Lebanon Gasket Company

I. Summary of facts
* Lebanon Gasket Company’s Topeka, Kansas Facility began operation in 1979.
* The company had operated in using mass production.
* In January of 2004 LGC had about 109 employees.
* The LGC Topeka plant relies on two main manufacturing processes – injection molding and extrusion molding.
* The injection molding process has three main product families- OS1, TX4 and KC13, more than 100 product models are produced across these three product families.

* The extrusion molding process has two main product families-LX22 and KB8, more than 75 product models are produced across these product families. * LGC hired Tom Walsh as the plant manager of its Topeka Facility in January of 2004. * Tom Walsh has 20 years of experience as a manufacturing engineer; his knowledge in accounting is very limited. * Walsh’s job at LGC was to turn around the plant that had been suffering from declining profits and margins, excessive waste and inventory levels, unsatisfactory on-time customer delivery performance, and shrinking market share * The plan to achieve this was to focus on one core strategy, “Operational Excellence”, by focusing on a lean production strategy. * 18 months later the LGC, with Walsh and his co-workers had accomplished many goals related to the plans lean transition. * Implementing the lean approach dramatically changed the goal of the Topeka plant’s manufacturing processes and the routings for all of its products. Previously, the goal of the plant’s mass production process was to achieve the lowest possible cost per unit by maximizing employee and equipment productivity. * Even after a successful transition in the plant’s production strategy, the profits continued to decline. * The Financial and Production Departments are blaming each other for the issues with the declining profits. II. Major Problems

Tom Walsh’s strategy at the Topeka facility was to focus on operational strategy. Following this approach he started a transition to lean production. Even though the lean training program helped to improve order-to-delivery cycle and consequently sales, the financial results were still unfavorable. The goal of the plan’s cellular oriented lean approach is to deliver customer-driven value and Tom Walsh believed that once this goal was achieved by properly managing the manufacturing floor, financial results would improve. However, this was not the case. Walsh asked for the assistance of his Finance Manager Mike Dwyer to explain the reason for declining profits. Dwyer pointed out three operational efficiencies: 1. Purchasing agents were paying too much for raw materials (Unfavorable direct materials variance) 2. An unfavorable direct labor variance indicated a high level of labor inefficiency; and 3. An unfavorable overhead variance indicated poor equipment utilization and overhead cost recovery.

Dwyer suggested that the costs could be reduced by laying off a few laborers due to the low level in efficiency. Walsh is not comfortable with the idea of laying off employees and believed that if the production process had been changed dramatically, the finance function had to change as well. In addition, he believed that since Dwyer was planning on retiring soon, he had no interest in critically reviewing the department’s procedures and reporting practices. Three main questions would help solve the problems at the Topeka plant: 1. Do the traditional accounting practices adopted in 1979 support the new lean environment? 2. How can the accounting function aid in decision-making regarding capacity planning, aligning employee incentives with goals and product mix decisions? 3. How can the accounting function aid value stream profitability analysis, linking strategic goals to operational performance measures and eliminating non-value added activities. In the following sections we present an analysis of operations and accounting data to find a solution to the problems at Topeka Plant.

III. Discussion

The Lebanon Gasket Company (LGC) hired Tom Walsh as the plant manager of its Topeka, Kansas, facility in 2004. LGC was impressed by Walsh’s 20 years of experience as a manufacturing engineer, including four years of employment as a manager in Toyota’s Georgetown, Kentucky, facility. Walsh’s charge at Topeka was to turn around a plant that had been suffering from declining profits and margins, excessive waste and inventory levels, unsatisfactory on-time customer delivery performance, and shrinking market share. To overcome these problems, he focused on one core strategy, “operational excellence”. Walsh intended to abandon the mass production mindset that had guided the Topeka plant in favor of the lean thinking approach he had seen work effectively at Toyota. After practicing lean production 18 months on the job, two value streams and four manufacturing cells up and running, and other goal accomplishments, Walsh realized the financial results were disappointing.

The absorption income statements showed that the plant’s net operating income and return on sales had continued to decline from the 11.5% that was reported for the fourth quarter of 2004. In addition, organizational in-fighting was at an all-time high since the Finance Department blamed the Production Department for the plant’s declining performance, and vice versa. Walsh was concerned and stressed, he wondered “Where do I go from here?” He decided that it was time to have a conversation with his Finance Manager, Mike Dwyer, to explore the role accounting in a lean enterprise and to get an explanation for the plant’s shrinking return on sales. Realizations came about regarding the 109 employees at Gasket and about “injection molding and extrusion molding”, the two main manufacturing processes that produce a variety of rubber sealing systems for automotive, healthcare, plumbing, and telecommunications applications. Walsh retained all employees when transitioning to lean production with the belief that layoffs would lower employee morale and decrease the likelihood of a successful lean implementation.

Implementing the lean approach dramatically changed the goal of the Topeka plant’s manufacturing processes as previously, the goals was to achieve the lowest possible cost per unit by maximizing employee and equipment productivity. The goal of the plant’s cellular-oriented lean approach is to deliver customer-driven value. Dwyer identified three inefficiencies that dealt with cost inputs of raw materials, direct labor, and overhead. Walsh was confused by the language and terms of accounting and it was difficult for him to understand. Dwyer suggested lying off employees, but Walsh did not like the idea. Dwyer was disinterested in the lean concept as he has had more than 30 years of experience with standard costing. Dwyer was planning to retire in the near future and didn’t have an interest in critically reviewing his department’s procedures and reporting practices. Walsh realized that he needed consulting advice and met with three consulting firms. Finally, Walsh hired Lean Enterprise Development from Chicago, Illinois to help him recover the company. IV. Suggested Solutions

The traditional accounting practices adopted by the Topeka plant in 1979 to support its mass production process have no value in the lean environment. When a company adopts Lean Production it is required to adopt Value Stream Accounting or Lean Accounting reporting methods as well. Lean Accounting shows the potential value of the various performance improvements during a lean transition. Conventional cost systems designed for mass production environments cannot provide insights into either 1) What causes the decreased profits, and 2) The real benefit of going Lean. The core problem is that conventional cost systems do not map cost to value streams; instead, they link them to production processes and then to products. Lean Accounting focuses on each stream line and produces independent financial information for each segment. In other words, traditional cost systems view the production process as a series of independent steps performed in geographically isolated machining or service processing centers, not as an integrated flow along a value stream. Absorption Income Statement

Mass production
Variable Cost Income Statement
Lean Production
To illustrate better the differences between Mass Production Accounting methods and Lean Production Accounting methods, let’s take a look at some numbers from the Absorption Income Statement and the Variable Costing Income Statement.

Variable Cost Income Statement provides a better picture of the financial advantages of Lean Production. Return on sales had a dramatically increase of 2% after the adoption of Lean Production. Unfortunately, an Absorption Income Statement does not show the real improvement after the lean transition.

Another way to look at the advantages of Lean Accounting reporting methods would be the following graph: There is clearly a positive trend under the Lean accounting reporting methods (Variable Cost). While there is a negative trend under the mass production reporting methods (Absorption Cost).

Another advantage of Variable costing income statement is that information is divided into value stream lines. Variable Costing Income Statement allows accountants and other stakeholders to see the contribution of each segment to the company. Overall the company seems to be doing better after the Lean Production transition, but that does not necessarily means that every segment is accepting the change.

If we divide the Variable Costing Income Statement into manufacturing segments we get the following information:

This section of the Variable Costing Income Statement clearly shows a lower return on sales on the Injection Molding value stream line. This figure is a red flag showing that some part of the Injection Molding segment is not performing as desired. If we go even deeper into the Injection Molding section of the Variable Costing Income Statement we get the following information:

A deeper analysis of the Variable Costing Income Statement shows that the OS1 portion of the Injection Molding segment is running at a loss. The reason is clear, the contribution margin is not enough to cover fixed expenses. Since we cannot lower fixed costs, the only solution to this problem would be to increase production of OS1 to increase the contribution margin. In order to increase production of OS1, management has to come out with an employee incentive program to encourage employees. Overall the company is doing better under the Lean Production procedures, but we cannot ignore the fact that a section of the Injection Molding segment is running at a loss. With a good capacity planning and an employee incentive program we can bring this section to positive numbers, and raise even more our return on sales. In conclusion, implementing lean accounting reporting methods will show the real financial performance of the company after the lean transition. Implementing an employee incentive program will result in more production. Raising production on OS1 will create profit on the only segment running at a loss, resulting on an even greater return on sales.