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.