Last blog, I made the case for why standard costing is a poor, non-Lean way to make decisions in a Lean company. In case you missed it, here’s the link: https://maskell.com/?p=894 You may agree or disagree.
This time, I want to keep the discussion going and make the case for why Lean Accounting – and in particular the Lean Box Score – puts a powerful tool in your hands for decision making within your Lean company.
I’ll cover three common scenarios: setting product prices, assessing the profitability of new business, and measuring the profitability of customers or markets.
Using Product Cost to Set Price
Even though everyone knows that price and cost are not at all related, many companies continue to make pricing decisions based on the standard margin of a product. Many companies set policies of minimum standard margins, often times based on financial budgets, in order to analyze the profitability of its products.
Companies use standard margin in a variety of ways. Some set a company policy that all products must have a minimum standard margin or they will be discontinued. This is like saying you’ll give that business straight to you competitors. Another common method is to calculate the desired price for an individual product from its standard cost. As if your customers care!
Linking price to a standard product cost leads to irrational behavior. Products with margins less than the minimum are often discontinued or outsourced.
Sometimes without people fully understanding why, when the lost productive capacity that results from this irrational behavior is not replaced with other demand, overhead rates increase, which lowers margins on existing products which results in more products discontinued or outsourced. You get a sort of death spiral effect. This is not news in the Lean world. David Drickhamer, as far back as his 2004 IW article, cites this as one cause of decisions that are not only “wrongheaded, but tragic.” (You can read the entire article on the IW web site, or at this link: Novel Number Crunching.)
If you need more convincing, read Brian Maskell’s recent blog about the bankruptcy of GM and Chrysler … it’s quite a cautionary tale about what can result. Here’s the link: https://maskell.com/?p=559
Another typical behavior is to focus on reducing the cost of a product or products. Since direct labor drives product cost, companies will do a lot of analysis to adjust production run rates, fine-tune labor rates and reallocate overhead rates. While this work can result in reducing a product cost, it does not change total company costs.
Standard costing is a closed system – changing any part of the system only reallocates costs differently to products and only reallocates absorption and variances. Crunching the numbers differently does not reduce actual costs. The only way to do that is to spend less money.
As a Lean CFO, it’s your job to stop all this nonsense. Most sales and marketing people know exactly what price the market will bear. The real question is whether your company is delivering all the value the market (a.k.a your customer) wants. The trends in your lean performance measurement system will tell you whether your company is improving how it delivers value to the market. Sales and marketing need to work closely with operations to clearly define and measure customer value, then focus on improving measures 20% per year.
Having everybody on the same page with the Lean Box Score is the way to go.
Profitability of New Business
In traditional business decision-making, comparing the actual margin of a new order to a minimum required margin is often times the difference between accepting or rejecting new business.
Using the Lean Value Stream Box Score changes the entire analytical process, and often the outcome as well. It works something like this:
Obviously an order will increase value stream revenue (because you sold more stuff.) Material cost will also increase because you need to purchase more material.
To determine if any other value stream costs will increase, you have to understand the impact of the new business on your value stream capacity. If you can see that there is enough available capacity (i.e. people and/or machines) to produce the expected volume, then there are no additional costs to produce the new business.
There won’t be any incremental cost increases unless you don’t have enough available capacity. Then you have to acquire it and you will then include the incremental actual costs in your financial analysis. If the return on sales of the future state box score is greater than the current state box score, the business decision makes financial sense.
A properly constructed box score will give the best answer.
Determining the Profitability of Customers, Markets, Business Units, Etc.
Product costing seems to makes it very easy to look at profitability from many different angles. There are a variety of reasons why companies do these types of analyses. For example, you may want to understand how well a part of your business is performing (e.g. look how profitable my customers are!) You might want to understand why the company’s profitability is less than desired. (e.g. which market segment or business unit is under performing?) But, rounding up the usual suspects just doesn’t work in Lean companies.
Putting together a truly useful financial analysis is not as simple as slicing and dicing the standard costing numbers differently.
Remember, in a Lean company, your financial analysis rests on the value stream as a whole. The Box Score analysis begins with understanding the impact on value stream operating performance.
As the Lean CFO your best bet is to set up standard work for decision-making so that the people making these decisions take into consideration the following Lean focused issues:
- What is the impact of the demand from the customer or market has on value stream quality, delivery, productivity, lead-time and flow? If the demand makes value stream performance worse, then there is a cost impact.
- How much waste is created in the process due to this customer, market or business unit?
- What would future state value stream performance measures be if a particular customer or market segment’s demand is removed from the value stream?
- What would we do with any available capacity created by less demand from this source?
Once these questions are answered, then you have what’s needed to do a box score analysis, and you will have the basis for a sound decision.
Next time: Going all the way: extending Lean decision making methods into every part of your business.