2.16.2016

Traditional Accounting Systems -- They Don't Properly Value Time

Lean advocates have long been critical of the fact that traditional accounting systems motivate over-production and promote building inventory. In her book, The Monetary Value of Time: Why Traditional Accounting Systems Make Customers Wait, the author, Joyce Warnacut, discusses the fact that traditional accounting systems don’t properly value time. I asked her directly: "How is this different from the Lean perspective?" and here is her complete response:

Lean objections are based on the fact that absorption costing requires overhead allocation. The cost per unit is driven down by making more and spreading the cost over a larger number of units. H. Thomas Johnson (Professor of Business Administration, Portland State University) wrote the following in his article Work Lean to Control Costs: “Producing more and more output to reduce average unit costs is a time-honored pathway to excess, delay, and abnormal variation – prime drivers of higher total cost.”

These concerns are valid, and yet the total impact of traditional accounting goes far beyond overhead allocation. The matching principle, one of the foundations of traditional accounting, requires matching of production cost to revenue. This means that if you spend $1,000 making a product this month, but don’t sell it until next month (or next year), the matching principle requires you to stash $1,000 away in inventory. This puts the $1,000 on your balance sheet as an asset and keeps $1,000 in production costs off your profit and loss. The $1,000 will be recorded as a cost of sales at the time the product sells (i.e., the cost will be “matched” to the revenue).

Note that the $1,000 cost – and the resulting profit from the transaction – is exactly the same whether the product sells today or several months from today. Is this true? Inventory costs (storage, handling, carrying costs, planning, expediting, moving, counting, potential obsolescence, etc.) are allocated in some fashion over production. The allocation may be as simple as units or hours (volume-based allocations are by far the most common) or a more complex allocation formula.

But no matter what formula is used, the cost recorded for that particular product is the same whether the product is sold immediately or held in inventory for months. Intuitively, most people would think that product sold directly off the production line contributes more to the bottom line than product that is carried on the books for a month or more. From an accounting perspective, however, this is generally not the case.

Resources that are invested in inventory are valued no differently than resources invested in product that can be converted to cash immediately. What if our accounting methods put a value on time? What if product cost increased for every day the product was held in inventory? What if our shop floor operations were evaluated based on how quickly they turn orders into cash? What different motivations might this create? What changes would be made in how we allocate resources?

Although accountants recognize the time value of money when comparing investment alternatives, the same principles are not applied in how we value inventory, how we allocate resources, nor in how we evaluate the profitability of our products. 

What do you think of Joyce Warnacut's perspective here? Does your organization function under a traditional accounting system? Have this system undercut the true value of your Lean initiative?

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