Standard Costing Debunked – Part 1

Most of the last year (give or take) I’ve been blogging about how Lean Accounting works and why it works best for Lean companies.

Now, it’s finally time to say “good bye” for good to Standard Costing.  Maybe, for a while, it was the only game in town.  We know it’s been used historically in manufacturing companies to keep track of, measure, or analyze three main things:  (1) operating performance,  (2) profitability analysis and (3) inventory valuation.

Lean Accounting offers a better way to do all of this. Just to review:

Last October, I started a 3-part series that laid out how a Lean Performance Measurement system will work best.  In case you missed the series, here’s a link that will get you all three:   I hope I convinced you that a well-designed Lean Performance Measurement system should completely replace typical standard costing measurements such as efficiency, utilization and absorption.  Why? Because Lean provides simpler, more actionable, timely, and transparent measurements that really work better to manage Lean operations.

In the last year or so I and my colleague Brian Maskell have done a number of blogs in which we’ve made the case that Lean accounting offers better financial tools for managing value streams and understanding their profitability.   These tools are compliant with GAAP and tightly aligned also with Lean Principles.  Follow this link, in case you missed any of this far-ranging discussion:   In many ways and using many examples, we’ve shown  how to put value stream accounting to work  identifying  spending patterns and linking cost improvement and financial benefits to changes in operating behavior.

Also, in my most recent blog series I showed how you could decouple standard costing entirely from the financial analysis associated with business decision making by using the Lean Box Score.  Here’s a link that gets you to that group of blogs:

That leaves inventory valuation as the last holdout reason for keeping standard costing around.   CFO’s know that standard costing serves one temporary purpose only –   to value inventory in a high inventory environment.   I’ll cover that is a later section of this blog series, but for now, I’ll just say it’s definitely possible to eliminate  standard costing altogether, but this will depend on how fast you reduce inventory.

How Standard Costing  Historically Values Inventory

Standard costing systems rely on accumulating  a great amount of detailed information about production rates and material usage.   This would typically be used to create standards.   Such systems also track and store detailed cost information as actual production happens.

Then the system measures operating performance by reporting the achieved actuals  against every standard production rate in the system. This detailed costing information, combined with production information creates product costs, which is a convenient, simple method for non-operating people to use for analyzing costs at a micro-level,  including  product profitability.  Using product costs is the simplest, easiest way to value inventory for financial reporting purposes when you have a lot of inventory on hand.

Standard costing worked for mass production manufacturing because mass production manufacturing’s operating principles rested on stability and repetition.  Frederick Taylor’s Principles of Scientific Management (1911) formed the foundation for this;  Taylor  stressed optimizing and simplifying tasks by using time studies. Workers then are assigned specific tasks, which are designed to take a specific amount of time.  Actual times would then be collected and compared to standard times to measure operating efficiency.

Because inventories in mass production companies were often large, specific pegging of inventory costs became too difficult to do manually. That led to the development of automated standard costing systems that made “scientific” inventory valuation possible.

Since standard costing created product cost information, product profitability analysis evolved.

 Charting the Course to No Standard Costs

If you are a  CFO in a Lean company you have no doubt recognized early in the Lean journey that standard costing conflicts with a Lean business strategy.  Lean practices wreak havoc on a standard costing system.  Why?  Because Lean is all about changing and improving, about perfecting the process and reaching for single-piece flow,  about pushing the initiative for making change happen down into the organization, about empowering workers, and the pull of customer demand.   Lean companies live by the 5 principles.

The many assumptions that drive a standard costing system are just not applicable to Lean manufacturing.   For example, Lean will cause fluctuations  in  absorption & variances that make these even more difficult to explain. This happens  because the velocity of change happening in good Lean operations invalidates  the assumptions used in standard costing.  The rate of customer pull has replaced the repetitive rate designed  by time  studies.   Kaizens happen; empowered workers create and change standard work.    Even with automated systems, it’s impossible to keep all the assumptions within the system up to date.   Trying to do so in a Lean operation  rapidly becomes “busy” work, and that is NOT where you want to be spending your time and resources.

Here’s a diagram showing the functions and data flows involved in a typical standard costing ERP system.   Pretty complicated.

Typical ERP data

If your company is beginning its Lean journey, you have to begin simplifying standard costing systems earlier rather than later precisely because of the havoc Lean will wreak on standard costing.

Being proactive in this regard will prevent a lot of unnecessary work in the future, like trying to explain, “what’s going on with standards or variances?”   Earlier rather than later you need to put accounting and finance on a Lean journey too.   You can start by simplifying the system and working towards the goal of eliminating as much of the standard costing system as possible as soon as possible.

How you go about simplifying standard costing will  depend how your ERP system uses various pieces of data and information to calculate standard costs.  Fortunately, all ERP systems pretty much do this the same way.  Typically, standards for production information will be stored within the system.  Labor and overhead costs will be calculated and set up.  You can think of this as your production’s “rules of the road.”   Then to measure actual against standard information, ERP systems consume tons of transactions to record actual information for each standard assumed.  The terminology each ERP system uses may be different, but in essence they all work the same way.  How you design routers, bills of material, material costs, labor and overhead rates determines the complexity of a standard costing system.

All this also presents opportunities for Lean companies.  In my next blog,  we’ll get into the “how to’s.”  This is where things will get very interesting very fast.