January/February 2018

Lean Tools forAccountantsHow to Implement Lean Financials Convergence of Lean and Standard CostingTPS: True Lean Systems

Lean Tools forAccountantsHow to Implement Lean Financials Convergence of Lean and Standard CostingTPS: True Lean Systems

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14 COST MANAGEMENT JANUARY/FEBRUARY 2018

L ean account ing refers to acollection of principles, prac-tices, and tools that are usedby lean companies to measurethe business, control opera-

tions, analyze and make sound financialdec is ions , and improve f inancia lprocesses . Lean account ing prac t iceshave been around since the early 1990s,and since then there have been some thatargue that lean account ing prac t icesdon’t comply w ith general ly acceptedaccount ing pr inc iples (GAAP). Thisargument usually leads to a debate aboutlean account ing versus convent iona linventory valuation systems.Conventional inventory valuation is

usually done using an enterprise resourceplanning (ERP) system, and it does agood job of inventory valuation for GAAPpurposes in companies with high inven-tory. A very simple explanation of howthis works is as follows: Each purchasedpart is assigned a cost. Labor and over-head rates are created for each produc-

tion work center. Production reportingsystems track the movement of materi-als from receipt through the productionprocess, and final ly to shipment. Pro-duction reporting builds a product costthrough the reporting of completed pro-duction. The ERP system can calculatethe cost of any individual product, the totalraw material, work in process, finishedgoods inventory, and the cost of goodssold at any point it t ime. It also producesmany types of variances, comparing theactual to the set rates in the system.The process of setting material costs,

labor rates, and overhead rates is commonlycalled setting standards, which can be setannually or more frequently. How each com-pany determines its rates is unique toeach company. Conventional inventoryvaluation systems that set rates are com-monly referred to as standard cost ingsystems. For the sake of simplicity, thisarticle will use the term “standard cost-ing” when referring to these conventionalinventory valuation systems.

LEAN INVENTORY VALUATION: LEAN

ACCOUNTING AND GAAP COMPLIANCE

N ICHOLAS S . KATKO AND SCOTT A . OL INGER

NICHOLAS S . KATKO , CPA , i s a s en ior con su l tant w i th BMA, Inc . , and l i ve s in Lex ing ton , Kentucky. Ni ck ha s ove r25 year s o f e xp e r i ence in l ean a c count ing a s bo th a CFO and con su l tant . He i s t h e author o f The Lean CFO , c o -author o f The Lean Bus ine s s Management Sy s tem and b l o g s reg u lar ly on l ean a c count ing at www. the l e anc fo. comand Linked In . Ni ck can b e rea ched at nkatko@gma i l . com or 859 -608 -0683 .

SCOTT A . OLINGER , CPA, CPIM , i s a v i c e p re s ident a t Hard ing , Shymansk i & Company, P. S .C . Ce r t i f i ed Pub l i cAccountant s and Con su l tant s , an independent membe r o f t h e RSM U.S . Al l i ance . Hard ing , Shymansk i & Company,P.S .C . prov ides account ing , tax , and consu l t ing s e r v i ce s to c l i ent s f rom of f i ce s in Evansv i l l e , Indiana , and Loui sv i l l e ,Kentucky, and is one of the largest locally owned CPA firms in Indiana and Kentucky. Scott can be reached at solinger@hsc-cpa . com or 502 -584 -4142 .

Each lean manufacturing company must create a lean inventor y valuation methodology that

works best for itself in complying with GAAP and being cons istent over time.

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Standard costing systems can be time-consuming and complex to maintain.Factors that can impact the maintenanceof standard costing systems include, butare not l imited to, the number of rawmaterial items purchased, raw materialprice stability, the number of manufac-turing work centers requir ing labor andoverhead rates, rate calculat ion, and theanalysis of the output such as variancesand absorption numbers.The issue is not whether lean account-

ing complies with GAAP, or whether leanaccounting is better than standard cost-ing. The real issue is how does a leanmanufacturing company with low inven-tor ies comply w ith GAAP in terms ofproperly stat ing inventory and cost ofgoods sold in the leanest way possible.The proper valuation of inventory for

GAAP is a complex issue when invento-ries are high because the materiality ofmisstatement can have a dramatic impacton reported profits. However, in a leancompany, low inventor ies reduce themateriality and create the opportunityto comply w i th GAAP us ing s implermethods.In this ar t icle, we wil l look at the rel-

evant accounting principles, then explainin genera l te rms how and why l eanaccount ing complies w ith GAAP, andfinal ly look at some lean inventory val-uation methods that companies use today.

The accounting principlesAccounting standards are governed byGAAP in the United States and by Inter-national Financial Report ing Standards(IFRS) throughout the rest of the world.For reference purposes, inventory valu-ation is covered in U.S. GAAP by Account-ing Standards Codif icat ion Topic 330(ASC 330) and internationally by Inter-nat iona l Account ing Standard No. 2 .There are a few technical differences inthese standards. What is important toknow is that both standards basical lysay the same thing about inventory val-uat ion requirements.For the sake of simplicity, this ar t icle

will use the acronym GAAP to mean bothU.S. GAAP and IFRS, and wil l periodi-cal ly cite ASC 330.

The valuation of inventory and cost ofgoods sold is one of the most importantissues for financial report ing because itis material to the proper determinationof income. Inventory valuation is one ofthe most unique components of account-ing because GAAP requires companiesthat carry inventory to capitalize a por-t ion of production costs into inventoryto determine the proper repor t ing ofincome. ASC 330-10 states:

Inventory has financial significance becauserevenues may be obtained f rom its sa le , orfrom the sale of the goods or serv ices in theproduction of which it is used. Normally suchrevenues arise in a continuous repetitive processor c yc le of operat ions in which goods areacquired, created, and sold, and further goodsare acquired for addit ional sales.

Thus, the inventory at any given date is thebalance of costs applicable to goods on handremaining after the matching of absorbed costsw ith concur rent revenues . This ba lance i sappropriately carried to future periods providedit does not exceed an amount properly charge-ab le aga ins t the revenues expec ted to beobtained from ultimate disposition of the goodscarr ied forward. In pract ice, this balance isdetermined by the process of pricing the ar t i-cles included in the inventory.1

What this means is that a port ion ofa company’s expenses are moved from theincome statement to the balance sheet.Expenses are reduced, and this increasesprofits. Because inventory is usually oneof the largest current assets on the bal-ance sheet, it’s easy to understand whyinventory valuation is material for properfinancial report ing.There are two issues related to inven-

tor y valuat ion: the value of inventoryon the balance sheet and the determinationof cost of goods sold.ASC 330-10-30 states that inventory

must be valued at cost, which is the sameas all other assets on a balance sheet. Costis defined as the actual expenses incurredto get goods (products that are sold) in con-dit ion for sale. These expenses are theactual cost of materials plus a portion ofthe actual costs of production. ASC 330also recognizes the inherent complexityof inventory valuation: “It is understoodto mean acquisition costs and productioncost, and its determination involves manyconsiderations.”2 The matching principleis more of an overall, general accountingprinciple and states that all expenses rec-

15LEAN INVENTORY VALUATION JANUARY/FEBRUARY 2018 COST MANAGEMENT

THE REAL ISSUE ISHOW DOES A LEANMANUFACTURINGCOMPANY WITHLOW INVENTORIESCOMPLY WITH GAAPIN TERMS OFPROPERLY STATINGINVENTORY ANDCOST OF GOODSSOLD IN THELEANEST WAYPOSSIBLE.

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16 COST MANAGEMENT JANUARY/FEBRUARY 2018 LEAN INVENTORY VALUATION

ognized in any per iod should be theexpenses incurred to generate the revenuesrecognized. Because cost of sales is often-times the largest expense on the incomestatement of a manufacturing company, itis material to the proper determination ofincome. ASC 330 states this as follows: “Amajor objective of accounting for inven-tor ies i s the proper determinat ion ofincome through the process of matchingappropriate costs against revenues.”3

The issues in a manufacturing com-pany in determining cost of goods sold arerelated to the continuous nature of man-ufactur ing. Products produced in oneperiod may not be sold until a subsequentperiod. The pr ices paid for purchaseditems may change, and actual productioncosts change over time. This makes match-ing the specific actual production coststo the revenue reported quite difficult.GAAP recognizes that calculating the

exact cost of an item (in inventory and costof goods sold) cannot be done because ofthe timing issues of goods produced andsold, changing material costs, and deter-mining the exact manufactur ing costsincurred for goods in inventory. ASC 330states: “Although the principles for thedetermination of inventory costs may beeasily stated, their application, particu-larly to such inventory items as work inprocess and finished goods, is difficultbecause of the variety of considerationsin the allocation of costs and charges.”4

To overcome th i s prob lem, GAAPa l lows companie s to u se a cos t f lowassumption to value inventory and costof goods sold in a consistent and sys-tematic manner that best reflects income.Companies must use a cons is tent

method over t ime, which means a com-pany can’t simply switch cost flow assump-tions year to year. By consistently applyinga cost flow assumption to value inven-tory, the cost of goods sold will also beproperly stated. If a company changes itscost flow assumption, it is considered achange in accounting method and mustbe disclosed in audit reports.There are four cost f low assumptions

that can be used: first-in, first-out (FIFO),last-in, f irst-out (LIFO), average cost,or specific identification, which are sum-marized in Exhibit 1. (Note: IFRS does

not al low the use of LIFO, which is oneof the mos t s i gn i f i c ant d i f fe rencesbetween it and U.S. GAAP.)In practice, cost of goods sold is really

the difference between goods availablefor sale (beginning inventory plus pur-chases) and ending inventory. As longas management’s method of inventoryva luat ion approx imate s cos t and i sapplied in a consistent manner, the com-pany’s financial statements are compli-ant with GAAP. Determining if inventoryapproximates cost and is applied in aconsistent manner is usually determinedby the company’s outside auditors, whowil l issue an unqualified opinion on thefinancial statements.During an external audit , the audi-

tors w il l test the company’s inventoryvaluat ion methodology to determine ifit approximates cost. If it “passes” theaudit tests, inventory is considered prop-erly valued. If the tests are not passed,the company may need to adjust inven-tory to obtain an unqualif ied opinionon the financial statements.

Lean inventory valuation and GAAPcomplianceOne of the major impacts of lean is sig-nif icant reduct ions in inventor y overt ime. It’s common to see annual inven-tory reductions of 25–50 percent as leanpract ices become established in manu-facturing operations. A common goal inlean is to have inventory levels of 30–60days or less. When inventory levels reachthis range, the financial r isk of inaccu-rate inventory valuat ion decreases sig-n i f i c ant ly, and the r i sk of mater i a lmisstatement of profit is reduced. Lowinventories also create the opportunityfor accounting to use simpler methodsto value inventory and cost of goods soldfor financial report ing purposes.Lean inventory valuation methods use

the cost flow assumption of average cost.With low inventories, it’s easy to identifythe actual material and production costs,especia l ly when us ing a va lue s t reamincome statement. Calculating the aver-age cost can also be done at a higher levelthan each part, which is the basis for sim-plification of inventory valuation.

THERE IS NOT ASPECIFIC METHODLEAN COMPANIESHAVE EMPLOYED

TO SIMPLIFYINVENTORY

VALUATION, BUTTHERE ARE

ENOUGH LEANCOMPANIES THATHAVE DONE THIS

TO PROVIDEGUIDANCE ON

HOW TO CREATE ACONSISTENT

METHOD THAT CANBE USED OVER

TIME TO COMPLYWITH GAAP.

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Migrat ing away from a typical stan-dard costing system, in which each uniquepart it costed to a simpler system, is a two-step process. First, determine the lean-est, simplest system to value material,then determine how to capitalize pro-duction costs. The greatest opportunityfor s impl i f icat ion and el iminat ion ofwork is in how a lean manufac tur ingcompany capitalizes production costs.There is not a specific method lean

companies have employed to s implif yinventory valuation, but there are enoughlean companies that have done this toprovide guidance on how to create a con-s is tent method that can be used overt ime to comply with GAAP.

Lean inventory valuation: MaterialCalculating the value of material inven-tory is generally dependent on three fac-

tors: the number of purchased items, pricestability, and rate of flow of materials.For a company with thousands of items,

calculating the average material cost perunit should be done at either the indi-vidual item level or by common productfamily. A company with few items of pur-chased raw material or components cando an overal l average material cost.For stable material prices, the average

cost may be calculated less f requently(annua l ly or semiannua l ly) . In caseswhere material prices are highly volatile,the average cost may have to be calcu-lated more frequently, such as monthly.The final factor in calculating average

material cost is the rate of f low of mate-rials, which is typically measured in daysof inventory. The rate of flow helps deter-mine which costs to average. For exam-ple, if a company has 30 days of inventoryon hand, this means that the inventory

17LEAN INVENTORY VALUATION JANUARY/FEBRUARY 2018 COST MANAGEMENT

EXHIBIT 1 Codified Cost Flow Assumptions

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18 COST MANAGEMENT JANUARY/FEBRUARY 2018 LEAN INVENTORY VALUATION

was purchased in the last 30 days, and aver-age cost would be calculated based on costchanges over the last 30 days.The fol lowing sect ions prov ide two

examples of the actual mechanics of leaninventory valuat ion for material.

Many purchased parts and mult iple value

streams. Most manufacturing companiesfal l into this category. In this case, sim-plif icat ion comes mostly f rom gett ingaway f rom a unique standard cost foreach part and moving to an average costfor each part or product family, whichcan simply be last pr ice paid in a lowinventory environment.It’s most practical to continue to track

material quantit ies and transact ions inan ERP system, given the number of partsand volume of t ransact ions. The ERPsystem wil l continue to value each rawmaterial part individually and, based onthe transact ions, w il l also value mater-ial inventory in total and material costof goods sold.

Few pu rchased pa r t s a nd f ew va l ue

streams. If a manufacturing company fallsinto this category, additional simplifica-tion can be done by getting away from indi-v idual par t cost ing and moving to anoveral l average cost. In this case, pur-chases can be expensed directly to thevalue stream income statement. At month-end, the value of material inventory cansimply be calculated by the quantity ratioof material on hand to total material pur-chased. Material inventory can be recordedby using a journal entry between inven-tory and cost of goods sold.In both examples, GAAP inventor y

valuation compliance is achieved becauseactual material costs, either per unit oran overa l l average , are being used tovalue material inventory. The material coststhat appear on a value stream incomestatement wil l represent the actual costof materials consumed to generate the rev-enue recognized, which meets compliancewith the matching principle.

Lean inventory valuation: Capitalizationof actual production costsThe leanest method for capitalizing actualproduction costs into inventory is to dothis at the level of total production costs

rather than on a part-by-part basis. Asimple journal entry at the end of eachmonth wil l adjust the capitalized pro-duct ion costs on the balance sheet toactual. Here is the process a lean com-pany usually follows to capitalize actualproduction costs using a journal entry.The first step in the process is to gather

actual production costs for the period. Ina lean company,creat ing a va lues t ream incomestatement for eachvalue stream is thebes t method togather actual pro-duc t ion cos t s .Many lean com-panies use thevalue stream income statement approachbecause oftentimes value streams pro-duce different products and have differ-ent cost structures. A value stream incomestatement approach works well to achievea “cons is tency over t ime” that GAAPrequires in regards to production costs.The next step is to determine the best

method to use to calculate the value ofcapitalized production costs each month.Exhibit 2 shows some s implif ied pro-duction cost capitalization methods thatlean companies have used. What methodworks best for a company must be spe-cific to that company.Each of these methods uses a simple,

but consistent, rat io to determine whatthe capitalized production costs need tobe on the balance sheet at month-end.The adjust ing journal entry is simply todebit or credit capitalized product ioncosts and cost of goods sold so the bal-ance sheet equals the calculated amount.GAAP requires the capitalization of pro-

duction costs to be consistent over t ime,so it’s best to take some time to study this.Based on experience, it’s best to tr y afew methods over t ime before making afinal decision.If a lean manufacturing company is

audited, it’s also best to bring the audi-tors in on this discussion, as they will wantto be able to perform the necessary audittests on any simplified valuation method-ology. External auditors a lso look forconsistency in histor ical margins and

THE PRIMARY BENEFITOF LEAN INVENTORYVALUATION IS THEELIMINATION OFUNNECESSARY WORK,WHICH CREATESCAPACITY (TIME) TOREALLOCATE TO OTHERTASKS.

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his tor ica l capacit y, and these fac torsmust be taken into considerat ion.

Getting started with lean inventoryvaluationAfter lean inventory valuation methodsfor material and capitalized productioncosts have been decided, a date needs tobe set to cut over to lean inventory val-uation. The end of an accounting periodis best because changes need to be madein the ERP system. For accountants, thisprocess is similar to conducting a phys-ical inventory, where shop floor operationsare locked out of performing transac-tions, so the physical inventory quanti-ties can be adjusted to actual. The stepslisted in Exhibit 3 are then followed.

The benefits of lean inventory valuationGAAP for inventory valuat ion are morea se t of broad pr inc iples rather thanspeci f ied methodolog ies . Account ingprinciples focus on requir ing a consis-tent method of valuat ion over t ime thatproperly reflects the determinat ion of

income primarily by selecting one of thepermissible cost f low assumptions.Lean inventory valuation uses the aver-

age cost flow methodology and attemptsto get the broadest average possible. Pro-duction costs are capitalized at a macrolevel v ia a journal entry. Material aver-age costs can be by item level or at higherlevels, depending on each company’s spe-cific circumstances.The pr imar y benefit of lean inven-

tor y va luat ion i s t he e l im inat ion o funnecessary work, which creates capac-ity (t ime) to real locate to other tasks.Much of account ing’s work required inconvent ional inventor y valuat ion is nolonger required. The t ime and effor t ofsetting detailed labor and overhead ratesis el iminated. The t ime spent analyz-ing , explaining, and reconci l ing prod-uc t cos t in format ion , var iances , andabsorption is also eliminated. The aver-age mater ial cost is relat ively s imple tocalculate and probably doesn’t need tobe updated too of ten unless the mater-ial is a commodity.Lean inventory valuation can transform

the traditional cost accounting function

EXHIBIT 2 Production Cost Capitalization Methods

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20 COST MANAGEMENT JANUARY/FEBRUARY 2018 LEAN INVENTORY VALUATION

into a proact ive team member of leanoperations that provides relevant finan-cial information and analysis to makesound business decisions that support alean business strategy.Lean inventor y va luat ion a lso pro-

vides benefits to operations through theel iminat ion of produc t ion-repor t ingtransactions. Many transactions requiredunder conventional inventory valuationmethods are not required under leaninventory valuation, which frees up oper-at ions capacity that can be real locatedto fi l l ing customer orders.

Practical adviceIt’s up to the accounting function to leadthis effor t, because inventory valuat ionis a f inancia l account ing requirementunder GAAP. Begin with the goal in mind— maintaining GAAP compliance in theleanest way possible. Each lean manu-factur ing company must create a leaninventory valuat ion methodology thatworks best for itself in comply ing withGAAP and being consistent over t ime.

Learn from others; talk to other leanmanufacturing companies that use leaninventory valuation. Learn how they madethe transition, the issues they faced, andthe methods they use. There are both pri-vate and public lean companies that havetransitioned from standard costing sys-tems to lean inventory valuation systems.If you use externa l auditors , br ing

them into the discussion early and havethem partner with you as you transit ionto lean inventory valuat ion. They wil lprovide ver y clear guidance on main-taining GAAP compliance.Lean inventory valuation represents a

great oppor tunit y for the account ingdepartments of lean companies to elim-inate unnecessar y work, create capac-i t y, and use that capac i t y to prov idevalue-added ser v ices to your internalcustomers. n

NOTES1“FASB Accounting Standards Codification Topic 330,

Inventory ,” FASB (2014).2 Ibid.3Op. cit . note 1. 4 Ibid.

EXHIBIT 3 Steps to Begin Lean Inventory Valuation