This article is also an old one dusted off and improved, but a critical consideration if you want to be agile or use Agile, DevOps, or Lean!
To a large extent, a traditional industrialized worldview drives the makeup and use of conventional financial metrics, which is an ill-fitting match for agile environments. This challenge is not new to agile environments but quickly became apparent when organizations started embracing Lean in the 1990s.
Why are traditional financial ratios so problematic and often misleading in Agile, DevOps, and Lean environments?
Some background to the conversation is essential. Although some evidence of the use of financial ratios dates back to 300BC, the proliferation of investing in companies as a business; highlighted the utility of financial ratios. The problem they solved was simple. Using ratios allows investors to compare investments in companies that are vastly different in makeup, industry, risk, and market. Using ratios, an investor can consider if they should invest in a company manufacturing wooden boxes in India, an auto manufacturer in the USA, or a financial institution in the EU. Looking at the key ratios makes it easier to make the call.
There are different types of financial ratios that inform investors or shareholders about various aspects of the business, including;
- liquidity ratios measure a company’s ability to repay both short- and long-term obligations,
- leverage ratios measure the amount of capital that comes from debt,
- efficiency ratios (also known as financial activity ratios) measure how well a company is utilizing its assets and resources,
- profitability ratios measure a company’s ability to generate income relative to revenue, balance sheet assets, operating costs, and equity, and finally
- market value ratios evaluate the share price of a company’s stock.
We are not suggesting that none of the traditional ratios is useful in Agile environments. But, you can quickly see that many of these ratios will tell a pretty different story if measured over a month, six months, a year, five years, or even ten years, depending on the window of the view.
The problem with traditional accounting practice (and financial ratios) is that it thinks about financial reporting periods as something with a beginning and an end. Therefore, it is also simple to apply the traditional measurements and measurements to waterfall projects — after all, the definition of a (waterfall) project states that it has a beginning and an end. In this instance, it’s pretty easy to calculate ROI by comparing the cost versus benefits realized (and yes, you need to consider the time value of money and all that stuff).
The way one looks at the performance of the business in Lean is very different.
There is a focus on improving all performance measures continually — there is no beginning and no end. Therefore, most traditional financial ratios and accounting practices do not make sense when using Lean (or agile). Using traditional ratios may lead to short-term improvements with negative long-term results. Lean would instead make long-term improvements, often even if it means negative short-term results.
Lean companies soon found that radically different financial practices were needed that involved a much broader systems view of the organization and what constitutes ‘good’ financial performance. The moment this realization dawned, Lean Accounting was born.
So what does this have to do with Agile?
Well, since in Agile there is no start or end date of a project (there is, in reality, no project, just the delivery of value in short increments), there is no upfront or finite view of what we will do over time, as requirements are allowed to evolve constantly, we cannot make a decision based on ROI, IRR or MPV, or any of the traditional ratio’s we use when considering an investment in new or improved products delivered the Agile way either, a different set of measurements is needed.
What makes it worse is that we expect continual improvement (which traditionally was an operations activity exclusively) to form part of every iteration in an agile environment, blurring the lines between ‘operation projects’ and ‘operations run environments’ even more.
As with Lean environments, the correct measures of success now becomes;
- Improving flow
- Improving quality
- Improved performance (delivery, lead times, productivity) and, as a consequence
- Improved profitability
The focus of Lean (Agile) accounting is to have a broad, system view. We may report on improvement in a specific window to course-correct, but we understand that these reports are an interim measurement and do not necessarily reflect the company’s long-term health.
This changed view means that the practice to fund a department or a project no longer makes sense. Since an organization’s income directly relates to its products’ performance, it is more prudent to fund products where the funding is both project/change and operations run. We must think about the entire value stream that creates, sells, services, and maintains the product — yes, end-to-end. This systems view is a significant departure from what accountants learn at university!
The new Lean/Agile way of looking at return on investment (ROI) is more holistic. To effectively measure investment performance, we must contrast the total of everything that consumes resources across the value stream with gains achieved by selling a product to customers. Reporting must become a time-sliced instance compared to performance, over time, on a continuum, rather than reporting that reflects company performance as a series of un-related instances.
You may argue that the total cost of the value stream that derivers a product versus the income derived from that product is still essentially ROI, and yes, it is. But, how does that help us in the future? Past ROI is a very unreliable measure of the future ROI of new initiatives or product performance.
The problem with ratios like ROI is that they are lag indicators — it may tell us that we did not achieve the desired return on investment, but it is useless as a measure to continually and quickly course-correct. It is for this very reason that Lean accounting focuses on improvement as a lead indicator of performance.
Interesting side-note: One of Toyota’s goals is to improve everything in the company every year by 2%. It sounds like little, but they have achieved that since 1950, and the compound effect is huge!
If we improved some stuff this month and last month, and the month before, we should be well on our way to improved ROI. If we have not improved this month, we need to do something immediately to correct the course.
An initiative of the Agile Alliance between 2012 and 2016 to address agile accounting standardization, judging the initiative’s output, largely failed to look at agility as an integrated, value-stream-wide, continuous approach to evaluate financial performance in Agile environments.
Lean accounting, for now. It is the best way to look at investment decisions in an Agile environment, but it requires a substantial shift in our understanding of what accounting is and how we do it in an organization.
So what is the point of all this?
Focus on improvement and metrics that are lead indicators. Financial reports hardly ever positively change organizational performance, but focusing on performance on a day-to-day basis, that’s a different story!
Be proactive, make a difference, and if you need to make a call on which products to offer, other methods like Agile ADapT are available to help you make that call!
One of my bugbears is how traditional management and financial metrics undermines business agility efforts. Especially some financial measurements make it very difficult for organizations to reap the results of agile or lean efforts.
Eli Goldratt famously said that not removing controls put in place to lessen the effect of a bottleneck, will also lower the benefits of improvements made to remove the bottleneck.
You have to remove the controls when you implement the solution. This applies to accounting controls as well!
Draw this line of thought through to all the improvement efforts you are busy with, and you will be amazed at what you can achieve!