It’s About Spending, Not Costs – Part 2

Last blog, I laid out my CFO experience (and probably yours) using what I’ll call “traditional” cost management methods.    In this blog, I will lay out an alternate (and I believe much better) way for Lean companies to manage costs.   As the Lean CFO Job # 1 for you is to transition your company away from traditional types of cost management and create a lean cost management system.

I call it: Lean Cost Management

Why do it? The short answer is:  the five Principles of Lean (which form the foundation of a Lean Enterprise) demand it.

Continuing to use traditional cost management systems in a lean company will create conflict.  A management “conversation” based on traditional cost management systems will invariably lead to discussing the wrong things – and traditional solutions which conflict with lean will be the result.

For the Lean CFO (and for you too, Reader!) “it’s about spending, not costs” must be your mantra.  By word and deed, the Lean CFO needs to send this message constantly and consistently.

Furthermore, I maintain you don’t need to concern yourself with trying to calculate the cost of anything!   Be it a product, customer, process, product line, etc.  – it’s all worthless information.   Focusing retrospectively on costs (as traditional methods do) leads to thinking about allocations and discussing the basis of allocations, and so on.    This ends up in a conversation that has nothing whatsoever to do with the root cause of the costs.  The truly Lean enterprise ought to be focused on creating customer value through Lean operational processes.  The truly Lean enterprise will foster a culture where the work of empowered people, who actually can get at the “Who, What Where Why and How,” use Lean continuous improvement to control costs and reduce spending.

Spending money involves making a business decision or taking some specific action. If decisions or actions can be changed, then spending will be changed. If spending can be changed, costs ultimately will change. This is the basis for having a Lean performance measurement system.  In operations, for example, you create simple, relevant measures that identify where lean processes deviate from or reinforce your Lean strategy. Then you use Lean improvement events to remove root causes and improve performance.

It’s the same for understanding spending.  The “simple, relevant measure” in Lean Cost Management is Value Stream Costing. Identifying issues and removing root causes is based on the weekly reporting of spending to the value streams.

How does this work?

The first component of a Lean Cost Management System is what we call “Value Stream Costing” (VSC for short.) VSC assigns actual, direct costs to value streams. All costs are assigned to the value stream where the spending actually occurs.  This means that costs that are traditionally allocated under a product costing system are no longer allocated.  You do this so lean problem-solving methods can be applied directly to where they can be acted on and can produce the right result. This is an example of what is meant by “Lean Pursuit of Perfection.”

Effective Lean problem-solving depends on identifying root causes.  Once a root cause is understood, it can be changed, eliminated or managed.   This is how continuous improvement is supposed to work in Lean manufacturing operations and likewise,   from a cost perspective, the root cause of the cost comes from some kind of decision or action.  By assigning actual costs where the spending decision occurs; and by not allocating these any further, we can get everyone in the company involved in root cause analysis of spending. This means “Empowering” the people to do what is necessary.

Then by increasing the frequency in which costs are reported, from monthly to weekly, it becomes easier to identify root causes and to change or reduce spending. Let’s look at some examples of how it becomes much easier to manage spending with VSC.

Material Spending

In financial accounting, there are components of inventory on your balance sheet.   In a Lean enterprise, using VSC, these are treated as expenses when incurred.  I know right now many of you are screaming “But that is not GAAP!”

Keep calm, and read on.  Remember what we are trying to do operationally is to reduce spending on materials.   For this we do not need a discussion about GAAP.  Instead, material spending needs to be analyzed by its components – price and quantity.  Bottom line here, we are looking at the Lean principle of FLOW.

In traditional product cost systems, typically all that matters is the lowest material price. Unfortunately, this leads to non-lean behavior like buying way too much material in order to secure the largest purchase price discount.  On the other hand, Lean companies recognize that price is just one component of the entire supplier relationship which also includes lead-time, delivery and quality. All four components must be considered in terms of specific performance required of suppliers to maintain and improve material flow within your value streams.  Lean companies understand the price they pay for materials is based on the value received from the supplier. In general, unless you can dictate all terms to your suppliers, it’s best to concentrate on developing excellent relationships with your suppliers based on the value you require from them.

Material quantity is where a real difference can be made in material spending. By reporting actual material spending on a weekly value stream income statement, the company can drive value streams to reduce material spending by using the following lean practices:

  1. Single piece flow: You establish single piece flow within your value streams by putting lean practices such as pull systems, kanban, and level scheduling.   When these systems are working well, you reduce the quantity of material purchased because you have limited it to actual demand plus some (small) buffer stock. Pure single piece flow may be difficult to achieve, but it should be your goal.  Use the right amount of materials in the right time frame and costs will take care of themselves.
  2. Reduced scrap and rework: By doing this, you will also reduce material spending. For this to work, you need to measure quality incidents at every production cell daily and in every value stream weekly.  Notice:  I said nothing about trying to figure out the cost of these incidents. The cost of failures is NOT relevant!  What actually happened in the value stream to cause the scrap and rework is what you are looking for.  Lean performance measures such as First Time Through or First Pass Yield will help you get at the true root causes of quality.   From this you can take corrective action.   The right corrective actions will take care of the cost.
  3. Product design: A Lean company also reduces material spending in product design.  They redesign products to use less material or they substitute less expensive materials when possible.   In all cases, Lean companies consider design changes in terms of customer value, not simply on material cost.

You will notice, throughout the discussion above, I have always tried to tie the actions taken back to the guiding Lean principle.    This same approach applies to managing spending of all other material costs within a company, such as manufacturing supplies, spare parts and office supplies.

Next time, we’ll tackle Labor Spending.

It’s About Spending, Not Costs – Part 1

During my days as a working CFO, my #1 job was financial review and analysis. I had to explain my company’s financial results to all those reading our financial statements.  Like all CFO’s, I had to understand the company’s costs, their trends and identify opportunities. I don’t think there is any CFO anywhere who wouldn’t like to reduce costs.

Our years of professional training and CFO experience teach us that cost analysis for financial accounting has to align with your financial statements, SEC reporting (if applicable) and industry standards.  Most all companies do a good job in this area.

That’s not what this blog is about.

Instead, I’m going to look at how a truly Lean company analyzes its costs internally. I maintain this is not a case where you can be “right, wrong, or indifferent.”  In fact, I strongly believe that how you, the CFO, analyze costs will have a crucial influence on the success and sustainability of Lean in your company.

Let’s get to it.

I’ll start with my experience (and probably yours) using what I’ll call “traditional” cost management methods.

Traditional Cost Management

The name of the game here is to establish rigorous links between operational performance and financial results. Companies using traditional cost management methods will typically use a variety of tools to do this:

Annual budgets are set and actual results compared to the budget.

  • Some companies create a financial forecast, which is essentially an updated budget, and do actual-to-forecast analyses.
  • Manufacturing companies use production-reporting systems to track and explain operational performance to plan.
  • Finally, companies use product-costing systems, such as standard costing and activity-based costing, to explain the impact of inventory on the financial statements.

These tools all share common characteristics:

  • They are based on analyzing historical costs.
  • They are complex and time consuming.
  • They use GAAP-based financial statements.
  • They rely on actual-to-plan analysis.

Analyzing historical costs – The analysis of any cost is historical. You are looking backwards to understand why a cost occurred. Sure, you can find out the reason the cost was incurred, but all you can do is explain it. You cannot change it.  It’s a little like doing an archaeological dig – you do all that work to develop information that you essentially can’t act upon.

Annual budgeting – Think about how much time and effort goes into your annual budgeting process.  In the end many people are skeptical of the budget and feel it’s out-of-date even as it is published.  Think also about how much time goes into your monthly analysis to explain the actual to budget numbers. If you have a standard costing system, think about how much time goes into setting standards, then comparing actual to standards. At the end of the day, how many people truly believe that these systems are very effective at what they are intended to do, namely, to manage costs?

GAAP-based reporting – Non-financial people in your company often have a difficult time understanding GAAP-based financial statements. They don’t understand the accruals, reserve adjustments and inventory valuation work that must be done to create GAAP-compliant statements.  Worse, they don’t understand why thinking about these, and talking about them in meetings has much of anything to do with what they are actually doing to meet customer demand and make money.

Annual budgeting – Finally, people seem to really dislike the annual budgeting process or annual standard setting process.  This is usually because of all the assumptions they must make about the future, the “fuzz factors” and predictions about what might happen months down the road. If your company creates a monthly detailed expense budget by department (many do,) you are asking your managers to be fortune tellers. They had better come up with the right predictions, or there will be some explaining to do – and hard questions to answer monthly about actual-to-budget results.  No one can accurately predict what business conditions will be like months in advance; if you could, you would make a lot of money doing that for a living.

Stick around. In my next blog, I will show you an alternate (and better) way for Lean companies to manage costs.