Author: nkatko@maskell.com

Value Stream Costing Categories

In value stream costing, we like to categorize value stream costs either as direct costs; shared costs or business support costs.

Direct value stream costs are the costs that a value stream controls through operational activities and decisions. Direct value stream costs are rather easy to identify once value streams have been identified and mapped. From an accounting perspective, value stream direct costs can easily be charged to one value stream when posting to the general ledger. The cause – the spending decision and the effect – the expense posted to the general ledger, are quite clear, direct and natural. The 4 primary types of direct value stream costs are material, labor, machine/equipment costs and other direct costs. Each of these will be discussed in detail later.

Shared value stream costs exist because resources or consumption of goods & services may be shared by value streams. Shared value stream costs are operational in nature and each value stream can influence the total cost through operational practices and decisions, however the actual spending decisions and management of the costs are outside of any one value stream. The 3 primary types of shared value stream costs are facilities & warehouse; production monuments and operational support functions. Each of these will be discussed in detail later.

Business support costs are all the other traditional organizational costs that would be considered selling, general and administrative costs. These costs are typically not assigned or allocated to value streams.

In manufacturing organizations, there could possibly be a 4^thcategory of costs – product development. Lean manufacturing organizations consider product development a separate value stream, beginning with product concept and ending with product launch and there would be applicable direct value stream costs for the product development value stream.

Material

Value stream material cost is the actual cost of material consumed by a value stream, and can be identified either at the point of purchase or the point of issuance. Purchased material is used when the 100% of the material goes into one value stream.

If purchased material is shared by multiple value streams, then the material cost would be based on material issued to a specific value stream.

Using material consumed to establish direct cause and effect relationships between material entering a value stream and the 3 operational outcomes – produce and sell (which is the desired outcome); scrap or stock.

Labor

Value stream labor cost is based on the employees assigned to work in specific value streams. Through the process of value stream organization, value streams become the primary unit of operational organization, replacing operational departments.

Once these employees have been identified, the simplest method to assign the costs are through a company’s payroll system. Payroll systems have fields such as cost centers or departments, and this allows companies to assign employees and auto post labor costs to the general ledger. Auto posting of labor costs to value streams can be accomplished by modifying the proper field in your payroll system.

If this level of detail poses an issue due to the confidential nature of salaries, it is possible to assign labor costs based on ratio of full-time equivalent employees in a value stream to total employees in all value streams. If this method is preferred, it is recommended to only use whole numbers of full-time equivalent employees and avoid fractions or percentages.

Machine & Other Costs

Value stream machine/equipment costs consist of the depreciation, repairs/maintenance, tooling and utility costs. Value stream maps identify the specific machines in each value stream, and actual costs can be recorded into the general ledger through accounts payable process.

Any other cost which can naturally be charged in the general ledger to one specific value stream can be considered a direct value stream cost. Avoid creating allocation systems in accounting to try to be precise. It’s also important to consider the materiality of any other costs because in most cases labor, machine and material costs make up the majority of direct value stream costs.

In the next blog we will look at shared value stream costs.

Lean is a multi-faceted business strategy, with a primary focus on employees and learning. Through the use of various lean tools, practices and methods, employees learn to master their work, solve the right problems and help an organization learn how to doing things tomorrow it cannot do today. That’s why we should always talk about “lean thinking” as opposed to “doing lean”.

In the broadest possible context, lean accounting is a financial learning system for the entire organization, not just the accounting function. Because the economics of Lean changes the relationships between operations and financial numbers, the whole business must learn the new relationships and incorporate the dynamic context of these relationships in their financial analysis.

Deeply rooted paradigms exist about understanding and managing costs, usually based upon traditional financial management practices, industry practices or external financial reporting requirements. Many of these paradigms conflict with lean thinking, and if these paradigms are not changed, then eventually there will be conflict between the lean strategy and cost management & analysis practices.

The solution to this problem is value stream costing, which is a set of new paradigms based on the true cause & effect relationships between lean operating practices and costs. In this series of blogs, you will learn:

• The lean thinking cost paradigms which must be established in lean organizations
• The difference between direct value stream costs and shared value stream costs
• How lean organizations define fixed and variable costs
• Examples of typical value stream direct & shared costs

Lean Thinking Cost Paradigms

Value stream costing makes a lot of sense if it is viewed through the lens of lean thinking cost paradigms, so this is the first step toward establishing value stream costing in a lean organization. As you read through the following paradigm comparison, ask yourself 3 questions:

• Which traditional cost paradigms are present in my organization?
• At what organizational levels are these traditional cost paradigms entrenched?
• What level of discussion should be established to begin changing thinking towards lean cost paradigms?

Labor

For financial reporting, labor is an expense and because of this reporting requirement, it has created traditional thinking paradigms that conflict with lean thinking. Traditional financial thinking says expenses must be managed & controlled and possibly reduced due to business conditions. This leads to managing headcount, controlling salaries and when necessary reducing the number of employees in an organization.

Lean thinking organizations view people as their most important asset. Through the use of various lean tools, practices and methods, employees learn to master their work, solve the right problems and help an organization learn how to doing things tomorrow it cannot do today. That’s the idea behind the phrase “lean thinking”. Continuously improving productivity is what matters the most to a lean organization, and as a result labor expense will be controlled.

Time & Costs

Another traditional cost management paradigm is the perceived relationship between processing time and costs: the longer it takes to produce a product or deliver a service, the higher the costs. The genesis of this paradigm is based on the desire to understand the cost of individual products or services.

Lean thinking organizations view time as their second most important asset and develop a deep understanding of value-added activities and non-value added activities. The never-ending goal is to eliminate non-value added activities (“eliminate waste”), free up capacity (time) and apply this capacity to value-added activities. The cause-effect relationship is between revenue and value-added activities: the more time resources (people and/or machines) spend on value-added activities, the more revenue will increase. Sure, eliminating waste may achieve some direct cost savings, but it will not be to the degree that revenue will increase.

Cost Analysis

Traditional cost analyses are usually based upon complex allocation schemes in order to understand costs from many aspects, such as product/service costs, business unit costs and the cost of serving customers. The primary issue with cost allocation schemes is they try to allocate as many costs as possible and the allocation bases can be quite subjective.

Cost, or an expense on an income statement is an outcome, due to operating practices or managerial decisions. Lean organizations apply “lean problem-solving methodology” to cost analysis through understanding the dynamic relationships between operating practices and spending decisions, which results in preventing costs from being incurred.

Cost Management Objectives

The two primary traditional methods to manage costs are “actual-to-budget” analysis and requiring costs to be reduced. Both are “top-down” methods where the organization sets the goals and the rest of the organization must “make it happen”.

Contrary to what some people think, lean organizations are very concerned about costs. The general goal is to reduce costs over time through:

• Continuous improvement
• Clearly understanding the dynamic cause-effect relationships between operating performance, capacity requirements and actual costs.

Fixed & Variable Costs

Traditional definitions of fixed and variable costs are usually based on conventional cost accounting systems in manufacturing, where labor, material and overhead are assigned to products. In this environment, direct labor is often considered variable and in some systems a portion of overhead is considered variable.

Lean organizations tend to shy away from using these traditional definitions of fixed and variable costs. Variable costs are defined as costs that vary with volume in the short term. Fixed costs do not vary with volume in the short term and are typically influenced by management decisions.

In the next blog we will look in detail at value stream costing.

The purpose of a value stream income statement is to analyze current value stream costs compared to current value stream performance measures to determine root cause analysis of current costs.

Actual production costs for any value stream include the labor costs for people that work in the value stream, costs to own, lease, operate and maintain machines in the value stream, a portion of the facility/factory costs and any other production cost that can be directly attributed to the operation of a value stream.

It’s important for the entire accounting function in a lean manufacturing company to learn & understand the relationships between value stream performance measures and actual production costs on a value stream income statement. Understanding the root causes of value stream performance measurements reveals direct insights into the current state of production costs and also what improvements can be made operationally to reduce and/or better control production costs. Let’s look at some examples.

The cost of labor & machines in any value stream can be explained by understanding value stream productivity. A typical lean productivity measure is output / resources to produce the output. The output numerator is usually related to revenue. The resource denominator is usually based on number of people, actual hours worked by people or machines.

The primary root cause of low productivity is the resources are spending too much time on wasteful activities, rather than the activities that generate revenue. Eliminating the waste frees up capacity, increasing revenue without a corresponding increase in costs.

Labor and machine costs increase when additional capacity is needed.

Machine maintenance costs can be understood better by understanding the root causes of downtime. Reducing downtime will reduce these costs, as well as increasing productivity.

On a typical value stream income statement, actual material, labor and machine costs will account for the overwhelming majority of value stream costs, possibly up to 80% of total costs. Accounting should concentrate all efforts understand the root causes of these 3 costs using lean performance measures to create value-added financial analysis.

In the world of Lean Accounting, you will hear that a value stream income statement needs to show “actual material cost”, and is typically defined as actual material purchased. This confuses accounting professionals because it appears to be in conflict with the matching principle of accounting. So here is my attempt to clear up this confusion.

If a lean manufacturing company has about 30 days of inventory, then actual material cost will be what is purchased in the period. But in many cases, especially early in the lean journey, manufacturing companies have more than 30 day of inventory. In this case, material purchased is much different than the material cost of goods sold. This is the reason accountants think a value stream income statement is not compliant with GAAP.

What is important for accountants to remember is a value stream income statement for internal use only. The purpose of a value stream income statement is to explain the financial impact of lean progress. The accuracy & precision of a value stream income statement is not based on GAAP but on how it represents the current state of lean progress.

So, I’d like to clarify the definition of actual material cost, based on where a company is in its lean journey.

I believe a good starting point in creating a value stream income statement is to define actual material cost as “actual material consumed” by each value stream. This would be the actual cost of material released into the value stream.

I use this definition because there are three operational stages for material after it enters a value stream:

1. Sold – material can be processed through the value stream and sold
2. Scrapped – material is defective and scrapped during operations
3. Stored – material can be stored as inventory, and subsequently either sold or scrapped

At the beginning of the lean journey, material in most value streams will likely be in all 3 stages. Then as quality & flow improves, the quantity of material scrapped & stored will reduce. Eventually if a company can reach 30 days of inventory, actual material cost will be what is purchased & sold within period.

Accounting’s responsibility is to financially analyze material cost its impact on value stream profitability based on what happens to the material as if flows through a value stream. Let’s look at this in more detail.

Obviously, any financial analysis involving changing sales volume would have a corresponding change in material cost.

As lean manufacturing operations improves quality, value stream material cost will decrease because less material is being consumed. Using a standard lean performance measure such as First Time Through or scrap rate, it’s not difficult for accounting to calculate the financial impact of better quality.

As lean manufacturing operations improves flow, it will also lead less material being consumed. Using a standard lean performance measure such as inventory days or inventory turns, accounting can calculate the financial impact. This is very important to show on a value stream income statement, because the external financial statements will not show this as reducing inventory only has a balance sheet impact – improving cash.

One financial analysis accounting needs to move away from in a lean manufacturing company is simply analyzing material price. Don’t get me wrong – the logic of lowering material prices does have a positive impact of profits. But in lean manufacturing operations, material price is balanced with supplier quality, delivery & lead time.

The price of anything is a reflection of value. Lean manufacturing operations values short lead times, high quality and on time delivery from its suppliers because this type of supplier performance will increase flow, and thus increase revenue. Suppliers that provides the best overall performance with lowest price usually become preferred suppliers.

The danger of focusing financial analysis simply on lowering material prices is the only short term solution is large volume purchases from suppliers that offer volume price discounts. But this is “anti-lean” because it increases inventory.

Accounting’s financial analysis of material costs based on “actual material consumed” will provide real time financial information to management to clearly show the impact of lean operations on material costs.