Today’s blog is Number One in a series that will take a deep look at how and why Lean Accounting differs radically from traditional accounting. My plan is to use a straightforward “compare and contrast” approach. This will not be polemical, just the facts.
Most importantly, I’ll try to show how each approach does or does not support Lean Principles. (Click the following link to view a mind map showing the five principles of Lean: Five Principles of Lean ) I’m going on the assumption that if we support the five principles of Lean Thinking, then we will be supporting Lean throughout the company; operations, product development, sales and marketing, and administration.
If you are already a Lean Accounting enthusiast, this will be a handy review for you. You already understand the value and importance of what you are doing. If you are not familiar with Lean Accounting, then I hope this and the next few blogs will help you understand enough to make an informed judgment for your company.
So here we go.
I’m going to start with some definitions.
Standard Costing is an accounting technique in which standard product costs are calculated for every part, sub-assembly, and finished product. Throughout the operations that use or produce the part, detailed “actual” information is gathered. After all the costs are in (usually after month-end) these are compared with the “actual” costs, and reports are created to analyze the variances from standard.
Typically, a standard costing system is complex to set up and requires millions of wasteful and time-consuming entries of the “actual” data. I am using the word “waste” in the Lean context as “any activity that does not add value in the eyes of the customer.” Very few people in the company understand how the standard costs are calculated and yet they are expected to improve them, make decisions based on them, and even price products using them.
Value Stream Costing is an accounting method using actual cost information to record the revenues, spending, cash flow, and profits of the company’s value streams as a whole. Value Stream Costing usually does not need to address the costs of individual products, although there are methods to do this if required. When a company is making good progress with Lean Thinking and methods, all the reporting, analysis, and decision-making can be done better at the value stream level.
Lean organizations manage their business by the value streams. The value streams are where the value is created and the money is made. Value Stream Costing is entirely aligned with the value stream. It is quick, simple and timely. It is clear and easy for non-financial people to understand and to act upon because it directly addresses the value stream structure. It requires very few transactions because the information is collected at a higher level. It also supports Lean performance measurements and the Lean Box Score.
EXAMPLE OF THE PROBLEM
Here is a simple example I like to use to explain that standard costing is unhelpful when it comes to Lean flow.
From the diagram, you can see that based on the labor hours the cost of Product A is different from B. But based on Lean flow, we run at a cycle time of 10 units per hour. And, in that hour the total spending of our value stream is $580 per hour. If the material costs for both A and B is the same ($42), then the cost of either product A and B is $100.
This example is, of course, overly simple. However, it actually tells a pretty important story about the potential for antagonism between standard costing and Lean value streams. From this we can see that standard costing is not only complex and wasteful, but it also gives cost information that (in a Lean environment) is just plain wrong. In a truly Lean environment I have seen this lead to wrong decisions related to pricing, cost, outsourcing, etc. What you get are low profits and tepid growth.
WHY IS THIS IMPORTANT?
If a company is working to become a Lean enterprise and continues to use standard costing methods (or it’s bigger and more complicated brothers like activity-based costing, RCA, and others) the financial reporting will motivate anti-Lean behaviors among the people working in the company. The variance reports will lead them to sub-optimize the value stream flow and costs. The overhead absorption variances will motivate large batches, over-production, long lead times, and high inventories.
The decisions made using traditional standard costing will – in a Lean environment – lead to bad decisions. In the competitive global business environment where we find ourselves today, it is impossible to overstate the importance of this. That’s why I am devoting an entire section of this multi-part blog to the subject. For now, let’s just say the company will turn away good work based on standard cost “profit margins.”
Lean companies are constantly striving for simplicity and transparency. The complexity of standard costing creates waste. The opacity of standard costing leads to bad decisions. The huge number of wasteful transactions required to support standard costing (and the reports, meetings, and reconciliations) drains the people’s time and degrades productivity.
As you can see, the difference between Lean Accounting and Traditional Accounting impacts all five of the Lean Principles, namely: 1.Customer Value, 2.Value Streams, 3.Flow & Pull, 4.Empowered People, and 5.The Pursuit of Perfection.
In blog Number 2 we will delve a little deeper by exploring the differences in the cost accounting that come from Lean Accounting vs. traditional standard costing.
I’ll leave you with these thoughts: Traditional standard costing focuses on hundreds or thousands of cost centers. Lean Accounting focuses on the company’s (relatively few) value streams because this is where the value is created. This is where the customers’ needs are understood and fully met. This is where the company turns value into profit and cash flow.