Standard Costing Debunked – Part 2

For all you standard costing folks out there – let’s start with a heretical propositionPropositionBox

Now that we’ve got that off our chest, and (at the risk of mixing metaphors) have shed a millstone from around our neck, the way is clear.    In my last blog I made the case for why you need to simplify standard costing.  Here’s that link:  and I promised we’d get into the “how to.” 

So here we go.

Simplifying Standard Cost

In standard costing-based ERP systems, material cost is developed from the bills of material.  Four factors contribute to complex material costs: 

  1. The number of bills of material
  2. The number of parts on bills of material
  3. The “quantity used” of each part on bills of material
  4. The material cost per unit of each part

Reducing the Number of Bills of Material

Your ERP system bills of material are created for any product that gets recorded as completed production. This means that all your finished goods as well as any sub-assemblies that get recorded into stock as completed production must have bills of material.  In traditional manufacturing, sub-assemblies are typically produced independently of the finished good they are part of.  The bill of material for the finished product will have on it all sub-assemblies taken from stock as well as other raw materials consumed. 

In a Lean operation, you implement FLOW and then PULL everything at the demand of the customer.   FLOW eliminates the need for sub-assemblies to be stocked as inventory because they are produced in conjunction with a customer order, which means they don’t have to be reported as completed production.  The bills of material for sub-assemblies can be eliminated when FLOW is working.  A typical first goal for reducing bills of material is to match the number of bills of material to the number of finished goods that the company sells.

The benefits of doing this include less work in process control, less shop floor paperwork, fewer tracking transactions all along the process and overall lead-time reduction by eliminating unnecessary intermediate transactions.

It is possible to further reduce the number of bills of material if your company has custom or configurable products. In traditional thinking, each unique SKU must have a bill of material and as you create / configure products to sell, the number of bills explodes exponentially.

If your ERP system supports it, you might use “configurable” bills of material.   These are created for customized products as the material is consumed during production.   These are appropriate to use in a highly customized manufacturing environment.   Or, you might have another feature that allows the part substitution on existing bills of material. In both cases, you leverage your ERP system features to reduce the number of bills of material on file that you have to maintain.

Number of Parts and Quantity Used

Traditional manufacturing companies will list every possible part on their bills of material, no matter how large or small. The reasons for this are for variance analysis, inventory control and purchasing analysis.  

But using this level of detail creates unneeded complexity in material costs. Every part listed on a bill of material must have a quantity used.  This gets quickly into a lot of hair splitting.  For discreet parts should the quantity used be the actual quantity used to produce the product?  Or should it include a yield rate, which is the scrap rate?  Including yield rates  “helps” for inventory control and purchasing purposes, but it also creates complexity in costing.  Even trickier are “parts” which are actually consumable supplies such as paints and powders.  The quantity used is often difficult to measure (e.g. who really knows exactly how much paint is used to coat a discrete piece?)

Traditionally, then, to get operating performance data, actual material information has to be recorded to get variances against your “standard.” Purchase Price Variance (PPV) requires each part received to be entered as well as the actual invoice price. Material usage variance requires actual material consumed to be reported at each production step.   Failure to do any of this or to do it correctly causes waste and degrades usefulness of the resulting information.

On the other hand, in a Lean company, the pull systems in place on the shop floor and with your suppliers will regulate the quantity of material purchased and used. There is no need for the ERP system to track everything and determine when parts and supplies need to be ordered.   You can also simplify bills of material by eliminating small parts, such as screws, or difficult to measure ingredients. Treat these items as shop supplies.

Material Cost

Traditional companies spend a great deal of time figuring out the “standard” material cost to enter for each part they purchase.  The main reason for so much effort is so they can measure purchase price variance (PPV.)   Some companies keep it simple – entering the price the supplier charges. Other companies try to get creative by entering the price they would like to pay so they can somehow gauge how effective the purchasing department is by using PPV. In some cases, determining the purchase price is difficult. One example, commodity prices can fluctuate frequently.  Sometimes suppliers may change prices without warning.

Lean companies recognize that PPV is a meaningless measure. You can simply cost material by always using the last price paid as the “standard”. After all, whatever you are paying for your material is the actual cost. The price you pay for material reflects the value you receive in terms of lead-time, quality and delivery.

What you really want is to simplify the process and reduce the amount of nonproductive time that goes into maintaining material standards. You reduce complexity by reducing the factors that cause the “standard” material cost to be complex.  In other words, you can get rid of a lot of the waste involved in the care and feeding of material cost by just reducing complexity among the factors that impact the standard material cost. 

This means cutting the number of bills of material, the level of part detail on bills and not trying to define the standard unit cost.  What you will do eventually in the long run is to report material costs at actual cost of materials in your operation.

In summary:  the following diagram draws the contrast between what compels the complexity of Bills of Materials in traditional systems and what drives simplicity in Lean.

BOM Simplification