Objectives of this Workshop

1. 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

2. A Brief History of Lean Management Taiichi Ohno develops ‘The Toyota Production System’ (TPS) based on Ford’s principles of 1926 1979 1926 1911-1915 Henry Ford influenced by Frederick Winslow Taylor’s ‘Principles of Scientific Management’ Ford introduces mass production Today… 1945 on… 1934 on… Toyota develop ‘PullProduction’ (producing only for actual sales) in response to resource shortages. This was inspired by a visit to a US supermarket chain Toyota starts producing vehicles, developing Kaizen teams in 1936

3. 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

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

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

6. Traditional thinking and lean thinking are in conflict Traditional Standard Costing Lean Thinking ASSUMPTIONS 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 • 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

7. 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

8. 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

9. Actively work against lean manufacturing Inspect & Pack Drill on CNC Machine Batch 2500 1 minute 4 minutes Machine on Lathe Grind 4 minutes 6 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%

10. 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.

11. Lean improvements Machine on Lathe Drill on Drilling Machine 4 minutes 4 minutes Lean Cell Grind Inspect & Pack 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%

12. 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.

13. Traditional income statement Period 1 Period 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 £1,621,169 81% £1,687,800 82% GROSS PROFIT £380,274 19% £360,886 18% 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 £129,889 6% £135,215 7% NET PROFIT £197,695 10% £99,723 5% What does Gross Profit mean? Why have the earnings fallen so much in period 2? How would you explain this someone in production?

14. “Plain English” Income statement Period 1 Period 2 REVENUE OEM £998,977 £1,039,440 Systems £1,002,466 £1,009,246 £2,001,443 £2,048,686 Materials £829,936 41% £849,526 41% Direct Labor £305,767 15% £312,984 15% Support Labor £340,245 17% £342,421 17% Machines £113,862 6% £116,550 6% Outside process £60,043 3% £53,731 3% Facilities £40,250 2% £41,200 2% Other Costs £12,009 0.6% £9,664 0.5% TOTAL COST £1,702,112 £1,726,076 GROSS PROFIT £299,331 15% £322,610 16% Inventory Adjustment (£41,593) (£161,426) Corporate Allocations £60,043 £61,461 NET PROFIT £197,695 10% £99,723 5% What does Gross Profit mean? Why have the earnings fallen so much in period 2? How would you explain this someone in production?

15. 6 minutes 6 minutes 3 minutes 6 minutes Prepare for Mounting Mount Components Product B Product A Align & Secure Inspect & Pack Output 10 per hour 4 minutes 4 minutes 6 minutes 6 minutes Misleading cost information Actual Production Cost = £580 per hour Material cost = £42 per item Product Cost = ?

16. Misleading cost information Product A Product B Standard Cost = £109.85 Material = £42 Labor 24m @ £25/hr = £9.69 Overhead 600% = £58.18 Actual Cost = £100 Material £42 Production £580/10 = £58 Standard Cost too high Standard Cost = £90.06 Material £42 Labor 17 mins @ £24.23/hr = £6.87 Overhead 600% = £41.19 Actual Cost = £100 Material £42 Production £580/10 = £58 Standard Cost too low

17. Poor decision making: Outsourcing product B Traditional Approach 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 Standard Cost = £109.85 Outsourced Cost = £85.00 “Savings” of £24.85 per unit

18. 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

19. 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.

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

21. 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

22. 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

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

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

25. Box Score - Financial Impact Caspian Company PA Motors GOAL Current 31-Mar 5-Feb 12-Feb 19-Feb 26-Feb 5-Mar 12-Mar 19-Mar 26-Mar Units per Person 31.77 30.46 32.51 32.19 33.71 35.2 On-Time Shipment 96.2% 98.2% 98.5% 97.6% 97.2% 98.0% First Time Thru 42% 44% 43% 47% 54% 62% OPERATIONAL Dock-to-Dock Days 12.50 11.9 10.94 9.33 8.90 8.0 Average Cost £115.78 £115.78 £114.62 £112.66 £111.74 £107.01 AP days - AR days 8.0 8.0 8.0 8.0 8.0 8.0 Productive 22% 22% 22% 21% 21% 22% CAPACITY Non-Productive 58% 58% 58% 41% 41% 37% Available Capacity 20% 20% 20% 38% 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 FINANCIAL 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 ROS 44.13% 36.06% 37.12% 35.29% 35.75% 36.91% 46.00% Hurdle Rate -1.87% -9.94% -8.88% -10.71% -10.25%

26. Example: Italian Client

28. Value Stream Profit and Loss Account VALUE STREAMS New Product Support TOTAL Motors Systems Spare Parts Design Costs DIVISION Sales £326,240 £748,894 £453,215 £1,528,349 Additional Revenue £0 £0 £12,422 £12,422 Material Costs £111,431 £232,774 £149,561 £87,909 £12,764 £594,439 Conversion Costs £57,628 £70,406 £81,579 £203,769 £37,645 £451,027 Outside Process Costs £32,433 £22,991 £22,661 £7,531 £85,616 Other Costs £16,040 £57,816 £29,459 £72,721 £176,036 Tooling Costs £4,843 £12,544 £6,588 £23,975 Value Stream Profit £103,865 £352,363 £175,789 (£364,399) (£57,940) £209,678 ROS 31.8% 47.1% 38.8% -23.7% -3.8% 13.7% £925,314 Opening Inventory £918,807 Closing Inventory (£6,507) Inventory Change £51,147 Corporate Overhead Division Profit £152,024 Division ROS 9.9% THE VALUE STREAMS MUST MAKE A MINIMUM OF 46%

29. Italian Client Value Stream Profit and Loss Account

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

31. 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