The Big Idea: An Introduction to True AccountingTM
How to Stop Playing the Standard Cost Game
The cost accounting system is dead.
The archaic cost accounting system ingrained in today’s manufacturing plants is useless and not fixable. It’s dead and should be buried immediately!
It’s an outmoded approach that’s costing companies like yours millions of dollars a year in unrealized profits.
It produces data that’s not only flawed but extremely misleading to people at every level, from the Board of Directors, to the Chief Executive Officer, to the Chief Financial Officer, to the line managers, all the way to the shop floor.
Those are the conclusions of Ian Thompson, founder of Hagen & Co.
After completing 350 performance improvement projects at 80 global manufacturing enterprises, Thompson says, “Cost accounting covers up the hidden cost of underperformance – cost that can equal 30% to 100% of a plant’s present profitability.”
Actually, the cost accounting system is ideal for one thing: hiding poor performance. It enables everyone to play games with performance data and make the data seem better than they really are.
Why the cost accounting system (CAS) is useless (or worse)
Cost accounting was invented in the 1920s, before global manufacturing networks and enterprise systems. Today it’s strangling profit and productivity improvement in thousands of plants around the world.
Part of the problem is that its assumptions are simply wrong. The CAS compares actual costs to budgeted costs. But the budget is based on historic standard costs, so it includes all of the costs of non-performance – all of the scrap, downtime, slow running, and much more.
According to the CAS, the cost of these is zero – that is, they’re an unavoidable cost of doing business. As we’ll see, this is absolutely untrue.
If these “unavoidable” costs were small, it wouldn’t matter. But the truth is that they are enormous.
There's another serious problem with the CAS: since it's based on the past, it doesn’t account for the value of opportunities presented by dynamic market conditions. So most plant managers and employees are struggling to achieve an arbitrary annual budget that has no connection whatsoever with the facility’s true profit potential.
The third major problem with the CAS is that even if we believed the variance that it shows us – and we already know it’s inaccurate – we still can’t drill down and find the reasons for the losses.
This can be extremely frustrating to the people (perhaps you’re one of them) who are charged with productivity and cost-cutting: how are they supposed to know what to work on in order to save the most money in the least time?
It’s just not possible to use CAS to manage material loss. The same goes for balanced scorecards and benchmarking. They provide insights into what is and what has been – not what could be saved.
The Lake of Soup
Responding to a change in consumer preferences, a global food-processing company changed its soup recipe to include larger chunks of meat and vegetables.
The Vice President of Operations was painfully aware of the need to run his high-speed canning plant at maximum efficiency. In a brutal marketplace, with massive overcapacity and extreme market pressure, he knew he had to be – or be very close to – the lowest-cost competitor.
The problem: The larger pieces of meat and vegetables didn’t always fit through the ports in the 30-year-old filler machine, causing them to leak.
When Hagen & Co. analyzed the plant for all waste, by line and by sub-process, we discovered that a large lake of soup was forming under the filling machine; in fact, there was an operator whose job was to wash the lake away every day!
How much were these leaks costing the company? When we asked, the manager replied, “Losses? There aren’t any losses. Line 7 is well ahead of budget.” He didn’t care about the waste, partly because he didn’t know what it cost.
Armed with a stopwatch, a bucket, and some cost data, a waste reduction team calculated the cost of the leak: $750,000 a year. In the six years since the recipe change, this canning line had washed $4 million worth of soup down the drain.
Yet it took only $50,000 worth of larger filler valves to make the lake of soup disappear.
KPIs and other failed solutions
Programs like Six Sigma and Lean Enterprise are frequently unsuccessful because they fail to uncover the reasons for underperformance. And even if they do find the causes, there’s no way to evaluate them.
So most companies have invested in another set of cumbersome, non-financial metrics – called “Key Performance Indicators” (KPIs) – that attempt to evaluate improvement via such measures as scrap, downtime and customer complaints.
But even with this second layer of metrics, the plant’s accounting system continues to hide tens of millions of dollars of recoverable profits. Says Thompson, “We’ve discovered that up to 50% of a plant’s capital and labor is wasted.”
The problem with KPIs is that they don’t compare apples with apples.
You may have an issue that’s causing six hours of downtime on one line, a second issue causing six minutes of slow running on a second line, and a third issue that’s causing 6% scrap on a third line. Which is the most important?
It is impossible to say – because we don’t know the financial impact of 6% scrap or six hours of downtime.
Even if we just looked at downtime, we couldn't tell which is more important – six hours of downtime on Line 1 or six hours of downtime on Line 2.
Result: Managing by instinct
As you probably know all too well, managers end up having to use their gut instinct to tell them what to work on.
Yes, it is possible to work out the cost of a single issue, but that’s a laborious, time consuming mathematical calculation. Imagine doing it for every problem in a plant. You would have time for nothing else!
So managers are forced to use an ad hoc combination of the data from the CAS and the KPIs, plus anecdotal evidence from what people tell them, in order to figure out what to work on.
You can verify this lack of focus with a very simple experiment.
Gather 15 or 20 people in a plant, people from different functions and levels. Ask them to list the five most important issues that should be addressed to improve plant performance. They’ll have no difficulty coming up with answers.
You would hope that there would be very close agreement on the critical issues. What you will find is wild disagreement You'll get 50 or 100 separate problems, each of which is considered critical by an individual or group.
“That’s why it takes forever to get anything done around here.”
When we run these sessions, they always end in laughter – at the complete absurdity of the situation.
Everyone will agree that without an accurate financial cost, it’s impossible to prioritize. Invariably, someone will say something like, “No wonder it’s impossible to get anything done around here. We just can’t agree on what’s most important.”
So how do we stop playing the standard cost game?
There’s a very simple answer: Measure performance versus true potential. Measure profits, not costs.
Instead of comparing costs against a budget, compare the profits that you made with the profits that you would have made if everything had run to its true potential.
When you know the real size of these lost profits, break the total down into the individual reasons that caused the loss. In other words, calculate the true cost of every single driver of non-performance.
Rank these drivers according to the size of the loss. Track the size of the loss, over time, for the most expensive ones. That’s how you find out if your remedies have been effective or not.
Establishing true potential: Unleashing the power of belief
Establishing true potential for each critical operation in the business is an extremely interesting inquiry. It brings you face to face with the beliefs that have built up in the minds of the people in the plants.
What you discover is that people operate and manage their processes in accordance with their beliefs.
If an operator believes that the maximum speed of a machine is 8, that’s probably as fast as he or she will run it. If the engineering manager believes that you should replace the gearboxes every two years, they will be replaced every two years.
To calculate true potential, you need a process for discovering it, as well as a method that enables the people responsible for each critical operation to discover true potential for themselves.
This is the only reliable way to get people to change their minds about what their process or machines are capable of – because, of course, these beliefs have not been arrived at idly. People have worked on these processes, day after day, month after month, year after year, trying to find ways to improve them.
When they reach the point of diminishing returns, an understandable human tendency kicks in. It's not easy to admit that “We just can’t find any more ways to overcome the outstanding issues.” It's much easier to say, “We have indeed determined the natural limitation of the machine (or operation).”
So to understand the optimal performance of all your processes, you must have a system that any group of people can use to challenge their sacred cows...and the myths and black magic that grow up around each operation.
True AccountingTM and true potential
Our patented method, called True AccountingTM, contains the tools that allow your people to challenge their mental barriers – and establish for themselves the genuine limits of every critical process. What they discover is that in the great majority of cases, their processes are capable of much more than they believed possible.
We’ve seen it happen in every time. In every case we've worked on – at 350 manufacturing sites in over 20 industries on three continents – the plant people found that by installing True AccountingTM, they were able to achieve performance levels that they had believed impossible.
By establishing true potential, they were able to make giant strides in closing the gap between current performance levels and true potential.
Calculating Financial Performance vs. Total Profit Potential
To effectively measure and improve plant profitability, employees need a way to see every dollar of avoidable cost and potential profit.
Says Thompson, “Over the last 10 years, we’ve developed accounting methodology that compares actual profits to the profits that would have been achieved if the manufacturing plant produced to its true potential. The approach also identifies and values each problem that makes up this profit gap.”
True AccountingTM doesn’t replace a company’s financial reporting system. Instead, it serves as a management decision system that establishes the true profit potential of each part of the business.
When they install True AccountingTM, employees discover that their production systems are capable of generating much higher profits. Then, as they implement the improvement process, they make giant strides in closing the profitability gap.
We typically see remarkable increases in plant profits within 12 months. Recent installations yielded:
- An $8.6 million increase in profits in a packaging division in 10 months – up 78%
- A $6 million increase in profits in a consumer products division in 12 months – up 100%
- A tripling of profits in a chemical business in eight months.
And these gains all came without additional capital investment.
Each month, managers must sift through inch-thick reports that show only variances versus budget.
What they need are three simple pages that tell them (1) the total profit opportunity broken down by plant and line, (2) the reasons for the problems that limit profitability, ranked by value, and (3) a resolution trend over time that ensures that the most costly problems are being fixed.
Most industrial companies are paying their plant managers for the wrong things. They’re rewarding performance to a negotiated annual budget, not for achieving a plant’s potential profitability.
Thompson insists that “today’s senior management team should not be satisfied with 5% to 8% improvements in their annual business plan while spending millions of dollars in capital. Most executives would be stunned to learn how much more profit their existing assets can generate. We need a new accounting approach for a new era when manufacturing performance must provide critical competitive advantage.”
True AccountingTM contains the tools for eliminating every reason for non-performance.
One of the most powerful aspects of True AccountingTM is that it enables people to eliminate – permanently – every reason for non-performance.
How is this possible? Consider that all manufacturing processes are multi-variant, with dozens – often hundreds – of variables that the affect their performance. True AccountingTM shows how to optimize such a complex system.
It works on any system – mechanical, chemical, or human. It enables you to optimize each of the variables – in the shortest time with the least expenditure of effort.
It’s been validated on thousands of different machines and processes, from highly complex chemical reactions...to geological problems in coal mining...to human systems such as scheduling and order taking.
With True AccountingTM , you can get to the heart of issues that have defeated all other approaches -- and do it in a matter of days or weeks.
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The problem with benchmarking: A matter of time
Clients often say, “Why bother with true potential? Why don’t we just use benchmarking?”
Benchmarking contains two fundamental flaws.
(1) People often insist that their plant can’t be compared with another – they have different machinery, different products, different run lengths, and so on – so they deny the validity of the benchmarking process.
(2) The “gold standard” plant, against which the plants are measured, may itself be running well short of its true potential.
“So what?” you ask. “We struggle to get our plants up to the same level as our best performing plants. We can’t even make that happen, so why should we worry about even higher levels of performance?”
The answer is that time is short. You may have a year or two – or perhaps not even that long – to show significant improvement. And it’s extremely slow – and painful – to drive improvement with benchmarking.
But when your people use True AccountingTM to establish true potential, they’ll be able to make extremely rapid progress in closing the gap.
True AccountingTM engages the people
When people use True AccountingTM to establish the true potential of their processes, they’re able to break through the mental barriers that have constrained them.
They find these breakthroughs extremely rewarding. They become energized and motivated -- because now they believe that they really can overcome problems that have previously defeated them. These high levels of involvement by plant people are quite different from what we see with other approaches designed to improve performance.
Finally, people get a real answer to the perennial “what do we work on first?" question.
Since True AccountingTM shows the cost of every reason for non-performance, it becomes very easy to build consensus as to what’s important.
True AccountingTM also shows you whether the actions you’ve taken have been effective in eliminating problems. So for the first time, everyone is singing from the same song sheet.
New breakthroughs, new culture
Plant people frequently comment that although they’ve saved surprising amounts of money, the thing they value most about True AccountingTM is the change of culture.
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The results that senior managers like you have achieved by installing True AccountingTM are remarkable. People sometimes say they are “unbelievable.” But once they understand exactly how True AccountingTM establishes true potential, though, they quickly see that huge savings are entirely feasible.
Companies typically achieve a profit increase of 20 to 30% in a year. Some companies have doubled profits in this time. And we have examples of companies that have used True AccountingTM to triple profits in less than 12 months
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See it to believe it...
This may be one of the few things that’s too good to be true -- yet is true. You have to see it to believe it...so please give us a call.
We’d be delighted to visit you and show exactly how you can use True AccountingTM to save your company millions of dollars per year and to achieve your business goals.
We’ve done it for companies like yours, over and over again. In every one of over 350 projects, we have delivered.
If you’re frustrated at the time it takes to get things done in your organization...if you’d like to see your people to cut costs and improve profits, faster than you thought possible...if you’re disappointed with the results of your improvement programs (which may promise much but deliver little), then please give us a call.
You’ll find that True AccountingTM allows you to address [fix?] each of those issues. And you’ll see how you can finally answer the difficult question of how to build an enduring competitive advantage.
Enduring competitive advantage in seven weeks.
Today there’s excess capacity in nearly every industry. There’s enormous downward pressure on process; margins are squeezed to the bone. Practically every company has access to the same technology and the same levels of human and capital resources.
How do you create an enduring competitive advantage? How do you ensure that your company will survive and flourish in the years ahead?
True AccountingTM provides an answer. If you can achieve performance levels that are way beyond what your peers can achieve, you can cut costs, provide higher quality products, and take market share.
True AccountingTM lets you drive up the profits that you can make from your existing assets. It also shows how you can acquire companies that are not using True AccountingTM, thereby creating millions of dollars of shareholder value.
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You can install True AccountingTM on a demonstration basis in just seven weeks.
Typically, you’ll see savings of $100,000 or more – sometimes much more. You’ll discover that your people can use True AccountingTM to establish the true potential of their processes, to break through their mental barriers, and to build unprecedented consensus about the issues to work on.
They prove to themselves that the reasons for non-performance can be permanently eliminated.
To find out how True AccountingTM delivers these benefits, please call us. We would be happy to meet with you and your colleagues.
Every time we’ve shown senior managers how they can use True AccountingTM in their business, they get extremely excited, because they see that they can achieve their business goals more easily and in less time.
We look forward to having the opportunity to explain how you can join the growing numbers of companies that are growing profits beyond what they ever thought was possible...with True AccountingTM.