A standard costing system generates rate & volume variances by design. Standards are entered into the system, actual is reported into the system and variances are created. Because standards are used to value inventory and cost of goods sold, actual variances are reported on the income statement to bring the financial statements back to actual. In a “traditional” manufacturing company these variances are often used as performance measures by operations itself, senior management and/or accounting. The definition of a performance measure being “to measure and manage operations.”
A standard costing system is also designed to maintain GAAP/IFRS compliance regarding inventory valuation. GAAP/IFRS states a portion of manufacturing production costs must be capitalized on the balance sheet as inventory in a consistent manner. A standard costing system within an ERP system automates this process. This process creates overhead absorption on the income statement, which can be favorable (increasing profits) or unfavorable (decreasing profits). Overhead absorption is also often used as a performance measurement.
Because variances and absorption both appear on an income statement, the accounting function of a manufacturing company must be able to understand, analyze and explain these numbers to perform the necessary function of financial analysis.
When a manufacturing company begins its Lean journey, the entire infrastructure built to support the standard costing system & related analysis must also adapt to Lean. Here is how the accounting function can lead this process.
Variances as Performance Measurements
Using variances as performance measurements in a lean manufacturing company will not work. Variances are designed to drive mass production manufacturing behavior – building inventory, long production runs and buying lots of raw material to get a lower price. Lean practices totally opposite of this.
Accounting must accept & understand this, and must explain this to any other part of the organization that believes differently. Accounting must also get behind 100% on deploying lean performance measures. Accounting may not have to do the actual deployment, as many experienced lean practitioners can do this. At a minimum accounting needs to participate in the development of the measures, actively support their operational uses and learn how to integrate these measures into their financial analysis.
Variances on the Income Statement
It’s easy to “stop” using variances as performance measures and replace them with lean performance measures. But the standard costing system is still being used and variances will appear on the income statement. The good news is that accounting has the opportunity to lead in modifying the standard costing system to potentially eliminate some or many of the variances on the income statement.
The first step for accounting is to team up with some IT and manufacturing people to study exactly how your ERP system calculates variances. Determine if it is possible to change ERP settings to “turn off” variance calculations.
Next, learn exactly what “actual” information the ERP system uses to do its calculation (every variance is simply actual to standard). Study the manufacturing floor to learn how that information gets into your ERP system. Get IT to set up a test database of your company and practice not entering actual transactions and look at the impact on your income statement. Here are some examples of what to try:
- Stop reporting actual labor and machine time to work orders
- Stop reporting differences in material SKU’s used to work orders
- Implement back flushing reporting
After learning how the ERP system reacts to changes, you can make the necessary changes in your live database and shop floor reporting to eliminate variances.
Based on personal experience, I am confident you will find some ways to eliminate variances on the income statement if you make an investment in time to learn specifically how the ERP system works.
It’s important for accounting in a lean manufacturing company to address standard costing variances early in the Lean & Lean accounting journey. Educate the company on why standard costing variances will not work in a Lean manufacturing company. Support & assist Lean operations in developing and maintaining lean performance measures. Finally, dive into your ERP system and make the necessary changes in the system. You will be pleased with the results.