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Columnist: H. James Harrington

Photo: Scott Paton, publisher


Looks Good on Paper

Inflated accounting systems cost dearly in inventory, scrap and rework.


he heart of today's quality problems lies in an accounting system that has remained unchanged for more than 60 years. The cost accounting system used today in the United States and many other parts of the world is based upon the Sloan School of Management's M model (i.e., men, materials and machines).

Let's look at how the Sloan accounting model came into existence. In 1920 General Motors found itself in trouble, and Pierre S. du Pont bailed it out with a $38 million investment that put the DuPont company in charge. DuPont, which had created a fortune by manufacturing gunpowder, suddenly found itself actively involved in the automotive industry.

Due to its timely investment, DuPont was able to appoint key managers within GM. Donaldson Brown, often referred to as the father of modern cost accounting, was appointed treasurer, and Alfred Sloan, president. Sloan's approach to financial management was to maximize return on investment (ROI) for stockholders--and particularly, DuPont--with little or no focus on cash flow or market share.

The concept of focusing on investor ROI isn't all bad. After all, every organization has a primary obligation to provide a fair return to investors who supply the money that allows the organization to provide products and services to its customers. It's not a chicken-and-egg operation; an organization must have money before it can produce a product to sell. If it can't provide its investors with a better ROI than they can get elsewhere, the business will never be launched. Competition for investment capital is much fiercer than competition for external customers.

Sloan's and Brown's approach to financial accounting focused on defining what the organization would be worth if it were liquidated. You might think of this as a shortsighted way to look at an organization, but that was the way DuPont, GM and General Electric were--and still are--financially managed, and the way that most publicly owned companies are handled today.

The problem with this approach is that it assigns much the same value to inventory and cash. They're both considered to be assets, like working capital. To provide maximum value for this type of accounting system, management is pressured to keep personnel and machines operating at as close to 100-percent utilization as possible. This results in an increased focus on batch manufacturing processes, which require a push type of management system with large inventories. On the books this might look good, but from a practical standpoint it means devoting a large part of shop floor space to storage. At one point, Chrysler had 200,000 cars in its finished inventory.

This encourages organizations to adopt Sloan's accounting system, which allows products to be "sold" from one internal department to another, so that the sending department makes a profit on the transaction even though no money changes hands. This inflates an organization's value while it increases expenses, scrap and rework costs, and surplus-parts cost.

Sloan's accounting model has spread throughout the world. It's become the default system for public holding companies. It's embedded in the academic system, included in the CPA examination and is even codified into U.S. tax law.

I believe that the only real cash in an organization is what a customer pays for a product or service. Inventory is a liability, not an asset. An organization's key measurement should be market share and percent of profit (i.e., profit divided by total cost times 100). This is what I'd call lean accounting. It encourages a pull rather than a push manufacturing system. It also minimizes stock, which in turn greatly improves the number of inventory turns per year and the associated reduction in inventory costs, scrap and rework. This is the way Henry Ford Sr. first ran Ford Motor Co. and the way Toyota is run today. In 1923 Ford's River Rouge plant turned raw materials into finished cars in four or five days. Ford synchronized the manufacture of more than 100 cars per day--each car containing more than 6,000 parts--by using a "shortage chaser," a handful of "checkers" and a blackboard. Toyota does it with a few kanban cards. Is there really a need for complex, expensive manufacturing resource planning (MRP) systems? The object of an MRP is to drive the plant to an optimum inventory level, which is one that meets customer shipment needs at the greatest labor efficiency.

It's too bad that Ford gave up Henry Ford Sr.'s lean concepts and, like GM, installed the Sloan accounting system. This marked the downfall of the lean manufacturing movement in the United States.

If you think Japanese manufacturers invented lean, you're wrong. Toyota managers will tell you that they got their ideas from reading Henry Ford's 1926 book, Today and Tomorrow (reprinted by Productivity Press, 1988). If you haven't read it, I suggest that you do so as soon as possible.


About the author
H. James Harrington is CEO of the Harrington Institute Inc. and chairman of the board of Harrington Group. He has more than 55 years of experience as a quality professional and is the author of 22 books. Visit his Web site at www.harrington-institute.com.