Accounting and Financial Management
Budgeting is the Process of expressing quantified resource requirements (amount of capital, amount of material, number of people) into time-phased goals and milestones (BusinessDictionary.com, 2017). Budgets help decision makers to identify problems and to increase their understanding of the task environment (Ahrens 1997). For this reason, budgeting is “still regarded as an organizational imperative if costs are to be controlled and financial performance to be achieved” (Frow, Marginson and Ogden, 2010). The budget has historically entered the central stage of the management control system in most organizations (Otley, 1994). One of the main reasons that big companies get their budgets in the first place is to coordinate different parts of the business. By sharing accurate information publicly and based on a common set of decisions, ensuring harmonious interactions between units can lead to efficient processes, high-quality products, low inventories and satisfied customers (Jensen, 2001).
As such, traditionally, budgeting system has been considered to provide effectively four major benefits to the most organizations. (1) First of all, budgeting system provides the capability for managers to quantify the necessary resources and distribute these to the involved organizations prior to the beginning of the project. (2) Throughout the budget planning activities, the involved organizations will have a better interaction and communication to identify the problems, understand issues, pertaining to the tasks and then, finally allocate the necessary budgets to each organization. (3) Consequently it encourages each organization to conduct their task diligently and efficiently without wasting their resources. (4) Finally, It provides the persistent evaluation how the project performed under the budgeting planned and the great future index for the next budgeting plan.
However, under the current increased competitive global environment, requiring more dynamic and imminent resource allocation have raised the concern that the traditional budgeting systems are inefficient and incapable to satisfy dynamically changing environments and suggested the myopic decision making and budget games in which they proposed (Hansen et al., 2003; Ostergren and Stensaker, 2011). Also, Welch has described the unnecessary wage increase due to the misguided performance evaluation, inherited by the incorrect budgeting planned (Welch, 2005).
In addition to the inherited slow adaptive functionality and misguided performance evaluation. Jensen has described that the traditional budgeting process wastes time, twists decision making, consuming a huge amount of wasting executives’ time, due to the intentional false forecasts or manipulating critical information, consequently, twisting the resource allocation (Jensen, 2001; Jensen, 2003).
In addition to these human and organizational barriers, genuinely, it takes lots of unnecessary time and resources to create a proper budget, prior to the beginning of the tasks. Statistically, organizations spend 20-30% of their time in the budgeting process. Also, budgeting generally limits the likelihood of achieving high growth or significant cost savings by setting an upper limit of the allowable budgets. At the same time, budgets can hinder high growth because overspending over budget would cut costs in the short term in order to achieve margin goals, consequently, hindering long-term goals (de Waal, Hermkens-Janssen and van de Ven, 2011).
Recently, in order to overcome of the issues in the traditional budgeting system described above, a number of alternative methodologies have been proposed for the budgeting process, including activity-based budgeting, profit planning, rolling budgets and forecasts, zero-based budgeting, and beyond budgeting (Hansen, Otley and Stede, 2003). In particular, Jensen proposed a “A Linear Compensation Plan” to remedy the current budgeting process in which actual performance, regardless of budgetary goals, will be utilized to provide senior executives unbiased estimates for the planned achievable goal.
However, later, Jensen described that it can be problematical for organizations to simply adopt or implement the proposed linear compensation system. It is because Target-based bonuses are deeply ingrained in the minds of managers and in the managerial codes of most organizations. More than that, if the measures and evaluation were not correctly performed, executives will have the more risk of distorting managerial decisions, even under a linear bonus system. In addition, the positioning and slope of the bonus line are based on the prior year’s performance. Of course, it would reduce the risk of overcompensating for the performance, but it can cause the reduction of incentives for the increasing performance, which results in dropping the motivational effects of the performance targets. Also, the increased performance compensation would require companies to increase bonus caps way beyond traditional compensational levels, which can make organizations discomfort (Jensen, 2001).
In addition, more difficulties have described that the cost of changing the current budgeting process can be high due to the initial cost to implement the new system which requires the staffing time change, strategic planning, resource allocation, cost management (Neely, Sutcliff and Heyns, 2002), and eventually results in impacting on other unrecognized management processes, due to the lack of understanding of the current and future adopted systems (Waal, Jap Tjoen San and Zwanenburg, 2006).
To overcome the raised issues on the linear compensation schemes, the curvilinear schedule methodology has been proposed which actually, reintroduces a strong incentive in terms of the budget. Jensen has also later agreed that the budget process itself is not the root cause of unproductive behavior. Rather, determining the compensation should combine the budget goals to have proper performance measurements. He has also point out that performance indicators should reflect the functionality of other business units, to align with the departmental performance measures. Management flexibility, decentralization and delegation can also minimize the risk of measuring performance (Jensen, 2001).
Jensen criticizes managers for damaging their business because they lie to get more incentives. But currently, companies do not set incentives based only on manager reporting. Annual bonuses can be organized into three basic components: performance measurement, performance standards, and the sensitivity of the pay-for-performance relationship. Most companies rely on two or more measures of performance when evaluating manager performance, such as sales or revenue, earnings per share, operating profit or profit (Towers Perrin, 2005). Historically, accounting-based performance indicators are backward-looking and easy to lie, so firms can avoid cheating by using other measures such as operational or strategic performance goals, quality improvement, and scorecard-based systems.
If managers were still cheating as Jansen criticized, the incentive system would not have spread like it does today. In recent, the percentage of S
Lean Manufacturing: Concept Overview and Disadvantages
“The most noteworthy evolution of lean accounting in recent years has been a sharpening focus on value. Lean has always been centered on creating value for customers and eliminating non-value adding waste” (Asefeso, p 9). Lean accounting has been steadily making it possible for manufacturers to explicitly measure value in financial terms and to focus improvement efforts on increasing value. With many manufacturers now implementing lean, it becomes essential to discover what part of lean accounting has played in the changes made. This paper will give a brief background of lean manufacturing and a general overview of what lean accounting is. I will also explore some problems and disadvantages of lean accounting from various researched articles.
Background of Lean Manufacturing
Lean is a philosophy that spurred from the Toyota Production System (TPS). TPS was created by Toyota’s founder Sakichi Toyodo, Kiichiro Toyoda, and Taiichi Ohno. Much of TPS was also influenced by W. Edwards Deming’s statistic process control (SPC) and Henry Ford’s mass production lines. However, the Japanese were not impressed with Ford’s approach because it was filled with over-production, lots of inventory, and much waiting. Toyota identified these weaknesses in Ford’s production line and adapted the production line to create a more productive and reliable production line. TPS and lean also use just-in-time inventory where only small amounts of inventory were ordered and very little inventory was left waiting in the production line. This also was very different from Ford’s production line which usually bought high volumes of materials and had high inventory levels to lower costs.
After TPS proved to be successful for Toyota, many companies adapted their production lines to incorporate lean principles. Lean management was first introduced in the United States in the early 1980’s after a global study of the performance of automotive assembly plants. Essentially, the primary principle of lean is that it is a tool used in manufacturing to eliminate waste, improve quality, and reduce cost. Waste is eliminated by identifying non-value added activity. The main objective is to supply perfect value to the customer through a perfect value product that has no waste. “Eliminating waste along entire value streams, instead of at isolated points, creates processes that need less human effort, less space, less capital, and less time to make products and services at far less costs and with much fewer defects, compared with traditional business systems” (“What is Lean?”).
Companies may face certain challenges when applying lean to their production lines. First, lean should be applied to companies that have production lines that are routine, predictable, stable, and can be flow charted. Second, lean implementation may take years and can be very costly in large companies. Depending on how integrated the systems and how disciplined the production line is, it is quite possible that a lean implementation may fail. “There are several key lean manufacturing principles that need to be understood in order to implement lean. Failure to understand and apply these principles will most likely result in failure or a lack of commitment from everyone” (“Key Lean Manufacturing”). These principles are as follows: “1. Elimination of waste; 2. Continuous improvement; 3. Respect for humanity; 4. Levelized production; 5. Just-in-time production; and 6. Quality built-in” (“Key Lean Manufacturing”).
Management may also be discouraged to adopt lean manufacturing right away because the lean implementation is a long term investment. Most CEOs make decisions that benefit the company in the short run, and may choose not to adopt lean because it may show unfavorable results on the financial statement during the early stages. Lean will cause a decrease in inventory levels, causing assets on the balance sheet to drop which is not always favorable. However, these short term negative results will eventually become long run gains as the company benefits from less inventory holding costs and improved processes.
Background of Lean Accounting
While most people associate lean to manufacturing processes, it is now taking on a very important key role for companies to adopt lean throughout the other departments of the company. An example of a support function that uses the lean concept is the accounting field. Since accounting is a support department, it should apply lean principles after the manufacturing department has incorporated lean. Accounting’s main duty is to accurately measure and communicate financial activity, and by adopting lean accounting after successfully implementing lean manufacturing would allow for the accurate measurement of the new production system.
“Lean accounting evolved from a concern that traditional accounting practices were inadequate and, in fact, a deterrent to the adoption of some of the necessary improvements to manufacturing operations. While manufacturing managers knew that investments in automation and the adoption of lean manufacturing practices were the right things to do, traditional accounting was often an obstacle to such improvements, yielding numbers that only supported investments when they could be justified by reductions in direct labor, with little benefit ascribed to any improvements to quality, flexibility or company throughput” (Asefeso, p 10).
Lean accounting is the cornerstone of a completely different model of manufacturing management. By itself, lean accounting has limited value, but as the financial basis for the application of logistics, superior management, factory operations, marketing, pricing, and other vital business functions, lean accounting is very powerful. “A core principle of lean accounting is that the value stream is the only appropriate cost collection entity within the organization, as opposed to traditional accounting’s use of cells, cost or profit centers or departments normally based on smaller, functional groupings of work activity” (Asefeso, p12). The main idea behind lean is minimizing waste, therefore creating more value for customers with fewer resources.
Problems and Disadvantages of Lean Accounting
Lean accounting may reduce the manufacturing process to a few numbers, but it does not provide a lot of information. There are several flaws of using the lean accounting approach. “Speed gives you an advantage over the competition. No matter if you are first in a market or deliver a product faster, it will improve your competitiveness and hence your revenue. However, it is nearly impossible to determine this advantage quantitatively. How much does it get you to be in the market seven days earlier? One big thing in lean manufacturing is to reduce fluctuations. The more even your system works, the more profitable you will be. However, it is difficult to measure these fluctuations, even more difficult to determine the impact of an improvement on fluctuations, and hence nearly impossible to calculate the monetary benefit of reducing fluctuations. Yet another thing in lean is customer satisfaction, often described as value to the customer. What is the monetary damage if a delivery is delayed, if a product breaks, if service is slow, or if your people are unfriendly? It is nearly impossible to know. Even more difficult to determine is how improvement measures will actually influence the above. How much does it cost you to provide a better service, how will this influence customer satisfaction, and what is your benefit from this?” (“The Problems of”). Using lean accounting can also lead to bad decisions such as where to put the money when profits are maximized and where to take the money out that has been saved.
There are also several disadvantages of using lean accounting. “One disadvantage of lean accounting is that it requires a top-down, sometimes monumental cultural shift. Most manufacturing companies have cost accounting systems in place that measure production improvements in terms of short and medium-term cost reductions. However, lean accounting focuses on freeing up resources to increase the product or product line’s value to customers and make more money. Senior management must therefore change their thinking from one focused on the bottom line to one focused somewhere between revenues and profits. Without management’s full commitment, full implementation of an effective lean accounting system will stall” (Wright).
“Accounting systems traditionally generate internal reports that owners and management – both senior and departmental – review and discuss. Lean accounting aims to translate the information into numbers that task-based employees in various departments can use. These accounting systems focus on compiling cost-based data. Since lean accounting focuses on value creation, companies often need to completely overhaul their accounting systems, collection and measurement procedures, controls and software. Any system overhaul can be daunting, but the scope of an accounting system overhaul can be particularly exhaustive” (Wright).
“Lean accounting focuses on increasing revenues and profits by increasing the value of a company’s products and services. When lean accounting systems focus on value stream instead of cost, they may inadvertently omit costs or ignore issues related to specific costs. Until a company fully captures a product or product line’s value stream, accountants may not be able to appropriately price products or determine each product’s individual level of profitability” (Wright).
“Effective lean thinking and lean accounting require input and involvement by all employees. Many employees in a traditional manufacturing or distribution environment are reactive, following the orders given them. Companies must therefore invest in training, developing and empowering all their employees to help them become proactive. This can be expensive and time consuming” (Wright).
“Unless the accountants understand the way that lean works, in the worst case it seems to them that lean produces losses, not efficiencies. In a typical case, they cannot see the cost advantages. Those who were fighting to introduce lean into their companies reported over and over again that finding a way to reconcile accounting the way lean does it and standard cost accounting was proving to be much harder than it should be” (Woods).
“Lean practitioners think of accounting in cash terms. Lean is against creating data and reports for their own sake. That would be considered another form of waste. In general, lean advocates have a jaundiced view of enterprise software and any general-purpose automation tools. The lean approach measures how well your value stream is working” (Woods).
The difference between lean accounting and standard cost accounting can be explained in a simple weight loss analogy. “When dieting, standard cost accounting would advise you to weigh yourself once a week to see if you’re losing weight. Lean accounting would measure your calorie intake and your exercise and then attempt to adjust them until you achieve the desired outcome. While this analogy is oversimplified, it does get to the core difference between lean and standard cost accounting. Lean accounting attempts to find measures that predict success. Standard cost accounting measures results after the fact” (Woods).
“But even when the accounting types and the lean practitioners start to understand each other, problems remain. How can we reconcile the kind of data collection and accounting that lean demands and the standard cost accounting? Duplicated data collection and reporting is indeed a form of waste” (Woods).
“While lean accounting is still a work-in-process, there is now an agreed body of knowledge that is becoming the standard approach to accounting, control, and measurement. These principles, practices, and tools of lean accounting have been implemented in a wide range of companies at various stages on the journey to lean transformation. These methods can be readily adjusted to meet your company’s specific needs and they rigorously maintain adherence to GAAP and external reporting requirements and regulations. Lean accounting is itself lean, low-waste, and visual, and frees up finance and accounting people’s time so they can become actively involved in lean change instead of being merely “bean counters.” Companies using lean accounting have better information for decision-making, have simple and timely reports that are clearly understood by everyone in the company, they understand the true financial impact of lean changes, they focus the business around the value created for the customers, and lean accounting actively drives the lean transformation. This helps the company to grow, to add more value for the customers, and to increase cash flow and value for the stockholders and owners” (Maskell and Baggaley, p 43).
Asefeso, Ade. Lean Accounting, Second Edition. AA Global Sourcing Ltd, 2014. p 9, p10 and p12.
“Key Lean Manufacturing Principles”. www.lean-manufacturing-junction.com. Accessed February 25, 2017.
Maskell, Brian H. and Baggaley, Bruce L. “Lean Accounting: What’s It All About?”. Target Magazine. Association for Manufacturing Excellence, 2006. p 43. www.aicpa.org. Accessed February 25, 2017.
“The Problems of Cost Accounting with Lean”. www.allaboutlean.com. Accessed February 27, 2017.
“What is Lean?”. www.lean.org. Accessed February 25, 2017.
Woods, Dan. “Lean Accounting’s Fat Problem”. Published July 28, 2009. www.forbes.com. Accessed March 1, 2017.
Wright, Tiffany C. “The Disadvantages of Lean Accounting”. www.smallbusiness.chron.com. Accessed March 1, 2017.