SUMMER 2008

V O L . 4 9 N O. 4

Robin Cooper and Brian Maskell

How to Manage Through

Worse-Before-Better

Please note that gray areas reflect artwork that has

been intentionally removed. The substantive content of
the article appears as originally published.

REPRINT NUMBER 49415

FINANCE & MANAGING CHANGE

How to Manage Through

Worse-Before-Better
Like most major
change initiatives,
going lean rarely
looks good from the
start. The operating
efficiencies come
quickly, but sales and
profits for a while
get worse. The solution?
Adopt a new financial
reporting method
that captures whats

really happening in
the business.
Robin Cooper
and Brian Maskell

everal years ago, a Pennsylvania manufacturer of industrial sensors well call it

Caspian Corp. launched an ambitious effort to become a lean enterprise in hopes of
achieving higher quality, lower costs and better customer service. Managements goal
was to eliminate all unnecessary expenses and surpass its leading competitors in terms of
productivity and efficiency. During the first six months, Caspian, whose total annual revenues
were about $225 million, achieved significant operating improvements. Product lead times to
customers and on-time delivery performance were up sharply. Over the next six months,
operational performance continued to show impressive gains, and the vice president of
operations was pleased. Meanwhile, customer service was making significant strides as well,
and with greater efficiencies the company was able to reduce the number of direct labor
employees involved in production. Payroll savings in a single value stream alone amounted to
more than $40,000 per month around 20%.
However, the CFO saw a radically different picture. During the same initial months, she
saw no financial improvement at all: Sales were flat, and costs didnt decline. During the
second half of the year, Caspians revenues actually fell by 17%, and profits declined by an even
bigger percentage. The CFO was baffled: The sales forecasts had looked encouraging, and the
operations people had talked about significant savings. What happened? Unfortunately, she
was at a loss to explain the disparities to the companys board or to outside investors.
Caspians management spent the next 12 months attempting to generate stronger results.
Previously, the company had deliberately kept inventory levels high to ensure that customers would be well served. Now seemed like a good time to cut inventory something the
CFO hoped would lead to financial gains. With less inventory, she looked forward to having
more cash on hand. In addition, she anticipated that quality improvements would pay a nice
dividend in terms of lower materials costs. She certainly wasnt prepared for more bad news:
Despite higher productivity and efficiency, Caspians profits remained lower than they were
before the company began its transition to lean. Return on sales fell from 7% to zero.
At this point, the CFO and CEO were ready to pull the plug on the lean program and go
back to the good old days of mass production. They simply couldnt afford more surprises,
no matter the success of the overall effort.

The Allure of Lean

Many Western managers were introduced to lean production in 1990, with publication of
The Machine That Changed the World.1 Based on a five-year study of Toyota by MITs International Motor Vehicle Program, the book showed how management, line workers and
suppliers could join together to improve quality and productivity and to lower costs. Since
Robin Cooper is a professor in the practice of management accounting at Emory Universitys Goizueta
Business School in Atlanta. Brian Maskell is president of BMA Inc., a consulting firm specializing in lean
management in Cherry Hill, New Jersey. They can be reached at smrfeedback@mit.edu.

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then, thousands of managers have been drawn to the principles

of lean management. Managers have applied them to consumer
products (including automobiles and electronics), commercial
products (including aircraft landing gear, electrical components
and batteries) and a wide range of service environments (including hospitals,2 insurance companies,3 government offices,4 retail
stores5 and call centers6).
In contrast to traditional methods based on mass production
and economies of scale, lean management is built on responsiveness and economies of scope. It replaces Henry Fords any color
that you want, as long as it is black with any color you want. Lean
enterprises achieve this flexibility by adopting a just-in-time
production philosophy: They produce what customers want when
they want it, as opposed to manufacturing a limited menu of
products ahead of demand and forcing customers to choose from
whats available in inventory. For many companies, the initial
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decision to go lean is a no-brainer. In a

relatively short period of time, companies
have found that they can achieve faster
cycle times, reduced defect rates and sharp
gains in on-time deliveries. In addition,
for companies relying on inventory as a
buffer against uncertain supply, there is a
marked reduction in inventory levels
required across the supply chain. Logically, these changes should result in better
financial performance, especially because
companies achieve simultaneous declines
in manufacturing and service costs.
But the transition takes time, and it is
full of obstacles. One of the biggest and
most predictable hurdles is the crisis in
confidence that occurs when management
isnt able to improve financial performance
quickly enough. When the numbers fall
short of internal and external expectations,
managers often try to modify the lean
initiatives or abandon them altogether.
Orest Fiume, former vice president of
finance and administration at Wiremold
Co., a manufacturer of industrial and
domestic wiring systems in West Hartford,
Connecticut, describes what happens when
enthusiastic operating people square off
with finance and accounting managers
who are appalled by the deteriorating
results in their financial statements: Managers who still use standard costing say, I
dont know what youre doing, but whatever
it is, STOP IT! Youre killing our profits.7
Management needs to anticipate these challenges and to understand that traditionally measured financial performance will
decline before it can rise to new heights. That worse-before-better
phenomenon must be explained and clearly or everyone
from executives to floor employees to shareholders will get off the
lean bus long before better can be reached. To help managers
overcome the financial hurdles on the path to lean, we have developed new tools for anticipating the deterioration in financial
performance that invariably occurs as a mass producer goes lean
and for understanding the real performance improvements that
take place during this period. Our approach involves replacing (or,
at a minimum, augmenting) the traditional cost-accounting
system with a new, transparent accounting system that tracks the
companys value streams, which incorporate all of the valueadding and non-value-adding activities required to bring a product
or service from start to finish. This system is designed to help
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companies resist the pressure to show financial results that are

consistent with historic levels in the old production environment.

The Source of the Financial Performance Crisis

What happens to a companys financial performance as it transitions from mass production to lean? In a typical company, lean
management techniques generate a mixture of good and bad,
both externally and internally. Some of the most significant
developments involve operational improvements that affect
customers. (See The External Effects of Going Lean, p. 62.) The lead
time for providing products or services to the customers shortens,
and on-time delivery improves. These changes are good for
customers, but from the sellers perspective they affect customer
behavior negatively in the short term: Customers buy less (because
they can place their orders closer to the time they actually need the
products and hence can reduce their safety stocks), resulting in
revenue reductions. The result is a temporary decline in profits that
continues until customer inventories are fully drawn down, at
which time sales and profits return to normal levels.
Consider what happened at Caspian during the first three
years of lean transformation. The company eliminated most of
the queues in the production processes. This led to a reduction in
lead time from 12 weeks to around one week. At the same time,
because of improved reliability and quality, the on-time delivery
percentage to customers went from the low 70s to the high 90s.
These results are fairly typical for mature lean companies.
As customers come to rely on improved lead times and ontime performance, they begin to alter their buying habits,
shrinking their on-site inventories. Since these safety inventories
often represent as much as three months (or 25%) of a customers annual requirements, cutting back on inventory can have a
significant impact on sales. Although suppliers might see only a
modest drop in revenue (typically around 15% in months six to
12), their profits can drop by more (anywhere from 25% to 50%,
reflecting the difference between revenues and costs).
Internally, there is dramatic improvement in operating
performance as well. In particular, the cycle time for taking a
product from raw material to finished goods shrinks. As the cycle
time drops, so does the need for in-process inventory. Furthermore, as the cycle time shrinks, the company can shift from push
production (producing ahead of customer orders) to pull
production (producing to demand). (See The Internal Effects of
Going Lean, p. 62.) In response, the need for finished goods inventory drops from months of production to days of production.
As both types of inventories drop, the good news is that operating
cash flow improves dramatically as unneeded inventory is sold.
The bad news is that most cost systems allocate fixed costs to
products that are manufactured during the financial reporting
period. When sales levels exceed production levels (that is, when
inventory is declining), fixed costs that were previously capitalized
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on the balance sheet must be added back into the fixed costs for
the products that were produced and sold in the period. Thus,
when inventory levels are falling, the total fixed costs that are
incorporated into the profit and loss statements include some
from prior periods. Therefore, they exceed the annual fixed costs
of manufacturing, further reducing profits. (See As Inventory Is
Sold, Profits Are Further Depressed, p. 63.)8
Consider what happened to Caspian during the same three-year
period. Based on a reduction in cycle times from 12 weeks to one
week, inventory levels fell from around 200 days to around 30 days.
These improvements are typical of mass-to-lean conversions.
These inventory reductions and their effects are not one-time
occurrences. As companies become more experienced with lean
methods, continuous inventory reductions are the norm until
mature lean inventory levels can be achieved. Typically, the
reductions begin to have an impact about 12 months into the
lean transformation. It is not unusual for companies transitioning from mass production to lean to reduce inventory levels by
60% to 80% over a four- to five-year period. These reductions
can decrease a companys profits by 25% to 50%; with both forms
of inventory reduction occurring at the same time, the profit
decreases can easily range from 50% to 100%.

Why Financial Performance Lags Operational Performance

Despite the adverse financial implications, a successful transition
to lean always brings two positive changes: Productivity per
employee increases significantly, and a facilitys output capacity
improves as well. (See How Going Lean Increases Capacity, p. 63.)
For example, during Caspians lean transformation, the company
increased labor productivity by 1.5% to 2% per month. This represented a productivity increase of 36% to 48% over a two-year
period. These productivity gains apply to the entire work force, not
just those considered direct labor. The productivity improvement, in turn, adds to the companys productive capacity. Both of
these changes should be good. However, taking advantage of these
improvements in the short run is difficult, if not impossible, for
two reasons: First, lean companies arent in a good position to
reduce their number of workers; and second, companies cant
quickly find other ways to use the new capacity they create.
Laying off workers is not an option because the transition to
lean requires considerable involvement on the part of the work
force; for example, the traditional orientation toward the individual (with dedicated assignments) has to be replaced by a new
spirit of cooperation (with each team member playing multiple
roles). To spur these changes, senior management typically promises the work force conditional job security. Therefore, significant
reductions cannot be initiated even if productivity improvements
reduce the need for workers. Even without such a promise, there
is a practical consideration: the likelihood that further productivity improvements would not materialize if employees believed
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these improvements would lead to more layoffs. Given this reality, Caspians vice president of operations reassigned workers to
other lean tasks rather than let them go; as a result, there was no
overall bottom-line improvement.
Similar capacity improvements have been seen in service
processes as well. Methodist Hospital in Minneapolis held rapid
process improvement workshops for the staff of its endoscopy
clinic in 2004. A team of doctors, nurses and technicians applied
lean methods to their processes and found they could increase
capacity by 100%. Today, the clinic is able to see twice as many
patients as it did before, patients spend less time in the clinic and
doctors and nurses can devote more time to each patient.9
The additional output capacity companies create through
productivity gains cant be used for other purposes in the short
run, in part because companies need to maintain a stable
production environment. In many cases, moreover, it takes time
to find opportunities for growth. Stability is important in lean
transitions because the work flow has to be standardized and
this is difficult to achieve if order volume is increasing rapidly.
Smart transition teams wait about 18 months before trying to
increase sales volumes, even if they think they have spare capacity. This gives the sales force time to recognize that the additional
capacity is not a glitch, and it gives customers confidence that the
performance improvements will continue.

The Advantage of Value-Stream Accounting

Everyone knows that the stock market brutally punishes unexpected
poor financial performance. When financial results are worse than
expected, many executives will want strong evidence that going lean
was the right decision and that improved financial performance is
indeed coming. Without such evidence, some will lose confidence
and demand that the lean initiative be dismantled.
To help companies head off a crisis in confidence that could
evolve into a full-blown financial crisis, we have developed a
methodology for reporting financial performance during the
lean transition so that the potential value of the various performance improvements is visible throughout the process. The
method, which we call value-stream accounting, allows senior
management to maintain their confidence in lean while managing future opportunities and analyst expectations.10 The approach
takes full advantage of the simplified production environment of
the lean enterprise, in which there are typically only a few value
streams (usually no more than five).
Although value-stream accounting has been applied most
often in manufacturing companies, it also has been applied
widely to service businesses, including hospitals, banks and
financial service companies.11
It may seem strange that we created a totally new approach to
costing to help managers understand the downturn in financial
performance. However, conventional cost systems designed for
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mass production environments cant provide insights into either

(1) what causes the decreased profits; or (2) how much companies
are apt to benefit from going lean. The core problem is that conventional cost systems do not map costs to value streams instead,
they link them to production or service delivery processes and then
to products. In other words, traditional cost systems view the production or service delivery process as a series of independent steps
performed in geographically isolated machining or service processing centers, not as an integrated flow along a value stream.
Because lean companies allow customers to select any color
they want, their value streams tend to be organized around product families (for example, a consumer electronics company might
have one value stream for CD players and another for DVD players), with each product family following a similar production path.
Value streams typically comprise one or more dedicated production cells, which produce products or subassemblies one at a time,
from raw materials all the way to the finished product.
To maintain the discipline of lean, both physical assets and
people are assigned to a particular value stream. The physical
assets are right-sized so that they have enough capacity to
support a single value stream, and the work force is trained to
perform many tasks, not just as narrow specialists. Because the
physical assets and the work force are dedicated, there is no need
to assign their costs indirectly. Consequently, nearly all resource
costs (even electricity) are measured directly at the value-stream
level. The only major exception is floor space, which can be
assigned indirectly based on square footage.
Direct costing allows for the creation of much simpler income
statements, which can be read and understood by almost anyone
in the business. These plain English financial statements can
facilitate a companys transition to lean by showing how the
improvements employees make flow to the bottom line.
At Caspian, the CFO eventually overcame her opposition to
the lean transition and embraced value-stream accounting. The
first step involved developing plain English financial statements
for the whole company. The new statements were an immediate
success. Without resorting to standards, variances or opaque
accounting ideas, they showed how and when money was spent
during the period. Rather than requiring management to spend
time deciphering the numbers, the statements pointed management to actions they needed to take. For example, the lean
statement isolated the profit impact from a large reduction in
inventory from the profitability of the value stream. It reported
that the company made a healthy profit of $3.23 million from
revenues of $19.04 million, which had been eliminated by the
accounting impact of the inventory reduction. (See Comparing
Caspians Traditional and Plain English Income Statements,
right side, p. 63.) By contrast, in the standard cost statement,
the only reported number was a loss of $9,000, which totally
obscured the operating profit (see same diagram, left side).
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Looking Beyond the Bad News

Plain English financial statements can reveal hidden improvements in financial performance that are often masked by lower
sales, the vagaries of cost accounting and the time required to
grow the business. Direct cost assignment coupled with disciplined lean production enables managers to develop accurate
estimates of how different output levels might play out financially. In particular, it is possible to remove the negative
financial impacts of inventory reduction and add in the
impact of taking advantage of the increased productivity,
either by right-sizing or by producing at higher capacity levels.

Adjusting for External Inventory Level Decreases As customers

begin to decrease their inventory levels, they necessarily postpone sales. There are several ways to measure postponed sales.
The simplest is to estimate sales trends from earlier periods to
gauge what would have occurred. However, its possible to
create more accurate estimates by interviewing representative
customers and determining how they are changing their
buying behaviors. Either way, its important to have a reasonable estimate of what the revenue would have been if
customers were not eating into their safety stocks.
Once management determines the revenue adjustment, it
can estimate the corresponding costs. Value-stream accounting makes it relatively easy to estimate the bottom-line
impact of lost sales. All of the products that are manufactured in the value stream belong to the same family and have
similar economics. Therefore, it is possible to identify how
the average product consumes resources. Dividing the selling
price of the average product into the revenue adjustment
determines the volume of the postponed sales in units.
Factoring the variable costs of the average product by the
number of units gives the anticipated incremental costs of
the postponed sales. Typically, labor is considered fixed
(especially since workers have been promised that they will
continue to be employed), as are machine and facilities costs.
Only materials, utilities and external processing costs are
expected to vary. Because few costs are variable at the levels
of change were discussing (with the exception of materials),
almost all of the revenues go to the bottom line, which
explains why the impact of lost sales on profits is so high.
Adjusting for Internal Inventory Level Decreases The profitability of
the value stream if there are no changes in inventory can be
calculated using the same approach developed for postponed
sales: Once you determine the revenue from selling off the
inventory, identify the associated variable costs and add them to
the costs in the value stream. On the surface, one might expect
this to be relatively straightforward. However, the adjusted
profit and loss statement is different from the inventory62

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The External Effects of Going Lean:

Customers Buy Less (for a While)
When a mass producer converts to lean, its performance along two
key dimensions improves dramatically from the perspective of the
customer. First, the lead times between placing an order and getting
it delivered drop dramatically. Second, the percentage of on-time
deliveries increases dramatically. Together, these improvements
allow customers to reduce their safety stocks. The result is a reduction in orders for the companys products leading to reduced
sales and profits. Thus, while the companys operational performance
improves dramatically, it will report reduced profitability until the
customers safety stocks are brought into line with the new reality.

Mass
Producer

Long Lead Times

Poor On-Time Delivery
Customers keep
more inventory

Lean
Producer
Conversion
Phase

Short Lead Times

Excellent On-Time Delivery
Customers keep
less inventory

Customer sells off

safety inventory,
reduces new orders
Short-term reduced
sales and profits

The Internal Effects of Going Lean:

The Company Produces Less As It Sells Off Inventory
As the conversion to lean continues, the companys need for both
work-in-process inventory and finished goods inventory diminishes. The adoption of flow production (in which products are
manufactured in a continuous process) significantly reduces the
product cycle time. As cycle time decreases, so does the need for
work-in-process inventory. As a result, the company can begin to
produce to demand, which allows for significant reductions in
finished goods inventory. As both work-in-process inventory and
finished goods inventory levels fall, production levels also drop.

Mass
Producer

Long
Production Cycle
Much inventory and
work in process

Lean
Producer
Conversion
Continues

Short
Production Cycle
Less inventory and
work in process

Improved
cash flow
Reduced production levels

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As Inventory Is Sold, Profits Are Further Depressed

Mass
Producer

As production levels drop due to the reduced need for both work-in-process and
finished goods inventories, the way that fixed costs are treated by most cost systems depresses profits further. Cost systems assign both fixed and variable costs
to products and capitalize them into inventory. As the company goes lean and its
need for safety inventory declines, the capitalized costs attributed to the inventory are released from the balance sheet to the profit and loss statement, driving
down profits. The decrease in profits is caused by the need to recognize both the
fixed costs capitalized into the sold inventory and the fixed costs incurred in the
current period.

High Inventory
Total Fixed Costs
in Current P&L
Capitalized
from prior
periods

Costs of
Sold Inventory

Lean
Producer
Conversion
Phase
Inventory
Is Sold

Current
Production
Costs

From
current
period

Low Inventory

How Going Lean Increases Capacity

Two Alternative Lean Futures

As the journey to lean continues, the companys operational performance continues to improve. In particular, the output per employee
and the output capacity of the production processes increase. They
combine to help the company produce more products. The challenge
is to find new customers or create new products to take advantage of
these new capabilities. Unfortunately, the rate of capacity expansion
usually outstrips the companys ability to find new revenue opportunities. The result is a lag between the operational improvements and
gains in financial performance. Only as companies are able to realize
new revenue opportunities does the financial performance significantly improve.

There are two routes that the newly lean company can take. It
can decide there are no major growth opportunities and rightsize the assets and people at its current size, or it can decide to
grow into the newly created output capacity by developing new
products and finding new customers. At Caspian, the two statements demonstrate how much the lean transformation has
changed potential profitability. The right-sized statement
shows a profit margin of 19%, while the full-capacity statement
shows a profit margin of 25%. These statements gave senior
management confidence to support the transformation to lean.

Mass
Producer

Lean
Producer
Large potential
maximum sales

Low Productivity Per Employee

Low Output Capacity

Do Not Grow

Small potential
maximum sales

Lean
Producer
Conversion
Continues

High Productivity Per Employee

High Output Capacity
Large potential
maximum sales
Immediate improved
financial performance

Comparing Caspians Traditional

and Plain English Income Statements
The plain English P & L shows that the
value stream made an operating profit of
$3,229,000 and a loss of $9,000 after the
inventory reduction adjustment. In contrast,
the standard cost P & L only shows the loss
of $9,000. In addition, it requires a sophisticated understanding of standard costing
and variance analysis.

requires Purchase Price Variance

detailed
accounting Material Usage Varance
knowledge to Labor Usage Variance
understand
Overhead Absorption
Variance
Selling, General and
Administrative Expenses

Total Cost
Net Profit
Return on Sales

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Right-Size
Scenario

Full-Capacity
Scenario

Revenue
$22,453,000
Material Cost
$10,644,000
Employee Cost
$1,950,000
Outside Process Cost $2,080,000
Other Costs
$3,502,000

Revenue
$45,338,000
Material Cost
$21,376,000
Employee Cost
$3,900,000
Outside Process Cost $4,420,000
Other Costs
$4,313,000

Net Profitability
Return on Sales

Net Profitability
Return on Sales

$4,277,000
19%

YEAR TWO
July - December
Revenue
Cost of Goods Sold
Gross Profit

Grow

$11,329,000
25%

YEAR TWO
July - December
$19,040,000
$13,853,000
$5,187,000
($63,000)
$1,075,000
$927,000
$2,902,000
$355,000

Revenue
$19,040,000
Material Costs
$6,608,000
Employee Costs
$3,900,000
Outside Process
$1,442,000
Other Conversion
$2,513,000
Costs
Facilities
$993,000
Selling, General and
$355,000
Administrative Expenses
Operating Profit

$19,049,000
($9,000)
0%

Prior Inventory
Current Inventory
Inv. Adjustment
Corporate Overhead
Net Profit
Return on Sales

SUMMER 2008

both
report
the same
revenue

$3,229,000
$10,477,000
$7,391,000
($3,086,000)
$152,000

impact of
inventory
change
shown
separately

($9,000) both report

the same
0% net profit

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FINANCE & MANAGING CHANGE

Caspian Income Statement Adjusted for Lean Transition

At Caspian, the temporary sales reduction during year two July-December was estimated at $3,360,000. After accounting for the
associated variable costs (which amounted to 62% of this revenue), there were incremental profits of $1,248,000. With this adjustment,
the value-stream profitability increases from 0% to 6% (see middle P & L). Similarly, adjusting for both the postponed sales and inventory
reductions shows that the transformation has actually increased the companys ability to generate profits at its current level of sales
activity. The reported profit would have been $1,778,000 with a return of 8% (see right side P & L). Adding back the postponed sales
provides insights into the real level of product demand and associated profitability; the adjustment for the internal inventory decrease
shows how profitable the company would have been if the vagaries of standard costing had not been a factor.
TEMPORARY LEAN PENALTY
LEADS TO A LOSS
Initial Lean
Changes
Leading to
Reduced
Profits

Adjustment
for Temporary
Sales Reduction

$19,040,000

$3,360,000

$22,400,000

Material Costs
$6,608,000
Employee Costs
$3,900,000
Outside Process
$1,442,000
Other Conversion Costs $2,513,000
Facilities
$993,000
Selling, General and
$355,000
Administrative Expenses

$1,749,000

$8,357,000
$3,900,000
$1,696,000
$2,586,000
$993,000
$355,000

Revenue
value stream
labor kept
constant to
maintain value
stream team
integrity

IF SALES WERE NOT REDUCED,

A PROFIT WOULD BE REPORTED

$3,229 ,000

$4,513,000

$10,477,000
$7,391,000
($3,086,000)
$152,000

$10,477,000
$7,391,000
($3,086,000)
$179,000

Operating Profit
Prior Inventory
Current Inventory
Inventory Adjustment
Corporate Overhead

$254,000
$73,000

Net Profit
Return on Sales

$27,000

($9,000)
0%

adjusted statement because the inventory was created when the

company was a mass producer; the inventory in the adjusted report
was produced by a more efficient lean enterprise. The adjusted profit
for the lean enterprise is therefore higher than the conventionally
reported profits, even though the revenue stays the same. Comparing the prior periods profit and loss statement (when no inventory
changes occurred) and the adjusted profit and loss statement highlights the real improvement in value stream performance. (See
Caspian Income Statement Adjusted for Lean Transition.)

Adjusting for Increased Productivity The need to establish standard

work and the challenges of finding new sales growth opportunities
make it difficult for lean companies to take immediate advantage
of new output capacity created by the transition to lean. To help
senior management understand the economic potential of the
increased capacity, it is useful to develop two alternate future-state
profit and loss statements one for the right-sized business and
one for the full-capacity business. (See Two Alternative Lean
Futures, p. 63.) The right-sized statement assumes that sales stay
the same but that the value stream changes by reducing the costs
of both labor and dedicated production equipment. The fullcapacity statement assumes that all of the newly available capacity
will be utilized by selling more of the current mix of products.
Unlike the inventory reductions that occur only for companies that
64

Income Statement
Adjusted for
Sales Reduction

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$1,248,000
6%

IF INVENTORY WERE NOT REDUCED,

PROFITS WOULD HAVE BEEN EVEN LARGER

Adjustment
for Inventory
Reduction

Income Statement
Adjusted for Sales &
Inventory Change

$22,400,000
all but labor
costs increase
because of
increased
production
owing to sales
increase

$2,153,000
$313,000
$90,000

$10,510,000
$3,900,000
$2,009,000
$2,676,000
$993,000
$355,000

all but labor

costs increase
because of
increased
production
owing to
maintaining
inventory levels

$1,957,000
$3,086,000

$10,477,000
$10,477,000
of
$0 impact
inventory
$179,000 reduction

is eliminated

$1,778,000
8%

have large inventories in their value and supply chains, these adjustments are applicable to all businesses that go lean.
Right-sized scenario. Managers can develop the right-sized
picture by adjusting the resources dedicated to the value stream
so that they are properly aligned with current revenues. We
suggest using a five-year horizon. The material and outside
processing costs remain essentially unchanged, as they already
reflect the changes in efficiency, but the other costs (particularly
labor, machine and facilities costs) need to be modified. First, for
labor costs, managers need to determine the number of individuals required to produce the output. This calculation is fairly
straightforward (multiplying the number of units by the production cycle time for each product). Second, where appropriate,
machine costs must be adjusted for right-sized machines. This
adjustment is difficult for some machines because they are
expensive to acquire and have low resale values; therefore, these
machines need to be retained. Finally, managers need to reduce
their facilities costs to reflect any reductions in floor space that
will be dedicated to the value stream. The right-sized profit and
loss statement will typically report profits approximately twice
that of the value streams current performance.
Full-capacity scenario. The full-capacity picture can be
created by identifying the long-term bottlenecks in the value
stream and fully loading them (in most settings, there will be
SLOANREVIEW.MIT.EDU

only one long-term bottleneck). Typically, expensive machines

operating at full capacity create bottlenecks; to relieve the bottleneck, the company needs to buy another machine. By contrast, if
the restriction is labor, management can usually add people. To
calculate the revenue associated with loading the bottleneck,
managers need to divide the time per unit into the machines
available capacity, and then multiply the full-capacity volume by
the average selling price of products made in the value stream.
Realistic levels of capacity utilization must be incorporated into
the full-capacity future-state financials. Instead of assuming that
100% of available capacity will be utilized, it is safer to assume
that 20% remains available to allow for fluctuating demand. The
labor loading for each production step in the value stream is
calculated using the standardized work estimates, and finally the
associated outside processing costs are estimated. Over a five-year
period, the full-capacity future state will report profits that are
typically four to eight times higher than the value streams
current performance.

Managing Into the Future

Because lean transitions take several years to accomplish, management needs to update the alternative-scenario profit and loss
statements on a regular basis to reflect ongoing improvements in
the performance of the value stream. By integrating statements
that reflect external, internal and inventory changes with the fullcapacity view, managers will find that even as they report the unavoidable profit trough, the companys potential profitability increases.
Furthermore, these forward-looking statements should send
important messages to the product development team and the
sales department. The product development team should begin
working on new products that take advantage of the enhanced
lean capabilities of manufacturing. These products should be
ready to roll out as capacity frees up and manufacturing is ready
to ramp up production. Meanwhile, the sales department must
actively seek out new markets for both existing and planned
products to fill as much of the newly created capacity as possible.
If successful, this should lead to the full-capacity scenario.
As management navigates through the profit crisis and the
company gets back to normal financial performance, it can
discontinue the adjusted statements. However, many lean companies continue to use right-sized and full-capacity statements
because they show how well lean productivity improvements are
being incorporated into future plans. Senior managers should
accept that for the foreseeable future their efforts to keep the
value stream at full capacity will generally lag behind the
continuous growth in productivity. In other words, the fullcapacity future state will always be more profitable than actual
performance. The imbalance will not disappear for several years,
until the value stream reaches lean maturity and capacity
increases become more gradual.
SLOANREVIEW.MIT.EDU

have short-term adverse

impacts on a companys bottom line. However, managers need to
understand that the bad news isnt really bad its part of the
necessary process of establishing a stronger, more productive organization. Traditional accounting systems are not designed to help
senior managers understand the causes of these adverse impacts or
to see the future benefits that will accrue from the much-improved
operational processes. Our approach helps managers confront this
problem by giving the CFO and divisional controllers tools to plan
for the short-term financial impact, monitor the progress of these
issues, understand the operational improvements and develop
strategies to maximize the longer-term benefit.
When the financial impacts are effectively communicated
throughout the organization and the executive team, expectations are
set realistically. Eventually, organizations see superior results, which
tend to benefit everyone investors, customers and employees. By
being clear about the challenges and expectations, and demonstrating the companys strategy for achieving longer-term profitability
and growth, managers dont have to worry about Wall Street surprises and negative impacts on stock price or investor confidence.

LEAN TRANSFORMATIONS GENERALLY

REFERENCES
1. J. Womack, D. Jones and D. Roos, The Machine That Changed the
World (New York: Scribner, 1990).
2. C. Peota, Lean Machine, Minnesota Medicine 89, no. 4 (April 2006): 18-20.
3. C.K. Swank, The Lean Service Machine, Harvard Business Review 81,
no. 10 (October 2003): 123-129.
4. L.D. De Bakker and R. Aernoudts, Changing a Public Sector Agency:
Dutch Alimony Payments Office (LBIO) (presentation at the Lean Service
Summit Conference, Noordwijk aan Zee, Netherlands, June 23, 2004).
5. J. Womack and D. Jones, Lean Thinking (New York: Simon & Schuster,
2005): 37-49.
6. S. Barlow, S. Parry and M. Faulkner, Sense and Respond: The Journey
to Customer Purpose (Basingstoke, United Kingdom: Palgrave Macmillan,
2005), 181-190.
7. O. Fiume and J. Cunningham, Real Numbers: Management Accounting
in a Lean Organization (Durham, North Carolina: Managing Times Press,
2003), 113.
8. Variable costs do not create a problem, as they automatically adjust to the
level of production.
9. D.K. Wessner, Toyota System Helps Patients and Health Care, Minnesota Star Tribune, June 18, 2005.
10. B. Maskell and B. Baggaley, Practical Lean Accounting (New York:
Productivity Press, 2003).
11. For more discussion about applying lean to service environments, see G.
Taninecz, Pulling Lean Through a Hospital: Departments at Windsors
Htel-Dieu Grace Request Lean Initiatives, December 1, 2007, www.lean.
org; Transforming Healthcare at HDGH, www.hdgh.org; and J. Seddon,
Freedom From Command and Control: Rethinking Management for Lean
Service (New York: Productivity Press, 2005).

Reprint 49415.
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SUMMER 2008

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