Lean Is Not As Simple As ABC

by BILL WADDELL

My last post warned against ignoring a 1980's idea - Eli Goldratt's Theory of Constraints.  You don't want to hang on to everything from the '80's, however.  Disco, for one, is best left behind.  Another to distance yourself as much as possible from is Activity Based Costing (ABC).  The same two clients I mentioned in the prior post were spending a lot of time working on, polishing, and waxing eloquently about their ABC concepts.

Let me make it very, very clear: Activity Based Costing is not Lean Accounting, it does not support lean manufacturing, it is not better than traditional standard costing, it is not leaner than traditional standard costing.  It has no role whatsoever in the lean journey.  It's most recent attempt to rise from the grave - "Time Driven Activity Based Costing" - is like putting an Armani suit on a monkey.  It may make him look a little more sophisticated, but it does not change the fact that he is a monkey.

At the end of the day, Activity Based Costing is nothing other than a more complicated method of assigning costs to products, even though those costs have little or nothing to do with the products.  Jean Cunningham, a true lean wizard if there ever was one - wrote a book along with a few other folks about lean accounting called "Real Numbers".  Activity Based Costing does not enable you to generate 'real numbers' - just different numbers.  ABC generated numbers will not help you make any better decisions.  If anything, they will drive you to make more bad decisions.

One of the benefits you realize from reading Evolving Excellence is that one of the contributors - me - happens to be very old - old enough to have been one of the gang that met over the course of several years in Dallas back in the 1980's under the auspices of an organization called CAM-I (Computer Aided Manufacturing- International) in which Activity Based Costing was born.  So I know very well what we were thinking and what we did.  And I know that, in spite of good intentions, we were wrong.  We were still suffering from the illusion that Full Absorption Accounting was basically right, and that taking all of the costs to the balance sheet through inventory valuation was the right thing to do.  Worst of all, we were driven by the belief that GAAP based income statements and balance sheets were correct, and that the challenge was to find a better way to manage the details to better control those GAAP generated results.  In short, we lacked the wisdom, courage or both to step up to the fatal flaws in traditional cost accounting.

Lean Accounting is the only approach to manufacturing accounting that will give you accurate, relevant information.  It is driven by three fundamental principles:

1.    Cash is the only real money.  Your accounting must be cash based as much as practical

2.    Allocations are inherently inaccurate.  (This is where ABC falls flat.  It is just another allocation method)

3.    Costs must be accumulated in Value Streams, rather than 'cost centers'

The good news is that ABC is complicated and difficult.  So stop doing it and save yourself a lot of time and aggravation.  Lean Accounting is straightforward and simple.  Stop using standard costs no matter how they were calculated for anything - especially measuring yourself or setting prices.  Get on with Lean Accounting, and get on with the lean journey.

Comments

[Dragan Bosnjak]

I found very usefull one other book about lean accounting: "Lean Cost Management" by James Huntzinger who makes a very good work of collecting all the best lean accounting practices explained in previous works and gives a guideline on how to realise practically the lean accounting in your organisation.

[Tom Pryor]

Bill:

I agree with some of your statements, disagree with others and propose something new in the process.

For example, I agree that Lean principles are very sound, i.e., focus on keeping the customer order moving, not machines or people. My cohorts at the Texas Manufacturing Assistance Center (TMAC) have demonstrated to me the benefits of Lean in many, many companies, small and large.

I disagree that ABC is not useful. The basic principle is as sound today as in the 1980's during my years as director of the CAM-I CMS project: activities consume costs and products/customers consume activities.

I have combined the principles of Lean and Time-Driven ABC. People such as Doug Hicks and others see value in my approach. Would you be open to reading the article?

[William Pietri]

Hi! That quick summary of Lean Accounting principles is pretty exciting. For those of us unfamiliar, could you post some links to more information about it?

A general introduction would be great, but I'm also very interested to see how Lean Accounting addresses the desires that normally lead people to do cost allocations.

[Preston Sumner]

Tom, can you post a link to your article?

[G. David Dodd]

Bill,

I strongly disagree with your assessment of activity-based costing. I am an advocate of lean, value stream costing, and ABC, and I have not found that ABC conflicts with lean assuming, of course, that the ABC cost model is developed in the right way and that ABC cost information is used for the right purposes. If you use ABC cost information to create traditional variance reports, there certainly can be a conflict with lean.

I won't go into a long-winded defense of activity-based costing, but let me give just three examples of how ABC can be used in conjunction with lean.

1. I've used ABC to demonstrate the value of lean improvements. ABC is particularly useful here because it makes the cost of non-value-adding activities visible, usually for the first time.

2. ABC cost information fits very well with the process of "target costing" which many lean organizations use when they are developing new products or when they are faced with customer demands for lower prices.

3. ABC is the only accurate way to measure customer profitability.

Like any tool, ABC can be (and has been) misused. I prefer value stream costing for managing day-to-day operations. But if ABC is used correctly, it will not undermine lean.

[Douglas T. Hicks]

Bill:

I fear that you are one of the very wise blind men who touched an elephant in one place and then believed that he knew exactly what an elephant looks like. The same was true of those folks at CAM-I twenty plus years ago. The ABC of twenty years ago is a convenient straw man to attack because it was, like lean accounting, the view of cost information from only one of the many perspectives required for a company to make economically sound business decisions. But the application of ABC’s underlying cause-and-effect principles continues to be the only method of creating a valid economic model of an organization.

Using GAAP-based, full-absorption accounting information as the basis for any business decision is foolish. Business decisions must first be framed appropriately (an issue no one seems to pay much attention to) and then the appropriate cost information – based on an economically valid model of the business – developed to support that decision. Within certain frames, the type of information created by lean accounting is appropriate. Within others, it is totally inappropriate. It does a great disservice to those fighting to survive in an ever more competitive world to imply that any concept with limited applicability, like lean accounting or twenty-year-old ABC, should be used as if it were a universal truth.

By the way, I’m an old guy, too.

[Brian Maskell]

In answer to William Pietri:

There are some new videos describing Lean Accounting on www.leanaccounting.ning.com

An article "Lean Accounting; What's It All About" can be downloaded from http://www.maskell.com/stuff.htm

I hope this is helpful.

Brian

[Brian Maskell]

I know this ABC issue is going keep grinding on. But in my company we used ABC for quite a long time before we realized that this is not only not helpful be actively anti-lean. I don't want to write a lot about this, but ..

1. ABC is traditional absorption costing made more complicated. The argument about cause and effect is spurious because the people who need to understand cause/effect are the front-line people doing the improvement. They are never impressed by complicated ABC analysis and they have other (better) tools for getting to root cause and these tools are fundamental to lean.

2. The idea that you can calculate the customer profitability using ABC has two problems. First is that this is largely nonsense. The profitability of a particular customer is a spurious idea because profitability comes from all the customers and products in the value stream. Second, Lean Accounting methods have better ways to calculate the impact of specific customers or range of customers.

3. The idea that there are decisions for which Lean Accounting is not helpful may well be true. No one is claiming that Lean Accounting is a panacea, and of course it is designed for lean organizations. But I have not yet come across a routine business decision where the information from lean accounting is misleading or "a disservice" (to use Doug's phrase) to companies. I would like to see some examples.

4. We have found the use of Lean Accounting in Target Costing to be highly beneficial because it addresses the value stream. Once again to look at an individual product and it's costs outside of the context of the other products within the value stream is not helpful. This would lead to false savings.

5. Similarly the idea of using ABC to show the cost savings of lean is - IMHO - a complete misunderstanding. Hard savings from lean improvement is show on the box score for the value stream. Clear, unambiguous, bottom-line savings. Often though hard lean does not create short-term hard savings because the waste if removed and additional capacity is freed up. The lean accounting box score shows the operational improvements, the financial impact, and how the capacity changes as a result of lean improvement - both short term and long term. IMHO this gives us a great deal of insight and leads to better decisions for maximizing the benefit of lean.

And...... by the way ..... lean accounting does not require any new software.

Enough of this. Let me know what you think.

Brian

[Fred Wiersma]

Bill,

I don't know much about Lean Accounting. Could you expand on that, and compare it with TOC's Throughput Accounting?

I'd be interested in reading your views on that!

Thanks,
Fred

[Michael F. Martin]

"10 things most MBA programs fail to teach you about startups

1. No amount of strategic planning will ever substitute for managing your cash flow. Financial statements are great. The most important one is your bank account statement."

Thought you'd like that. Here's the link:

http://entrepreneur.venturebeat.com/2009/07/27/10-things-business-schools-wont-teach-you/

[Cash Powell, Jr]

Bill, The lean experts know this already but Wall Street hasn't caught up yet. I knew there was a reason I kept this WSJ article, July 21, 2005, "GM Reports Net Loss of $286 Million." GM offered an employee discount in June at retail level of 224,000 vehicles therby reducing inventories by about 18 %. However,the article goes on to say " GM books revenue on production, not retails sales. Its second-quarter North American production was down by 142,000 vehicles, or about 10%. GM moved inventory at the expense, [repeat expense] of moving vehicles directly off the assembly line. If we had kept inventories at the high level, we would have been break even for the quarter." This occurred about three years after a 100 year old, publicly owned, well respected machine tool builder in Ohio was purposely building inventories, at the direction of the CEO, in the spring of 2002 so the profit figures would look good for Wall Street by June 30. They, too, went Chapter 11 and are sold. In the wake of the past few years, has the FASB caught up with lean accounting? Until they do and Wall Street does, and the universities, the public companies will be where they have always been.

[Jeff Schroeder]

Bill,

Below in quotes is a response I received from our Controller. We have been working on taking the waste out of our standard costing methods but I have yet to convince this organization we are improving something we should not be doing at all. If you, or anyone, has advice to help me please let me know

"Good article and very similar to what we have seen before. I too was schooled under the activity based costing method of standard costing, and taught that it was the way forward for traditional standard costing. I agree with the article that most of it is not value added and like many ideas from those inglorious accountant professors it seeks to impress itself through intricacy with lots of calculations rather than measuring itself in terms of value to the company or the customer.

Nevertheless, the proposal to “stop doing standard costing” is parochial as well. As long as we are a global consumer products company operating in nearly all major markets with X distinct businesses that require SKU level costing across its product lines for planning, pricing, decision making, and inventory valuation, I don’t think we can stop doing standard costing. No similar company that I know does it much differently. In most of the literature I’ve seen the LEAN accounting gurus are quick to bash traditional cost accounting but have yet to map out a better method for companies with business models like ours. I think taking the detailed effort out of standard costing, providing Sales with up to date cost information at the bellwether SKU level, and working towards a longer term costing model that integrates manufacturing and sales systems is our best bet for now.

As a LEAN disciple I am of course open to all ideas that take “muda” out of our processes so as better ideas, blogs, articles come across let’s keep the exchange going."

[Brian Maskell]

Jeff:
I would be glad to map out for your controller a better way to do business in the kind of environment he describes. I am not sure if he is saying that there is no better way to address the issues of "planning, pricing, decision-making, and inventory valuation" or if he is saying that he is stuck with it because of corporate requirements.

I would certainly be happy to map out a better way, but I agree that it is difficult for large multi-national corporations to make these changes. This is true of lean in general. There are few - if any - large multi-national corporations that have been able to embrace lean beyond relatively superficial application of the tools. Sadly GM was one of those. They put great effort into lean manufacturing but were unable to become a lean organization.

The radical improvement I have seen in smaller organizations has not occurred in larger companies. But this is not owing to a lack of methods like Lean Accounting that truly work - but a lack of management ability to embrace lean as a strategy rather than a traditional cost-cutting tool.

One touch-stone I have found within the financial side, is the "make the month" mentality. Companies with strong emphasis on making month-end numbers severely reduce their chances of making significant inroads with lean. This is one instance of the clash of cultures between traditional BMA school management and lean thinking.

Incidentally, we have individual divisions of large multi-national companies that have significantly embraced Lean Accounting and continue to provide the corporate organization with the information they require. We have one massive multi-national company with hundreds of divisions and locations that is making significant progress with Lean Accounting. It is a slow business of change but it is moving ahead step-by-step.

I would be glad to discuss these issues with you and your controller - if it would be helpful.

Brian Maskell
bmaskell@maskell.com