When Better Operations Make Reported Profit Look Worse

Darren Dolcemascolo

More than a decade ago, I worked with the CEO of a privately held custom product manufacturing company facing serious financial pressure.

The company carried too much inventory. Cash was tied up throughout the operation, lead times were long, and customer orders moved through the business far more slowly than they should have.

The CEO understood the severity of the situation. He was not pursuing Lean as a corporate program or management fashion. He was trying to improve the company’s operating performance and preserve its future.

Working together, we made substantial progress.

Inventory declined significantly. Cash flow improved. Orders moved through the company faster. The business became more responsive to customers and less dependent on carrying excessive amounts of material.

Operationally, the changes were working.

But the owners saw something different.

The Accounting Signal Conflicted With the Business Reality

As the company sold existing inventory and did not immediately replenish it, reported short-term profit appeared to decline.

This can occur in manufacturing organizations using absorption accounting. When inventory is produced, a portion of fixed manufacturing overhead is assigned to that inventory and carried on the balance sheet. When inventory levels increase, some costs that would otherwise appear on the income statement remain embedded in inventory.

Reducing inventory can create the opposite effect. Costs accumulated in previous periods flow through the income statement as the inventory is sold, while less current-period overhead is deferred into newly produced inventory.

The business may be generating more cash and operating more effectively, while reported accounting profit temporarily looks worse.

That was the conflict in this company.

The CEO focused on cash flow, working capital, lead time, responsiveness, and the company’s ability to survive.

The owners focused on the apparent decline in short-term profit.

The Improvement Was Rejected

The owners did not object because frontline employees had gained too much authority. They were not concerned that problem-solving had moved closer to the work. They did not believe that respect for people threatened their status.

Their objection was financial—or, more precisely, based on the way financial performance appeared on paper.

They removed the CEO and attempted to reverse the direction he had established.

Inventory was increased again, eventually reaching levels even higher than before. The accounting results may have appeared temporarily more favorable, but the underlying business condition deteriorated.

The company ultimately went out of business.

Lean Did Not Fail

It would be easy to describe this as another failed Lean transformation.

That would be the wrong conclusion.

The operating improvements produced the intended effects:

• Inventory was reduced.
• Cash was released.
• Lead times improved.
• Orders moved through the business faster.
• Customer responsiveness increased.

The methodology worked.

The failure occurred because the organization’s governance and performance measures did not support the economic reality of the improvement.

The owners evaluated the CEO’s decisions using a short-term accounting signal that conflicted with the company’s actual operating and financial condition.

The improvements were not abandoned because they failed. They were abandoned because the people with ultimate authority defined value differently.

The Problem Was Not Resistance to Change

Executives are often described as resistant to Lean, resistant to employee involvement, or unwilling to relinquish control.

Those explanations may apply in some situations, but they are frequently too vague to be useful.

In this case, the owners were not resisting change in the abstract. They were responding to a specific measure that told them the company was performing worse.

The problem was not simply leadership attitude. It was a failure to align:

• the business condition;
• the definition of value;
• operational measures;
• financial interpretation;
• governance expectations;
• and the time horizon for evaluating results.

The owners believed they were protecting the company’s financial performance. In reality, the measures they relied upon encouraged decisions that consumed cash and weakened the business.

Measures Shape Decisions

Organizations often say they want lower inventory, better flow, shorter lead times, and improved cash generation.

But those objectives will not survive if leaders are rewarded or evaluated primarily through measures that encourage the opposite behavior.

A company cannot reliably pursue flow while celebrating inventory growth as profit.

It cannot prioritize cash while managing exclusively through income-statement effects.

It cannot ask leaders to improve the operating system and then punish them when the accounting consequences of that improvement appear unfavorable in the short term.

Measures do more than report performance. They influence what leaders perceive, which tradeoffs they accept, and which actions they reward or reverse.

When measures conflict, the organization will eventually follow the one connected to authority, compensation, or governance.

The Executive Question

The most important question is not whether leadership supports Lean.

It is:

Do the organization’s measures, governance mechanisms, and decision processes reinforce the operating results it claims to want?

Leaders should examine several questions before launching or evaluating major improvement work:

• Are financial and operational measures telling a consistent story?
• Could a genuine operating improvement create a temporary adverse accounting effect?
• Does the board or ownership group understand that effect?
• Are leaders rewarded for cash generation and enterprise value, or primarily for short-term reported earnings?
• What time horizon is being used to judge the work?
• Are the measures helping leaders understand the business condition, or obscuring it?
• Could the organization reverse a successful improvement because the wrong metric appears unfavorable?

These questions should be addressed before the improvement becomes politically vulnerable.

Execution Reliability Requires Alignment Above the Process

Improving the process is not enough.

The leadership and governance system must be capable of recognizing the improvement, interpreting its effects correctly, and sustaining decisions long enough for the organization to realize the value.

That requires alignment among:

• business conditions;
• objectives;
• measures;
• leadership ownership;
• operating cadence;
• financial understanding;
• and follow-through.

When those elements are aligned, operational improvement can translate into sustained business results.

When they are not, even a highly successful improvement can be reversed by leaders who believe they are protecting the company.

The lesson from this company is not that Lean failed.

The lesson is that execution becomes unreliable when the organization’s definition of value contradicts the business condition it must address.

Would you like to discuss how EMS Consulting Group can help align operating measures, governance, and execution priorities?  Contact us.

This article reflects EMS Consulting Group's perspective on execution reliability, operational excellence, financial interpretation, leadership governance, and the systems required to turn improvement activity into sustained business results.