Real Numbers

by Orest J Fiume

  This signaled a serious problem in the finance and accounting functions. Basic information —the numbers of a business —is very simple. It is all about adding, subtracting, percentages and ratios —skills that are taught in grade school. Yet, when Jean gave it some more thought, it began to make sense. People feel they have to learn “the numbers” because we throw around terms like ROI, margins, variances, turnover, utilization, ROA and DSO like a complex code. This is what keeps us separated from the rest of the organization.

  Consider the organizations that have gone to open-book management —a move that companies make in order to promote trust and a sense of personal ownership in the business. It’s a big step in most companies, to commit to this kind of openness, and the roadblocks are more numerous than one might envision. Imagine trying to throw open books that are written in code. It is doubtful that management would be trusting and employees would feel more committed to the company’s success when confronted with impenetrable code.

  Some businesses have gone the route of teaching all the people in a business how to understand the numbers. We have seen companies create two- and three-day classes for everyone in the organization —every single associate —to help them understand the numbers. In effect, they are trying to provide the Rosetta stone of accounting. The American Management Association has a course called Accounting for Non-Financial Managers that appears to be wildly successful, where students study for an entire week just to receive the keys to the financial reports.

  Wouldn’t it be easier to make the numbers understandable? Shouldn’t we use the tools and language that people already understand like adding, subtracting and percentages? Change the reports, not the people. (In the chapters on Performance Measurements and Plain-English Management Financial Statements, you will find some great tools to break down accounting codes into easily digestible statements.)

  At Lantech, there would be monthly business group meetings at the cafeteria. Shop floor guys in their coveralls would slouch into chairs; a few executives would stand around the edge, clutching coffee in disposable cups. Someone would welcome new employees and then give Jean her cue: “Let’s talk about the numbers.”

  Jean would put up her overhead slides and explain that last month they shipped more than the month before. A few people would be nodding. Then she would start to explain the profit variances. The standard for the product was less than it actually took to build, Jean would explain, and materials variances were a little lower because the vendor charged less. At this point, Jean would usually glance around the room to see if anybody has a clue of what she was talking about. Sometimes she wasn’t sure she understood either. There would be no questions from the small audience; nobody looked like they were paying any attention at all. So, Jean would drop down to profits and show that profit had dropped from the month before even though more product was shipped. Now there might be a few people shifting uneasily in their seats, but still no comments. On those months, Jean expected more profit to be shown and everyone else probably did too, but nobody said anything. They had seen others ask the question before and knew already that the answer was nothing to which they could relate. And Jean was forced by time constraints to give little more than superficial answers.

  At Lantech these days, no financial person needs to be at hand to present the numbers —anyone can do it —and the whole company comes to the cafeteria to participate. There are colored graphic slides that show the level of shipments and someone will make specific comments about product lines —which one is selling —and focus on new demand. Then the presenter can say, “As go shipments, so go profits.” If there is not a direct correlation, there is a clear reason. Someone might say, “This month we had lower profits because we had a large trade show and a lot of people had to travel.” People ask questions about the quality of a particular product, or ask questions about warranty returns. Finally, everyone understands that cost is a function of quality.

  From this description alone, it is clear how Jean changed her position within the company. Once an outsider with highly segmented information, also known as a traditional accountant, she is now a business partner. No longer chained to her desk, Jean and her team know they belong in the purchasing area, on the shop floor, in the accounting department —anywhere they can provide information. Jean concentrates more on providing help with decisions about product pricing, investments and hiring, on pulling the numbers together to help clarify choices.

  So maybe this sounds like a great idea, but where does one begin to change? First, take a good look at the people in the accounting area. What are they doing right now? The triangle in the above illustration (Figure 2.1) is a simple way to describe the work content in an accounting team. In the largest part of the first triangle are the ubiquitous transactions. Probably two-thirds of the people in most accounting departments are working on transactions: paying bills, collecting money, filing taxes and paying people. Then there are a few cost accountants, fixed-asset accountants and someone responsible for creating the financial statements. There might be a couple of financial analysts checking to see how much is being spent and evaluating capital investments. Finally, there is probably a controller or CFO who goes to the business planning meetings and works on the budget and planning. We’ll refer to that last category as consultants or business partners. If the area in the triangle represents time spent, the base of the first triangle shows that the largest amount of total time is spent in transactions.

  Then we need to ask, what does the business need from us? What does the CEO value enough to pay our salaries? Unfortunately, those CEOs probably want help understanding the numbers. But they also need our help growing the business profitably. The CEO wants help finding the resources to fund a new project; she wants to know where we can improve costs in products and services, and she wants to know whether improvements made have resulted in financial gain. The CEO needs help seeing where the company has improved or declined and what the future looks like given the current circumstances. The CEO asks, “What are my choices?” Answers to these questions are worth good money.

  On the other hand, what are most businesses paying for now? Sure, the bills need to be dealt with, money collected and people paid. Taxes must be paid to keep us all out of jail. But the first triangle must be turned upside down without necessarily adding new staff. At Lantech, there was the same number of accountants in 2001 as in 1991, even after doubling the business.

  To get to the point where Lantech could double the business without doubling the accounting department, and have accounting become more relevant, the office needed to be overhauled. The newly lean accountant will need to exert all the leadership qualities he or she has in order to overcome resistance. This is not a duty that can be delegated; leaders must create the vision that will overcome constraints. It’s hard to take a chance and change a well-established routine. Everyone has relied on these time-honored approaches for a very long time. This book should give you confidence, however, in knowing that there are others who are finding ways to change.

  As a preview, here are a few things the finance and accounting leader will hear as you struggle toward change:

  “We have always done it that way.”

  “This is what the contract says.”

  “Our auditors told us to do that.”

  “I need those files.”

  “We will lose control if we eliminate that.”

  “That’s too risky.”

  “We need the hard copy.”

  “I need those files.”

  “I won’t do anything outside of GAAP.”

  “I need to know the exact cost of that item.”

  “That isn’t the right answer.”

  “I need those files."

  Overcoming resistance to change is often very time consuming, so be prepared. The leader of change must take the time to talk, ask questions, probe further. We need to ask: “Why do you need that? What happens with that information?” This should not be a shaming ex
perience for the employee; this must be a learning experience for the leader if we are to find the best path to proceed. Listen with an ear toward moving forward with the new information you are gathering, not stopping the journey.

  In accounts payable at Lantech, for instance, we would pay the bills for the week and then sort the bills alphabetically by vendor name, carefully putting them away in the proper vendor folder.

  It was a time consuming activity and it wasn’t clear that it was adding any value. When Jean suggested change, however, the initial reaction was, “We have to do it that way. When Acme calls to see if I’ve paid the bill, I can go to that folder directly and answer.”

  The next question might be: How often does that happen? In Lantech’s case, the answer was that Acme calls maybe once every three months. When they did call, it took no time to look up, but the actual collating and filing was time consuming indeed.

  How about if, instead, we just file the invoices by the date they were paid? When the vendor calls with a question, a clerk can look on the accounts payable system to see what day the bill was paid, then search the file containing bills for that particular payment date. It would take longer to find the specific bill and answer the question, but less time than it took to alphabetize and file every bill, every week. At Walker Systems, a subsidiary of Wiremold, adopting this method saved an entire man-year of work. That is a small example of time savings, but the real point is listening to your people. When people know they will be listened to, that their concerns will be acknowledged and we will look for logical conclusions to make everyone’s work easier, they will be more willing to be open to new solutions. In this case, leadership is listening and making sure that accountants feel they are part of the solution.

  One refrain a CFO is likely to hear in a transformation is, “The system makes me do it that way.” This one is a particular favorite. Lantech used to keep books of all the sales invoices sent out, organized by month and order number. There were cabinets full of these books lining the walls, pushing into open areas and used as space dividers. “We need hard copies of every invoice,” accountants told Jean, “in case we have to look it up.” It was the system.

  Jean gently pointed out that all the same information was available on computers. “Wait,” the accountants said, “what if I need to fax a copy of the invoice to the customer?” That’s a valid point; it does happen occasionally. Of course, the clerk could just print it out only when asked and then fax it to the customer, thereby saving all of the copying, printing and filing motions for every single invoice. Taking it a step further, Lantech eventually purchased fax software so anyone could fax directly from a personal computer. No paper involved.

  Lantech sold those cabinets that used to hold the books, and now the accounting team has more space to move around than any area at Lantech —even after moving the information-technology staff into accounting. This is the kind of hands-on leadership that will be required to make the change to lean accounting.

  Make no mistake: there will be barriers. Once a company dramatically lowers inventory, the financial statements will get confusing, especially if standard cost and variance-style income statements are still used. The cost from the old inventory must be included in the expense column. The result will be opposite of what most organizations would expect. For a time, profits will look lower and the results will look worse from doing the right thing (see example in Figure 2.2). Just remember, the real expense of carrying inventory was hidden under the old system. (You will get hints on how to deal with this in Chapter 6.) That’s one more barrier to advancing toward lean management accounting.

  The pressure to make the month is another barrier. For public companies, there is terrific pressure to meet the projected numbers every quarter. Even the smallest reduction in your earning, compared to projections or prior quarter results, can mean a death toll for the stock price. Sometimes, it means the job of the CFO. And this is not just a problem for public companies. Often there are bonus programs ted to profits or sales, or bank loans tied to results or inventory balances. These are real issues and must be considered, not as a roadblock but as a factor to include as you make necessary improvements. There is no single magic answer to show public companies how to deal with this issue. One public company that implemented lean made huge reductions in inventory and was forced to recognize the high cost of old inventory, which reduced reported profit. They worked closely with the Wall Street analyst that covered their company, however, and were able to show the real cash flows and business benefits of reduced inventories through lean practices. This way, the analyst could understand the positive future implications of the current events.

  As you work through the barriers, take courage from knowing that many obstructions are of our own making. Over time, you have become locked in certain measures and those same measures have very likely become improvement barriers for other departments. Consider accounting’s complicated ways of figuring the worth of a machine, for instance. Our measures —our rows of logical numbers —keep a piece of equipment constantly utilized. Accounting said this machine must be run constantly to make it profitable, keep unit cost low and keep from having unfavorable variances. So the company buys materials it doesn’t need, pays an operator to run parts that are not needed and puts unnecessary wear and tear on the machine. This is all done because account¬ing blessed the machine’s purchase based on specific parameters, which included sales projections that were too optimistic. Now we say, if you don’t need the parts, don’t run the machine. We need a new mindset regarding idle time.

  All barriers aside, we do acknowledge that there are good guidelines, or retaining walls, that accountants depend on. Be assured that nothing in Lean Management Accounting violates GAAP (Generally Accepted Accounting Principles). Pick up any beginning accounting textbook and you will find the four basic tenets of accounting:

  Materiality

  This is one of the tenets most misunderstood by modern accountants. The concept is simple but applying it on a daily basis is not. The official version issued by the Financial Accounting Standards Board states:

  “Materiality is a pervasive concept that relates to qualitative characteristics, especially relevance and reliability. Materiality and relevance are both defined in terms of what influences or makes a difference to a decision maker, but the two terms can be distinguished. A decision not to disclose certain information may be made, say, because investors have no need for that kind of information (it is not relevant) or because the amounts involved are too small to make a difference (they are not material). Magnitude by itself, without regard to the nature of the item and the circumstances in which the judgment has to be made, will not generally be a sufficient basis for a materiality judgment. The Board’s present position is that no general standards of materiality can be formulated to take into account all the considerations that enter into an experienced human judgment. Quantitative materiality criteria may be given by the Board in specific standards in the future, as appropriate.”

  In addition, the Securities and Exchange Commission (SEC) offered this opinion:

  “Exclusive reliance on certain quantitative benchmarks to assess materiality in preparing financial statements and performing audits of those financial statements is inappropriate; misstatements are not immaterial simply because they fall beneath a numerical threshold.”3

  3 Securities and Exchange Commission, Staff Accounting Bulletin No. 99: Materiality released in August 1999.

  The bulletin then discusses at length the circumstances under which a misstatement may be considered material, with specific focus on decisions made by the investment community. It states in part, “A matter is ‘material’ if there is substantial likelihood that a reasonable person would consider it important.” The Supreme Court has also addressed this subject, with similar results.

  Thus we do not want to underestimate the complexity involved in making decisions about materiality, especially when publicly issued financial statements ar
e involved, but will address the issue from an internal standpoint. This is information that management is using to make daily decisions about the business.

  Put another way, Materiality is where precision and accuracy get confused. Precision is knowing the answer down to the third decimal point. Accuracy is the answer that is correct for the decision you’re trying to make. A good example of this is gas mileage. When you bought your car, mileage was probably part of the equation. If the dealer’s sticker promised 22 miles per gallon, you probably expected between 20 and 24. To get an accurate portrayal of your real gas mileage over time, you would record your miles traveled and divide that number by the gallons of gas you bought. This gives you an accurate picture. Precision is when you hire an accountant to ride in your car with you and calculate down to the third decimal that you get 23.947 miles to the gallon on this trip, 24.237 on the next, etc.

  When defining materiality, ask if you would change the business decision you’re about to make if you knew the answer to the question within plus or minus 1 percent, 5 percent, or 10 percent? This will tell you the materiality threshold for that issue, and where the borderline is between precision and accuracy.