It’s About Spending, Not Costs – Part 3

It’s About Spending, Not Costs – Part 3

Continuing my discussion about Lean Cost Management: last blog, I made the case for a Lean Cost Management System vs. using “traditional” cost management methods, focusing on Materials Spending.

Today, I’ll tackle two more topics: Labor and Machines.

Labor Spending


The CFO’s traditional approach to managing labor costs is deceptively simple – try to keep reducing it. When you look at it from a “total labor cost perspective,” you naturally get into measuring headcount and overtime hours.  And, because traditional costing methods are always focused on standard product cost, reducing direct labor cost becomes important to reducing the cost of your products; typically, you will do this by examining your variances and making sure that production resources are used as efficiently as possible.

From our discussion last time, about materials spending, we saw that this leads to big batches and more waste. [i] The same goes for labor resources.  Seems sensible, right? Having people standing around idle is bad; having them making something is good.  But Lean teaches us that making too much, making the wrong stuff, or making poor quality is a bad way to keep busy.

By now, we should be able to guess the traditional approach to labor cost will not be effective because it doesn’t address the real root causes of how much a company spends on labor.

We have to change the discussion from “How much did we spend?” to “How well did we spend?” on labor.

The Lean CFO will look at labor as an operating expense, not as a component of product cost.  We see labor is a resource; labor provides the capacity to create the value your customers will buy from you.  The Lean CFO will be very interested in how well our labor spending met customer demand.

This leads us to a discussion of root causes.  I believe the two primary drivers of your labor cost are 1) the total amount of labor required to make the all products your customer buys and 2) how productively our labor resource was used.

By this approach, the total amount of labor is the aggregate cost of all the people that are assigned to your value streams.  The Lean value stream is the “engine” that produces our revenue, and maximizing FLOW within the value stream is how Lean companies make more money.

Truly Lean companies quickly understand that traditional departments create barriers.  Barriers separating front-line production operations and traditional manufacturing support functions (such as quality, maintenance and engineering) are especially harmful; they actually impede flow and make it harder to improve it.   This is exactly why Lean companies work to destroy these impediments by assigning as many people to work full-time in value streams as possible.  Value stream costing recognizes this as labor expense on the value stream income statement.

Lean CFO’s understand labor spending best in the context of the Value Stream and how the labor cost is being spent. They are not as concerned with the total amount of labor spending, as long as productivity continues to increase. This is the reason why lean CFO’s simply charge the actual cost of labor to value streams. They want value stream managers to focus more on measuring and improving productivity while meeting customer demand.

In this context, productivity is the ratio of output to input of the entire value stream. Lean companies define output as demand or shipments, not production volume. Input is the total labor, such as hours worked. If productivity is improving, then output (demand/shipments) is increasing at a greater rate than input (hours worked). This means that the rate of spending on labor is increasing at a lower rate than the rate of revenue growth, which means profits are increasing.

What matters most is consistently improving productivity by 10-20% annually.

What will keep people from these productivity gains?   If the processes they work in, which have been designed by the company, are not Lean they will not see improvements in productivity.  Low productivity is generally not the fault of the people doing the work.   It’s caused by poorly-designed or poorly -performing processes.

Using traditional measurements like labor efficiency or total headcount sends the non-lean message that poor productivity is the workers’ own fault.   But the Lean CFO knows that productivity will only increase when waste is eliminated from the value stream and the people are focused on delivering value.

In a Lean environment, productivity in increased by perfecting the process; adding more people means that demand is increasing. As long as productivity improvement is maintained when people are hired, it doesn’t matter how large your headcount. You will be making money.

Machine Spending


The traditional approach to managing machine costs focuses on maximizing utilization.  It seems sensible, right?  You make maximum use of an expensive resource to get maximum pay back. This usually means long production runs with fewer change-overs.  This typically results in large batch sizes and too much inventory.

The Lean CFO thinks about machines pretty much like labor:  they are a component your capacity.  The focus should be on improving productivity, not maximizing the use of the machine.  This means thinking about root causes.   To improve machine productivity, lean companies focus on identifying the drivers that cause machine-related problems that impede flow.   The question becomes: “Why can’t the machine run if customer demand is present?”

One area of focus is downtime. Lean companies want to minimize unplanned downtime, as that disrupts flow. Total Preventative Maintenance (TPM) practices will minimize unplanned downtime and because PM is planned, flow will not be disrupted.

Other drivers of poor productivity will focus on quality problems related to making the product and the rate of production of the machine. If a machine is producing poor quality, costs go up. If the machine is producing at a lower rate than customer demand, then costs go up as well.

Changeover is another driver that the Lean CFO will address. To improve machine productivity, changeover must first be stabilized and standardized, then reduced.  Continuous improvement activities will address on-going changeover time.  If changeover cannot be avoided, then it must be managed using level scheduling techniques.

In summary:  Lean managers will use an analysis that shows the “How Well” they are spending their resources.  The following illustration shows one way to analyze this in a manner that us really useful and supportive of lean improvement. [ii] The data that underlies a report like this comes right out of the value stream map coupled with aggregated monthly costs of employees and machines, broken out by the cells and processes that belong to the value stream. A report such as this does not have to include money.  It could also be done in time units,  In either case, it is useful.  [iii]

Click to enlarge.

Next time: spending on Quality.

[i] Think about going to a big box store like Costco to buy duct tape.  Wow!  You can get 24 rolls for half the price of buying them one at a time.  But, is it really a bargain if you only need 10 feet of tape and it takes you the rest of your life to use all the rest?

[ii] From Practical Lean Accounting.  A Proven System for Measuring and Managing the Lean Enterprise.  Second Edition.  Brian Maskell et. al.  CRC Press, 2012 p. 89.

[iii] There’s a lot more detail about this in the book Practical Lean Accounting. It follows an extended example of how a company tracks its improvements and how these relate to their finances, using Lean Accounting methods.