Lean Accounting

Learning Objective 8 Understand the principles of lean accounting

• focus on costing value streams rather than products and limit arbitrary allocations

Another simplified product costing system that can be used with JIT (or lean production) systems is lean accounting. When a company utilizes JIT production, it has to focus on the entire value chain of business functions (from suppliers to manufacturing to customers) in order to reduce inventories, lead times, and waste. The resulting improvements in the value chain have led some JIT companies, such as Toyota, to develop organizational structures and costing systems that focus on value streams—all value-added activities needed to design, manufacture, and deliver a given product or product line to customers. For example, a value stream can include the activities needed to develop and engineer products, advertise and market those products, process orders, purchase and receive materials, manufacture and ship orders, bill customers, and collect payments. The use of manufacturing cells in JIT systems helps keep a company focused on its value streams.

Lean accounting is a costing method that focuses on value streams, as distinguished from individual products or departments, thereby eliminating waste in the accounting process.^* If a company makes multiple, related products in a single value stream, it does not compute product costs for the individual products. Instead, it traces many actual costs directly to the value stream. More costs can be traced as direct costs to value streams because companies using lean accounting often dedicate resources to individual value streams. We now illustrate lean accounting for Manuela Corporation.

Manuela Corporation manufactures toner cartridges and ink cartridges for use with its printers. It makes two models of toner cartridges in one manufacturing cell and two models of ink cartridges in another manufacturing cell. The following table lists revenues, operating costs, operating income, and other information for the different products.

Using lean accounting principles, Manuela’s managers calculate the value-stream operating costs and operating income for toner cartridges and ink cartridges, not individual models, as follows:

To gain insights, Manuela’s lean accounting system, like many lean accounting systems, compares value-stream costs against costs that include costs of all purchased materials. Doing so keeps the company focused on reducing its direct materials and work-in-process inventory.

Manuela allocates its facility costs (such as depreciation, property taxes, and leases) to value streams based on the square footage each value stream uses. This encourages managers to use less space for production and for holding and moving inventory. Note that Manuela excludes unused facility costs when calculating the manufacturing overhead costs of value streams because unused facility costs do not add value to value streams. Instead, it flags these costs as plant or business unit expenses. Increasing the visibility of unused capacity costs creates incentives to reduce these costs or to find alternative uses for the company’s capacity.

Manuela also excludes rework costs when calculating its value-stream costs and operating income because these costs are non-value-added costs. Companies also exclude from value-stream costs common costs such as corporate or support-department costs that cannot reasonably be assigned to value streams.

The total cost of the toner cartridges based on direct materials purchases rather than direct materials used from line (e) of the preceding table and including unused capacity costs and rework costs is $1,296,000 $(\mathrm{\$}\text{597,000}+\mathrm{\$}\text{699,000}).$ The value-stream cost using lean accounting is $\mathrm{\$}\text{1,174,000}$ (which is $90.6\mathrm{\%}\times \mathrm{\$}\text{1,296,000})\mathrm{.}$ The difference of $122,000 $(\mathrm{\$}\text{1,296,000}-\mathrm{\$}\text{1,174,000})$ represents the opportunities for improving the company’s profitability by reducing unused facility and rework costs and by purchasing direct materials only as needed for production. Making improvements is particularly important because Manuela’s current operating income for toner cartridges is only 2.6% $\left[\right(\mathrm{\$}\text{13,000}+\mathrm{\$}\text{21,000})÷\text{1,300,000}]$ of its revenues. Manuela’s ink cartridges portray a different picture. The total cost for ink cartridges based on direct materials purchases rather than direct materials used from line (e) of the preceding table and including unused capacity costs and rework costs is $1,267,000 $(\mathrm{\$}\text{741,000}+\mathrm{\$}\text{526,000}).$ The value-stream cost using lean accounting is $\mathrm{\$}\text{1,175,000}$ (which is $92.7\mathrm{\%}\times \mathrm{\$}\text{1,267,000})\mathrm{.}$ The ink cartridges value stream has lower unused facility and rework costs but its direct materials purchases are much higher than the direct materials it needs and uses. Moreover, Manuela’s current operating income from ink cartridges even after taking into account non-value-added costs is 8.7% $\left[\right(\mathrm{\$}\text{79,000}+\mathrm{\$}\text{39,000})÷\text{1,350,000}]$. Of course, Manuela’s managers would like to reduce non-value-added costs for both value streams.

Lean accounting is much simpler than traditional product costing. Why? Because calculating actual product costs by value streams requires less overhead allocation. Consistent with JIT and lean production, lean accounting emphasizes improvements in the value chain from suppliers to customers. Lean accounting encourages practices—such as reducing direct materials and work-in-process inventories, improving quality, using less space, and eliminating unused capacity—that reflect the goals of JIT production.

Critics of lean accounting charge that it does not compute the costs of individual products, which makes it less useful for making decisions. Proponents of lean accounting argue that the lack of individual product costs is not a problem because most decisions are made at the product line level rather than the individual product level and that pricing decisions are based on the value created for the customer (market prices) and not product costs.

Another criticism of lean accounting is that it excludes certain support costs and unused capacity costs. As a result, decisions based on lower value-stream costs may cause managers to underprice products. Proponents of lean accounting argue that the method overcomes this problem by adding a larger markup on value-stream costs to compensate for some of these excluded costs. Moreover, in a competitive market, prices will eventually settle at a level that represents a reasonable markup above a product’s value-stream costs because customers will be unwilling to pay for non-value-added costs. The goal must therefore be to eliminate non-value-added costs.

A final criticism of lean accounting is that, like backflush costing, it does not correctly value inventories under Generally Accepted Accounting Principles (GAAP). However, the method’s proponents are quick to point out that in lean accounting environments, work-in-process and finished-goods inventories are immaterial from an accounting perspective.