Essential Information for Finance, Lean, Six-Sigma, & CI Teams

Executive Summary

When organizations are faced with financial and operational challenges, the CFO is often looked upon as the “go-to” person expected to provide leadership that will navigate the organization through troubled waters.?Unfortunately, many executives having this responsibility may not have the wherewithal, tools, or systems to succeed during economic challenges and they, in turn, reach out to others for assistance.?As such, the CFO and the Finance team often have a symbiotic relationship with other improvement initiatives such as Lean, Six-Sigma, Continuous Improvement (CI), etc., that depend on and trust Finance to provide timely and accurate financial information.?However, according to the Chief Financial Officer Insights from the 2017 IBM C-Suite Study…

?“Only 16% of the CFOs believe the finance organization is effectively combining information from different parts of the enterprise – of vital importance.”

?A critical component to effective financial and operational performance management is accurate data by which informed management decisions can be based.?To that end, organizations rely mostly on financially-based costing systems which are void of the necessary information to make such decisions and, as such, the wrong conclusions usually result in the wrong solutions.?For example, an important component missing in most managerial cost-accounting systems is the inclusion of non-financial information – critical to the determination of value.?Information, including perceptual and experiential data, is often missing and is most critical in the identification of value or the lack thereof.

?In addition to understanding critical financial and operational information, executives need tools to gain a more accurate and truer picture of the costs and profitability of their products and services.?However, financial information alone is not enough to identify breakthrough opportunities in performance.?Tools necessary to improve financial and operational performance should include, but are not limited to, the means to lower costs, improve quality, enhanced revenues, engaged employees, mitigate risks, and not just create satisfied customers but a growing legion of loyal customers as well.

The information contained in this paper provides the informational linkages necessary to achieve, oftentimes breakthrough, improvements in organizational performance on several levels – costing, revenue production, value improvement, all while achieving improved stakeholder satisfaction and loyalty – the goals and objectives shared with Lean, Six-Sigma, as well as a host of other improvement initiatives.

?Introduction

Given the responsibilities that the Chief Financial Officer, or CFO, and their Financial staff have regarding their support of performance improvement, their role can be described in terms of the timeframes that form the basis of their responsibilities…

…whereby:

• Past – Controllership responsibilities that include reporting historical financial performance.
• Present – Administration of the day-to-day responsibilities of the Finance function including regulatory requirements such as Sarbanes-Oxley, ASC 606, etc.
• Future – The CFO is responsible for leadership and partnership along with other C-Level peers for the financial and operational well-being of the organization.?The CFO has been specifically chartered with the responsibility for identifying, from a financial perspective, where the organization is performing well along with identifying areas where enhancements are required to meet financial and other organizational objectives.?To carry out their responsibilities, their role includes supporting performance improvement efforts within the organization.?This role is getting more attention these days due to more global competition, economic upturns (opportunities), and downturns (crisis management).

Symbiotic Relationship

Given the responsibility of Finance and FP&A to lead the efforts to improve operational performance and the reliance upon Finance by Lean, Six-Sigma, Lean Six-Sigma and Continuous Improvement initiatives to provide accurate cost information, a symbiotic relationship should be established between these entities.??

Also, Finance can utilize these initiatives as tools or “levers” that can be pressed to carry out the improvement objectives expected from Finance.

?There are numerous programs and methodologies designed to enhance performance aimed at cost reduction, revenue improvement, quality improvement, customer satisfaction, employee engagement, etc., but these techniques are often disjointed and void of critical information that might tie these initiatives together to achieve overall performance objectives.?Let’s start with product and service financial analysis.

Assessing the Financial Situation - Product and Service Costing

One of the first steps taken by CFOs and their Financial Planning & Analysis (FP&A) staff to understanding the financial well-being is to determine the costs and profitability in for-profit or spending in public-sector and non-profit organizations.

?Oftentimes, the first place to seek understanding of the financial well-being of the organization is to examine the organization’s financial statements.

First, let’s describe the most commonly applied cost-accounting systems:

Conventional Absorption Cost Accounting (ACA) – Having its roots going back to over a century, conventional absorption costing remains the dominant method that is used for costing products and services.?As the name implies, ACA is the method by which Overhead and Indirect (O&I) expenses are commonly “allocated” to the Lines of Business (LOB) or outputs of the organization.??O&I costs are allocated to the LOBs typically using metrics associated with each LOB.?Such metrics include direct labor costs, machine hours, number of employees, floor space, and revenues.?For example, LOBs having proportionately greater revenues often subsidize LOBs having smaller revenues that may, in fact, carry greater O&I expense.?O&I costs, sometimes exceeding 50% of all spending, are typically aggregated then allocated to the LOBs using one or more LOB-identified metrics.?The major drawback is that resulting LOB costs may be grossly inaccurate as LOBs will be assigned costs unassociated with the creation, selling, and delivery of the specific product or service.?Also, changes in the metric’s volume may not necessarily be accompanied by a change in O&I spending.

Cited in the January, 2017 McKinsey white paper “Who Should Pay for Support Functions” – “…one of the basic problems with allocation practices: they often result in business units [LOBs] paying for costs that they cannot control [costs not incurred by the LOBs]” and “…what [leaders] want most from an allocation system is actionable information.”

Conventional Driver-Based Activity Based Costing (ABC) – ABC utilizes a two-stage process for costing LOBs.?First, resource costs are allocated to activities, then secondly, activity costs are allocated to products and services which creates the potential for significance errors.

Stage 1, the first source of error.?Resource costs are allocated to the activities using resource drivers.?A commonly used resource driver is the distribution of total effort expressed as a percentage of time or Full-Time Equivalency (FTE) effort as per the instructions given by a leading ABC software tool – “wages coming the GL system will be allocated to activities according to the distribution of total FTEs associated with those activities.”

Perhaps the easiest way of describing this method is by a simple example.?a) Assume a department consisting of a manager and 3 other employees, b) total department wages are $400,000 per year, c) each employee represents 25% of total FTE effort, and d) each employee performs only one unique activity.?The following table shows how the wages are distributed to the activities performed:

Although total department costs can be assigned to activities, the error within each activity is quite significant and becomes more inaccurate and misleading if additional activities are performed by the department (including shared activities among departmental employees along with cross-functional activities performed across departmental boundaries).

Stage 2, the second source of error.?The manner in which activity costs are allocated to cost objects (e.g., LOBs, channels, customers, etc.).?A single principal Activity Cost Driver (ACD) is identified for each activity and an average cost per ACD is computed and used to assign activity costs to objects based on the consumption of the number of drivers consumed by each object.?The two main issues associated with this approach are: 1) the selection of a single driver that represents the cost behavior of the activity when, in actuality, the activity may be influenced by a multitude of drivers, and 2) the use of an average ACD rate.?The ACD rate may be comprised of a wide dispersion of costs for which the average rate often is not representative of any individual product or service.?Also, ACD rates contain both fixed and variable costs, yet are treated as purely variable for which product or service costs vary directly with changes in ACD volume.?As a result, LOBs receiving the activity costs in this manner will be over- or under-costed.

Time-Driven Activity Based Costing (TDABC) – TDABC is a costing method that uses the time required to complete each step in a process to produce a product or deliver a service.?The cost of a product or service is determined by multiplying the total time required to complete a series of process steps by the capacity cost rate, whereas the capacity cost rate (expressed as a cost per unit of time) is determined by the total cost of capacity supplied (such costs include personnel; benefits; management; occupancy; utilities; equipment costs; and allocated indirect and overhead spending) divided by the practical capacity of resources (expressed using a unit of time) within a given time period.?Similar to ACA, indirect and overhead costs are “allocated” (in many cases in an arbitrary manner) such that they represent an overhead cost to the department that is performing the prescribed process.?Since managerial and O&I costs are blended into the total cost of capacity supplied, the activities associated with these O&I costs cannot be determined so the value resulting from such costs cannot be established.?Since many tasks that, at best, can be identified as “knowledge work” or variable in time consumption, such activities cannot be described in terms of specific process-step time and therefore, they cannot be adequately costed and yet may represent a significant portion of total spending.?To refer to TDABC as activity-based costing may be a misnomer as it does not follow the tenets associated with conventional ABC and more closely resemble Industrial Engineering process-based costing and ACA.

It is oftentimes believed that errors (over and under costing) associated with conventional driver-based ABC and TDABC tend to cancel each other and any residual errors are insignificant and immaterial. On the contrary, such errors compound – errors in object costs resulting from inaccurate activity costs which, in turn, result from errors in resource-to-activity allocations are magnified and as such resulting object costs cannot be relied upon to make informed management decisions.?Oftentimes, because of such errors, total ABC or TDABC costs do not match total expenditures as reported in the GL, undermining management’s confidence in the results.

?If the answers to the following questions regarding managerial cost-accounting systems leaves much to be desired, consideration should be given to an alternative approach.

1. ?Is the way you compute and measure product/service costs and profitability hurting the organization’s ability to make informed decisions?
2. Do you know exactly what employees are actually doing to create value?

A Unique Perspective of Managerial Costing – Activity Value Management

Activity Value Management (AVM) – AVM is a new way of thinking about cost and the ultimate use of financial and non-financial information to achieve breakthrough opportunities in performance management.?Unlike ABC and TDABC, AVM has its roots, not in accounting, but in the integration of process/activity analysis following the tenets of Value Engineering.?As such, AVM extends beyond simply costing, but focuses on value creation necessary to improve performance while enhancing stakeholder loyalty and engagement.?The objectives of AVM are to:

• Improve LOB costing by eliminating the types of errors found in more conventional approaches;
• Diagnose performance in terms of costs, profitability, customer loyalty, employee commitment, processes, and activities – a precursor to Lean and Six Sigma initiatives;
• Focus on value creation and cost optimization rather than cost reduction;
• Improve customer loyalty while improving employee engagement and satisfaction;
• Enhance resource utilization, productivity, and strategic alignment;
• Provide knowledge transfer and engage the entire workforce in the improvement effort.

These objectives are achieved by…

1.???Using a revolutionary costing approach that directly assigns all organizational cost and effort simultaneously to activities, products, and services without any intermediate cost aggregation, averaging, or indirect allocations characteristic of more outmoded techniques.?All costs (including O&I costs) are treated as direct to improve accuracy and precision of costing and profitability assessment while preserving a bi-directional audit trail between all resource costs, activities, and cost targets.?Since all unbundled costs, gleaned directly from both the GL and HR systems are directly assigned, the outcomes match GL costs and, as such, may be considered as being closely GAAP compliant.

2.???Delivering a business assessment system that improves financial and operational performance by seamlessly linking qualitative experiential stakeholder input with activities, costs, and cost targets, then applying a unique set of prescriptive analytical tools to identify breakthrough opportunities.

Unlike most financially-based quantitative methods described earlier which are void of qualitative stakeholder input, AVM provides the connections between customer/employee commitment and organizational performance.

The project structure represents a “tops-down” approach to ensure that the diagnostic outcomes will gain the utmost support and commitment from upper management necessary to ensure success.

The project is managed by a Certified AVM Specialist working in tandem with an Internal Facilitator (for knowledge transfer) as well as a cross-functional AVM Implementation Team, all reporting to a “C-Level” Oversite Committee.?Once the diagnostic assessment is performed and target areas selected, the Implementation Team, along with the Internal Facilitator, will facilitate a number of project teams (Lean and Six-Sigma teams may be utilized for this purpose) responsible for developing/implementing solutions – all reviewed and approved by the Oversight Committee.?This structure overcomes a number of common obstacles associated with Lean, Six-Sigma, Continuous Improvement, and many other improvement initiatives (e.g., leadership, time, project selection, and ensuring that the right data is utilized).?The study follows a comprehensive and comprehensible project plan that is relatively straight-forward and time/resource efficient…

Step 1: Planning.?During this step, organizational information is capture; processes and activities defined; the data-collection schedule is developed; and the project is introduced to all management personnel.

Step 2: Data Collection.?Quantitative data collection is performed whereby a profile for each resource component is established, defining the cost and/or effort attributed to the activities performed for each product/service target.?Note, for employees both the cost and a measure of effort are used, permitting measurements such as staffing by activity or activity fragmentation (defined as the number of employees engaged in an activity as compared to the FTE equivalent).???Qualitative experiential data is captured from stakeholders (e.g., employees, customers, customers of competitors, vendors, etc.) representing issues, concerns, roadblocks, and performance opportunities for which the information is assigned to processes, activities, and product/service targets.

Step 3: Synthesis.?Various diagnostic reports are defined, produced, reviewed, and updated if necessary.

Step 4: Data Analysis.?Diagnostic information is analyzed necessary to identify the most opportune areas requiring corrective and/or improvement actions.?Normally, the most important 5 to 7 target areas are selected for specific solutions which are proactively managed by the AVM Implementation team.?The remaining opportunities are addressed on an on-going basis.

Step 5: Solutions.?Specific solutions are developed including, but not limited to, financial analysis, resource requirements/responsibilities, milestone metrics, progress reporting, etc.

Note: The Oversight Committee is briefed after each step in the process to ensure that time and resources remain committed, and any roadblocks are removed.

Lean vs Relevance

Lean – Much has been written regarding the benefits associated with Lean Management.?There are numerous variations as to the definition of Lean.?However, the most prevalent theme regarding Lean Management is…

?The removal of waste from processes – less materials, less human effort, less time, less space, less energy, etc.

?Relevance – On the other hand, AVM focuses on relevance which addresses the necessity of the process or activity in relation to the strategic direction of the organization.?Relevance and Lean work hand in hand with the first diagnostic assessment being that of relevance, or alignment, of the activity with the strategic direction of the organization and secondarily to perform relevant processes and activities using Lean thinking.?In other words, Relevance takes precedence over Lean.?There is no need to improve a process that should not be performed in the first place – commonly referred to “paving a cow path.”?Additionally, there is no greater Lean improvement than total elimination.

?Common Tools & Analytical Analysis

AVM employs numerous strategic and tactical tools which augment those of Lean, Six-Sigma, etc., –?some of which are oftentimes considered “off limits” to Lean/Six-Sigma teams but directly contribute to organizational performance…

…with the following preliminary target areas based on:

Overcoming Resistance

The AVM system is designed to produce significant results in the form of solutions designed to improve financial and/or operational performance.?Change will be required and often change is met with resistance as people naturally feel more comfortable with the status quo.?However, if the Management Oversight Committee expects, and is given the possibility of, significant results, they will be more committed to supporting the effort and implementing the recommended changes.?However, the challenge that remains is overcoming resistance by those more directly affected by the change.??In addition to the tools often associated with Lean management, AVM provides additional “ammunition” that might be necessary to motivate those impacted by the change.?Below are just two strategies that can be used to reduce resistance:

• Provide Overwhelming Information – The lack of supporting information is often the underlying cause of resistance.?To reduce resistance, information must be generated to build the case necessary to “disrupt the status quo.”? Lean, 6S, and CI teams have the obligation to validate the viability of projects in terms of financial/operational benefits or outcomes.?Any pertinent and missing information will create uncertainties regarding the change proposal.?However, the AVM approach provides the causal metrics as to the reasons for the recommended change, for example:
• The true cost and effort associated with processes and activities as well as both the cost and profitability of the lines of business (LOB) along with the bi-directional audit trail that provides the necessary supporting evidence which cannot be generated using conventional managerial cost accounting systems as described earlier.
• Unnecessary and avoidable overlap and duplication of effort by process, activity, and LOB.
• Negative stakeholder experiential information regarding the performance of processes, activities, and LOBs.
• Fragmentation – activity fragmentation is a major cause of inefficiencies.
• Misplaced effort – work performed by the wrong people in the wrong departments.
• Inappropriate utilization of resources – people working below their grade level, highly-compensated employees performing work that should be performed by lesser-compensated employees.
• The amount of non-mission and/or non-critical work performed within each department that does not align with organizational strategies.

Note: The above information can be produced manually for smaller organizations, but larger organizations greater than 50-75 employees may require some computing muscle necessary to process the information.

Evaluate Risks and Rewards of Change – Oftentimes, rather than accepting some risk to achieve a greater good, many play it safe by focusing on short-term initiatives or to adhere to the status quo.?Borrowed from psychology, the Risk/Reward matrix can be used to clarify the risks and rewards associate with implementing organizational change.?The purpose of this matrix is to compartmentalize fears and/or objections to organizational change and hopefully minimize any possible risks.

Oftentimes the worst-case outcomes of not attempting the change (quadrant 4) can be rather dire, such as declining financial performance, loss of jobs, and perhaps even the closure of the business.?The question that remains - “Is the organization willing to risk the worst-case outcomes of attempting the change (quadrant 2) to avoid the worst-case outcome of not attempting the change (quadrant 4), and to hopefully achieve the best-case outcomes of the attempting the change (quadrant 1)?” More often than not, this matrix will help clarify the advantages and disadvantages associated with organizational change.

Case Study

A financial services organization was facing a $25 million profit shortfall and to mitigate this challenge they embarked on several responses:

• ?Implemented Lean Six-Sigma – struggled with a slow start and little bottom-line impact.
• Hired a “Big-5” consulting firm – failed to quantify a perceived “revenue leak.”
• Unsuccessfully initiated an Activity Based Costing (ABC) study.

?In addition to the financial shortfall, management expressed additional concerns regarding the:

• Lack of understanding of the true cost and profitability for 15 lines of business (LOB).
• Flat revenue growth over the previous 4-5 years.
• High number of customer complaints and defections (60% churn every 2 years).

?In summary, what they did…

• Formed both an Executive Oversite Committee and a cross-functional AVM Implementation Team.
• Defined nearly 500 cross-functional processes and activities (2 weeks).
• Captured and directly assigned the cost and effort of nearly 2,400 employees and 7,000 non-personnel expenses to all activities in support of 15 LOBs – performed without using pooling, aggregation, or allocations.?Captured nearly 2,600 performance-related commentaries from employees, existing customers, customers of competition, and defected customers related to issues, concerns, roadblocks, and opportunities all of which were assigned to the costed processes and activities – linking financial data with performance information necessary to assess value (5 weeks).
• Synthesized the information necessary to identify over three dozen opportunities related to improving financial/operational performance as well as customer loyalty and employee satisfaction.
• Presented their findings to the Executive Oversight Committee to distill the opportunities down to the top 5-7 opportunities for which the Oversight Committee identified four major areas in which to concentrate…

In summary, a sampling of what they found and for which solutions were implemented…

• ?The cost and profitability of each LOB.?Any cell in the following reports can contain experiential information captured from customers, employees, and perhaps customers of competitors regarding issues, opportunities, and possible solutions.?Each cell contains a complete audit trail of specifically-identified component cost and effort (personnel and non-personnel) captured by activity, department, and LOB.

• Because a mature LOB was originally believed to have both low and declining profitability (based on an absorption cost accounting system), customers were being migrated to a highly technical replacement offering.?It was discovered that the mature LOB was actually operating at a 45% operating margin while customers were migrated to the replacement offering operating at a negative 13% margin – the source of the $25M profit shortfall.

• Customer churn was a major concern of management, knowing that it represented a loss of revenues and a high cost associated with responding to the issues expressed by customers.??The process of “Supporting Customers” was costing nearly $24M annually (nearly 10% of total spend) yet garnered close to 500 experiential stakeholder comments and was cited as a major cause of customer defection.?The cost of Customer Support consisted mainly of $13.6M from Sales and $8.7M from Operations.?Input from Sales identified this effort as representing nearly 200 FTEs within Sales and was non-mission-related work as the primary group responsible for customer service was not in Sales but resided in Operations.?Sales performed this work because of the lack of trust of Operations to resolve customer issues and they expended this effort to salvage discontented customers necessary to preserve revenues.?Unfortunately, customer dissatisfaction continued.?Also cited was the dissatisfaction on the part of Sales personnel associated with the loss of commissions from new sales due to the diversion of effort to customer support.?This non-mission diversion of Sales effort was eventually determined as a source of lost revenues of $45M annually.

Note: To demonstrate the importance of capturing activity effort in terms of FTEs in addition to costs, is that activity fragmentation (e.g., the comparison between the actual number of employees engaged in an activity and the FTE equivalent) will identify excessively fragmented activities which negatively impact productivity.?Also, the cost per FTE can be computed and used as an indicator to identify work activities that could be performed by lesser-compensated employees while freeing higher-compensated and experienced employees to concentrate on more mission-critical activities.

• Of the nearly 500 stakeholder experiential comments captured that related to customer support, many of which were negative as well as offering possible opportunities.?Given the previous finding, an analysis of the Sales organization in terms of effort was performed whereby a 50% improvement in mission-related activities was achieved by shifting non-mission-related effort expended on supporting customers to their mission of generating revenues resulted in an additional $45M of annual revenues – a remarkable achievement given that revenue growth had been flat for the previous 4-5 years.

• The AVM Implementation team, working with other functional areas, took responsibility for re-pricing service offerings (both higher and lower) to improve profitability, re-designed the Sales compensation plan, identified LOBs that should be sunset, and restructured the number and location of Sales offices – all such actions would have been traditionally considered “off-limits” to previous Lean Six-Sigma teams.

Case Summary

Due to the discoveries attributed from a thorough diagnosis of total operational performance, the organization refocused their Lean Six Sigma initiative, and working in partnership Finance, “moved the needle” with regard to implementing over $30M (>11% of total spending) in repeatable financial improvements, achieved additional revenue growth of $45M (12.5% growth) , both of which were accompanied by a significant reduction in customer churn achieved by enhanced customer satisfaction/loyalty – all accomplished without any negative impact on staffing.

?Contribution to Performance-Improvement Initiatives

Oftentimes, selection of performance-improvement projects is based on the “squeaky wheel” or intuition.?The data-driven improvement cycle that forms the basic tenet of Lean and Six-Sigma - Define, Measure, Analyze, Improve and Control (DMAIC) - is missing an important element – Diagnosis.?You cannot define what you have not diagnosed!?The prescriptive diagnostic capabilities of AVM will identify the most opportune areas of concentration for other improvement initiatives such as Lean management, Six-Sigma, Lean Six-Sigma, Continuous Improvement, and Balanced Scorecard to ensure the highest possible ROI by focusing on the most important areas that hold the promise of performance improvement.

?Brian Higgins is a Principal at Management Resource Technologies, Ltd., in Aurora, Colorado.?Mr. Higgins has extensive experience in the development of advanced FP&A systems associated with performance management.?He can be contacted via LinkedIn at linkedin.com/in/brianhiggins5

?