Lean accounting: a few key lessons from Wiremold
INTERVIEW – In this interview, the former CFO of uber-lean company Wiremold explains why our finance people hold the key to our transformation and gives us the lowdown on lean accounting.
Interviewee: Orry Fiume, author and former VP of Finance and Administration and Director of The Wiremold Company
Roberto Priolo: In a recent presentation, you said that time is the currency of lean. Can you explain this idea to Planet Lean readers?
Orry Fiume: When I first heard the phrase ‘eliminating waste’ – a concept that lies at the heart of lean thinking – my accounting brain immediately interpreted that as cost reduction. However, as I studied what Toyota does and the seven wastes, I realized that eliminating them has nothing to do with cutting costs. Instead, eliminating those seven wastes will free up the time consumed by activities that don’t add value, and with it free up capacity. (At this stage it is critical to give people reassurance that nobody is going to lose employment as a result of the productivity gains achieved through lean.)
When you embark on this journey, leadership comes under a lot of pressure to use the capacity that was freed up to grow the business. Say I am selling phones. When I suddenly have extra capacity, what’s the cost of producing an extra unit? People are already there, the lights are on, and the factory is heated – the only incremental cost you’ll incur is materials needed to make the next phone. In this sense, freed-up capacity, which happens because of freed-up time, is financing growth. That’s why I say, “Time is the currency of lean.”
RP: You also shared a lot of insights on metrics. Could you share a few pointers for organizations that are struggling to pick the right ones?
OF: Ultimately, the fundamental question you need to ask yourself is, “Does the metric support my strategy?” That’s just common sense. We cannot tolerate metrics that stand in the way of our strategy, whether it’s a lean strategy or some other strategy. So do the metrics we picked work towards moving the lean strategy forward? If the answer is yes, great. If they aren’t, what are we going to do about it? Either change them, if they can be altered to support the lean strategy, or stop using them and use metrics that do.
RP: And how do you make sure the metrics are meaningful to the people doing the work?
OF: You should make sure they are process-oriented and not financial in nature, or people won’t be able to relate to them. A process metric measures the physical activity that takes place in the process, which is something the people in the process can see.
RP: The terms productivity and efficiency are used interchangeably by people, but you made a very clear distinction between the two. Can you explain it to us?
OF: Productivity is the relationship between the output of a given process and the resources consumed to produce that output. By resources, I mean all resources: materials, labor and every overhead item. You are going to want to measure the productivity of all the significant inputs – if you are making aluminum, for instance, power is significant input, so you are going to want to measure the productivity of your power usage. Certainly, in most businesses, labor (both factory and office) is a significant input, so we want to measure its productivity.
Efficiency asks how my actual performance measures against what I expect, i.e. against the standard. But that is comparing two inputs: actual and standard and the assumption is that the standard input is correct, which it never is.
People do use these terms interchangeably, which means they don’t understand them. Most lean companies, at the beginning at least, measure efficiency in the classical sense of the term – at Wiremold we stopped using that metric, and thus that word, early on, completely focusing on productivity instead.
RP: Wiremold is one of the best examples of complete turnaround that the lean community has witnessed to date. You said that profit was not something you tracked in the organization – does this reflect the culture that led to Wiremold’s extraordinary numbers?
OF: Well, naturally we did prepare financial statements every month, and therefore did calculate profit. However, profit was not one of the five “hierarchy” metrics we used to run the company on a day-to-day basis. They were customer service, inventory turns, productivity, defect reduction and visual control, including rigorous 5S practices. This is the embodiment of the belief that if you do the right things you will get the right results. It wasn’t just empty words in our case. Every performance meeting we had was based on that list of metrics that did not include profit; every Friday morning, value stream leaders would report against that list.
RP: We have this amazing, very early example of real lean, and yet so many organizations are still struggling to understand the methodology. This leads me to believe that an important reason behind Wiremold’s success was its leadership team. What leadership behaviors could one see at Wiremold?
OF: The success of Wiremold came from a combination of things. Art Byrne was certainly the catalyst, and the body of knowledge that allowed it to happen because he had already turned around other companies at Danaher (we at Wiremold could see them, because they were our neighbors). That allowed us to run at full speed from day one.
I must say, companies often don’t understand lean because their CFOs don’t. Why did I get it? I don’t know! Maybe luck, maybe circumstances. In 1989 – before Art came in – we were looking at just-in-time and thought we should give it a try. We didn’t know what we were doing, and we made pretty much any mistake you can ever make (almost putting ourselves out of business, as our operating income went down 82%). I had been CFO with Wiremold since 1978, and every year since then the company’s financial performance had improved – until we started experimenting with just-in-time. When we started to go downhill in 1989, I tried to analyze the financial statements to understand the reasons behind the slump and I realized they were completely useless. They were telling me nothing. Around that time, Johnson and Kaplan wrote Relevance Lost: The Rise and Fall of Management Accounting, which confirmed everything I was experiencing. That started me on the path of looking for a better way. When Art came in, I had already been working for over a year on the accounting changes he wanted to introduce.
More in general, what I would say about the role of leadership is that every single improvement program I have seen in my career has the phrase attached to it “…and it needs the support of top management.” Every single one of them. The trouble is that lean doesn’t need the “support” of top management, whatever that means; it needs active, hands-on “doing” leadership. At Wiremold we used to organize “President’s kaizens” in which all executives participated, together with the workers in one of our facilities. That is more than just support! Think of what it did for the people in that factory to see all of top management on the shop floor, in their blue jeans, moving machines around. It told them that we were serious about lean, and that we are all in it together. It’s doing leadership, not talking leadership, that you need to make lean succeed. One of our HR managers at Wiremold use to say regarding leadership, “the tongues in their shoes speak louder than the tongues in their mouths”.
RP: In what way can financial people become barriers to lean change?
OF: In a manufacturing company that has just started down the lean path, the financial results in the first two years will almost always go down. It’s predictable, and it can be calculated beforehand, but financial people tend to not see this and when results go down they say lean is killing the organization.
In traditional standard cost financial statements you cannot explicitly segregate transitional effects (there is an entire chapter on this in the book I wrote with Jean Cunningham, Real Numbers). Under Generally Accepted Accounting Principles (GAAP), the “matching principle” says that if I build something today, but don’t sell it today, I need to take the labor and overhead associated with making that product and put them on the balance sheet, in the account called inventory. But these are not a true “asset”, but just deferred cost: when I build inventory and do not sell it, I am artificially improving my current year’s income because I am taking current cost out of the income statement and putting it on the balance sheet. When I start with lean and I improve my inventory turns (which is a good thing), I am reducing inventory and the deferred labor and overhead from previous years has to come off of the balance sheet and go somewhere, and it goes as a non-cash charge against current earnings. This always happens. If you want to calculate by how much of this non-cash charge you are going to incur next year, just go to your operations people and ask them what their inventory reduction plan for WIP and Finished Goods for next year is. Once you know that information you can quickly calculate what the reduction to next year’s profit will be due to the improvement in inventory turns. In what we call the “Plain English P&L” we isolate that number as a GAAP adjustment below a line called Manufacturing Profit so that everyone can see it. In addition, this makes the gains that are being created more clearly visible above that Manufacturing Profit line.
In addition, most people – including most CFOs – don’t understand that when you improve a process and create a productivity gain, that gain will not automatically show up as improved profit. I mentioned a little while ago that the company has to give its employees a guarantee that no one will lose their employment as a result of productivity gains. Therefore, although we have created a productivity gain in a specific process, the people who are no longer needed in that process have been redeployed and are still on the payroll. At the company level, then, no additional profit. And that condition will remain until leadership does something to actualize those gains into profit by 1) selling more, 2) reduce overtime (and therefore FTEs), 3) hold onto attrition and 4) insource things that are being done by vendors that can be done in-house. At Wiremold, over 10 years we averaged about a 14% annual productivity gain and had to do all four of those things every year in order to actualize our productivity gains into profit improvement. Understanding this will take a lot of pressure off of the people who created the gains (the workers) and put it where it rightfully belongs… on leadership. It’s up to leadership to actualize the gains. It will also take away the fear people have, and the misunderstanding over what’s happening. When financial people don’t get it, they will say lean is making things worse, when it is not.
RP: Wiremold used profit sharing as a reward system. Are there risks associated with this approach?
OF:Certainly, and there are lots of companies that do it wrong, by trying to manipulate the payout. Once you do that, it becomes a disincentive. That’s why our plan was simple and straightforward: we make a dollar, we share 15 cents. There were no “hurdles” to overcome before profits were shared and no limit on the amount that could be shared. Also, it was not a “deferred” profit sharing plan, but one that was paid quarterly, in cash.
This article is also available in Polish here