Amortization

The concept of amortization is that the initial payment for an intangible asset does not always correspond to the useful life of that asset.

For example, let’s assume that your company bought the rights to a brand, such as “Twinkies”. That would be a sizeable expense that has to be paid right away, but the benefit would be spread out over a long period of time as the snack cakes are produced and sold. If you just took the expense in the year when the rights were purchased, your company would face an incredibly bad first year, and then incredibly good years for the subsequent years.

Amortization is controlled by accounting rules, so companies are not able to take liberties with its application and create potentially fraudulent financial results.

Amortization generally applies to things like patents, copyrights, or goodwill. Goodwill is a specific financial term for the inherent value of an acquired company above and beyond the book value of the assets that came with it.

You may find some other unique assets that can be amortized, such as taxi licenses or the like, but those will still have specific rules that pertain to them.  Only qualified financial gurus should determine what can be amortized. They are also the ones to determine how to best amortize the asset.

The concept of amortization is also used to describe the adjustment of the value of a loan on the books.

Amortization is for intangible assets. Depreciation is very similar but is for tangible assets. That includes things like buildings and capital equipment.

Continuous improvement efforts are much more impacted by the financial decisions surrounding physical assets than intangible ones. But there will be some effect on your improvement efforts by how you amortize your non-physical investments, though.

Continuous improvement changes the nature of the equations for the financial team. With larger growth due to the ability to provide more value at a lower cost, the expectations change when a Lean company takes over an asset. Your planners can count on a larger return on investment and can make the bet that your company can turn any assets it purchases into more profit than the prior owners did.

This creates a lot of pressure on the team, though. More often than not, intangible assets are purchased when they are distressed. That means that they are underperforming, and it takes faith that your company can do better.

Amortization as a General Term

There is one other main area where the general concept of amortization affects your continuous improvement efforts. It is very similar to how setup time is applied to your products.

Setup time has to be allocated out to the parts that are produced during the period between setups. You can think of the setup as a loan, and the allocation to each part is the repayment schedule.

When you look strictly at the math, it seems that long runs are the best way to reduce the unit cost for setup.

The problem is that the amortization of setup time only covers part of the expenses associated with large batches. Larger batches present a host of other cost-sapping side effects.

There is the risk of unnoticed quality problems. There are larger storage costs. There is a need for more space to hold bigger batches. There is more risk for loss or damage with piles and piles of parts sitting around. And there is a problem that when you are trapped in long production runs, you can run out of the right product even though you have piles of inventory everywhere.

Setup reduction lowers the time that has to be allocated and changes the amortization calculations. In truth, you may end up with more overall setup time after your reduction efforts, but they will be smaller, more frequent changeovers that reduce other costs. When parts move in small quantities approaching single-piece flow, the cost savings from the whole system more than offsets the increase in per-part amortization of setup time.