by Nick Katko and Sérgio Caldeirinha
Sérgio is a value stream manager for a manufacturing company. His team recently completed a kaizen event, and he is going to visit the new CFO, Nick, to understand how to quantify the financial impact of the event.
Sérgio: “Thanks for meeting with me Nick. How is your first day going? I wanted to meet with you to review my financial analysis of a recent improvement event we completed.”
Nick: “Nice to meet you Sergio. My first day is going good so far. OK, help me out a bit. Why do you want me to review your financial analysis of the improvement event?”
Sergio: “Accounting requires
us to show cost savings for every kaizen event. I want to make sure it makes sense to you.”
Nick: “Sure I’ll be glad to take a look.”
Sérgio: “Our kaizen event was to reduce the changeover time on the Atlas machine in our value stream. It’s the bottleneck in the value stream, so reducing the changeover time will improve flow. We average one changeover per day and the changeover time averages about 2 hours, and through the kaizen event we reduced it to 15 minutes.”
Nick: “Wow, that is great!”
Sérgio: “I prepared a table showing the financial impact of this event. I’m using the required fully burdened labor rate of $29.8716 per hour to calculate the cost savings. But I rounded it up to $30 per hour. Here is what I calculated”
Table 1: Cost Savings Table
Nick: “This looks good Sergio, but where did a rate with 4 decimal places - $29.8716/hour come from?”
Sérgio: “The CFO that recently retired required that all events show a cost savings, and he calculated that rate and told us to use it. I’m not really sure where it came from.”
Nick: “I’m pretty sure the rate came from our product costing system, which is used to value inventory. To keep it simple, accounting takes all your overhead costs and divides it by planned labor hours to calculate an overhead rate.”
Sérgio: “But, why 4 decimal places?”
Nick: “To calculate a precise product cost and margin.”
Sérgio: “Sounds complicated.”
Nick: “It is. Product costing has been around 100 years. Even some accountants don’t really understand it. And it really confuses non-financial managers that have to use it. I can explain more later, what I want to do is focus on your event.”
Sérgio: “OK, what would you like to know?”
Nick: “What were the lean operational reasons you wanted to reduce changeover time?”
Sérgio: “To improve on-time delivery and reduce lead times. We’ve been working on this for a few years.”
Nick: “Do you measure on-time delivery and lead time?”
Sérgio: “Yes, delivery has improved 25% and lead times have been reduced by 50% over the past two years. The impact of this event was to reduce lead times by 3 more days.”
Nick: “Good, plan on using those numbers in your report out. The 3 day reduction in lead time is a direct operational impact of this event.”
Sérgio: “But I’m required to show cost savings! Every month accounting asks me why my actual costs are not being reduced because of improvement events. And executives complain that costs are not going down. I dread those meetings and all I want to do is pull my hair out!”
Nick: “Well, I’m bald because I’ve been dealing with the same issues for years, but I have a solution that is better than trying to show imaginary cost savings.”
Sérgio: “Yes, please! Anything but an hourly rate with 4 decimal places! That isn’t even a real number. All I’m trying to do is reduce lead times, improve delivery and serve customers better. Whenever I say this to accounting, they look at me like I’m speaking some foreign language.”
Nick: “Well, you really are when talking to them, but I’ll work on that later. What is the average cycle time for parts on the Atlas machine?”
Sérgio: “That’s an easy one. It’s 10 minutes.
Nick: “What’s the average sales price and material cost?”
Sérgio: “The sales price of the parts produced on the Atlas machine is $1000 and the material cost is $600.”
Nick: “That means the contribution margin per part is $400 or 40%.”
Sérgio: “What is the contribution margin?”
Nick: “It’s the sales price less the variable costs, and it is called contribution margin because it is how much the part contributes to covering the fixed costs and profitability.”
Sérgio: “OK, I get that.”
Nick: “You said you reduced changeover time from 2 hours to 15 minutes.”
Sérgio: “Yes, we freed up 105 minutes per day; 525 minutes per week and 2100 minutes per month.”
Nick: “That time you freed up is called capacity and the numbers you just said are another direct operational impact of the event. You eliminated waste and created capacity on the Atlas machine.”
Sérgio: “I agree, but what about the cost savings?”
Nick: “We are going to show different numbers. Don’t worry, I’ll explain them during the report out. I’m the new guy, so they can’t fire me for not showing cost savings.”
Nick: “Next question. Can you produce and sell more items?”
Sérgio: Yes, the sales forecast is increasing. With the additional capacity we created we can make and ship 10 more parts per day; 52 more per week and 210 more per month.
Nick: “Yes. And if you sell more, what costs increase due to the increase in sales?
Sérgio: “That would be the material cost. I think I get it. You are saying that reducing the changeover time allows us to sell more and the financial impact is the increase in contribution margin, not a cost savings. That makes sense to me. Maybe I should also work in accounting!”
Nick: “Exactly! The actual financial impact of your improvement event is an $84,000 increase in contribution margin per month.”
Table 2: Increase in Contribution Margin due to improvement event
Sérgio: “I always thought of improvement events like this but could never explain it the way you just did. Sales has told us that our improvement in delivery and lead times has driven the sales growth because we are serving customers better. It’s creating a competitive advantage for us.”
Sérgio: “I can’t wait to give my report out and explain that reducing changeover time from 2 hours to 15 minutes is going to make the company $84,000 more per month. That’s almost $1.000,000 per year! That’s a lot better than any cost savings numbers.
When the executives see this, their heads are going to explode! All they do is rant about not seeing cost savings for improvement events, and yet our sales have been improving, and so has profitability!
Nick: “I hope their heads don’t explode; it would be quite messy! This contribution margin analysis validates what has been happening financially due to your improvement in lead times and delivery.”
Sérgio: “Yes! I knew this but never could show it with financial numbers. I can’t wait to let the other value stream managers know about this! Does this analysis have a name?”
Nick: “It’s called a lean management accounting system. It is based on understanding the actual cause-effect relationships between lean operating improvement and financial improvement.”
Sérgio: “Am I thinking about this the right way? The reduction of changeover time reduced lead time and created 2100 minutes of capacity on the machine each month.”
Nick: “Yes.”
Sérgio: “And we can use that capacity, 2100 minutes, to produce and ship 210 more products per month, which will have a financial impact of $84,000 increase in contribution margin per month.”
Nick: “You got it. That’s exactly how to explain the financial impact of your improvement event. You understand lean accounting! I plan on introducing the lean accounting to the company, and I’d like to pilot it in one value stream to demonstrate it to everyone. Want to pilot it in your value stream?”
Sérgio: “Yes, for sure.”
Nick: “OK, the report out we do will be a way to begin introducing lean accounting to the executives and operational leaders. Then we can begin working on a pilot.”
Sérgio: “I have one more question, based on other improvement events we have completed in the past. What would the financial impact of my event be if there was no increase in demand? I talk with the other value stream managers, and we all feel like we are sometimes searching for a needle in a haystack for financial impact.”
Nick: “Great question. You reduced changeover time and created 2100 minutes of capacity per month on the Atlas machine. You also reduced lead times. Those numbers are the direct operational impact of the event. If demand wasn’t increasing, there would be no immediate financial impact. But that is OK. Continuous improvement events always have a measurable operational impact. They can create capacity. They can have a direct financial impact. Or an event like yours can have an both an operational and financial impact. It all depends on the specific event.”
Sérgio:” So we need to study each improvement event independently and understand the operational and financial changes. Thanks Nick, that was eye opening. I’m looking forward to working with you more on lean accounting.”
This story was adapted from a presentation Nick & Sergio made for the 2023 Lean Global Connection.
To view the session: https://www.youtube.com/watch?v=bWcZqri8Bok&list=PLA4yUhT8Mjbxf-qnggo6YQs-bl1-he-Vy&index=83
Lean Global Connection 2023: https://youtube.com/playlist?list=PLA4yUhT8Mjbxf-qnggo6YQs-bl1-he-Vy&si=gKuiLI4MRvFS9R_N
To learn more about Lean Accounting, please consider buying Nick’s books:
The Lean CFO and Practicing Lean Accounting, both available on amazon.com.
Nick Katko has over 30 years of lean accounting experience, both as a CFO and consultant. Nick is Since 2002, Nick has leveraged his lean accounting experience and philosophy in assisting companies around the world in their lean accounting transformations.
Nick is a regular speaker at the annual Lean Accounting Summit and has also presented at conferences in the United States, Europe, Asia and Australia.
Nick is the author of “The Lean CFO” (2013) and co-author of “The Lean Business Management System” (2007). Nick’s newest book, co-authored with Mike De Luca is “Practicing Lean Accounting” (2021).
Sérgio Caldeirinha's expertise is the application of the principles of lean thinking and practice in a wide range of scenarios. Held positions as quality assurance, production engineering, product engineering, and customer liaison, among others. After 2002, transitioned to consulting, working with a diverse range of firms in achieving exceptional levels of performance and operating 'world class' results.
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