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September 4, 2009

What is Lean Accounting ?

Lean accounting helps organisations going through lean transformation to develop their management accounting systems to support the lean philosophy. We have about a dozen clients in Europe transforming their accounting systems. Traditional accounting systems (particularly standard costing) result in decisions which are anti-lean. There are plenty of resources for you to look at. Our websites and have further information and articles. A number of books have recently become available on Amazon on the topic of lean accounting, one of the most useful for implementation being “Practical Lean Accounting”. It is always useful to read around the subject to get a range of options and views. There is a list of recommended books on lean accounting in the Knowledge Base on this site.

A short example will illustrate why traditional accounting approaches can lead us to the wrong decisions. Let’s assume a company runs a traditional standard costing system with a Standard Cost of £27 per piece made up of materials £12, labour £5 and overhead (absorbed on a labour hours basis) of £15. A request for quote comes in from a major potential customer for 10,000 pieces. The customer’s target price is £29 per piece. Should we take the order ? In its standard costing system the company adds 15% to its standard cost when making quotes, thus it would quote this customer £31.05 per piece and not take the order.

Is this the right decision ? The answer is we don’t know. The Standard Cost approach doesn’t tell us whether we have the spare capacity to produce the order, it doesn’t tell us whether we have the potential to improve our Value Stream to produce the order and so on. In fact the Standard Cost tells us nothing.

What we actually need to do is take an incremental (marginal) costing approach to the decision. The materials to produce the extra product will cost £120,000 (at £12 each). If we have enough spare capacity in the Value Stream then there will be no extra labour cost, but let’s assume we need to work £50,000 of overtime to complete the order. There won’t be any extra overheads, but let’s say there would be £15,000 of extra energy costs and consumables. Thus the incremental income from the order would be £290,000; and the incremental costs would be £185,000 (£120,000 + £50,000 + £15,000) = an extra £105,000 contribution to profit.

Thus, based on Standard costing we would refuse a profitable order. Of course there are other factors to take into account – what impact would this price of £29 have on our other customers ? Is this a one-off order or a potential long term relationship ? etc etc. I am not saying that this approach gives us the whole picture, but it gives us more of the picture than a standard costing approach.

The purpose of lean accounting is to tell us about the flow through the Value Stream; to tell us about the capacity for extra work in the Value Stream; and to tell us about the incremental costs of alternative decisions and actions. Traditional accounting tells us nothing about these things.

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