A standard costing system is typically used in 3 ways in a manufacturing company:
- Performance measurement
- Inventory valuation
From an accounting perspective, performance measurement and decision-making are part of a company’s management accounting system. A management accounting system is the internal information used by management to measure, manage, control operations and also to make business decisions.
Inventory valuation, on the other hand, is part of financial accounting. Companies must comply with accounting principles related to inventory valuation for financial reporting.
What’s the Problem?
A primary weakness of a standard costing system is that all of the information created & used is based on some combination of product cost information and production reporting information. In general this information comes from bills of material and in routings, as well as standard rates for material, labor and overhead. Typically an ERP system does mathematical calculations and creates different types of variances, absorption numbers and the actual inventory valuation.
Conventional performance measurement focuses on improving rate, volume and overhead absorption variances. These variances are created because inventory & cost of goods sold are valued at standard cost, but actual costs never match standard. In order for the financial statements to be correct, these variances appear on the income statement and impact profitability. So this type of performance measure also has a direct impact on reported profits.
Performance measurements are supposed to drive behavior. These measures drive one type of behavior, which is to make the variances as favorable as possible since favorable variances have a positive impact on profits. But the real operating behavior is “anti-lean”: build inventory, long production runs, fewer change-overs, produce in anticipation of future demand and large batch sizes. Any behavior that results in good product being produced improves these variances.
To be blunt, these measures simply will not work in a lean company†. Lean companies must stop using these measures.
Every effort should be made to stop using these measures as soon as possible on the lean journey. The solution is simple – develop and deploy lean performance measurements that focus on such things as improving productivity, quality, flow, delivery, cost and lead time.
A lean company must also work to eliminate these variances from even being created because these numbers are on the income statement and as long as they appear on the income statement, they will impact profits and have to be analyzed. I’ll address how to eliminate these variances later.
We Need Better Decision-Making
Decision making using standard costing is based on the standard cost of each product. Decisions on the profitability of products, customers, business units and orders is usually based on comparing the projected margin to the standard margin. Sourcing decisions are usually based on the comparison of the standard cost to the purchase price. There is motivation to try to reduce a product cost to improve profitability.
The weakness of using standard costing in decision making in a lean company is that a standard cost doesn’t reflect the actual costs involved in the decision being make. Every business decision must stand on its own financial analysis, based on the actual revenues, costs and investments required. Lean companies must eliminate the use of standard costing for all business decisions. A Box Score can be used to evaluate a business opportunity’s impact operational performance, capacity and materials, which will drive the financial analysis.
What is a Box Score (4 min video)
Inventory valuation is based on the standard product cost of each item in inventory. This creates a tremendous amount of complexity and work because the database used to create these product costs (all the information on bills of material and in routings, as well as all standard rates for material, labor and overhead) must be maintained. Standards must continuously be compared to actual in order to keep standards up to date.
What’s the Solution?
Lean companies take a different approach to inventory valuation. Lean Accounting is concerned primarily with the total value of inventory on the balance sheet, rather than the specific value of each individual item held in inventory. From a financial reporting view (and also an external audit view) what is important is that total inventory is correct. Lean Accounting uses the average cost method to value inventory and cost of goods sold.
Material can be valued at average cost per unit, either for each specific item (if a company has many SKU’s) or a simple average of all materials (if a company has few raw materials). Product costs (labor and overhead) are capitalized onto the balance sheet in total by a simple journal entry, rather than item by item.
Since capitalized production costs calculated at a macro level, all labor and overhead rates can be set to zero, as they are no longer needed. Setting labor and overhead rates to zero immediately eliminates most rate, volume and overhead variances because any number multiplied by zero equals zero. Purchase price variance can be eliminated by moving to average cost instead of standard cost.
Lean Accounting is Simple
Lean Accounting breaks the link of using production-reporting information and product cost information for inventory valuation, reporting profits and performance measurement.
Lean Accounting recognizes that the weakness of using variances and overhead absorption to measure performance. The behaviors required to achieve good performance measures with directly conflicts with lean principles (e.g. build inventory to absorb overhead vs. make-to-order). Lean Accounting:
- Creates a set of lean performance measurements that are typically process-based non-financial measures used to control and improve operations.
- Lean Accounting uses a value stream income statement to report & analyze profitability internally.
- Lean Accounting uses a value stream income statement which reports actual revenue and actual costs by value stream. No standard product cost information appears on a value stream income statement.
- Lean Accounting simplifies inventory valuation because it is concerned with the total inventory value, rather than each individual item. This makes the process of inventory valuation is simpler & easier and much waste is eliminated.
Lean Accounting Takes Much Less Time
There is much less maintenance of costs as compared to conventional product costing schemes. The average material cost is relatively simple to calculate and probably doesn’t need to be updated too often unless the material is a commodity. Labor and overhead rates can be set to zero, as they are no longer need to calculate individual product costs.Setting standards and the practice of analyzing “actual-to-standard” can also be eliminated. This will free up a tremendous amount of time in accounting.
Finally, shop floor reporting can be simplified. It’s no longer necessary to track actual costs by work order since analysis of individual product costs no longer occurs. Most work order reporting transactions can simply stop. The only real necessary transaction to report to a work order is completed production, which moves raw material into finished goods in an ERP system.
Early in a company’s lean journey it is necessary to outline a plan to eliminate standard costs from your business. This is true whether the company is a privately held family business or a publically traded international company. The larger the company, the longer it may take to eliminate standard costing. But it must be done.
† The use of overhead absorption bankrupted General Motors and Chrysler in 2007. Both company claim to be “doing lean” but their traditional accounting methods and incentives bankrupted the companies, and gave US tax payers an opportunity to see their money used to prop-up failed organizations. Read more.