A few years ago I was working with a software company its lean transformation. During a training session someone made the statement that they must charge higher prices to their new clients for training because their training costs are higher. I opened up a discussion on that statement and the general consensus was “it takes us longer to train our new clients on our software that the competition.”
I raised the point that the software company’s training costs are fixed – based on the number of trainers they have on staff. I then facilitated a quick “5-Why” exercise and the primary root cause of why their training takes longer was the complexity of their software.
The thinking inside this software company was the longer it takes to perform the training, the higher the costs for the software company. This is the same thinking that exists in manufacturing – the longer it takes to produce a product, the higher its costs.
The root cause of this thinking is based on traditional cost allocation methods, whether it be allocating training costs to a software implementation project, to a complex tax return in an accounting firm or to a product being manufactured.
Under this thinking, each business would seek to reduce the time it takes to process the products/services to “reduce” costs. Or prices would be adjusted to “cover” the additional costs.
In Lean Accounting, we want to stop allocating costs based on time because it just isn’t really an accurate way to understand costs. In order to make this transition, financial thinking in an organization needs to change.
- Processing time creates value: Lean companies recognize that the time to produce a product or service is based on the value-added processing time (e.g. cycle time). Typically, the more value that needs to be created, the more time it will take resources (people and/or machines) to create the product or deliver the service.
- Waste adds to costs: any of the 7 wastes of lean adds costs to the business as well as increasing lead times to produce products or services. Some costs may be direct, such as poor quality in manufacturing increases material costs. Other costs are less direct – a company hires more people than necessary because waste exists in the processes.
- Lean companies also recognize that the cost of the resources, to the business, is typically fixed. This means the business will incur these costs on a regular basis regardless of time spent of individual products or services. Lean companies make cost decisions based on long-term trends rather than which work must get completed today.
Lean Financial Thinking – Labor Costs
Labor costs are fixed based on how many people are employed. Companies hire more people based on total demand projections. Full-time, hourly employees work a 40-hour week, regardless of demand. Yes, a company may have temporary or part-time workers that they can bring in or send home based on demand, but usually these are not the primary workforce.
Measuring the waste in a process and understanding the capacity of a process is what will control labor costs. Employment of continuous improvement and other lean practices eliminates waste, improves capacity and creates time. This time is then applied to value-added activities, which improves productivity and prevents lean organizations from having to hire additional people.
Lean organizations consider their employees to be their most important asset, which is counter to how employee cost is shown on the financial statements – as an operating expense. The second most important asset of a lean organization is time, which does not appear anywhere on financial statements.
Lean organizations develop employees’ thinking so on a daily basis they become experts in the difference between value added activities and waste and have the skills to eliminate the waste on a daily basis. This work is done through observation and daily performance measurements.
Cost allocation systems, which are primarily used by managers, really work in direct conflict with daily improvement activities and measures. It’s important for the financial leadership of every lean organization to eliminate the use of cost allocation methods.