Connection to Value Stream Analysis (Cell Manufacturing Analogy)

The traditional accounting approach consists of gathering, by department, division, or segment, direct costs, which include all variable costs of production plus fixed costs benefitting a single unit, and allocating common costs (shared fixed costs) to all units that benefit from the common costs. In contrast, Lean accounting, like Lean operations, focuses on establishing, for a value stream (a production flow for a particular product or family of products), a flow of data that rapidly produces high-quality information (Maskell and Baggaley, 2004, 910). For example, if processing accounting transactions individually, one by one, speeds up the flow of information to operating managers, that methodology is preferred even though batch processing of data may be a more cost-effective process. Most Lean accounting advice, though, applies to operations, not to activities of the accounting department itself.11 Applying Lean accounting concepts to an operation where costs are aggregated by value streams, established for each product line or family of products, requires "dedicated" value stream resources. Each stream is designed to speed the flow of production and minimize arbitrary cost allocations. Dedicating resources to each stream results in some duplication of resources. Duplication of resources, of course, increases costs. Production, however, is speeded up and revenue is earned more rapidly.

Lean accounting recognizes the arbitrary nature of allocating common (shared) fixed costs and attempts to avoid this issue either by dedicating resources to individual value streams where allocations are limited to product family members or just not allocating common manufacturing overhead costs such as those for buildings, security, human resources departments, etc. Demonstrating the strong tendency to revert to accountants' extensive traditional accounting education, however, two Lean accounting books (Maskell and Baggaley, 2004; Huntzinger, 2007, Chapter 17, see especially p. 259) recommend allocating common fixed resources in order to produce a total cost per unit. A fully allocated cost per unit, though, is of dubious value to managers.

Advantages of Lean Accounting

Lean accounting proponents claim that through participating in kaizen events, an attempt to attain continuous improvement and referred to as a kaizen blitz(SM)12 when performed by a focused team over a short period of a few days, the exposed opportunities for improvements can be supported by accounting measures and reports. By understanding and reporting the results of Lean initiatives, Lean accounting supports improvements such as: Reduction, frequently dramatic, in work-in-progress (WIP) inventory13; Elimination of non-value-added processes resulting in decreased total processing times; Increased company productivity; Reduced setup and changeover times; Increased on-time deliveries (Womack et al., 1990, 81; Liker, 2004, 36; Polischuk, 2009; Shipulski et al., 2009).

These advantages are the result of applying Lean concepts throughout an organization or a supply chain. Even with accounting support, realizing benefits promised by Lean initiatives is extremely difficult.

Disadvantages of Lean Accounting

General lack of success in copying another organization's strategy has been experienced, if not reported, by many firms. Attempting to reproduce improvement results on other than a short-term basis without supporting behavioral and cultural changes generally has not been successful. Failures of Lean implementations, and Lean accounting, have pointed to the following deficiencies: Top management does not actively and continuously support Lean initiatives; Accounting/finance people are not included in Lean training sessions (a not uncommon situation for all improvement initiatives); Information flows are not adapted to match new Lean flows (value streams); Publicizing local "successes" creates competition among various units of an organization; Appropriate performance metrics are not developed (Achanga et al., 2006; Stuart and Boyle, 2007; Pullin, 2009; Shook, 2009).

In addition to the new accounting developments discussed previously, some traditional accounting techniques such as standard costs and master budgets have remained powerfully in place.

Traditional Budgeting, Capital Budgets, and Control Mechanisms

While some organizations disparage the budgeting process (Anonymous, 2003; Hope and Fraser, 2003; Nolan, 2005; Weber and Linder, 2005), most companies still go through the annual angst of budget preparation with all the pomp, posturing, and political maneuvering of a public sporting event. Even if bad behaviors erupt, there are good reasons, such as detailed planning, company-wide coordination, and synchronization of effort, to undergo this process.

Regardless of the particular accounting methodology used to record and report transactions internally, most organizations, including governments, prepare budgets for various time periods, typically for a quarter or annual period, but sometimes for three- or five-year periods. Budgets not only can be for differing time periods, but can be very specialized, such as a budget for a new product introduction or another individual project, an operating budget focusing on expected (or hoped for) operating income, a capital budget for asset acquisition, or a budget covering an entire organization, called a "master" budget.14

Master Budgets

Comprehensive (master) budgets should follow carefully laid strategic plans (although sometimes they proceed, or evolve into, the strategy). This process forces introspection and consideration of underlying assumptions and intended or possibly unintended consequences. In addition, budgets can project cash flow shortages in time to acquire bank-lending commitments at favorable times-before the cash is needed. For convenience, an annual master budget typically is broken down, somewhat arbitrarily, into monthly or quarterly subperiods and can require many months of back and forth communications between the finance department or budget committee and affected departments, business units, or segments (Bragg, 2007a, 30).

Financial planning includes preparing a projection of what the company hopes to accomplish for the next period. The typical budget process begins with projected sales in units and in currency, on a monthly basis, for a 12-month period.15 Based on expected sales and certain information concerning desired inventory levels, production in units, material acquisition (in units and currency), labor costs, variable overhead elements, and other production fixed overhead amounts to be incurred are estimated, both in terms of cash outflows and overhead applied, for each month of the period. At this point, cost of sales, including materials, labor, and applied overhead, is computed for each month. Next, a schedule of general, selling, and administrative expenses, usually divided into variable and fixed components, is prepared.

Using the previous information, along with assumptions concerning collections from customers, payments to suppliers, asset acquisitions, and the timing of other cash inflows and outflows, a statement of changes in cash is prepared. Only then is sufficient information available for projected income statements and balance sheets. (See master budget relationships, in the diagrams, in Hilton, 2009, 350; Garrison et al., 2010, 375.)

Capital Budgets

One of the largest cash requirements involves acquisition of additional assets. In large, decentralized organizations, capital budget requests are prepared by investment centers that have responsibility for return on assets as well as profit and loss. These centers require additional resources in order to fulfill their stretch goals and do not (and probably cannot) predict the impact of their request on the entire organization. Therefore, executive committees usually schedule marathon sessions where managers come in and present their cases, using projected cash flows and net present values, for additional investment. The committee then must decide which proposals to fund16 based on logical analyses of short, compelling, and often competing presentations.

Due to the time required to achieve budget agreement on budgets of all sorts, management is frequently reluctant to revise budget numbers when original assumptions are invalidated. Thus, the data formulated during the fall for a calendar-year company may be used for the next 12 to 15 months.

Once the budget period begins, large organizations typically prepare periodic flexible budgets, which are based on actual results of the critical area of the organization on which a master budget is originated. For example, if a company has excess capacity, the first schedule in a master budget is sales units, followed by projected sales in the organization's currency, followed by production schedules, material schedules, etc. Therefore, once sales are known, expected costs associated with those sales can be prepared. If a company has more demand than it has resources to fulfill, however, the master budget must begin with a production schedule featuring the desired product mix. Then sales, in currency and other supporting schedules can be derived. Later, actual production and sales of various products, along with expected costs, can be combined in a flexible budget. Flexible budgets present more meaningful interlocking data once actual critical area performance is known.

Use of Budget Data

In addition to their planning role, budgets frequently are used in performance evaluation. Because a master budget contains budgets for each area of an organization, it is easy to engage in performance to budget, where actual results for each area are compared with budgeted predictions and favorable or unfavorable variances computed and reported. Flexible budgets, as reported by every cost and management accounting textbook produced in the last several decades, control some, but not all, of the damage of this type of performance report.

Advantages and Disadvantages of Traditional Budgets

Advantages of budget preparation include the following: Planning for future periods is required.

Budgets facilitate communication throughout an organization.

Goals (expectations) are set.

All areas of the organization have input into the process.

Upcoming creditor covenants can be met or renegotiated.

Resource requirements can be established (Hilton, 2009, 348349; Garrison et al., 2010, 369).

Disadvantages of the budgeting process and its uses are that it: Sets an upper bound on performance (diminished incentive to "outperform" the budget); Encourages padding of requests (gaming) in anticipation of forced reductions; Results in a lack of budget ownership (budget numbers frequently are dictated by upper-level management); Encourages competition between areas for resources; Can encourage dysfunctional behavior in order to meet budget amounts; Is cumbersome and too expensive (Cunningham and Fiume, 2003, 133139; Hope and Fraser, 2003, Chapter 1; Hilton, 2009, 375376).

TOC Approach to Planning, Control, and Sensitivity Analysis

As amazing as it may sound, TOC makes the strong assertion that all the allocation gyrations of traditional and newer accounting methodologies are not necessary and generally serve to confuse and obfuscate rather than enlighten. In fact, implementing TOC (or any other management improvement initiative) without changing the internal accounting and reporting system will send mixed messages to the troops and eventually, by encouraging people to go back to old and out-of-date policies and assumptions upon which previous reporting is based, will undermine the new system.

Planning

At its most basic level, planning includes establishing strategy and then implementing the chosen strategy. Because this subject is treated in detail in later chapters in this Handbook (Chapters 15, 18, 19, and 34), treatment of strategy and tactics are deferred until later.

The typical starting point for planning in a Throughput environment is recognition of the organization's most binding constraint (Step 1 in TOC's Five Focusing Step [5FS]-process). If raw materials are in short supply, vendors may occupy this position. Most often, though, an organization's demand from its customers poses the most binding constraint, especially in times of recession in the economy as experienced in the last half of 2008 and in 2009. Because of company policies, however, it is not unusual also to find one or multiple internal constraints.

Finding the Best Product Mix

Accounting people typically think about capacity in terms of facility capacity, not the capacities of individual resources used to produce a company's products. If demand is greater than any one of an organization's resource capacities, however, products must be prioritized.

The traditional approach is to prioritize products based on one of the following: (1) selling price, (2) gross profit, or (3) contribution (gross) margin. An activity-based accounting system prioritizes products based on activity-based gross profit for each product.

TA uses explicit recognition of an internal constraint when prioritizing products. One of the most familiar TOC formulas used to determine the best product mix when demand is greater than production capability (an internal constraint exists) is throughput per unit of constraint time. Accountants will have learned this concept under the name contribution margin per unit of constraint, which is recommended to determine product priorities when an organization faces a single constraint.17 This process most easily is illustrated with an example.

Figure 13-1 is adapted from the original "P-Q" example developed and presented by Eli Goldratt in numerous workshops all over the world and in one of his books (Goldratt, 1990, Chapter 12). Rather than two products, Fig. 13-1 has three products, but the basic idea of a stable environment with no significant uncertainties is the same. Given Fig. 13-1 and some basic information as shown in Tables 13-1 and 13-2, a TOC-trained person can compute the optimal product mix (Product Z, then Product X, then Product Y) and expected operating income in a matter of minutes.

Three elements in Fig. 13-1 have darker outlines because their output is required in more than one product. Resource 1, task 2, and Resource 2, task 3 produce a common component from Raw Material #3 that is used in both Product X and Product Y.

Figure 13-1 shows a production view (combining both bills of materials [BOMs] and routings for items flowing through the facility) of the organization's operations where each of the four resources can perform different tasks. A typical accounting view would show the materials flowing through four stationary resources.

FIGURE 13-1 Product flows through resources for a simple company.

Within five minutes, most people familiar with TOC concepts recognize that Resource 2 does not have sufficient capacity to produce all units demanded and therefore would compute the Throughput (contribution margin) per minute required of Resource 2 as follows: Product X: $300 $60 materials $8 VMOH $32 VSC = $200/(20 min of Res. 2) = $10.00/min Product Y: $260 $50 materials $5 VMOH $22 VSC = $183/(20 min of Res. 2) = $9.15/min Product Z: $195 $45 materials $2 VMOH $15 VSC = $133/(5 min of Res. 2) = $26.60/min TABLE 13-1 Demand, Selling Prices, and Variable Costs TABLE 13-2 Additional Information TABLE 13-3 Operating Profit Resulting from Various Accounting Priorities Therefore, product priority would be Product Z, then Product X, then Product Y. Weekly income would be computed as $12,858 (total Throughput-or contribution margin-of $30,470 minus total fixed costs of $17,612), using all 2400 minutes of Resource 2.18 Following reasonable assumptions,19 the traditional gross profit or gross margin approach would result in first priority going to Product Y, then X, then Z. (See a complete list of 13 assumptions, some of which we will not need for the examples in this chapter, in a spreadsheet, "Throughput_Examples")20 Similarly, ABC21 would result in gross profit priorities of Product X, then Y, then Z. Table 13-3 compares the operating income (for simplicity, taxes are ignored) for four methods (Throughput, traditional, traditional contribution margin, and ABC).

Once the best product mix is determined, a formal master budget can be prepared.

Preparing a Throughput Budget

Throughput budgeting would follow the same general flow as that described in the section on traditional budgeting, but with conscious consideration of a possible internal constraint. The budget preparation process best proceeds when production provides the following data: (1) BOM for each product; (2) routing for each product; (3) prioritized expected sales of each product; (4) required inventory sizes; (5) available resource capacities; and (6) proposed acquisition of land, buildings, or equipment during the period.

With an internal constraint, the budget process would begin with the estimated production of the most profitable product mix (in units), and consideration of constraint availability. Then estimated sales (in units and in total revenues), production costs, and all other elements of a traditional budget would be prepared. Following preparation of the cash budget, the income statement would be prepared in two formats: the direct costing format used by Throughput accounting22,23 and the traditional GAAP format (revenues minus cost of sales, subtotaled into gross profit, minus general, selling, and administrative expenses to find operating profit). (See a complete treatment of Throughput budgeting in Bragg, 2007b, Chapter 5.) The Throughput budget would be used for planning purposes only, and not for control as traditionally practiced.

Throughput Control

TOC maintains that three straightforward metrics-Throughput, sales revenue minus all variable costs (manufacturing and general, selling, and administrative), Inventory (or Investment), the funds an organization has expended to be in position to produce, and Operating Expenses, the repetitive expenditures a company must incur each period in order keep the company operating-are all the measures needed for day-to-day operating decisions (Goldratt and Cox, 1984). These three metrics have occupied space in every cost and management accounting textbook, under slightly different names, since at least the 1960s (Dopuch and Birnberg, 1969).