No, this is not a blog post about losing weight or getting leaner, rather it is about LEAN Accounting. My colleagues over at the LEAN Accounting Blog recently published a great article on Why LEAN Really Matters. Many people do not understand LEAN Accounting and I believe if they did, they would be more profitable.
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The purpose of LEAN Accounting is to support LEAN practices as a business strategy. It seeks to move from traditional accounting methods to a system that measures and motivates excellent business practices in the LEAN environment. LEAN is a process that considers the expenditure of resources for any goal other than the creation of value for the end customer to be wasteful, and thus a target for elimination. Working from the perspective of the customer who consumes a product or service, "value" is defined as any action or process that a customer would be willing to pay for.
Recently, the LEAN Accountants sat down with business executives to discuss LEAN and its benefits. We discussed how LEAN is for more than just manufacturing and how its concepts can be implemented in other non-manufacturing industries, such as construction or service organizations. Through the discussion, we talked about the key concepts of LEAN (the Eight Deadly Wastes) and the tools available to eliminate these wastes, such as Value Stream Mapping, 5S, Standardized Work, Total Productive Maintenance, Cellular Manufacturing, and Set-up Reduction, just to name a few.
During the discussion, we kept thinking about the value of LEAN and how a simple change in efficiency can reap huge long-term profitability benefits. A simple change in a production line or a process flow in a back office could increase output without increasing operational costs which is pure bottom line profit.
As we thought deeper into these profitability gains through increased efficiency from LEAN, we started to think more about the real long-term benefits of LEAN. For the business owner, what benefits does LEAN provide long-term?
McKonly & Asbury, LLP works with a number of family owned businesses. Most of these businesses have a few shareholders and most of them are primarily S-corporations. At the end of the day, these owners have invested their lives into their business and for most of them, their business is the single biggest asset in their personal investment portfolio. These owners are always looking for ways to maximize the value of their business and increase their cash flow after taxes.
For these business owners, the greatest benefit of LEAN is not going to be the short-term cash flow improvements through efficiencies gained. No, in fact, we would argue that the greatest benefit to the business owner through the implementation of LEAN will be the long-term increase in business value that the owner will recognize.
As LEAN operations are implemented, more likely than not, the business owner will see an increase in overall business value. Even if top line revenues would remain flat, if profit margins are improving then bottom line profit and cash flow income will certainty follow. What this means for the business owner is improved cash flow short-term but an increase in long-term business value.
Most business valuations of ongoing businesses will look at two main factors to determine value: Income Stream and Marketability. The income stream is usually based upon free cash flow of the business. The traditional methodology is looking at the businesses EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). With a few adjustments for working capital and capital additions, most value is based upon this cash flow analysis. Improving efficiencies in operations will drive improvements in free cash flow even if top line sales are flat or even slightly down. Free cash flow is about what cash is free and available to the business owner once all expenses of the operation are paid. Having increasing revenues but no available free cash at the end does not increase the value of a business, contrary to popular belief.
From a marketability perspective, acquirers will look at a business’ cash flow stream and pay a market multiple for that cash flow stream based upon similar or recent transactions. Most acquirers of businesses want to know what the true available free cash flow from a business is. When acquirers review the books and records of a company, they will want to see the historical results of the business as well as what the future projections of the business are. A business investment in LEAN that increases business value through additional available cash flow can drive benefits to the acquirer that they will certainly pay for through the purchase price of the business.
Showing improvement in margins due to LEAN implementations will drive future cash flow improvements. These future cash flow improvements will be part of any acquirer’s analysis of future projected cash flows. Strong margins and strong cash flow will certainty make a company more attractive with a higher purchase value. This along with unique LEAN operation methods will also provide a differentiating factor that will possibly command a higher purchase value or multiple of earnings.
There are many justifications for why LEAN is important. Outside of those traditional justifications of internal process improvements and customer satisfaction, it is clear that LEAN will provide long-term benefits typically not discussed in most circles of the LEAN world. When thinking about implementing a LEAN project, remember to include in your analysis: 1)Potential increase in long-term business value; 2) Increased marketability of the business due to LEAN operations; and 3) Attractiveness to a potential acquirer due to improved margins and cash flow.
For further information on this article or about LEAN, please contact me.