Month: September 2018

A standard costing system generates rate & volume variances by design. Standards are entered into the system, actual is reported into the system and variances are created. Because standards are used to value inventory and cost of goods sold, actual variances are reported on the income statement to bring the financial statements back to actual. In a “traditional” manufacturing company these variances are often used as performance measures by operations itself, senior management and/or accounting. The definition of a performance measure being “to measure and manage operations.”

A standard costing system is also designed to maintain GAAP/IFRS compliance regarding inventory valuation. GAAP/IFRS states a portion of manufacturing production costs must be capitalized on the balance sheet as inventory in a consistent manner. A standard costing system within an ERP system automates this process. This process creates overhead absorption on the income statement, which can be favorable (increasing profits) or unfavorable (decreasing profits). Overhead absorption is also often used as a performance measurement.

Because variances and absorption both appear on an income statement, the accounting function of a manufacturing company must be able to understand, analyze and explain these numbers to perform the necessary function of financial analysis.

When a manufacturing company begins its Lean journey, the entire infrastructure built to support the standard costing system & related analysis must also adapt to Lean. Here is how the accounting function can lead this process.

Variances as Performance Measurements

Using variances as performance measurements in a lean manufacturing company will not work. Variances are designed to drive mass production manufacturing behavior – building inventory, long production runs and buying lots of raw material to get a lower price. Lean practices totally opposite of this.

Accounting must accept & understand this, and must explain this to any other part of the organization that believes differently. Accounting must also get behind 100% on deploying lean performance measures. Accounting may not have to do the actual deployment, as many experienced lean practitioners can do this. At a minimum accounting needs to participate in the development of the measures, actively support their operational uses and learn how to integrate these measures into their financial analysis.

Variances on the Income Statement

It’s easy to “stop” using variances as performance measures and replace them with lean performance measures. But the standard costing system is still being used and variances will appear on the income statement. The good news is that accounting has the opportunity to lead in modifying the standard costing system to potentially eliminate some or many of the variances on the income statement.

The first step for accounting is to team up with some IT and manufacturing people to study exactly how your ERP system calculates variances. Determine if it is possible to change ERP settings to “turn off” variance calculations.

Next, learn exactly what “actual” information the ERP system uses to do its calculation (every variance is simply actual to standard). Study the manufacturing floor to learn how that information gets into your ERP system. Get IT to set up a test database of your company and practice not entering actual transactions and look at the impact on your income statement. Here are some examples of what to try:

• Stop reporting actual labor and machine time to work orders
• Stop reporting differences in material SKU’s used to work orders
• Implement back flushing reporting

After learning how the ERP system reacts to changes, you can make the necessary changes in your live database and shop floor reporting to eliminate variances.

Based on personal experience, I am confident you will find some ways to eliminate variances on the income statement if you make an investment in time to learn specifically how the ERP system works.

It’s important for accounting in a lean manufacturing company to address standard costing variances early in the Lean & Lean accounting journey. Educate the company on why standard costing variances will not work in a Lean manufacturing company. Support & assist Lean operations in developing and maintaining lean performance measures. Finally, dive into your ERP system and make the necessary changes in the system. You will be pleased with the results.

If you are in the accounting department in a lean manufacturing company, and your company uses a standard costing system, it is inevitable that the accounting department will be faced with confronting how its standard costing system is being used.

I stress the term inevitable,because based on my own experience both as a CFO and a consultant, I have seen it happen consistently. Sometimes the confrontation will occur early in the lean journey, sometimes later, but it is going to happen.

My advice to the accounting people in accounting departments of lean manufacturing companies is to lead rather than react. Be the leaders of proactively evaluating how the standard costing system is being used as your lean journey begins and come up with a plan.

Coming up with a plan is not difficult, as long as you understand the issues. Fortunately, these issues happen to be very common across lean manufacturing companies that use standard costing systems. For the next few blogs, I am going to write in detail about the issues, look into exactly why these issues occur and lay out solutions.

I see 6 issues that accounting will have to deal with in a lean manufacturing company:

1. The financial & operational impact of variances and overhead absorption
2. The financial impact of inventory reduction
3. Internal financial analysis & business decision making
4. Inventory valuation
5. Maintaining GAAP/IFRS compliance
6. Other – such as transfer pricing or maintaining local regulatory compliance

Before we get into the issues, I think it’s important to get some background on why standard costing even becomes an issue in lean manufacturing companies.

The Root Cause

The primary root cause of why accounting will have to deal with standard costing is twofold. Accounting needs standard costing to value inventory but lean operations does not need, nor have any use for, the performance measurement & financial analysis aspects of a standard costing system.

Conflict between accounting and lean operations occurs when each side doesn’t understand each other’s reasoning.

Lean operations people don’t like the performance measurement & financial aspects of a standard costing system because standard costing systems are based on mass-production manufacturing practices and lean operational practices are 100% opposite of mass-production practices.

It’s important for accounting to recognize this and not try to force lean operations to use standard costing information to measure or manage lean operations.

Accounting needs standard costing to value inventory for GAAP/IFRS compliance. In most manufacturing companies with high inventory and many SKU’s, this is the simplest and easiest way to value inventory. And ERP systems are set up to do this, which automates the process. Accounting has another obligation, which is being able to explain the financial impact of the financial information a standard costing system produces, such as variances, absorption and margin.

It’s important for lean operations to understand accounting responsibility for maintaining GAAP/IFRS compliance and “stop using standard costing” is not a simple to do.

First Steps in Leadership

I mentioned earlier that accounting should lead the discussion on using a standard costing system in a lean manufacturing company. Here are 4 initial leadership steps accounting can take.

• It’s a company problem not an accounting problem. Accept that your lean manufacturing company will have to deal with standard costing. Information from standard costing systems are used in all parts of a manufacturing business, and for many different reasons. The entire company will have to be part of the solution.
• It’s a long journey not a short destination. It’s going to take time to adapt, improvise & overcome a standard costing system. Just like a Lean journey, there will be successes, and adjustments along the way. The larger to company, the longer it will take.
• Begin communication of the issues. The CFO needs to begin talking to senior management. The controller needs to engage lean operations management. The entire accounting function needs a continuing dialogue on this topic. Begin laying out the specific issues your company is going to face over the long run.
• Lean accounting practices & methods do provide a path & solution to resolving these issues in your lean manufacturing company. Learn about Lean Accounting.

In the next blog, we will begin discussing the issues in detail.