Standard costing, as we know, does not work for Lean companies. What do we do? We “round up the usual suspects” [i]
This often means people are all too ready to bash the accountants – because they are their people who come up with the numbers. “Why are this month’s numbers bad” … or “Why don’t this quarter’s profits square with the budget?” Go ask the accountants – the keepers of the standard costing numbers.
However, it isn’t only the accountants who are hanging onto standard costing. The reasons go to the heart of how a company is traditionally managed and run.
If you agree that standard costing systems and Lean get along about as well as a snake and a mongoose, then you have to take a hard look at why companies want to keep using them.
In this blog, I’m going to look at the primary reasons companies keep on using standard costing, even when it doesn’t work. My list includes valuing Inventory, making business decisions, measuring operating performance, and ERP.
This might be the only valid reason why Accounting needs standard costing.
If you are just getting started with Lean, your company probably has high inventory levels. The easiest, simplest way to value inventory is to use standard costing. No matter what your inventory, you have to value it for financial reporting. This basically means you have to capitalize a portion of actual manufacturing costs into inventory. A company that cannot accurately value inventory is not in compliance with GAAP and is basically in all kinds of trouble. Accounting still has to use standard costing to value inventory in the near-term. It’s not practical for Lean people to demand that standard costing be turned off ASAP. This is okay for a time.
Now, listen up Lean people! Here is what needs to happen: you need to implement Flow and Pull and reduce inventories ASAP. The faster you do this, the quicker inventory quantities are reduced and the quicker Accounting can let go of standard costing. I’ve seen too many companies going “Lean” not focus enough on Flow and Pull.
And, Accounting – you are on the hook too! You have two responsibilities.
- First, do all you can to help eliminate traditional performance measures (absorption, variances, etc.) for Lean operational performance measurements ASAP. Focus on using your standard cost systems ONLY for inventory valuation.
- Second, maybe you can’t dump it right away, but you can and should simplify standard costing. Also ASAP you can implement the simplest, leanest way possible for managing inventory valuation.
– Routings, bills of material, work centers, labor rates and overhead rates need to be simplified to do one thing – the proper valuation of inventory for financial reporting. See my blog series about debunking standard costs for useful ways to go about this. READ HERE
– Stop worrying about individual product costs (more on that in a bit). GAAP and its minions — auditors – only care if the total amount of capitalized manufacturing costs is accurate. They really don’t care about individual product costs.
Company Decision Making Information
This is the second reason companies hang onto standard costing systems. Many companies use established types of financial analyses based on standard costing for managing the business. Here are some examples.
- Business Unit Reporting – some companies create business units by product-type or customer-type and these business units are given responsibility for profits of the business unit. Therefore, business unit income statements are required. Most of the time the business units don’t align with the natural value streams, which leads to a complex cost allocation system using standard costs.
- Sales/Marketing Reporting – many companies to this day still allow their sales and marketing people to manage their business based on standard margins. Also many companies still use product cost to set prices!!!! In both cases, maintaining a standard costing system makes it easy to get this information
- Product Design and Product Engineering – the people responsible for the design of products often want to know the cost of the product. And they want the information readily available & dynamic.
- Senior Management and Cost Savings – many senior management teams seem to be obsessed with reducing costs. They want to see margins improve and/or product costs to go down. Senior managers usually like high-level summary financial information. The standard margin analysis is such a tool
- Purchasing/Supply Chain – reducing material cost is a typical goal. The easiest way to show this is with a favorable purchase price variance report.
I’m sure you can think of you own examples.
In the course of working with many finance people in many companies, I think most finance people recognize the weaknesses of standard costing systems. They believe their internal customers want this information so Accounting has to maintain the systems that produce this information. The types of analyses I’ve listed above are usually deeply embedded within the company.
A Lean company has to change its internal customer requirements in order to begin eliminating standard costing. It has to put effective Lean controls and tools in place, then make sure they are used for all operations, evaluations, and decision processes. It’s up to the company’s leadership to initiate the change.
Measuring Operating Performance
There are still many companies out there that use overhead absorption and production variances to measure operating performance. The only way to produce this information is to maintain standards: routings, bills of materials, run rates, labor rates, overhead rates and cost allocations. Most of the work setting standards is the responsibility of Accounting (i.e., “the usual suspects.”) because comparing standard to actual is the job of cost accounting. Lean companies, on the other hand, need to develop effective Lean Methods for evaluating performance. At BMA we have published numerous blogs about why and how performance measurements have to change. READ HERE
ERP systems make gathering and reporting detailed product costing and production reporting an easier task. Of course, when the company information requirements and decision-making methods are based on standard costing, ERP can get the job done.
Most ERP systems can be configured in great detail to collect and summarize this information for the business. There are many companies out there purchasing new ERP systems to improve inventory management and valuation.
Don’t get me wrong; ERP systems serve an important purpose in companies. But the minute any company thinks that an ERP system is going to help it improve product cost accuracy the company is headed down the wrong path. You don’t want the tail wagging the dog. Just because it’s easy, doesn’t make it right! (Note: I devote an entire chapter in my new book The Lean CFO, to taming the ERP beast.)
Accountants know they need standard costing for inventory valuation, if inventory levels are high. Most accountants would love to simplify or eliminate standard costing. But they have no control over inventory levels. So if there is a desire to eliminate standard costing, first eliminate the inventory.
Accounting has many internal customers. If their information needs are based on standard costing data, it’s up to the company’s management to change the information requirements away from standard costing. Accountants can’t make unilateral changes.
So my message is this: before simply putting blame on accountants for all the problems standard costing creates, do some root cause analysis in your company to determine exactly where and why standard costing is used.
You will probably find many root causes. Then, get to work on eliminating them. ASAP.
[i] This phrase comes from the 1942 film “Casablanca.” It refers to a situation in which people place blame on a handy scapegoat rather than on the actual perpetrators of the “crime” or “problem” in question.