It’s About Spending, Not Costs – Part 2

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.