The Real Relationship between Costs & Time

One of the primary weaknesses of a product costing system is the fact that the longer it takes to make a product, the more it appears to cost. This is because the direct labor dollars associated with any product are calculated based on the direct labor rate multiplied by the standard production time. Additionally, overhead is calculated based on the direct labor dollars multiplied by the overhead rate. This appearance of a higher cost can lead to poor decision making regarding pricing, make or buy or product rationalization decisions. 

The product cost calculation makes it appear as if direct labor and overhead costs are variable, based on time to produce as the driver. In reality, direct labor is a fixed cost. Your full-time employees are paid the same no matter which products are produced. Likewise, just about all overhead costs are also fixed, meaning they don’t vary directly based on labor time.

In lean accounting, the relationship between costs and time is based on developing an understanding of what is driving time, or capacity. The time of your employees can be spent creating value (value-added capacity) or not creating value (non-value added capacity). The amount of time spent on each is a function of process performance, not people performance. The more non-value added activities there are in a process, the more people you will need.

Here is a simple example. If 50% of a value stream’s time is spent on non-value added activities, and you need to hire one employee, you will have to hire two employees to get the output of one because there is 50% waste in the value stream.

Your labor cost is a function of the amount of capacity you need, which is driven by expected demand and the amount of non-valued added activities in your value streams. Want to do a better job of managing your labor costs? Don’t focus on the direct labor of the products, focus on understanding capacity of the value streams.

If you focus on continuous improvement, you will eliminate waste and create capacity, which you can utilize to create more value (and more sales) or reallocate to not have to add more people (and add cost). That’s the economics of lean in action.

Conversations, not Conclusions

One of the primary differences between traditional management accounting and lean management accounting is lean management accounting focuses on creating conversations, while traditional management accounting focuses on drawing conclusions.

In traditional management accounting, information about past performance flows upward in a company to accounting and executives, who draw conclusions about performance and dictate “changes” that need to be made. It is then up to the managers to implement the changes dictated.

Lean management accounting focuses on creating cross-functional, collaborative conversations about current operating and financial performance and how to improve both over time. These conversations focus on understanding the true cause-effect relationships between lean operating practices and financial performance. Box Scores drive this conversation.

The effectiveness of lean operating practices are measured by the Box Score’s lean performance measurements. Capacity measures how effectively a value stream is “spending its time” on productive, value-added activities or nonproductive, non-value added activities. Capacity also measures how much capacity is created by improvement activities – available capacity. The value stream income statement in a Box Score reports the actual revenue and actual costs of a value stream. 

The three components of a Box Score create conversations around questions such as:

  • What level of improvement is necessary to actual serve customers better and drive sales growth?
  • What is the financial impact of improving quality, delivery and lead times?
  • If we want to improve financial performance, what operational changes and improvements are necessary?
  • How do lean practices manage costs?
  • How can we increase capacity without increasing costs?
  • What is the operational and financial impact of a business decision we have to make?

The relationships between lean operating performance and financial performance are dynamic, not static. Understanding these dynamic relationships requires using PDCA to understand the root causes, and PDCA requires the right people to have a conversation and draw the right conclusions about root causes.

Want to ensure the success of a lean management accounting transformation? Don’t think of a Box Score as a method of reporting, think of it as a conversation piece to be discussed.

Podcasts – Practicing Lean Accounting

Here is a list of podcast links where we discuss our new book Practicing Lean Accounting:

Podcast Links – Practicing Lean Accounting

Mark Graban

Stephen Dowling

Mark DeJong

Katie Anderson

Gemba Academy

https://blog.gembaacademy.com/2021/11/25/ga-399-practicing-lean-accounting-with-mike-de-luca-and-nick-katko/

JIT Cafehttps://www.jitcafe.com/post/finance-meets-lean