs by hiring temporary labor and increasing overtime.

All these decisions aren’t anchored in reality. As Locher explained at the Leadership Summit, “Think about what happens to cash. If you run smaller batches, and produce only what’s needed, you don’t have to buy as much material. You don’t need to hire or pay overtime. And you don’t have the storage costs.”

Storage costs factor into acquisition costs too. Say a custom fabricator gets a good deal on corrugated boxes. To get that good deal, the shop buys a huge amount at a time, and so dedicates a dozen racks to hold them all. But what about the costs of paying people to manage and organize all those boxes? Most significant, what about the opportunity costs? Could a productive machine or assembly cell be put there instead? In other words, if the fabricator acquired smaller batches of boxes, could that unproductive storage space be turned into productive space?

Absorption costing can also distort make-versus-buy decisions. Locher recalled when he ran an aerospace machine shop for a large corporation in the 1980s. To reduce costs (in theory, at least), top management decided to outsource second-shift work. Their logic stemmed from overhead absorption. As part of a large corporation, the machine shop had to account for multiple aerospace engineers and other personnel in its overhead. Purchasers sent the work out for bid and found that a nearby machine shop could produce it for less than their calculated cost, even after the machine shop’s markup.

But the overhead absorption distorted the calculation. Locher stepped back and asked a basic question: How much cash does the company pay with the second shift outsourced, and how much cash would the company pay if the second shift was brought back in-house?

They calculated the cash spent for material, machine operators, supervisors, and extra facility costs, like electricity consumption, during the second shift. After adding it all up, they found that it was less than what they were paying to outsource the job.

“We focused on cash flow,” Locher said, “and within six months we brought the work back in-house and had the second shift running again.”

Myth No. 6: If It’s Precise, It’s Accurate

“This mistake is often the reason behind why we can’t close the books quickly,” Locher said. Business software systems may assign a cost to a part that goes out umpteen decimal places. It looks precise, but that doesn’t mean it’s accurate.

As Locher explained, the Generally Accepted Accounting Principles don’t require it either. They require materiality: Does the financial information help people make decisions? Cash flow probably does; the exact amount of overhead a job absorbed probably doesn’t.

Myth No. 7: Financial Reporting Should Drive Decisions

This myth leads to the classic situation in which a manager tries to make the numbers look good for a certain month, quarter, or year.

Locher described the typical “hockey stick” scenario, with the end of the stick (representing revenue) jutting upward near the end of a financial reporting period.

A manager’s boss asks his vice presidents: Sales are looking soft this month. What can we do about it? The manager can’t magically create new orders, but he can perform a little accounting magic. He asks his production manager to pull a large, profitable order due the next month.

“Forget about our current commitments,” Locher said. “Forget about on-time delivery. We need to make the numbers this month!”

Of course, this creates a void during the next month. So yet again managers try to make the numbers look good by pulling profitable orders that aren’t due immediately.

Locher said that this behavior isn’t anyone’s fault; it’s an incentives problem. “Humans will react in a way they feel they’re being held accountable.”

Custom fabricators in Locher’s conference seminar said they knew this story all too well, particularly with some of their larger customers that demand large orders in a hurry as a financial reporting period ends. Locher added that the hockey stick syndrome can spread up and down the supply chain, as OEMs and suppliers alike are incentivized to “make the numbers.” In doing so, they create unlevel, chaotic, and inefficient production that ends up costing companies more.

Myth No. 8: Financial Data Is Always Accurate

When it comes to cash, financial data is usually accurate, Locher said. After all, dollars and cents can be measured in, well, dollars and cents. But what about other financial data, like setup costs or inventory carrying costs?

This relates directly to another common metric that, according to Locher, drives bad decisions: the economic order quantity, or EOQ. The idea is that as volumes rise, setup costs go down and inventory carrying costs go up. The EOQ is the sweet spot, where ascending inventory carrying costs intersect descending setup costs, resulting in the lowest possible per-unit cost.

The concept itself isn’t necessarily flawed, Locher said, but the data behind it usually is. “The economic order quantity has been around in economics since the 1960s, and it’s very flawed. And they still teach it in school. The problem involves bad data—garbage in, garbage out.

“Generally, most companies grossly underestimate their inventory carrying costs. Many peg it at around 3 percent of the cost of capital. But it’s probably 20 to 40 percent, depending on your business. At the same time, companies overstate their setup costs, because they throw overhead into it, which has nothing to do with how many setups they’re doing. When they believe setup costs are higher, you get bigger batches.”

What’s the solution? Locher put it simply: “Don’t use economic order quantity to make financial decisions. Just use cash.”

Myth No. 9: The Budgeting Process Controls Costs

“I have worked with large companies that spend months on the budgeting processes,” Locher said, “and it’s already out of date by the time the ink dries. The fact is that the budgeting process adds costs and creates no value. Spend as little time on it as possible.”

This caught Locher’s audience off-guard. Without good budgeting, how can we plan?

Locher clarified that “budgeting” differs from a financial analysis to determine future needs, such as for capital spending like equipment and plant expansions, as well as hiring. “That’s looking at cash, what’s coming in and what’s going out. How many people do we need to hire? How much is this machine going to cost? That’s perfect.

“General budgeting is where we run into trouble. Budgeting tries to predict what your exact material and labor costs are going to be. Don’t forecast every dollar down to the department level.”

Detailed budget forecasting always creates variances. People respond by making changes that may lead to increased costs (more cash out) and lower revenues (less cash in).

For instance, a company not meeting the budget may put a capital equipment purchase on hold. That new machine would reduce costs (e.g., one operator produces more in less time) and free capacity that could be filled with more sales. And even if those increased sales don’t come to fruition, the company would still be spending less on labor (less cash out) than it otherwise would have.

Locher added that the opposite is true too: A variance in the budget may drive people to purchase equipment that’s not needed. Say the cutting department is costing more than expected. Managers talk to the supervisors, who say that their old machines cut too slowly.

So they invest in the latest and greatest cutting machine, only to find that cash flow hasn’t changed, nor have profits. Turns out the bending department is the true constraint, but because those press brakes run constantly, their metrics looked great.

Does It Jingle?

At the end of his talk, Locher repeated a mantra that ties it all together.

“If it doesn’t jingle, it doesn’t matter.”

Budgeting doesn’t jingle, but the result of that new equipment purchase does. Nothing jingles by cutting, bending, or welding nonstop, only to create a lot of unneeded work-in-process. But it does jingle if you improve part-flow velocity and shorten the order-to-cash cycle.

He added that focusing on cash comes naturally for the smallest job shops. The key is to maintain that commonsense simplicity as the accounting department grows.

Companies can do this by, again, continually asking one basic question: Does it jingle?