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 http://maskell.com/?p=1161where I described a pathway you can begin toward eliminating standard costs
- Part 2 https://maskell.com/?p=1237 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.
- Part 3 https://maskell.com/?p=1323 where I posited some ways you can simplify how you keep track of routings, and quickly eliminate detailed labor reporting.
So, we’ve laid the foundations, now it’s time for Standard Costing to “face the music.” Because you are CFO in a Lean company, you need a better way.
A Simpler Way to get Rid of Standard Costing
For most non-Lean companies, capitalizing manufacturing costs into inventory causes the most problems on your financial statements because of their impact on reported profits. The more inventory the company has, and the more your production rates don’t match your shipping rates, and the more complex this issue becomes. The typical result is that reported profits don’t make any sense when compared to shipments, and/or margins don’t make sense based on product mix. Companies (especially when they have feature-rich integrated computer systems) will typically throw more resources at the standard costing system: more detailed reporting, more detailed design, or more analysis. And more wasted effort to maintain.
Let’s instead back up a bit and think about what you are really trying to do.
Generally-accepted accounting principles (GAAP) require inventory to be valued at actual cost, but they do not require that each individual product in your business be assigned a standard cost. Standard costing is a system designed to approximate actual, but it requires constant care and feeding (and adjustment) to do this accurately. If your company is audited, auditors will test the standard costing system. Then, if it approximates actual inventory, it is considered to be valued accurately. If it does not pass the auditors’ testing, the auditors will require the company to capitalize a portion of its variances so inventory approximates actual for audit purposes. You and your people will jump through a bunch of hoops to comply.
But there is a much better way, no hoops involved! Mature Lean practices eliminate these problems. Make-to-order and Flow will minimize finished goods inventory. The result: valuing it for reporting purposes becomes less material to the financial statements. Production rates will match shipment rates. This creates the opportunity to simplify how you have to capitalize labor and overhead costs.
The Lean Accounting solution is to capitalize labor and overhead costs at a macro-level rather than product-by-product. This meets all GAAP requirements and can be done with a simple journal entry at month end.
As Lean production methods take root in your company, the magic number you are looking for is about thirty days of finished goods and work-in-process inventory on hand. If your company has about thirty days of inventory, it was produced during the month. At this point, your value stream income statement for the month will list the actual production costs for the month. The amount of production costs to capitalize will be the ratio of goods on hand to total production for the period. The journal entry simply adjusts the previous month’s capitalized costs to the current month.
The picture below shows an example of how to use a value stream income statement to capitalize inventory with a simple journal entry.
The primary issue in valuing WIP for traditional companies is figuring out the “percentage complete,” so that the proper amount of labor and overhead can be capitalized. This is why companies with high WIP have to report production against work orders. The work order becomes the vehicle for accumulating all the costs.
On the other hand, in Lean companies, the Pull System reduces and limits the amount of WIP on the factory floor. If your production cycle times are short, don’t bother even valuing WIP. You can value your inventory as either raw materials or finished goods. This is only possible because the amount of capitalized labor and overhead on your small amount of WIP is immaterial for financial reporting purposes. If your production cycle times are long, as in weeks, you can use a simple assumption that all WIP is 50% complete.
Using this method to capitalize labor and overhead means that you can set your system’s labor and overhead rates to zero. In turn, your system-calculated variances and absorption numbers vanish! If you combine this with changing material cost to last-price-paid, you will generate actual inventory numbers.
And here’s the best news of all. This method for capitalizing production costs into inventory will meet all audit requirements. This method is really the “weighted average method” to value inventory, which is one of three methods described by GAAP. The other two are FIFO and LIFO, which really become irrelevant as Lean manufacturing takes hold and inventories are reduced. Auditors are very receptive to this method of inventory valuation, because it meets GAAP requirements and has the bonus of greatly simplifying the audit process.
It really is possible to eliminate standard costing from your business. How fast? That depends entirely on how effectively and quickly your company deploys Lean practices. If your company truly commits to establishing Flow and all other Lean practices, inventories will be reduced dramatically over time.
Think of the amount of work that goes into calculating standards, reporting actual, analyzing variances, and sitting in meetings explaining the differences. This is all pure waste, and it can be eliminated once and for all from your business. And you, the Lean CFO, can lead the way.