The Financial Consequences of Lean

Why is it so hard to see the financial consequences of lean? Failure to answer this dilemma has derailed many lean initiatives. This is not such a problem if top management really understands the significance of focusing on getting everything to flow right-first-time-on-time to customers. Like top management at Toyota and Tesco, they know that good processes lead to good results. Alternatively if you have an experienced Sensei who knows where the gold lies buried and who has worked on similar situations before, there is a good chance that they can help you to deliver the kind of results you expect from lean.

But in my experience help is needed if you are pioneering lean in your organisation while at the same time trying to convince top management that it can deliver lasting financial results. This is particularly true when you are dealing with a complex shared pipeline with multiple steps and routings through which many different products or services flow. It becomes much harder to see where to act to deliver the greatest gains for the organisation and for its customers. And as my colleague John Darlington has shown traditional accounting systems and even sophisticated product costing systems end up rewarding the wrong kinds of actions.

As John puts it, they encourage overproduction by valuing what has been made not what has been sold, they do not recognise the importance of bottlenecks and constraints, they encourage point optimisation rather than flow, they have nothing to say about lead times, they promote the idea that bigger batches lower the unit cost and they encourage cost reductions that often prove to be mirages. In other words they fail to show the power of focusing on compressing lead times, which lies at the heart of lean. Struggling against this kind of headwind is almost impossible for any length of time.

Unlike Financial Accounting for reporting results to the outside world, we are free to choose how to construct our internal costing systems to drive the right kinds of actions. For instance lean organisations use Target Costing systems to focus improvement efforts in new product development. Why do we not do something similar to design and improve how well we run our end-to-end processes or value streams, particularly where they involve shared resources and cross several departments?

John shows how adding operating expenses to value stream maps for all the products going through these shared resources and turning inventories into time gives us the basis for Flow Costing, which relates the time products take to flow through the value stream (rather than to the cycle time through each operation) to the operating expenses of running it. Inventories (and delays in services) are the richest source of insight into how well we are using our capacity to generate money through sales.Shorter throughput times increase the ability to respond to quality problems and to introduce engineering changes, they may make it possible to raise margins and postpone the need for new investment, and meet due dates with lower finished goods stocks.

The real value of Flow Costing is to help set the priorities for lean improvement actions by being able to see the financial consequences in terms of increased sales, less cash tied up in inventories, reductions in operating expenses and postponed investments. These priorities can then be built into the policy deployment goals for each department, and the resources in their budgets to accomplish them. Flow Costing is a powerful way to help to bring throughput times much closer to value creating times, by which time the differences between Flow and Product costing systems almost disappear.