Standard Costing Debunked – Part 3: Labor Costs

Throughout most of this year,  I’ve been leading up to this – as I’ve written about the issues facing CFO’s in Lean companies.  About why standard costing just doesn’t work for companies that are Lean.  And why Lean Accounting offers a simpler, better way.   In case you want to reread my earlier blogs about standard cost, here are the links:

  • Part 1 where I described a pathway you can begin toward eliminating standard costs
  • Part 2 where is proposed that you don’t need to struggle making sure your product material costs are accurate,  because these are ways you can effectively reduce how much waste it takes to maintain your materials standards.

This time we’ll tackle labor reporting and how to approach this in a Lean company. Here’s another heretical statement to get the conversation started:


First Some Background

ERP systems calculate labor and overhead costs by assigning labor and overhead rates to work centers, and by creating routings for each product that is reported as completed production. How complex your  labor and overhead costs are depends on the detail level you keep track of in work centers, the number of routers you maintain, and the level of detail in labor and overhead costs.

To set this up and keep it accurate companies will first lay out all possible production steps in the factory in the ERP system. Typically these are called “work centers” or process steps. Next, routers are created which link each product to the specific work centers where the product is manufactured.  The idea is to detail out the actual production process steps for each product. The term “router” simply means the route which the product takes through the production process. Like bills of material, each product that gets reported as completed production—all finished goods and all sub-assemblies that have inventory locations—must have a router.

A lot of detailed information goes into each router. Each step must be given a run rate, which is the time is takes to complete one unit in that process step. Determining the run rate is very similar to determining the quantity of each part on a bill of material.

For some work centers, especially machines, the production run rate is easy to determine. In other work centers, this can vary due to a variety of issues, which can occur at any time. This is often the case when labor is involved.  It would not be unusual to find that an experienced worker is able to assemble a product 20% faster than an inexperienced worker.  What is the correct “standard” run rate to use?

Run rates are important to the ERP system, because they are used to calculate variances and absorb overhead costs.  Actual production times are captured for each step on a router so the system can calculate the variances.

The system then calculates absorption by multiplying the quantity of completed production (at that step) by the run rates. Some companies, in an effort to absorb more labor and overhead, inflate the run rates to include such activities as machine changeover time.

When standard costing is the primary source for performance information, companies will have as many work centers as possible with very detailed routers, so that the system can track production in great detail and can be constantly measuring and adjusting run rates to maximize absorption. This type of system requires actual information to be recorded against each production step on work orders.  This means a lot of transactions are collected in real time as production proceeds.

But the story doesn’t end there. Labor and overhead rates are developed for each work center based on how costs are assigned or allocated by the cost accounting function.  Some of these costs are easy to identify, such as how many people work in a work center.  Most of the costs are more difficult to assign to specific work centers. This is where “cost allocation” systems come into play. The traditional approach is to develop complex allocation schemes to assign as many costs as possible, so that the system can create an “accurate” product cost, which can in turn be used to understand the profitability of products. Worse, in a standard costing environment, this level of detail gets way beyond inventory valuation and has a tremendous impact on business decision-making.

When your company adopts LEAN your thinking has to change. You need to step away from the computer and start thinking about FLOW.

What you learn about your operations when you adopt Lean practices is that there is always variability.

Some of this variability is caused by how the production process has been designed, but other variability is beyond your control, such as the rate and mix of demand. The role of Lean is to do two things simultaneously: work to eliminate what variability that you can control through continuous improvement,  and manage what you can’t eliminate with Flow & Pull. The end result is that operations will be in a constant state of change.

Creating Flow involves  re-designing production processes based on Lean practices. Many times this means that work centers will be combined, eliminated, or sequenced differently. Continuous improvement will have an impact on the cycle times to complete a production step, the number of people needed in a production step, as well as eliminating downtime and changeover time. Eventually, today’s physical layout and work activities will not be the same in a few months, making it very difficult to keep detailed work centers and router information up to date.

What to do?

Step one for labor and overhead cost simplification is to minimize the number work centers and routers as much as possible. As opposed to a work center for every production step needed in making a product, you can create one work center for each value stream and monument.  Next, simplify routers by having as few steps as possible on the routers. This will reduce the number of transactions that have be entered into systems.

Properly designed Pull systems regulate both production and inventory in a value stream. Every resource in the value stream uses visual signals to know what needs to be worked on and when. Pull systems eliminate the need for detailed tracking of the movement of materials through production in ERP. Simplified routers eliminate a great deal of tracking transactions for both material and labor. The minimum amount of quantity information ERP systems need to know is the quantity of finished goods completed.  When Lean is working you can stop tracking labor time immediately, because all it does is create labor variances.

Step two for simplifying labor and overhead cost information is to reduce cost allocations and the number of labor and overhead rates. If inventories are greater than 30–60 days, you will probably have to maintain your standard cost system to capitalize labor and overhead. But you won’t be using product costing for financial analysis, nor will you be using variances and absorption for performance measurement. In this case, it’s best to minimize cost allocations and have one labor rate and one overhead rate for each plant.

Here’s a table that lays out these approaches:

Router Simplification

To Summarize:

Flat bills of material (see minimal work centers, one step routers, and single plant-wide labor and overhead rates will greatly simplify your standard costing system, while still allowing you to use it to value inventory.

This work can literally begin on Day One of your company’s Lean journey. By simplifying standard costing, you will be eliminating a tremendous amount of waste in your finance processes, and you can reallocate this created capacity towards Lean Accounting efforts.

Next time:  Eliminating standard costing altogether. As a CFO in a Lean company, this will be your Job #1.