© BMA Inc All rights reserved. Understand why traditional accounting, control & measurement methods need to change as the company continues the lean transformation Overview the primary methods of Lean Accounting that will be important to the company Develop a ‘Go Forward’ plan for your organization Objectives of this Workshop

© BMA Inc All rights reserved. A Brief History of Lean Management 1934 on… 1945 on… Toyota starts producing vehicles, developing Kaizen teams in 1936 Toyota develop ‘Pull Production’ (producing only for actual sales) in response to resource shortages. This was inspired by a visit to a US supermarket chain Taiichi Ohno develops ‘The Toyota Production System’ (TPS) based on Ford’s principles of Henry Ford influenced by Frederick Winslow Taylor’s ‘Principles of Scientific Management ’ Ford introduces mass production Today…

© BMA Inc All rights reserved. The Toyota Production System The idea of pull production (producing only for actual sales) was inspired by a visit to a US supermarket chain - ‘Piggly Wiggly’- shortly after WWII Levels of demand in the Post-War economy of Japan were low and the focus of mass production on lowest cost per item via economies of scale had little relevance TPS is a whole management system - it is not just about production

© BMA Inc All rights reserved. The Philosophy of Lean Maximize competitive advantage through operational excellence Why would you perform any activity that the customer is not willing to pay for? A time-based strategy – flexibility & speed of response to the customer & speed through the production/ service delivery process Improve the flow and you improve profitability

© BMA Inc All rights reserved. The Five Principles of Lean Production Specify value in the eyes of the customer Identify the value stream & eliminate waste Make value flow at the pull of the customer Involve & empower employees Continuously improve in the pursuit of perfection

© BMA Inc All rights reserved. Traditional thinking and lean thinking are in conflict ASSUMPTIONS Profit comes from full utilization of resources Direct labor is the most important conversion cost Control the business thru detailed tracking All excess capacity is bad Traditional Standard Costing ASSUMPTIONS Profit from maximizing flow on pull from customers. Waste is resources impeding the flow Control thru continuous attention to flow & waste Excess capacity provides flexibility Lean Thinking

© BMA Inc All rights reserved. Why Lean Accounting? Traditional Standard Costing was developed for mass production – The philosophy is that profitability is maximized when labor and machine utilization are maximized The focus of Standard costing is on lowest cost per item through economies of scale This does not apply in a high variability, multi-product environment – Here profitability is maximized when the rate of flow is maximized

© BMA Inc All rights reserved. What’s the problem? Traditional management systems: –Actively work against Lean Manufacturing & other lean improvements. –Are expensive and wasteful. –Provide misleading, wrong, and harmful information. –Motivate people to do the wrong things. –Are complex and confusing to people. Here’s a Few Simple Examples

© BMA Inc All rights reserved. Actively work against lean manufacturing Drill on CNC Machine Machine on Lathe Batch 2500 Grind Inspect & Pack 1 minute 4 minutes 6 minutes 4 minutes Total labor time: 15 minutes Labor cost: £5.00 Overhead cost: £15.00 Material Cost £1.50 TOTAL COST: £21.50 Lead Time: 6 weeks Inventory 25 days Batch size 2500 (10 days) On-Time delivery = 82%

© BMA Inc All rights reserved. Lean manufacturing changes Create a cell. Use an drilling machine with quick change over. Reduce the batch size. Reduce the lead time. Reduce inventory. Almost perfect delivery. Created additional capacity on the CNC machine.

© BMA Inc All rights reserved. Lean improvements Drill on Drilling Machine Machine on Lathe Grind Inspect & Pack 4 minutes 6 minutes 4 minutes Total labor time: 18 minutes Labor cost: £6.00 Overhead cost: £18.00 Material Cost £1.50 TOTAL COST: £25.50 Lead Time: 2 days Inventory 5 days Batch size 250 (1 day) On-Time delivery = 98% Lean Cell

© BMA Inc All rights reserved. The problem We have made great improvement. BUT…. the product cost has gone up and the project is cancelled. In fact, the changes were highly beneficial both operationally and financially. It is the standard costing that is leading us in the wrong direction.

© BMA Inc All rights reserved. Traditional income statement What does Gross Profit mean? Why have the earnings fallen so much in period 2? How would you explain this someone in production? Period 1Period 2 REVENUE OEM£998,977£1,039,440 Systems£1,002,466£1,009,246 £2,001,443£2,048,686 Cost of Goods Sold£1,621,16981%£1,687,80082% GROSS PROFIT£380,27419%£360,88618% ADJUSTMENTS Purchase Price Variance(£60,466)(£59,467) Materials Usage Variance£94,533£96,733 Labor Variance(£19,718)(£93,895) Overhead Absorption Variance£38,341£182,577 SG&A£129,8896%£135,2157% NET PROFIT£197,69510%£99,7235%

© BMA Inc All rights reserved. “Plain English” Income statement What does Gross Profit mean? Why have the earnings fallen so much in period 2? How would you explain this someone in production? Period 1Period 2 REVENUE OEM£998,977£1,039,440 Systems£1,002,466£1,009,246 £2,001,443£2,048,686 Materials£829,93641%£849,52641% Direct Labor£305,76715%£312,98415% Support Labor£340,24517%£342,42117% Machines£113,8626%£116,5506% Outside process£60,0433%£53,7313% Facilities£40,2502%£41,2002% Other Costs£12,0090.6%£9,6640.5% TOTAL COST£1,702,112£1,726,076 GROSS PROFIT£299,33115%£322,61016% Inventory Adjustment(£41,593)(£161,426) Corporate Allocations£60,043£61,461 NET PROFIT£197,69510%£99,7235%

© BMA Inc All rights reserved. Misleading cost information Actual Production Cost = £580 per hour Material cost = £42 per item Product Cost = ? Prepare for Mounting Align & Secure Inspect & Pack 6 minutes Product B Output 10 per hour 3 minutes 4 minutes 6 minutes Product A Mount Components

© BMA Inc All rights reserved. Misleading cost information Product A Standard Cost = £90.06 Material £42 Labor 17 £24.23/hr = £6.87 Overhead 600% = £41.19 Actual Cost = £100 Material £42 Production £580/10 = £58 Standard Cost too low Product B Standard Cost = £ Material = £42 Labor £25/hr = £9.69 Overhead 600% = £58.18 Actual Cost = £100 Material £42 Production £580/10 = £58 Standard Cost too high

© BMA Inc All rights reserved. Poor decision making: Outsourcing product B Traditional Approach Standard Cost = £ Outsourced Cost = £85.00 “Savings” of £24.85 per unit Actual Impact New Material Cost = £ 85 Old Material Cost = £ 42 Increase in Actual Material Cost = £ 43 Actual production cost per hour = £ 580 because no resources were eliminated Actual costs increase due to outsourcing

© BMA Inc All rights reserved. There is no “Standard” Cost! In a lean environment, the cost of the product is related to flow… Waste affects cost so that there is no one ‘standard’ cost of a product Cost varies with production, FPY, scrap, mix, quality, downtime etc If you control the flow, you control the cost By improving flow through the Value Stream we improve capacity = flexibility

© BMA Inc All rights reserved. Performance Measurements Traditional accounting performance measurements motivate non-lean actions. Measuring labor efficiency, machine utilization, and overhead absorption leads to large batches and high inventory.

© BMA Inc All rights reserved. Sales policies mismatch with lean capability Level Schedule Value Stream Suppliers Pull System Single Piece Flow Week 1 Week 2 Week 3 Week 4 Sales Orders & Shipments Result: High inventory Late deliveries Higher costs Confusion Conflict

© BMA Inc All rights reserved. Transaction-based control systems cost too much Entering and administering transactions is wasteful and time-consuming. EXAMPLE: A production plant with 150 people, 120 products, and revenue of £15M required over 4,000,000 transactions per year. Job costing, procurement, inventory control, accounts payable, accounts receivable: 38 equivalent heads spent processing and using the transactions. 12.7% of revenue

© BMA Inc All rights reserved. Two Aspects of Lean Accounting Applying Lean Thinking & Methods to the Company’s Accounting Processes Accounting for Lean & Supporting the Lean Transformation Cost accounting, labor reporting, production reporting & work orders Purchasing & accounts payable Inventory tracking & valuation General ledger simplification Month-end close, etc Reporting & decision-making to support lean manufacturing & other lean processes Financial reporting that is immediately understandable & useable to everyone Single lean accounting system for management accounting & external reporting Accounting processes focused on customer value, value streams, pull, empowerment, & continuous improvement

© BMA Inc All rights reserved. Lean is a set of collaborative and inquisitive behaviours that result in a culture of continuous improvement. Eliminating waste is done by people using rigorous problem- solving methods Involving people in lean is at least as important as lean tools. Behaviours that focus on improvement & problem-solving The aim of lean is a production system that highlights problems and a human system that produces people who are willing and able to identify and solve them Lean is a People Process All of this requires Trust

© BMA Inc All rights reserved. Lean Accounting has Seven Aims  Performance measures that motivate lean–cell & value stream measures  Value Stream Costing, replacing Standard Costing = Value Stream Profit & Loss Account  Support relevant, accurate & timely decision making using contribution costing  Elimination of unnecessary accounting transactions  Highlighting impact of lean improvements – eliminate waste, improve capacity, improve flow  Drive the growth of the business by increasing customer value using Target Costing  Motivate lean behaviour in the planning process – SOFP

© BMA Inc All rights reserved. Box Score - Financial Impact Caspian Company PA Motors GOAL Current 5-Feb12-Feb19-Feb26-Feb5-Mar12-Mar19-Mar26-Mar 31-Mar Units per Person On-Time Shipment96.2%98.2%98.5%97.6%97.2%98.0% First Time Thru42%44%43%47%54%62% Dock-to-Dock Days Average Cost£ £114.62£112.66£111.74£ AP days - AR days8.0 Productive22% 21% 22% Non-Productive58% 41% 37% Available Capacity20% 38% 41% Revenue£366,487£321,499£331,546£325,481£326,240£325,000 Material Costs£112,196£109,812£113,243£111,172£111,431£111,007 Conversion Costs£92,564£95,743£95,233£99,463£98,194£94,039 Inventory£310,622£295,712£271,857£231,848£221,163£198,798 Value Stream Profit£161,727£115,944£123,070£114,846£116,615£119,953 Value Stream ROS44.13%36.06%37.12%35.29%35.75%36.91% 46.00%Hurdle Rate -1.87%-9.94%-8.88%-10.71%-10.25% OPERATIONAL CAPACITY FINANCIAL

© BMA Inc All rights reserved. Example: Italian Client

© BMA Inc All rights reserved.

Value Stream Profit and Loss Account THE VALUE STREAMS MUST MAKE A MINIMUM OF 46%

© BMA Inc All rights reserved. Italian Client Value Stream Profit and Loss Account

© BMA Inc All rights reserved. Summary - Lean Accounting Performance Measurement Transaction Elimination Financial Impact of Lean Improvement Value Stream Costing Lean Decision Making Target Costing Primary method of lean control for meeting customer needs & driving continuous improvement Save time, money, & confusion by radical elimination of wasteful transactions Understand the financial impact of lean improvement & create a money-making strategy Simple, direct, & accurate way to create financial reports. Very few transactions Manage the business by value streams with accountability for growth, profitability & continuous improvement Drive the business from the customer value – not the cost

© BMA Inc All rights reserved. What Will Lean Accounting Do For Us? Increase sales & reduce costs through better decision- making information Clearly identify the potential financial benefits of lean programs Reduce costs through eliminating wasteful transactions & systems Motivate long-term lean improvement through lean- focused information & measurement Eliminate the problems caused by traditional costing methods