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LEAN MANUFACTURING A FINANCIAL PERSPECTIVE A Workshop for Finance, Accounting and Operations Personnel Presented By: Prakash R. Mulchandani October 12, 2001 Agenda Course Perspective Objectives of a Firm Financial Statements Ratio / Profitability Analysis Manufacturing Accounting

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lean manufacturing a financial perspective


A Workshop for Finance, Accounting and Operations Personnel

Presented By:

Prakash R. Mulchandani

October 12, 2001

  • Course Perspective
  • Objectives of a Firm
  • Financial Statements
  • Ratio / Profitability Analysis
  • Manufacturing Accounting
  • Cost-Volume-Profit Analysis
  • The Changing Business Environment
  • Lean Manufacturing
  • Measurables in Lean Manufacturing
  • Financial Impact of Lean Techniques
  • Conclusion
course perspective4

Objectives of the Firm

Financial Statements

Lean Manufacturing

Manufacturing Accounting


-First Time Through

-Overall Equipment Effectiveness

-Manufacturing Cycle Time (DTD)

-Build to Schedule

-Total Cost


-Operating Ratios

-Profitability Ratios


Course Perspective

objectives of the firm
Objectives of the Firm
  • Profit – achieve profit goals through increasing sales and reducing costs
  • Cash Flow – generate cash flow through profits and use it wisely
  • Liquidity – control the financial condition and solvency of the business
accounting system overview
Accounting System Overview
  • Objectives of the firm are usually translated into financial terms (common denominator)
  • Financial information is found in financial statements
  • Financial statements are prepared from accounting database and records of the firm
    • depend on accounting system
  • Accounting system has both, an external and internal focus
accounting functions

Accounting Data

Continuous Improvement

Day-to-day Operations


-Collect Money


Summary Financial Reports

-Stockholder, lenders, other stakeholders

-Uses GAAP

Revise Decisions

Management Reporting




-Very detailed

Tax Returns

-Federal, state, local

Analysis & Control


-Management Accounting


-Financial Accounting

Accounting Functions
financial statements10
Financial Statements
  • Income statement
    • Sales Revenue – Expenses = Profit = Net Income
  • Balance Sheet
    • Assets – Liabilities = Owner’s Equity
  • Statement of Cash Flows
    • Cash Flow from Income + Other Sources of

Cash – Uses of Cash = Net Change in Cash

income statement
Income Statement
  • Summarizes sales revenue and expenses for a period of time
    • yields profit
  • It is the main determinant of the balance sheet
  • Sales revenue increases an asset or decreases a liability
  • Expenses decrease an asset or increase a liability
  • Profits increase Owner’s Equity
    • shows up in retained earnings
income statement for 1999 00013
Income Statement for 1999 $(000)

Quantities sold times the sales prices for all products sold during the period.

Sales quantities times the unit cost of the products sold. Costs change over time and therefore the business has to decide between the first-in, first-out (FIFO) or the last-in, last-out (LIFO) method.

income statement for 1999 continued 000
Income Statement for 1999 (continued) $(000)

Operating expenses that are driven by sales volume. Examples are packaging costs, and storage costs. If sales volume were to increase 20%, then these costs would also increase by 20%.

Operating expenses that are driven by sales revenue. Examples are sales commissions based on sales prices.

income statement for 1999 continued 00015
Income Statement for 1999 (continued) $(000)

Operating expenses that are relatively fixed for the period. Examples are employees’ salaries, rent, property taxes, and insurance.

Listed separately because it is such an unusual expense. It is a portion of the total original cost of the company’s fixed assets (except land) that is allocated to this period. Calculated using straight line, DDB or SOYD methods.

income statement for 1999 continued 00016
Income Statement for 1999 (continued) $(000)

Depends on the amount of short term and long term debt outstanding during the year and the interest rates on each issue of debt.

Federal, state and local taxes.

The bottom-line profit for the period.

balance sheet
Balance Sheet
  • Measures financial condition of the firm
  • Lists Assets, Liabilities and Owners’ Equity
  • Assets are economic resources owned by the business
  • Liabilities are its debts (creditors, lenders)
  • Owners’ Equity is the residual claim on Assets after satisfying Liabilities
    • initial investments by owners, profits
  • Balance Sheet is a position statement
  • Summarizes financial condition at a point in time
balance sheet 12 31 99 000
Balance Sheet 12/31/99$(000)

Cash is usually in one or more checking accounts. Cash equivalents such as highly marketable, short-term securities may be included in the cash amount.

Three basic short-term operating assets.

Long-term operating assets whose useful lives range from 3 to 5 years all the way to 30 or more years for buildings. Their cost (except land) is depreciated over their useful life.

balance sheet 12 31 99 continued 000
Balance Sheet 12/31/99 (continued)$(000)

Cumulative portion of the original cost of the assets that has been changed to depreciation expense since the date of acquisition.

Non-interest-bearing, short-term liabilities that arise from 2 operating sources: (1) the purchase of inventory on credit, and (2) the acquisition of services and other items charged to expense that are not paid for immediately. In short, these are unpaid bills.

balance sheet 12 31 99 continued 00022
Balance Sheet 12/31/99 (continued)$(000)

Expenses that have been recorded to match all expenses for the period against sales revenue to measure profit for the period.

Unpaid portion of tax expense, usually due within 2 or 3 months.

balance sheet 12 31 99 continued 00023
Balance Sheet 12/31/99 (continued)$(000)

Interest-bearing liabilities from borrowings. Short-term means one year or less; long-term can be up to 20 or more years.

Owners’ equity arises from 2 sources: (1) capital invested by the owners for which they receive shares of stock; and (2) profit earned but not paid out as a dividend, which is retained in the business.

cash flow statement
Cash Flow Statement
  • Shows sources and uses of cash
  • Does not equal the profit for the period
  • However, profits do generate cash flow over the long run
    • may be lag before profit is converted to cash
cash flow statement for 1999 000
Cash Flow Statement for 1999$(000)

Net income is the starting point.

All three of these short-term operating assets increased; their ending balances were more than their beginning balances. These increases decreased cash flow.

cash flow statement for 1999 continued 000
Cash Flow Statement for 1999 (continued)$(000)

All three of these short-term operating liabilities increased; their ending balances were more than their beginning balances. These increases increased cash flow.

This is the net total impact on cash flow due to changes in the company’s short-term operating assets and liabilities.

cash flow statement for 1999 continued 00029
Cash Flow Statement for 1999 (continued)$(000)

Depreciation is not a cash outlay in the year recorded as expense. The cash outlay occurred years ago when the assets being depreciated were bought.

The business is free to do anything it wants to with this cash flow.

cash flow statement for 1999 continued 00030
Cash Flow Statement for 1999 (continued)$(000)

These purchases are called capital expenditures.

The company raised capital from these three sources during the year.

The company paid cash dividends of this amount during the year, which is about one-third of net income.

cost of capital
Cost of Capital
  • Business has $5.7 million in capital invested in net operating assets
  • This capital is supplied by debt ($1.9 million) and equity ($3.8 million)
  • Each one has an associated cost
  • The weighted average cost of capital is as follows:
ratio analysis
Ratio Analysis
  • Accounts Receivable Turnover

A measure of the ability to control accounts receivable. Measures how rapidly collections occur.

Accounts Receivable

Turnover = Credit Sales

Average Accounts Receivable

= $12,038 = 11.35 turns

$.5 (1,156+964)

Accounts Receivable Turnover (continued)

Days to Collect Receivables = 365 days

Accounts Receivable Turnover

= 365 = 32.2 days


Inventory Turnover

A measure of assessing capital tied up in raw material, work-in-process and finished goods inventory. Measures how rapidly inventory is converted into sales.

Inventory Turnover = Cost of Goods Sold

Average inventory

= $7,824 = 4.3 turns

$.5 (1,956+1,654)

Asset Turnover

A measure of asset efficiency, or use of assets to generate sales.

Asset Turnover = Net Sales

Average Assets

= $12,038 = 1.87 turns

$.5 (6,928+5,945)

Current Ratio

A measure of coverage of short term debt (solvency).

Current Ratio = Current Assets

Current Liabilities

= $3,859 = 1.90


Debt to Equity

Amount of assets provided by creditors for each dollar of assets provided by stockholders.

Debt to Equity = Total Debt

Stockholders’ Equity

= $3,130 = .79


Times Interest Earned

Measure of firm’s operations which provide protection to the long term creditor.

Times Interest Earned = Income before Interest & Taxes

Interest Expense

= $942 = 6.16


profitability ratios
Profitability Ratios
  • Return on Assets

Measure of how well assets have been employed.

ROA = Net Income

Average Assets

= $521 = 8.1%

$.5 (6,928 + 5,945)

Return on Assets (continued)

Sometimes use operating income divided by average net operating assets

ROA = Operating Income

Average Net Operating Assets

= $942 = 18.2%

$.5 (5,748 + 4,606)

Return on Equity

Measure of how well the stockholders equity has been employed. Usually higher than ROA due to financial leverage.

ROE = Net Income

Average Stockholders Equity

= $521 = 14.8%

$.5 (3,798 + 3,266)

Return on Sales

Measure of profitability as a function of sales.

ROS = Net Income

Net Sales

= $521 = 4.3%


Gross Margin Percentage

A broad gauge of profitability. Engineered products have high margins, while commodities have low margins.

Gross Margin Percentage = Gross Margin

Net Sales

= $4,214 = 35.0%


manufacturing accounting47
Manufacturing Accounting
  • Two common manufacturing cost processes encountered
    • Process costing (chemicals, beverage, foods)
    • Job order costing (custom furniture, airplanes)
  • Manufacturing Costs consist of:
    • Raw materials (purchased parts)
    • Direct Labor (production workers)
    • Manufacturing overhead (all other manufacturing costs)
manufacturing accounting continued
Manufacturing Accounting (continued)
  • Raw materials and direct labor are variable costs
  • Manufacturing overhead costs
    • Variable (electricity, supplies, indirect labor ?)
    • Fixed (rent, depreciation, manufacturing supervisor
    • Allocated to product using activity base (labor hours, machine hours)
    • Uses pre-determined overhead rate
  • Manufacturing costs are also called inventoriable or product costs
    • Expensed as cost of goods sold when sales take place
manufacturing cost report for year
Manufacturing Cost Report for Year

These 4 basic types of manufacturing costs are called product costs. They became attached to the product and thus are not charged off to expense until the product is sold.

The cost of the 1,000 units manufactured but not sold is added to the inventory asset account.


operating profit report for year
Operating Profit Report for Year

Cost-of-goods-sold expense equals the sales volume times the unit product cost.


Both sales-volume- and sales-revenue-driven expenses are shown here in one total amount.

These expenses are non-manufacturing cost, i.e., not part of the production process. They are called period costs because they are charged off to the period in which they are recorded and do not become part of product cost.

another example
Another Example
  • Let us consider another example of manufacturing costs
  • Beginning inventory exists in direct materials, work-in-process and finished goods
  • Pre-determined overhead rate for the firm is calculated as follows:

Est. total manufacturing overhead costs

Estimated direct labor hours

= $6,520,000

250,000 hours

= $25 / direct labor hour

Rate =

flow of manufacturing costs 000
Flow of Manufacturing Costs$(000)

Direct Materials

$30 BI



$50 EI


Sequential Tracking

$20 BI





$300 EI

$10 BI



$50 EI


Direct labor

24,000 hours @ $15/hr

Mfg. Ovd.

$25 / direct labor hr.

Mfg. Cost of goods sold

Finished Goods


  • Production far exceeded sales
  • Extensive inventory build

Raw material


Finished goods


  • Increased profits by $85
  • Possible reasons
    • Increase manufacturing efficiency
    • Increase utilization
    • Increase profits
  • Reporting for WIP and finished goods are also used to update inventory levels for material control (MRP)





backflush costing
Backflush Costing
  • An alternative to sequential tracking
  • Omits recording some accounting entries
  • We will consider example in which work-in-process inventory entries are not made
    • a variation also eliminates finished goods inventory
backflush costing58
Backflush Costing
  • Used in companies with JIT production systems
    • Toyota
    • Eagle-Gypsum
    • Amounts in WIP are small
  • Uses pre-determined material and conversion costs (labor and mfg. ohd.) for each product
    • These costs enter finished goods inventory
    • Variances are expensed as period costs is COGS
backflush costing flow 000
Backflush Costing Flow$(000)

Direct Material

$20 BI



$50 EI


100,000 units

@ $10 / unit


Finished Goods


$400 BI



$100 EI


100,000 units

@ $30 / unit

110,000 units

@ $30 / unit

Conversion Cost


Direct labor



$2,150 total

Mfg. Ohd.(actual)

100,000 units

@ $20 / unit

backflush costing observations 000
Backflush Costing Observations$(000)
  • Material and conversion costs per unit are predetermined
  • Difference between actual costs and predetermined costs are expensed in COGS
    • $150 in previous example
    • Total COGS thus equals $3,450 ($3,300 + $150)
  • Inventory consists of direct materials and finished goods only
    • $50 and $100 respectively
backflush costing observations 00061
Backflush Costing Observations$(000)
  • Eliminates WIP inventory and associated production reporting
    • Implications for manufacturing efficiency and WIP profits
  • Accounting does not strictly match GAAP
    • WIP exists, but not recognized
    • Users cite materiality concept in support of system
    • WIP very small
increasing profitability
Increasing Profitability
  • Operating Profit (also called Earnings before Interest & Taxes, EBIT) depends on three primary factors:
    • sales volume
    • unit profit margin (contribution)
    • fixed expenses
increasing profitability continued
Increasing Profitability (continued)
  • Let’s say,
    • selling price per unit = $250
    • variable cost per unit = $150
    • thus, contribution margin per unit = $100
    • fixed cost = $35,000
increasing profitability continued65
Increasing Profitability (continued)
  • Breakeven Point is when total contribution equals fixed cost
    • breakeven units = $35,000 / $100/unit = 350 units
  • Each unit sales above breakeven yields $100 profit
    • a very powerful concept
    • profitability is enhanced substantially with increased volume
  • For sales of 500 units
    • Profits = $100/unit x 150 units over breakeven

= $15,000

variable cost reduction
Variable Cost Reduction
  • We are able to reduce costs by $25 per unit
    • rework, scrap, productivity
  • Contribution margin increases to $125 per unit
  • Breakeven volume decreases
    • breakeven units = $35,000 / $125 contribution per unit

= 280 units

  • For sales of 500 units
    • Profit = $125 contribution / unit x 220 units over breakeven

= $27,500

improve quality decrease cost and increase sales
Improve Quality – Decrease Cost and Increase Sales
  • Rework / scrap costs reduced by $25 per unit
    • leads to improved quality
    • more customer orders
  • Sales volume increases to 600 units
  • Profit = $125 contr. / unit x 320 units over breakeven = $40,000
the changing business environment69
The Changing Business Environment
  • The last two decades have been a period of tremendous change in the business environment
  • Competition has become worldwide in scope
  • Pace of innovation in products and services has accelerated
  • This has led to lower prices, higher quality and more choices
  • Though good for consumers, this has been a period of upheaval for businesses
the changing business environment continued
The Changing Business Environment (continued)
  • Traditional ways do not work anymore, and major changes are needed in transforming processes and people
  • Improvement programs include:
    • Just-in-Time (JIT)
    • Total Quality Management (TQM)
    • Theory of Constraints (TOC)
    • Process Reengineering
    • Lean Manufacturing
the changing business environment continued71
The Changing Business Environment (continued)
  • Major benefits of these programs are to
    • enhance quality
    • reduce cost
    • increase throughput
    • shorten customer delivery time
    • increase profits (ultimately)
the balanced scorecard
The Balanced Scorecard
  • Balanced scorecard translates organization’s mission and strategy
    • into set of performance measures
    • provides framework for implementing its strategy
  • Focuses on financial and non-financial objectives
    • Short and long term
  • Four key perspectives
    • Financial (common denominator)
    • Customer
    • Internal business perspectives
    • Learning and growth
the balanced scorecard73
The Balanced Scorecard
  • Measures fundamental changes in the company
    • Signals prospects of creating economic value for the future
  • Management compensation is often tied to both financial and non-financial objectives
linking strategic intent to measurable objectives
Customer Perspective

Order Fulfillment

Delivery Performance

Build to Schedule



Financial Perspective

Cash Flow

Inventory $, Turns +DOH

Market Share and Growth


Internal Perspective

Lead Time

Manufacturing Cycle Time


Value-adding Ratio

Quality and Safety


Learning Perspective


Vision Development

Employee Involvement

Responsive Systems

Linking Strategic Intent to Measurable Objectives
lean manufacturing vision
Lean Manufacturing Vision
  • Develop a lean, flexible and disciplined manufacturing system defined by a set of principles and processes
    • That employs groups of capable and empowered people learning and working safely together
    • In the production and delivery of products that consistently exceed customers’ expectations
  • Lean means that we eliminate:
    • unnecessary duplication and waste in processes.
    • anything that doesn’t add value for the customer.
techniques continued
Techniques (continued)
  • Flexible is being able to:
    • take advantage of new information, changing markets and new technologies quickly.
    • produce a greater variety of products in smaller batches
    • produce just-in-time
    • minimize capital investment
    • launch new products faster
techniques continued79
Techniques (continued)
  • Disciplined means:
    • building according to a schedule based on customer demand
    • using common methods that keep processes stable
    • Fully use facilities and people without stops and starts because of fluctuating demand
techniques continued80
Techniques (continued)
  • Groups of capable, empowered people learning and working safely together means:
    • People are educated and trained to do their jobs and to continuously improve themselves
techniques continued81
Techniques (continued)
  • Working togetherallows people to build on the abilities of co-workers and themselves to:
    • impact cost, quality and timing
    • provide products that exceed expectations
techniques continued82
Techniques (continued)
  • Exceeding customers’ expectations means providing products that fill more than basic needs and wants when it comes to:
    • QUALITY – They are well built with superb fit and finish, with zero defects
    • COST – They deliver value for the money and trouble free ownership
    • TIME – Products are first to market delivered on schedule, when the customer wants them. Time is also speed of delivery (short lead time)
primary lean manufacturing measurables
Primary Lean Manufacturing Measurables
  • Manufacturing Cycle Time (Dock to Dock)
  • First Time Through Capability
  • Overall Equipment Effectiveness
  • Build to Schedule
  • Total Cost
manufacturing cycle time
Manufacturing Cycle Time
  • The elapsed time between unloading raw materials and releasing finished goods for shipment.

Total units in inventory of control part

“End of line” production rate


where does the time go
Where Does the Time Go?

95% Non-production time

5% Manufacturing Time

calculate end of line rate
Calculate End of Line Rate
  • Determine the end of line rate for the week by dividing the number of units produced by the number of plant production hours, excluding breaks and lunch.

units built per week of control part

production hours per week (plant)

EOL rate =

calculate mct production hours
Calculate MCT Production Hours
  • Total the units found in production, and then divide by the end of line rate

total units

end of line rate

MCT production hours =

first time through capability ftt
First Time Through Capability (FTT)
  • Calculates the percentage of units completing each sub-process (not scrapped, reworked, retested, diverted for off-line repair, or returned)

Units entering process minus defective units

Units entering process


  • Defects include:
  • Scrap
  • Rework
  • Retests
  • Repairs off line
  • Returns
why first time through ftt
Why First Time Through (FTT)?
  • Also called First Time Capability
  • Measures internal quality
  • Asks “Is it right the first time?”
  • Indicates waste, process efficiency, and quality containment effectiveness
overall equipment effectiveness oee
Overall Equipment Effectiveness (OEE)

OEE is a measure of the availability, performance rate, and quality rate of a piece of equipment and a capacity measure for constraint operations.

OEE = Availability X Performance X Quality

oee definitions
OEE Definitions
  • Availability

= Operating Time / Net Available Time

  • Performance Rate

= (Ideal Cycle Time X Total Product Run) / Operating Time

  • Quality

= (Total Products Run – Defective Parts) / Total Products Run

build to schedule
Build to Schedule

Build to Schedule reveals how well a plant executes plans to produce precisely what customers want, in the proper sequence and mix.

BTS = Volume X Mix X Sequence

bts calculate volume performance
BTS: Calculate Volume Performance
  • Volume Performance

actual number of units produced

scheduled number of units


bts calculate mix performance
BTS: Calculate Mix Performance
  • Mix Performance

actual units built to mix

lower of actual units produced or scheduled

  • Actual units built to mix

= the number of units built that are included in the daily production schedule (no overbuilds)


bts calculate sequence performance
BTS: Calculate Sequence Performance
  • Sequence Performance

actual units built to sequence

actual units built mix

  • Actual units built to sequence

= the number of units built on a given day in the scheduled order (only units after the first having a sequence number larger than all predecessors)


why total cost tc
Why Total Cost (TC)?
  • Measures total cost-per-unit
  • Total cost per unit equals the affordable business structure
  • Can we provide high quality products with desirable feature and performance at prices our customers are willing and able to pay for – and STILL make a profit?
traditional costing
Traditional Costing

Manufacturing Cost


Profit Margin


today s costing
Today’s Costing



Profit Margin

Manufacturing Cost

how can plant total cost be reduced
How Can Plant Total Cost be Reduced?
  • Total Cost can be lowered by:
    • Reducing material costs
      • Work with Purchasing and suppliers to create “win-win” opportunities
    • Reduce labor and overhead costs
      • Achieve best-in-the-world levels of efficiency
    • Reduce warranty costs
      • Build it right the first time
how can plant total cost be reduced continued
How Can Plant TotalCost be Reduced? (continued)
  • Total Cost can also be lowered by:
    • Reducing freight and other costs
      • Build to the production schedule
    • Make good trade-off decisions
      • $3 Material Cost Reduction for a $1 Plant Operating Cost Increase
  • Continuous improvement is critical for survival
  • Financial measures / metrics are the common denominator for business entities
  • Lean manufacturing is the optimum means for process improvement
  • Lean metrics are easily translated into financial terms