Lean accounting: Recognizing and realizing productivity gains as profits

<span>If I had a dollar for every time I have been told about conversations like this, I&rsquo;d be rich. The exchange demonstrates that a lot of executives don&rsquo;t fully understand what productivity gains are and are not.</span>

By Orest (Orry) Fiume

Picture this. A CEO says to his or her CFO: “Last month, our kaizen teams reported average productivity gains of 50 percent. Why can’t I see them in this month’s financial statements?”

The CFO responds: “I don’t know. I’m beginning to suspect that this lean stuff isn’t real.”

If I had a dollar for every time I have been told about conversations like this, I’d be rich. The exchange demonstrates that a lot of executives don’t fully understand what productivity gains are and are not. Oftentimes, accounting teams and systems focus on labor efficiency or the relationship of actual labor hours to standard labor hours. Penny pinchers want to think that the standards are correct, but this isn’t always the case.

Lean as a strategy

The concept of lean is widely known, yet often misunderstood. It is not simply a way to cut costs; it should be seen as a comprehensive strategy. Strategy is what you do to create sustainable competitive advantage, and lean is a fundamentally different way of thinking about how to do that. As such, lean requires us to reframe productivity.

Everything we do is in the context of processes, which are comprised of activities. These activities fall into one of three categories:

1. Activities that add value for customers.

2. Activities that don’t add value for customers.

3. Activities that don’t add value for customers but are required. An example is preparing and filing tax returns.

One of the underlying principles of the lean strategy is to eliminate all activities that don’t add value for our customers. In the lean lexicon, these activities are called “muda,” or waste. People don’t intentionally create a process that contains waste, but it does happen. It can occur when we define waste with an internal focus rather than a customer focus. We consider scrapto be waste. We consider people who are standing around the copy machine talking a waste of time. But as long as they are working, we don’t deem it as waste.

When Art Byrne came on as CEO at The Wiremold Company in 1991, I, as CFO, gave him a plant tour. At the end of it, he said, “This company has twice as many people as it needs.” This statement surprised me because as we walked around, what I saw was that everyone was working. But what Byrne saw was a lot of activity that didn’t add value for the customer. He had developed “lean eyes.” He had the ability to see between waste and value being added.

One of the stretch goals that Byrne set at the beginning of our lean transformation was to achieve a 20 percent annual labor productivity gain. None of us thought that was even remotely possible, but then, at that point, we didn’t understand the real nature of waste and productivity. From 1991 to 2000, we maintained an average of 14 percent annual labor productivity gain.

The nature of productivity

Productivity is the relationship between the output of any process and the resources consumed in creating that output. This applies to all resources, including materials, people, time, energy and supplies. It is possible to improve the productivity of all resources. When we do an improvement event (kaizen), some of the advancements yield immediate cash savings and show up in the financial statements quickly. In other words, they are true cost reductions.

For example, at Wiremold, we were able to decrease the amount of office supplies we use, which nearly cut our cost in half (48 percent.) This produced a quick cash saving and an improvement to our bottom line. Another example is a kaizen in which quality improvements result in reduced (or eliminated) scrap and therefore immediate reduced usage and cost of materials.

It is imperative that executives focus on supporting their employees, which includes providing assurance that no one will lose their job as a result of productivity gains. Their jobs may shift along with the work, but they have to know that their employment is secure. This guarantee is what some CFOs grapple with, because increased labor productivity frees up capacity, not money.

Actualize improvements into profits: A case study

So, in the context of lean strategy, how do you convert productivity gains into profitability improvement? At Wiremold, we actualized our gains into 13 percentage points of additional gross profit by accomplishing the following:

1) Sell more, do more.

This is the best way to actualize productivity gains into profit improvement. Since we already had the people and production facilities, the only significant production cost of the additional units we sold was their material content. Everything else (sales minus materials, which in accounting parlance is known as value added) improves gross profit. In order to sell more, we used time to create a competitive advantage. For example, we reduced the lead time for most of our products from weeks to days. This enhancement transferred to our customers in the form of a rapid replenishment system, which allowed them to stock less of our product at once, thereby freeing up their cash.

We also aggressively improved our new product development process, which resulted in reducing our lead time (concept to launch) from years to months. This yielded an increase in customer satisfaction, as we were able to provide a stream of more innovative products that our competitors could not match.

All of this growth was self-financed by our productivity gains. Several of our plants were able to more than double their volume with the same number of employees.

2) Reduce overtime.

Many companies, including ours, find themselves incurring significant amounts of overtime. Full Time Equivalent (FTE) employees are eligible for overtime, which makes FTEs expensive to employ, especially since overtime is paid at premium rates. By reducing our number of FTEs, we eliminated those expensive extra hours and turned this productivity gain into profitability improvement.

3) Embrace attrition.

Although we assured employees that no one would lose their job as a result of productivity gains, we did not guarantee a fixed level of employment. When someone quits or retires, see if you can maintain volume without replacing him or her. This will help you further actualize productivity gains.

4) Insource work.

If your company is paying a vendor to do work that you are capable of doing, bring the work in-house. By insourcing, you capture the vendor’s profit for yourself. You have the capacity, which was freed up by productivity improvements, to support insourcing, even if it means spending a little upfront money to buy minor equipment to complete the job.

Lean by example

When I teach workshops, I ask participants if their companies require complete cost-benefit analyses for each kaizen event. Almost everyone’s hand goes up. Then, I explain the error in doing this, because most improvements will be in the form of labor productivity gains, which do not necessarily result in immediate profits. This can be a hard fact to face, especially for executives, but education can help significantly. Accept a leadership role by teaching your company (a) the strategic value of lean and its ability to disrupt and create sustainable competitive advantage, (b) the nature of real labor productivity improvements and (c) the four things it must do to actualize the improvements into additional profits.

This article originally appeared in the Fall 2017 issue of Target magazine. Orest (Orry) Fiume is retired CFO and director of The Wiremold Company and co-author of the Shingo Prize-winning book, “Real numbers: Management Accounting in a Lean Organization.” Learn more about lean accounting and other financial management practices at AME Chicago 2019 this fall.