What CFOs Learn from the Factory Floor

The latest industrial revolution isn't emerging on the assembly line -- it's focusing on the bottom line. But the long-term gains don't come without some short-term strains.

Amid the rumbling, rhythmic sounds of machinery and the whiz and kaplunks of production lines, CFOs are finding unlikely allies. Enmeshed in the gears of industry (and etched in the silicon chips that run them) are the manufacturing theories of production pioneers like Walter Shewhart, George Box, and Taiichi Ohno. Indeed, there are corporate finance lessons to be learned from the ghosts in these machines.

Over the last century, as mass production lines churned out everything from Model T’s to microprocessors, theories such as Shewhart’s notion of total quality management, Box’s practical application of statistics, and Ohno’s just-in-time model turned traditional manufacturing on its head. Today CFOs are bringing these “lean” ideas to corporate finance, highlighting the practical differences between cost accounting and cost management, and recognizing how just-in-time manufacturing reveals a building tension between the income and cash flow statements.

First applied to the manufacturing process by James Womack in his 1990 book The Machine That Changed the World, the term lean describes the concept of driving out waste of any kind and matching production to demand with little or no additional capital expenditure. The seeds of lean, however, were planted much earlier, first when craftsmen were supplanted by mass production, and later when machines were fitted with changeable parts to mimic the craftmen’s customized products.

To be sure, wringing out waste and streamlining the asset conversion cycle — without increasing capex — seems like an idea most CFOs would readily embrace. But the long-term gains offered by lean processes are accompanied by short-term strains that are rarely discussed.

For example, synching just-in-time (JIT) manufacturing with standard cost accounting can prove disruptive, especially to public-company CFOs and controllers. Shareholders and Wall Street analysts expect quarterly gains, and they’re easily disconcerted by the temporary losses that the lean transformation imposes on the profit-and-loss statement. “Very often the income statement is taken as gospel,” says Jean Cunningham, CFO of Lantech.com LLC, an $80 million manufacturer of pallet stretch-wrapping machines. She notes, however, that “it doesn’t reflect the real-time benefits of JIT.”

Free Your Mind — and Your Finance Department

To be clear, lean accounting is not a single technique. It’s a philosophy, a way of thinking about business, emphasizes Cunningham, the co-author of Real Numbers: Management Accounting in a Lean Organization. Lean accounting doesn’t require huge investments in financial software, and there’s no big plan to put in place. Although many CFOs have found specific steps that they can take, says Cunningham, lean accounting actually embodies a promise to yourself to continually look for improvements the corporate finance function.

Lean accounting is iconoclastic. It tears down an old accounting system that was developed to accommodate batch manufacturing and track inventory value — both of which, she maintains, are immaterial measures for companies that employ continuous-flow-manufacturing processes.

And proponents of lean accounting are anything but mystics. On the contrary, a major goal is to clarify financial statements and give nonfinancial managers an unobstructed line of sight into the company. Lean advocates also vow to send CFOs and controllers to the factory, to better understand what, and how, operations managers think.

“Once a week I send my accountants out to the shop floor,” says William Funk, director of finance for the North American division of The Chamberlain Group Inc. (The JIT manufacturer is reportedly the world’s largest maker of automatic garage door openers — which functions “just in time” for end users, too.) The jaunts help finance department employees get an accurate picture about the impact of materials management, labor routines, and overhead spending. “It’s too easy to get subsumed by accounts payable,” says Funk. “The accounting staff needs to understand the bigger picture.”

Another reason these managers “walk the walk” is so they’re able to “talk the talk.” “The language of standard cost accounting is old, and [its ineffectiveness] becomes obvious on the shop floor,” muses Cunningham. She holds fast to GAAP’s cost-and-revenue matching principle, but she has reworked the language of Lantech’s internal financial statements to be more factory friendly. For instance, material usage variances and labor efficiency variances have been replaced by inventory and salaries respectively.

For Funk, operational language is in his job description. A divisional finance chief, Funk reports to two executives at the group level — the corporate controller and the executive vice president of operations. The dual reporting structure fosters an interdependency between finance, operations, and suppliers that’s worthwhile in and of itself — and that quells many of the motivations for playing accounting games, such as booking revenue prematurely.

Costly Accounting

“Traditional accounting is a post-mortem exercise” that’s not suited for a JIT environment, asserts Anand Sharma, president and CEO of TBM Consulting. Too often, he bristles, accounting information arrives late, is misleading, and is hardly understood by anyone outside the accounting function.

Retired CFO Orest Fiume — Cunningham’s co-author on Real Numbers — puts it even more strongly. Corporate accounting is on the brink of irrelevancy, according to the former finance chief of The Wiremold Co., which makes accessories that organize wires and cables in offices and homes. (Wiremold’s most familiar offering, introduced in 1916, might be raceways — those long, thin metal strips that protect electric wiring.) But studying accounting from the perspective of the factory floor, he believes, may revive accounting’s operational relevance.

Fiume defines accounting as a quantitative reflection of the business, and unless the bookkeeping is attuned to the rest of the organization, “the reflection looks like the image in a funhouse mirror.” Accordingly, Fiume makes a case against standard cost accounting, which relies on calculating unit costs, and instead favors cost management, which focuses on the cost of meeting customer demand.

In 1990, management at $30 million (in revenue) Wiremold launched a lean manufacturing effort. During a decade-long transformation, Fiume abandoned the cost-per-unit thinking that, he claims, misdirected attention to metrics such as overhead absorption rates and variance analysis — measures that invite dysfunctional behavior and gaming. By 2000, when the initiative had become the company culture, Wiremold was a $770 million manufacturer.

Fiume points out that nothing about lean accounting violates generally accepted accounting principles. In fact, lean accounting uses the same venerable standards of materiality, conservatism, consistency, and matching. But simplifying a complex company is tough, warns Fiume, and old accounting practices die hard. How hard?

All Hands, Brace Yourself for a Hit to the P&L

TBM’s Sharma explains that CFOs who adopt lean accounting should brace themselves — they will see lower profits, temporarily. They’ll need to put a little faith in the folks on the factory floor, and in the corporate commitment to go lean.

Alan Dunn, a self-described “factory rat” for 25 years and now the president of GDI Consulting and Training Co., explains how it goes down: When a company trims inventory to prepare for the transformation to JIT manufacturing, factory overhead isn’t reduced at the same pace. It takes more time to shrink overhead costs, such as warehouse space, utility fees, and salaries. The mismatch causes overhead costs to spread across lower production volumes; in a standard cost accounting environment, this creates a temporary negative variance. Only as the company moves through the lean transition does the accounting system catches up to the new, JIT manufacturing system.

The standard accounting system hides the cost of carrying inventory, says Sharma, and management has to be patient with JIT-style improvements as they ripple through the organization. Getting lean is a long-term goal, adds Sharma, and it’s not for the fainthearted.

CFOs from some public companies, however, know first-hand that patience is not always considered a virtue by Wall Street or by shareholders. When dealing with these constituents, it’s difficult to defend the lean transition — and those negative variances — according to one CFO of a midsize company who asked not to be identified. “Wall Street is less long-term-oriented than they like to tell you,” says the finance chief.

Despite reduced inventory and increased cash flow over a year’s time, claims the CFO, the temporary negative variances contributed to a 10-point slide in the company’s share price. While the stock has recovered and management’s lean strategy has proved successful, the finance chief cautions that “Wall Street and institutional investors are not forgiving or patient.”

Other public-company CFOs, who note similar reactions, contend even that preparing stakeholders for bad news doesn’t necessarily reassure them. One finance chief (who also asked not to be identified) categorized the negative variances as a one-time event, estimated that margins would be depressed for two quarters, and encouraged analysts and investors to consider the annual gains — which, again, included lower inventory levels and improved cash flow. Some institutional investors disdained the waiting game and sold the stock, while Wall Street frowned on the quarterly setbacks and punished the share price — albeit temporarily.

Internal support for lean ideas seems more likely. One company’s executive team gave up their raises and bonuses during the first year of implementation — in the short term, they realized, there would be less cash to go around — and board members gave the green light, agreeing that the transition “was the right move for the company.”

But if the corporate culture is myopic — or if the strategy isn’t endorsed at the top and communicated clearly throughout the company — then lean strategies can backfire. For instance, a controller who spots a decrease in inventory levels near the end of a quarter might direct factories with underutilized overhead to ramp up production, argues Dunn. Why? By spreading overhead costs among greater levels of inventory, he explains, the P&L will better absorb the overhead burden that would otherwise have registered as a negative variance.

Dunn concedes that there are legitimate reasons to increase inventory, such as responding to a blowout year that exceeds forecast, or even creating a buffer to help protect against a forecasting error. But usually, he says, inventory is built up so that lumpy variances can be smoothed out.

What’s more troubling is that the “variance game” can become chronic. Consider that at the start of every quarter, excess inventory causes management to ride the sales team to reduce the overstock, which they do — causing a drop in inventory levels, a negative variance rate, and the start of another cycle.

Playing the “constant improvement game sets companies up for failure,” comments the Chamberlain Group’s Funk. The trick to marrying the accounting and manufacturing functions, he maintains, is to drive costs and inventory down at the same rate. To do that, finance department staffers need to be “capital stewards,” insists Dunn, who grew up on the factory floor of his father’s precision machining company. That is, they must internalize an understanding of how the manufacturing process converts assets to cash.

Batches? We Don’t Need No Batches

Another lean lesson is to kick the batching habit. Batch accounting, like batch manufacturing, should have gone out with the Studebaker, say CFOs who lean toward lean thinking. Waiting to process payables or receivables on a monthly basis mars the cash conversion cycle with late payments, slow closes, and mistakes that go undetected for weeks, insists Cunningham.

Consider the Lantech CFO’s bold decision to eliminate vendor invoices. Cunningham worked with vendors to build a daily delivery schedule that would drastically reduce Lantech’s inventory, but her efforts let loose a flood of daily invoices that overwhelmed the accounts payable department.

So Cunningham wiped them away — the invoices, that is. Because Lantech’s purchasing department negotiates price and terms in advance, the CFO approved weekly payments to suppliers without an invoice paper trail.

Bob Kaiser, COO and CFO of Hi-Tec Sports USA Inc.— a $150 million manufacturer of athletic footwear — found another way to link his physical supply chain with his financial supply chain. Kaiser electronically linked his factory floor with the finance department using a Web-based middleman called TradeCard, which is provided on an application-service-provider (ASP) model.

According to Kaiser, the just-in-time cash management tool wiped out the reams of paper — purchase and shipping orders, supplier acknowledgements, currency transfer documents — that were used to track and facilitate transactions. And TradeCard provided him with complete transparency into the overall supply chain, from the purchase of boot leather, to the factory floor, to the freight forwarder, to the store shelf, and back into accounts receivable.

Hi-Tec had been under tremendous pressure, says Kaiser, from customers who were asking for more-frequent shipments of smaller quantities. In other words, retail shoe outlets had embarked on their own just-in-time campaigns, and trimmed-down shipments would help them reduce inventory and boost cash flow. To satisfy those customers, Kaiser used JIT cash management to reduce the total cost of each shipment, which allowed Hi-Tec to decrease the cost of delivered shoes by 20 cents per pair. That cost-cutting measure enabled Hi-Tec to offer more flexibility to its customers, in the form of smaller shipments — 800 pairs rather than 3,000.

A Free Sample from the Factory Floor

Some lean tactics have less to do with the synchronizing finance and manufacturing strategy and more with swiping ideas right from the shop floor. One example is multivariable testing (MVT), a process that can be retooled for use in the finance department.

MVT is a descendant of Ronald Fisher’s study of randomization in the 1920s and George Box’s analysis of statistics from experiments during World War II. The methodology allows management to test up to 40 variables simultaneously, then sort out which ones have what impact — good, bad, or none at all.

In the late 1960′s, an Oak Ridge Laboratory statistician named Charles Holland recognized the commercial value of a process he developed while working on weapons projects. He trademarked MVT and promptly sold large manufacturers on the idea — DuPont, Monsanto, and BASF among them.

At DuPont, for example, management improved the capacity of a waste incinerator by 41 percent by zipping through an eight-run experiment — testing eight factors, and their interplay, simultaneously. Total elapsed time to test the effects of varying purge flow, delta flow, breech temperature, and five other factors: 33 hours.

By the 1990s, MVT was being used for business processes as well as manufacturing processes. At SBC Communication Inc., says former CFO and CIO Ed Glotzbach, the telecom company completed its MVT experiment in less than three months. That might seem long — if you didn’t know that the testing weighed the impact of 24 variables, ranked in order of their effect on cash flow, simultaneously. And the results? SBC decreased bill cycle time by a day and a half, improved billing accuracy to 70 percent, and increased on-time bill mailing to 99 percent, says Glotzbach, who recently emerged from retirement to become CFO of Houston-based TPI Inc.

“There is an amazing level of sophistication at our factories,” asserts Hi-Tec’s Kaiser, who just returned from a visit to one of his leather suppliers, in China. Lantech’s Cunningham regularly visits the shop floor, too, learning what language makes sense to operations managers and “introducing production-line financial statements that better match the manufacturing process.” And Glotzbach, who rose through the ranks at SBC via operations, says that knowing the dial-tone business from bottom to top helped him tackle a “disastrous” billing problem.

So it would seem that GDI’s Alan Dunn — that self-described “factory rat” — may well be correct. Dunn counsels his clients to manage for cash, not for variances — and to force the finance team to walk the factory floor. “Follow the manufacturing process, and all of its complexity, to the end,” declares Dunn. “Go be a part for a day.”

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