Chapter 16
Operational Performance Measurement: Further
Analysis of Productivity and Sales
Cases
16-1
Dallas Consulting Group
Readings
16-1 “Examining the Relationships in Productivity Accounting” by Anthony J. Hayzen,
James M. Reeve, Management Accounting Quarterly (Summer 2000).
Change in profit of a firm or business unit can be analyzed in terms of a change in productivity and a change in price
recovery. Change in product quantities and change in resource quantity drive the change in productivity. Change in
product prices and change in resource prices drive the change in price recovery. These relationships can be
displayed to provide an instant visual analysis of the causes of profit change. Such visualization can provide a robust
method for analyzing strategy and stakeholder relationships.
Discussion Questions:
1.
2.
3.
What is productivity accounting?
How can productivity accounting guide the overall strategy of the firm?
Give an example showing that a traditional business performance indicator may give conflicting signals on a
firm's performance.
4.
5.
What are the elements in using productivity accounting to evaluate changes in profits?
What grid diagrams are needed in order to have an overall picture of the business's performance?
16-2: “Lean Accounting: What’s it All About?” by Frances A. Kennedy, and Peter C. Brewer,
Strategic Finance (November 2005), pp.27-34.
This article provides and introduction and illustration of the concept of lean accounting.
on an actual company, which is given the disguised name MIP.
The illustration is based
Discussion Questions:
1.
2.
3.
4.
Why lean accounting?
What are the five steps of the lean thinking model?
What four areas did MIP address in implementing lean accounting?
How is waste defined in lean accounting?
Blocher, Stout, Juras, Cokins: Cost Management 6/e
16-1
©The McGraw-Hill Companies, Inc 2013
Cases
16-1 Dallas Consulting Group
“I just don’t understand why you’re worried about analyzing our profit variance,” said Dave Lundberg to his partner,
Adam Dixon. Both Lundberg and Dixon were partners in the Dallas Consulting Group (DCG). “Look, we made
$800,000 more profit than we expected in 2012 (see Exhibit 1). That’s great as far as I am concerned.” Continued
Lundberg. Adam Dixon agreed to come up with data that would help sort out the causes of DCG’s $800,000 profit
variance.
DCG is a professional services partnership of three established consultants who specialize in helping firms in
cost reduction through time-motion studies, streamlining production by optimizing physical layout, and reengineering operations. For each project DCG consultants spent the bulk of the total project time studying
customers’ operations.
The three partners each received fixed salaries that represented the largest portion of operating expenses. All
three used his or her home office for DCG business. DCG itself had only a post office box. All other DCG
employees were also paid fixed salaries. No other significant operating costs were incurred by the partnership.
Revenues consisted solely of professional fees charged to customers for the two different types of services
DCG offered. Charges were based on the number of hours actually worked on the job.
Following the conversation with Lundberg, Dixon gathered the data summarized in Exhibit 2. He took the data
with him to Lundberg’s office and said, “I think I can identify several reasons for our increased profits. First of all,
we raised the price for re-engineering studies to $70 per hour. Also, if you remember, we originally estimated that
the 10 consulting firms in the Dallas area would probably average about 15,000 hours of work each in 2012, so the
total industry volume in Dallas would be 150,000 hours. However, a check with all of the local consulting firms
indicates that the actual total consulting market must have been around 112,000 hours.”
“This is indeed interesting, Adam,” replied Lundberg. “This new data leads me to believe that there are several
causes for our increased profits, some of which may have been negative. . . . . Do you think you could quantify the
effects of these factors in terms of dollars?”
EXHIBIT 1: 2012 BUDGET AND ACTUAL RESULT
Budget
Actual
Variance
Revenues
$12,600
$13,400
$ 800
Expenses: Salaries
9,200
9,200
Income
$ 3,400
$ 4,200
$ 800
EXHIBIT 2: DETAIL OF REVENUE CALCULATIONS
Hours
Rate
Budget:
Re-engineering
Streamlining production
Actual:
Re-engineering
Streamlining production
Amount
6,000
9,000
15,000
$ .60
1.00
$ 360,000
900,000
$1,260,000
2,000
12,000
14,000
$ .70
1.00
$ 140,000
1,200,000
$1,340,000
REQUIRED:
Use your knowledge of profit variance analysis to quantify the performance of DCG for 2012 and explain the
significance of each variance to Mr. Lundberg.
This case was written and copyrighted by Professor Joseph G. San Miguel, Naval Postgraduate School.
Blocher, Stout, Juras, Cokins: Cost Management 6/e
16-2
©The McGraw-Hill Companies, Inc 2013
16-1: EXAMINING THE RELATIONSHIPS IN
PRODUCTIVITY ACCOUNTING
By Anthony J. Hayzen, Ph.D., and James M. Reeeve,
CPA, Ph.D.
Productivity measures an organization’s ability to
convert labor, capital, and material inputs into valued
goods and services. This, of course, is not a new
concept. The challenge is to turn the concept into
useful measures management can use. Peter Drucker
put the case for productivity measurement as follows:
“Without productivity goals a business has no
direction, and without productivity measurement a
business has no control.” The purpose of productivity
measurement, therefore, is control. Linking changes
in productivity to resource allocation facilitates
control. Therefore, we believe a useful productivity
measure will link productivity changes to resources
and hence to profitability.
We will demonstrate this link through an
analytical technique we term “productivity
accounting.”1 This approach measures the change in
total resource productivity (that is, the changes in
labor productivity. in materials productivity, capital
productivity, and energy productivity) and the effects
of these changes, taken together or individually, on
the corresponding change in business profitability.
With this approach, a business can:
 monitor historical productivity performance and
measure how much, in dollars or percent return
on investment (ROL), profits were affected by
productivity growth or decline;
 evaluate business profit plans (budgets) to
determine whether the productivity changes
implied are overly ambitious, reasonable, or not
sufficiently ambitious; and
 measure the extent to which productivity
performance is strengthening or weakening its
overall competitive position relative to its
competitors.
SOURCES OF PROFIT CHANGE
Productivity accounting seeks to link the change in
profit to its underlying causes. Thus, we want to
provide a dynamic assessment of the profitgenerating ability of a company by focusing on
change in profit rather than static profit levels. The
drivers of profit changes will provide much greater
directional insight than will descriptions of profit
levels.
Blocher, Stout, Juras, Cokins: Cost Management 6/e
16-3
With the same basic accounting information used
to calculate revenues and costs, we can gain more
insight into the precise drivers of profit. We know
that change in product prices and change in product
quantities drive the change in revenue. Likewise,
change in resource prices and change in resource
quantities drive the change in the cost of producing
the products. All of this information is available in
traditional accounting systems. Thus, the change in
profit can be described as the sum of two elements:
the change in productivity and change in price
recovery.
Change in
Profit
=
Change in
Productivity
+
Change in
Price
Recovery
In the equation above, productivity can be
expressed in the following familiar way:
Productivity 
ProductQuanity (OutputQuantity)
Resource Quantity (Input Quantity)
Productivity is a measure of process execution, or the
ability to efficiently turn inputs into outputs. A
company with superior process execution has very
little waste or process leakage. Often this is the only
way to successfully compete in hypercompetitive
markets, such as consumer electronics.
Similarly, price recovery has the following
relationship:
Price Recovery 
Product Pr ice (Output Price)
Resource Price (Input Price)
Price recovery is a measure of structural
position, or the degree to which a firm is able to
capture value it creates through pricing power. For
example, a firm that has erected barriers to entry or
captured markets through patent protection may be
able to enjoy pricing power that would yield
attractive price recovery. Examples of attractive price
recovery can be found in firms in the aircraft repair
and overhaul parts business, where barriers to entry
due to customer-specific design and process
knowledge make it difficult for new entrants to
compete in the after-market parts sector.
©The McGraw-Hill Companies, Inc 2013
Some firms can compete on the basis of
on process execution (Nucor or Lincoln Electric), and
structural position (Microsoft or Coca-Cola), others
a few others on both (Intel).
Table 1: CONVENTIONAL PRODUCTIVITY MEASUREMENT
2006
2007
Value
Quantity
Price
Value
Quantity
Price
Sales
$99
11 units
$9
$110
11 units
$10
Rent
$52
26 sq. yards
$2
$78
26 sq. yards
$3
1. Profit
$47
$32
2. Sates per sq. yard
$99/26 sq. yards = 3.8
$110/26 sq. yards = 4.2
3. Productivity
Quantity per sq.
11 units /26 sq. yards = 0.42
11 units /26 sq. yards = 0.42
yard
Firms without structural position and only
gives a conflicting signal as it uses revenue in the
average process execution will find it difficult to
numerator, which contains both a quantity and a price
create and then capture value. More powerful supply
effect.
chain participants will likely capture any value
The first and third methods (profit and
created. Examples abound in the automotive OEM
productivity, respectively) give the correct signals.
parts business.
Profits have declined while productivity has
Productivity accounting decomposes these two
remained constant. What would cause this? We must
sources of economic competitiveness—process
complete the picture by taking into consideration the
execution and structural position—to guide the
effect the prices are having on the business. The
overall strategy of the firm.
productivity accounting method takes this into
consideration and links both the effect of quantity
TRADITIONAL MEASURES VS.
changes (that is, productivity) and the price changes
PRODUCTIVITY ACCOUNTING
(that is, price recovery) to the change in profit, thus
giving a complete picture of the performance of the
Traditional business performance indicators, such as
business.
sales per square yard, which is used in the retail
We can see from Table 1 what is happening in
industry; have the advantage of simplicity and
this
business:
Product prices have increased by 11%
familiarity Their main disadvantage, however, is that
($9
in
2006
to $10 in 2007) while the rent has
they can give conflicting signals because they do not
increased
by
50%
($2 per square yard in 2006 to $3
isolate productivity from price recovery effects.
per
square
yard
in
2007). Thus the decline in profit
To illustrate this we will use the example of a
was
due
entirely
to
an inability to recover input price
simple retail business shown in Table 1. This
changes
and
had
nothing
to do with productivity,
business had revenue of $99 in 2006 from the sale of
which
remained
constant.
11 items priced at $9 each. The revenue increased to
$110 in 2007, generated from the sale of 11 items at
NINE-BOX DIAGRAM
$10 each. The rent paid for the store was $52 in 2006,
which increased to $78 in 2007 for the same floor
Profit, by itself, provides little managerial
area of 26 square yards.
guidance. Rather, the manager needs information that
The first performance measure in Table 1
identifies the causes for change in profit. Using the
compares the profit of the business for the two years.
productivity accounting approach, one can take the
Profitability decreased from $47 in 2006 to $32 in
change in productivity and the change in price
2007.
recovery and relate them to the change in profit. If
The second approach uses the traditional ratio of
we now analyze the change in product quantities and
sales per square yard. This method indicates that the
change in resource quantities we get the change in
performance of the business improved because the
productivity. If, in addition, we analyze the change in
sales per square yard increased from $3.80 to $4.20.
product prices and change in resource prices we get
The third method in Table 1 measures the
the change in price recovery. Price indexes may be
performance of this business using productivity, As
used in situations where it is difficult to access
the table shows, productivity, and thus performance,
detailed price and quantity information.
has remained constant at 0.42 items per square yard.
Together the measures give the manager a
We therefore have three conflicting measures of
comprehensive analysis of how the changes in
the business’s performance. The second approach
Blocher, Stout, Juras, Cokins: Cost Management 6/e
16-4
©The McGraw-Hill Companies, Inc 2013
product quantity and resource quantity as well as the
change in product price and resource price, are
TabIe2: QUANTITY AND PRICE INFORMATION FOR TWO PERIODS
January 2008 (Reference Period)
Value
Quantity
Price
Products
Shirts
Cost Resources
Linen (sq. yards)
Labor (staff-hours)
Total Cost Resources
Capital Resources
Machinery
% ROI
February 2008 (Review Period)
Value
Quantity
Price
$150.00
10
$15.00
$216.00
12
$18.00
$ 40.00
$ 48.00
$ 88.00
10
6
$4.00
$8.00
$ 48.00
$ 60.00
$108.00
10
5
$ 4.80
$12.00
$1,000.00
1
$1,000.00
$1,000.00
1
$1,000.00
6.20
10.80
wrapping, premises, and so on, which are also used to
affecting the profitability of the business. Figure 1
produce the shirts.
shows a “nine-box diagram” summarizing these
In our example we compare the performance of
concepts.
February 2008, the review period, with the
The middle column of the figure explains the
performance of January 2008, the reference period, to
change in profit in the conventional way. But changes
arrive at the change in productivity and change in
in revenues and costs include both price and quantity
price recovery The data are shown in Table 2.
effects. Therefore, the change in profit also can be
Using the basic definition of productivity and the
explained by the middle row, which explains the
data shown in Table 2, we can measure the change in
change in profitability as a function of the change in
productivity for each resource contributing to the
productivity and change in price recovery. The
business operation. Viewed in this context, labor
change in productivity, in turn, is explained by the
productivity—by far the most commonly quoted
change in output quantities over input quantities (the
productivity statistic—is but one of many aspects of a
left-hand column). The change in price recovery is
total resource productivity analysis. For example, the
explained by the change in product prices over the
change in linen “productivity” can be measured as
change in resource (input) prices (the right-hand
the change in the output/input ratio between shirts
column).
and square yards of linen across the two periods. The
AN
EXAMPLE
ILLUSTRATING
productivity of linen in January was 10 shirts/10
PRODUCTIVITY AND PRICE RECOVERY
square yards, or 1.0, while it improved to 12 shirts/10
COMPONENTS
square yards, or 1.2, in February. The productivity
Evaluating changes in profit using productivity
change for linen shown in Table 3 is 20%, or (1.2 accounting requires measures of productivity change
1.0)/1.0. A similar calculation can be performed for
and price recovery change over periods of time.
To illustrate changes in productivity and price
productivity change in labor [44% =(2.4 -1.67)/1.67].
recovery, we will use a simplified example of a
Likewise, the productivity change in machinery must
business that manufactures shirts as the only product,
be 20% because the same number of machines
using linen and labor as the cost resources and
produced 20% more output (see Table 3 for a
machinery as the capital resource. We ignore for the
summary of these results).
sake of simplicity buttons, cotton, thread, labels,
Table 3: CHANGES IN PRODUCTIVITY AND PRICE RECOVERY
Profit
Variance
Productivity
% Change
Variance
A+B
Cost Resources
Linen (sq. yards)
Labor (staff-hours)
Total Cost Resources
Capital Resources
Machinery
Price Recovery
% Change
Variance
A
B
$ 9.60
$ 9.10
$18.70
20.00%
44.00%
(*) 33.33%
$ 9.60
$26.40
$36.00
0.00%
(20.00%)
(*) 9.09%
$27.30
20.00%
$12.40
20.0%
Blocher, Stout, Juras, Cokins: Cost Management 6/e
16-5
$ 0.00
($17.30
($17.30)
)
$14.90
©The McGraw-Hill Companies, Inc 2013
Total Resources
$46.00
Similarly, there is also a unique price recovery
relationship for each resource contributing to a
business operation (that is, cost per unit of input). For
example, the price recovery for labor can be
measured as the change in the output/input ratio for
shirt and labor prices across the two periods. The
price recovery of labor in January was $15/$8, or
1.875, while it deteriorated to $18/$12, or 1.5, in
February The price recovery change for labor shown
in Table 3 is -20%, or (1.50- 1.875)/1.875. There was
no change in the linen price recovery ($15/$4 =
$18/$4.80).
The price recovery for the machine is calculated
in the same way. The machine’s value remained
constant while output prices increased from $15 to
$18, thus leading to a positive price recovery of 20%
[($18/$1,000) - ($15/$1,000)]/($15/$1,000). This
approach intuitively accounts for the opportunity cost
of the machine. For example, if the machine’s value
increased by a hundredfold while the output prices
remained steady a strong argument could be made for
selling the machine instead of using it. Our approach
shows the impact of consuming this opportunity cost.
PRODUCTIVITY ACCOUNTING
CONTRIBUTIONS
The percentage changes in productivity and price
recovery are in themselves informative to
management but do not show the contribution these
changes have on profit change, impacts that are far
more important to management. The process for
converting percentage changes to variances is rather
complex as one must eliminate price recovery effects
in the productivity variance and productivity effects
in the price recovery variance in order to achieve
separation of the two effects.
To convert the percentage change in productivity
into a dollar measure we take the new resource
quantity (five staff—hours of labor) and multiply it
by the new price ($12 per hour) and then by the
percent change in productivity (44%), that is, 5 x $12
x 44% = $26.40. We have used the new price to show
the current effect of the change in productivity. We
determine the price recovery variance for labor by
first establishing the resource input at assumed
constant productivity. For labor, given that output
increased by 20%, the assumed labor (at constant
productivity) would also increase by 20%, or from 6
hours to 7.2 hours. Thus, we determine the variance
by multiplying the new price by 7.2 hours and then
by the percent change in price recovery (-20%), that
is, $12 x 7.2 hours x -20% = $17.30. Essentially this
calculation holds the productivity effect constant in
Blocher, Stout, Juras, Cokins: Cost Management 6/e
(*) 28.47%
$48.40
(*) (1.100%)
($ 2.40)
order to isolate the price effect. The linen variances
are calculated in the same way.
For the capital resources (assets) there is an
additional step to convert the asset values into a “cost
of capital.” The asset value must be multiplied by a
return on investment (ROI). The ROI could be the
ROI achieved in the reference period (January 2008),
the ROI in the review period (February 2008), or
some other target ROI. In our example we have used
the ROI in the reference period (6.2%) and applied it
to both the reference and review period assets. For
example, the productivity variance for the machinery
is 1 x $1,000 x 20% x 6.2% = $12.40. Software
developed by one of the authors can be used to
facilitate these calculations.2
For an illustration of the importance of
measuring both productivity and price recovers
notice in Table 3 that the financial benefit of the
increase in labor productivity was $26.40 but that the
unfavorable effect of price recovery of -$17.30
eroded this benefit. Therefore, the overall effect of
labor on profit only amounted to a benefit of $9.10
($26.40 - $17.30).
This simple example clearly illustrates the
importance of measuring not only productivity but
also price recovery so that the analyst can evaluate
the effect of quantity and price changes on the profit
of the business. The productivity accounting method
of measuring productivity and price recovery shows
that you can unambiguously evaluate each and every
resource to find its productivity and price recovery
impacts (that is, both change in index number and
dollar effect) on the products produced. Next we will
illustrate how this combined information can be
displayed graphically for easier interpretation.
GRAPHICAL INTERPRETATION
In order to easily interpret a productivity accounting
analysis for a business, the results should be
presented in a visual form that is quick and easy to
interpret. We will illustrate a grid format to visually
represent the analysis. The “nine-box diagram”
illustrated previously represents a large number of
interactions, each having different implications for a
business. A grid diagram helps to refine this
information.
THE PROFIT GRID
The Profit Grid shown in Figure 2 is used to explain
profit change in terms of a change in productivity and
a change in price recovery. The productivity variance
is plotted vertically and the price recovery variance is
16-6
©The McGraw-Hill Companies, Inc 2013
Figure 2: THE PROFIT GRID
Blocher, Stout, Juras, Cokins: Cost Management 6/e
Decrease in
Productivity
2
6 1
5
Price Recovery Variance
plotted horizontally. As the variances can be either
positive or negative numbers, the grid is segmented
into four quadrants with the origin in the center of the
grid. The diagonal line connects all points where the
productivity variance is offset by an exactly opposite
price recovery variance. That is, there is no change in
profit along this line. The segments above the
diagonal (Segments 1, 2, and 3) signify an increase in
profit while the segments below the diagonal
(Segments 4, 5, and 6) signify a decrease in profit.
For example, assume that the business increased
its profit by $20. This profit change arose from a $10
improvement in productivity and a $10 improvement
in price recovery. Moving from the origin +10 in the
vertical and horizontal directions places us in
Segment 2. Segment 2 performance indicates the best
of both worlds—the organization is improving
productivity and price recovery. But excessive price
recovery may create an opportunity for competitors
to undercut the business’s product prices and thereby
reduce market share and profit.
Now assume that the $20 change in profit arose
from a $25 productivity improvement, but the
business lost $5 from price underrecovery. This is an
example of a Segment 1 scenario. In Segment 1 the
organization has strong competitive advantages from
superior process execution while deterring
competitors with price underrecovery (that is, the
business has only partially recovered its resource
price change through its product price change).
Continuing the example, assume that the $20
change in profit arose from a $10 decline in
productivity, but there is a $30 price overrecovery.
This places us in Segment 3. Profit in Segment 3 may
be very temporary. It occurs primarily from very
aggressive pricing relative to resource inputs. An
organization will sustain such pricing power only in
the face of sustainable competitive position. Without
such position, competitors surely will be attracted to
the business and erode the margin opportunities,
leaving the firm to compete on weak process
execution.
Increase in
Productivity
Productivity Variance
43
Price Underrecovery Price Overrecovery
In each of these examples the same $20 change in
profit had very different strategic interpretations. The
favorable change in profit alone (that is, the
difference between revenue and cost) does not give
the insight necessary to evaluate business
performance and competitive position in the
marketplace.
SUMMARY OF GRIDS
In order to have an overall picture of the business’s
performance, one needs to evaluate not only the
Profit Grid but also the Quantity, Price, and
Productivity Grids. Evaluation will clearly show the
source of change in profit, productivity and price
recovers, which are essential for understanding
business performance. All four grids are shown in
Figure 3.
The business appears in Segment 1 of the Profit
Grid, indicating that the increase in profit arose from
an increase in productivity which, however, was
reduced by a price underrecovery. This places the
business in a strong competitive position as
competitors will require an even greater improvement
in productivity to counter the price underrecovery.
This segment is the classic position of the market
leader in a hypercompetitive market.
16-7
©The McGraw-Hill Companies, Inc 2013
Figure 3: FOUR-GRID FRAMEWORK
Productivity Variance
Profit
Grid
Capacity Utilization
Variance
Productivity
Grid
2
2
6 1
6 1
Price
Recovery
Variance
5
Quantity
Grid
Efficiency
Variance
5
43
% Change in Product Quantity
43
% Change in Product Price
Price
Grid
B
B
C
DD
C
DD
%
Change
in
Resource
Quantity
E
E
AFF
AFF
The Productivity Grid (Segment 1) shows that
the increase in productivity arose from a large gain in
capacity utilization, which was eroded by a decline in
efficiency. In the short term, if the business improves
its efficiency it will be able to increase productivity
and thereby profits. The increase in utilization
probably was due to increasing market penetration
from the business’s price leadership position.
We have introduced the concepts of efficiency
and capacity utilization here for completeness. These
concepts are used to distinguish between fixed and
variable resources. Typically cost resources are
regarded as variable and capital resources as fixed. In
practice these resources fall somewhere between
fixed and completely variable.
The Quantity Grid (Segment B) indicates that the
business increased its production while discharging
resources. In other words, it increased production and
Blocher, Stout, Juras, Cokins: Cost Management 6/e
reduced resource use, clearly giving an increase in
productivity.
The source of the price underrecovery, which
placed the business in Segment 1 of the profit grid, is
seen on the Price Grid. The decline of product prices
exceeded the decline of resource prices, placing the
business in Segment F.
Using this framework, it is clear that a business
can generate profit growth through productivity
growth or price overrecovery. The course that a
business chooses, however, has important
implications for its long-term competitive position.
STAKEHOLDER ANALYSIS
A simple value chain will link a company from the
supplier to the customer. The impact of productivity
and price recovery on suppliers and customers also
can be evaluated using the grids, as the profit grid in
Figure 4 shows.
16-8
©The McGraw-Hill Companies, Inc 2013
%
Change
in
Resource
Price
In the segments to the right of the vertical axis
the consumer pays a subsidy to the producer because
of increasing product price relative to resource price
(that is, product price is increasing faster than
resource price). In the segments to the left of the
vertical axis the producer is paying a subsidy to the
consumer because of decreasing product price
relative to resource price (that is, resource price is
increasing faster than product price).
In the segments above the horizontal axis the
resource supplier is harmed because of decreasing
resource content per unit of product (that is,
improved productivity). In the segments below the
horizontal axis the resource supplier is favored
because of increasing resource content per unit of
product (that is, declining productivity).
This type of analysis also can be applied to the
productivity, quantity and price grids. The expert
analysis report generated by the FPM software
automatically gives this analysis.
price. If all other factors are held constant, price
underrecovery translates directly into a decrease in
profits in the short term.
Instead of the conventional profit analysis
represented by the middle column of the “nine-box
diagram,” many corporations and business units now
analyze profit changes as a result of changes in
productivity and price recovery, as represented by the
middle row
These relationships then can be displayed to
provide an instant visual analysis of the causes of
profit change. Such visualization can provide a robust
method for analyzing strategy and stakeholder
relationships.
I
As descrjbed by
[1] A.J. Hayzen, “Financial Productivity
Management— An Overview;” WITS Industrial
Engineering Conference, February 1988.
[2] B.J. van Loggerenberg, “Productivity
Decoding of Financial Signals: A Primer for
Management on Deterministic Productivity
Accounting.” PMA Monograph, 1988.
2
Financial Productivity Management (FPM)
software.
THE COMPLETE PICTURE
We have seen that a corporation or business unit can
analyze change in profit in terms of a change in
productivity and a change in price recovery. Change
in product quantities and change in resource quantity
drive the change in productivity. Change in product
prices and change in resource prices drive the change
in price recovery.
A corporation or business unit can achieve
productivity improvement when product quantity
increases at a faster rate than resource quantity but
will experience productivity decline if resource
quantity increases at a faster rate than product
quantity. If all other factors are held constant,
productivity improvement will translate directly into
profit improvement.
When product price increases at a faster rate than
resource price, the result is price overrecovery. If all
other factors are held constant, price overrecovery
will translate directly into increased profits in the
short term. Price underrecovery occurs when
resource price increases at a faster rate than product
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16-2: LEAN ACCOUNTING: WHAT’S IT ALL
ABOUT?
BY FRANCES A. KENNEDY, CPA, AND
PETER C. BREWER, CPA
No, lean accounting has nothing to do with the South
Beach Diet! Heck, you don’t even need to count
calories to become lean! But you do need to count
what matters to the success of your business if you
want to practice lean accounting. Though measuring
what matters sounds intuitive, too many
organizations are attempting to drive operational
improvement with data that actually impedes the
goals of improving customer satisfaction and
financial results. Indeed, non accounting managers in
numerous lean organizations across the globe would
argue that their accountants are better off counting
calories or carbohydrates rather than tracking
LEAN THINKING AT MIP
As the new millennium dawned, Midwest Industrial
Products (MIP), a fictitious name for confidentiality
purposes, didn’t have cause for celebration. Bloated
inventories, excessive waste, disgruntled customers,
and unsatisfactory financial results were the order of
the day for this Fortune 500 U.S. manufacturing
company. In an effort to right the ship, MIP adopted
the principles of lean thinking featured in Figure 1.
The first step of lean thinking is to Define Value.
During this step it’s critical to understand who’s
doing the defining and what they are valuing. The
Blocher, Stout, Juras, Cokins: Cost Management 6/e
performance indicators geared to the bygone era of
mass production. The reason? Mass production
metrics contradict lean thinking and often compel
managers to make dysfunctional decisions. Lean
thinking is about eliminating all forms of waste.
To be a lean thinker, or a lean accountant for that
matter, you must relentlessly seek to view your
organization through the eyes of your customers.
Sounds simple enough, right? Yet a closer look at
most “customer focused” companies reveals that their
employees myopically optimize functional
performance, which results in enterprise-wide waste
and unhappy customers. And, yes, in case you are
wondering, the accountants often lose sight of the
customer as well. Let’s take a look at one company’s
experiences.
customers are the ones who define what they value in
specific products and/or services.
The second step is to Identify the Value Streams—all
the value-added activities that go into delivering
specific products and services to customers.
Inevitably, these value streams span functional
boundaries, thereby requiring employees to see how
their organization functions from the customer’s
viewpoint.
The third step, Make the Value Stream Flow, requires
a departure from the mass production era approach of
functionally organized batch-and-queue production
that leads to inventory build-up, unsatisfactory orderto-delivery cycle times, and excessive rework and
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waste. Instead, lean uses cellular work arrangements
that pull together people and equipment from
physically separated and functionally specialized
departments. The various pieces of equipment are
sequenced in a manner that mirrors the steps of the
manufacturing process, thereby enabling a
continuous one-piece flow of production. Employees
are cross-trained to perform all the steps within the
cell.
The fourth step is to Implement a Pull System where
customer demand dictates the production level.
Visual controls are used to trigger upstream links in
the value stream to initiate additional production. For
example, when a point-of-use storage bin of
component parts becomes empty, it automatically
signals the upstream link in the value stream to
replenish the parts without the need to prepare
ecoming a Lean Enterprise: A Tale of Two Firms” in
the November 2002 Strategic Finance.
GET OUT OF THE WAY!
With the transition to lean production under way, the
non accounting managers at MIP had one clear
message for their colleagues in accounting—add
value or get out of the way! Three sources of
discontent were underlying this message. First, the
accountants were relying heavily on variance data
that they tabulated in conjunction with the monthly
financial accounting cycle. Variance data tabulated
on March 5—five days after the month-end close—
was totally useless when it came to helping managers
make real-time operational decisions on February 5.
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paperwork such as a materials requisition.
Furthermore, establishing a takt time (the average
production time allowed for each unit of demand),
which is calculated by taking the total operating time
available during a period and dividing it by the
number of units demanded by the customer during
that period, ensures that the pace of production
remains in sync with customer demand.
The fifth step, Strive for Perfection, leverages the
process knowledge of frontline workers. Rather than
relying exclusively on management-level employees
to generate ideas for improvement, management
views all employees as intellectual assets capable of
improving the flow of value to customers. To learn
more about the principles of lean production, see
Tom Greenwood, Marianne Bradford, and Brad
Greene’s “B
Second, the accountants were providing data that
motivated managers to make decisions that
contradicted MIP’s lean production goals. For
example, lot size variances and production volume
variances motivated managers to maximize lot size
and to keep workers busy making product to stock.
Of course, these behaviors contradict the one-piece
flow and make-to-order “pull” aspects of lean
production where customer demand dictates the
amount of production. Third, the financial
accountants were inaccurately characterizing the
financial impact of operational improvements. Most
notably, the absorption costing income statement,
which treats direct materials, direct labor, and
variable and fixed overhead as product costs and all
selling and administrative expenses as period costs,
penalized managers’ inventory-reduction efforts with
a major hit to the bottom line.
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The reason? In the illogical world of absorption costing,
building up inventory increases income because of the
fixed overhead deferral, while reducing inventory
decreases income because of the need to expense
previously deferred fixed overhead. To make matters
worse, the absorption costing income statement was
unintelligible to operations managers and frontline
workers. Thanks to the concepts of closing out variances
and fixed overhead deferrals, MIP’s operations managers
were confused—and frustrated—by an absorption costing
income statement that didn’t reflect the economics of the
lean business model.
their efforts in four areas: (1) performance measurement,
(2) transaction elimination, (3) calculating lean financial
benefits, and (4) target costing.
Performance Measurement
Historical financial measures that focused on functional
efficiency were no longer going to get the job done.
Instead, the team sought to create a cohesive set of linked
strategic objectives and goals, value stream goals and
measures, and cell goals and measures. Figure 2 shows a
subset of what the value stream team developed. The
strategic objective of profitable growth links to the
strategic goal of sales growth, which is a function of three
value stream goals: economical processes, producing to
customer demand, and perfect quality at the source. These
three value stream goals link to on-time delivery, cost per
unit, first-time through, and units-per-person measures.
These value stream measures are improved by focusing on
five critical success factors at the cell level, namely quality
at the source, quick changeover, kanban and pull, effective
machine usage, and standard work processes. Finally, the
cell critical
the company’s strategic objectives. In addition,
frontline workers monitor the cell measures
ENTER LEAN ACCOUNTING
In an effort to respond to what the accountants viewed as
fair criticisms from their counterparts in operations, MIP
initiated a transition to lean accounting in May 2002 by
forming two cross-functional blitz teams that included
members from operations, purchasing, engineering, and
accounting to design lean accounting practices for one
manufacturing cell. The cross-functional teams focused
success factors link to the six cell goals and three cell
measures as shown. Notice that all measures link to
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throughout the day to enable real-time response, and
the operations managers monitor the value stream
measures daily and weekly to drive the continuous
improvement process.
Transaction Elimination
MIP’s accountants realized that lean thinking applies
to the information management side of the business
as well as to making products. Therefore, as
operations began to streamline its processes, the
accounting department found that it was able to
eliminate many of its transactions. For example, as
materials requirements planning (MRP) was replaced
with point-of-use visual controls (also called
kanbans), material receipts were recorded by
scanning bar codes rather than preparing receiving
documents. As blanket purchase orders became more
prevalent, the accountants authorized payment
according to the terms of the purchase order when
materials were received. This eliminated the need for
Calculating Lean Financial Benefits
Blocher, Stout, Juras, Cokins: Cost Management 6/e
accounts payable to perform the very timeconsuming three-way match of purchase orders,
invoices, and receiving documents that often required
discrepancy investigation. MIP has reduced 18 labor
categories to two, which is resulting in fewer errors
and quicker processing. Furthermore, senior
management is considering compensating its labor
force on a salary basis, thereby eliminating the need
to track labor hours altogether. Because
manufacturing variance reporting has been eliminated
and the value stream teams are using weekly value
stream statements to make management decisions,
MIP is considering closing the books on a quarterly
basis rather than a monthly basis. Finally, as lean
improvements have reduced inventory levels, cycle
counts are becoming more accurate, and the time
needed to perform these counts has declined. In fact,
MIP believes it may be able to eliminate physical
inventory counts altogether! Everything they need to
verify inventory levels is readily in view.
The team created two tools to quantify the financial
benefits of lean production. The first is a report called
a value stream cost analysis that spans all functions
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directly involved in responding to customer orders
for a particular product family. The second is an
income statement format that complements lean
production.
Value Stream Cost Analysis. Table 1 shows an
example of a value stream cost analysis report. The
top half of the report focuses on employees, and the
bottom half focuses on machines. The table’s top row
shows employees’ costs in total and for each link in
the value stream. Employee time is broken down into
four categories: productive, nonproductive, other, and
available capacity. These four numbers sum to 100%
for each column. So in Assembly, 40% of the
employees’ time is productively deployed, 25% is
nonproductive, 4% is categorized as other, and 31%
is currently idle. You interpret the data in the bottom
portion of the table relating to the machines in the
same fashion. The average conversion cost shown at
the bottom of each column is calculated by dividing
the total costs incurred as shown in each column by
the total number of salable units actually produced
during the period. M
ATERI
AL HANDLI
You can add material costs to this calculation’s
numerator to provide an actual average total cost per
unit produced. If a particular value stream is
characterized by product diversity, you can
differentiate the costs assigned to products based on
product features and characteristics. For simplicity,
we won’t explore this issue in detail. The benefits of
this report are that it:
For MIP, the value stream cost analysis highlighted
the fact that the transition to lean production reduced
waste and increased the amount of idle capacity.
Consistent with the philosophy of lean thinking, MIP
sought to redeploy its newfound idle capacity to grow
sales rather than to reduce available capacity by
cutting heads.
1. Shows where and how productively costs are
Income Statement Format. MIP’s traditional
incurred,
2. Is easy to understand,
3. Highlights areas of waste,
4. Shows actual costs rather than standard costs,
5. Identifies bottlenecks, and
6. Highlights opportunities to manage capacity more
effectively.
absorption costing income statement suffered from
three limitations. First, it obscured the impact of
changes in inventory on profits by burying the
“inventory effect” in cost of goods sold. Second, it
included adjustments to income resulting from the
use of standard costing that confused nonaccounting
personnel. Third, it didn’t depict costs from a value
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stream perspective. The product- vs. period-cost
distinction satisfied financial reporting requirements,
but it didn’t offer useful insights to operations
personnel. The lean income statement in Table 2
focuses on simplicity by attaching actual costs to
each component of the value stream, isolating the
impact of inventory fluctuations on profits, and
separating organization-sustaining costs (costs that
can’t be traced to specific value streams) and
corporate allocations from value stream profitability.
Arbitrary cost allocations are avoided except in the
case of occupancy costs, which are allocated to the
value streams based on square footage to encourage
minimizing space occupied. The profit for the total
plant reconciles to the profit reported using an
absorption format, but, unlike absorption costing, the
underlying detail of the value stream statement is
understandable to non accountants.
Target Costing
The lean team decided that traditional cost-plus
pricing was no longer acceptable because it was
based on the flawed assumption that customers would
be willing to pay what MIP deemed appropriate
based on its internal cost structure. MIP was taking
its internal cost structure as a given and attempting to
pass these costs on to customers rather than viewing
its costs as a set of inputs that must be aligned
profitably with the customer’s expectations.
Accordingly, the team turned its attention to target
costing. The reason? Target costing is based on the
premise that the pricing and continuous improvement
processes begin by understanding customer needs.
As Figure 3 shows, MIP’s target costing framework
includes four main steps that break down into 11
smaller steps. The initial focus of the process clarifies
customer needs and values followed by translating
these insights into target costs that can drive the
continuous improvement process. While MIP’s
transition to lean accounting is certainly not
complete, the accountants have initiated the process
of becoming a value-added partner to the
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organization’s operations managers. The results of
this partnership have been impressive. By May 2004,
inventory levels had declined by 52%, waste and
rework had decreased by 41%, and the timeliness of
customer deliveries had increased by 27%. Now,
instead of pleading with the accountants to move
aside, the message from the shop floor has changed
to welcome aboard!
HOW DO I BEGIN?
Implementing lean thinking within the accounting
function is a journey that takes thoughtful
consideration. Although changes in accounting can’t
outpace those in manufacturing, they should follow
closely. The first step is to assess where in the lean
journey your facility resides. Has production
converted to a one-piece pull system?
Good. Then it’s time to review performance metrics.
Have you established value stream teams responsible
for improvements? Good. Then it’s time to look at
value stream reporting. To assess your lean
implementation progress read Practical Lean
Accounting by Brian H. Maskell and Bruce Baggaley.
It outlines a logical maturity process that matches
accounting change with lean manufacturing changes
(see a complete citation for this and other resources
in “Resources at Your Fingertips” on p. 34). The
second step on the path to lean accounting is to fully
understand the length of the journey. For example,
what will your lean accounting income statement
look like? What does your income statement look
like now? What steps must you take to make the
transition? Who will be responsible for the change?
What resources will be needed? Perform this analysis
for each change in information accumulation and
reporting. Relentlessly ask yourself the questions: Is
this transaction still needed?
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Does it add value to our business? The third step is to
schedule dates to review implementation progress.
The reviews should take place often enough to
reinforce accountability and to communicate the
importance of the lean transformation—and far
enough apart to not drain resources. Include all
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stakeholders in these meetings, including value
stream and cell leaders as well as key employees
from purchasing, human resources, engineering, and
accounting. Keep all implementation team members
informed and on board.
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WHAT ABOUT SERVICE?
Lean thinking means identifying and eliminating
waste in whatever form you find it. For
manufacturers, such as MIP, it’s easy to visualize the
sources of waste—overproduction, waiting, defects,
transportation, unnecessary inventory, unnecessary
motion, and inappropriate processing. But how does
waste manifest itself in a service business? The root
cause often resides in the same type of functionally
organized batch-and-queue processes that plague
manufacturing. Hence, the logic of identifying value
streams that span functional boundaries, building
work processes that mirror those value streams, and
using a pull approach to synchronize the level of
output with customer demand is equally applicable to
service businesses. Functionally organized service
companies often find that it takes a piece of paper
numerous days to route through two offices in the
same building! The process view inherent in lean
thinking is likely to reveal that this piece of paper
could move through the system in minutes rather than
days if you eliminate the time it spends sitting in
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somebody’s inbox. Value stream maps are
particularly useful in this type of situation. A “current
state” map can be created that defines the flow of the
current process and its performance levels. Then a
“future state” map can be created to depict the
desired flow of the process and its targeted
performance levels. A modest number of specific
improvement initiatives can be pinpointed on the
“future state” map. Then a three-to-five-day
improvement project, known as a kaizen event, can
be scheduled and executed for each specific
improvement initiative to make the “future state”
map a reality. Whether you work in service or
manufacturing, lean thinking can help your company
improve its operations. The accounting function can
either impede lean thinking by continuing to provide
counterproductive information, or it can make the
transition to lean accounting. If your company is
making the lean transition, you can make the
accounting department a part of the lean team.
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