The Reality of Lean Financial Statements
At a recent event, a CEO wondered how to deal with an economic downturn in demand. “What would a lean CEO do?” I am excited to answer this question because it highlights the importance of lean financial statements.
First of all, no statement can provide the complete and final answer to this question. Although one of the most important purposes of a business is to provide a financial return (or adequate cash flow for nonprofit organizations), financial statements are meant to provide some of the feedback results for decisions. They provide data on what has been, not on what should be. What matters most for decision-making (thinking before the fact) is having the information that is really needed to support the evaluation stage when setting out and considering the available options. This is where lean management financial statements are essential. Lean financial statements provide the necessary information, and it reflects real-world costs, unlike standard cost-based statements.
One of the characteristics of lean financial statements is that they separate (1) the costs that are driven by volume from (2) the costs that are variable only in the medium term or are fixed. This is extremely important when making decisions about elastic demand and how to deal with it.
Standard cost systems, on the other hand, assume that all manufactured costs are completely variable. As a result of this hidden assumption, when forecasting the impact of additional sales, the impact on profits is underestimated. And, when forecasting the impact of lost sales, the reduction in profits is underestimated.
For example, if the “gross margin percentage” (gross margin includes both variable and fixed costs) adds up to 25%, this suggests that for every dollar of lost/gained sales, there is a $0.25 impact on profit. However, if the “variable margin percentage” (variable margin is based only on variable costs) adds up to 50%, a typical ratio, then the impact of lost/gained sales is $0.50 per $1.00 of lost/gained sales. And, of course, not all products have the same ratio.
If you thought that a new sale would add twice as much profit as you think now, how would that change your decision processes?
In a lean financial statement, the difference between variable margin and gross margin is clear. In addition, the GAAP (Generally Accepted Accounting Principles)-specific accounting transactions for inventory valuation are separated from the actual cost elements. This provides a direct and obvious clarification for decision-making.
Harvard Business Review published an article indicating that 50% of CEO decisions are made by intuition. Perhaps, with lean accounting providing hard and accurate information, the use of intuition as a primary tool could be reduced, adding confidence and reliability to the decision-making process, and the bottom line would probably increase.
Portuguese translation by Tamiris Masetto Manzano.
