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.

Lean Decision Making Framework Guidelines

Lean Decision Making Framework: General Guidelines

In this blog, I’d like to explain 3 general guidelines accounting should follow for creating an effective lean decision framework for your lean manufacturing company.

#1- Financial Impact on Value Stream Profitability

The general rule for lean decision making is to understand the financial impact of any decision is based on the impact on total value stream profitability. Hence, the necessity for value stream income statements in a lean manufacturing company. This is a departure for most accounting professionals in manufacturing, as many financial analyses get broken down by specific product, product family, business unit, etc.

The change in actual value stream profitability will accurately reflect the economics of lean, as described in an early blog. Another advantage of using actual value stream profitability is that the profitability impact will be realized because the analysis is based on actual revenue and actual costs.

#2 – Stop using Cost Allocations

Most cost allocations have a level of subjectivity in them (such as all rates in a standard costing system). And many cost allocations are an attempt to make a fix cost variable by linking it to units produced. Using rates in financial analysis is dangerous because they can make it appear that costs are decreasing, when in reality actual costs are not changing.

Here is an example in manufacturing – direct labor costs. Standard costing systems assigns direct labor based on a direct labor rate & volume produced. If a manufacturing business was considering eliminating a product or product line, the financial analysis would show a “direct labor savings”, because direct labor is assumed to be variable.

The reality in most companies is your full-time employees come to work every day and get paid a full day’s pay whether they produce 100 products per day or 500 products per day. If a company were to eliminate a product, these employees would still be full-time employees, which the actual labor cost for the company does not change. Actual labor would decrease only if fewer employees were employed.

Accounting’s responsibility is to begin to understand how costs change in a lean manufacturing company, without using cost allocations. If cost allocations are commonly used in your company in financial analysis, it’s time to begin migrating away from them by introducing the value stream income statement.

#3 – Lean Improvements create Capacity

This is a fact of Lean: eliminating waste creates time – the time spent on waste is now available to spend on creating value. This is also described as creating capacity.

This fact of lean must be incorporated into your lean decision framework. The creation of time has no financial impact, but how the business uses that time does have a financial impact. The majority of the time, a lean manufacturing company will use this newly created capacity to build & ship more products, and the financial impact will be increasing revenue.

In your lean decision making framework, it’s essential to be able to incorporate the amount of time being created so accounting can properly project revenue that can be realized.

In the next blog, we will begin to look at lean cost analysis in more detail.

Lean Accounting & Standard Costing Variances

A standard costing system generates rate & volume variances by design. Standards are entered into the system, actual is reported into the system and variances are created. Because standards are used to value inventory and cost of goods sold, actual variances are reported on the income statement to bring the financial statements back to actual. In a “traditional” manufacturing company these variances are often used as performance measures by operations itself, senior management and/or accounting. The definition of a performance measure being “to measure and manage operations.”

A standard costing system is also designed to maintain GAAP/IFRS compliance regarding inventory valuation. GAAP/IFRS states a portion of manufacturing production costs must be capitalized on the balance sheet as inventory in a consistent manner. A standard costing system within an ERP system automates this process. This process creates overhead absorption on the income statement, which can be favorable (increasing profits) or unfavorable (decreasing profits). Overhead absorption is also often used as a performance measurement.

Because variances and absorption both appear on an income statement, the accounting function of a manufacturing company must be able to understand, analyze and explain these numbers to perform the necessary function of financial analysis.

When a manufacturing company begins its Lean journey, the entire infrastructure built to support the standard costing system & related analysis must also adapt to Lean. Here is how the accounting function can lead this process.

Variances as Performance Measurements

Using variances as performance measurements in a lean manufacturing company will not work. Variances are designed to drive mass production manufacturing behavior – building inventory, long production runs and buying lots of raw material to get a lower price. Lean practices totally opposite of this.

Accounting must accept & understand this, and must explain this to any other part of the organization that believes differently. Accounting must also get behind 100% on deploying lean performance measures. Accounting may not have to do the actual deployment, as many experienced lean practitioners can do this. At a minimum accounting needs to participate in the development of the measures, actively support their operational uses and learn how to integrate these measures into their financial analysis.

Variances on the Income Statement

It’s easy to “stop” using variances as performance measures and replace them with lean performance measures. But the standard costing system is still being used and variances will appear on the income statement. The good news is that accounting has the opportunity to lead in modifying the standard costing system to potentially eliminate some or many of the variances on the income statement.

The first step for accounting is to team up with some IT and manufacturing people to study exactly how your ERP system calculates variances. Determine if it is possible to change ERP settings to “turn off” variance calculations.

Next, learn exactly what “actual” information the ERP system uses to do its calculation (every variance is simply actual to standard). Study the manufacturing floor to learn how that information gets into your ERP system. Get IT to set up a test database of your company and practice not entering actual transactions and look at the impact on your income statement. Here are some examples of what to try:

  • Stop reporting actual labor and machine time to work orders
  • Stop reporting differences in material SKU’s used to work orders
  • Implement back flushing reporting

After learning how the ERP system reacts to changes, you can make the necessary changes in your live database and shop floor reporting to eliminate variances.

Based on personal experience, I am confident you will find some ways to eliminate variances on the income statement if you make an investment in time to learn specifically how the ERP system works.

It’s important for accounting in a lean manufacturing company to address standard costing variances early in the Lean & Lean accounting journey. Educate the company on why standard costing variances will not work in a Lean manufacturing company. Support & assist Lean operations in developing and maintaining lean performance measures. Finally, dive into your ERP system and make the necessary changes in the system. You will be pleased with the results.

Lean Accounting and Standard Costing: An Introduction

If you are in the accounting department in a lean manufacturing company, and your company uses a standard costing system, it is inevitable that the accounting department will be faced with confronting how its standard costing system is being used.

I stress the term inevitable,because based on my own experience both as a CFO and a consultant, I have seen it happen consistently. Sometimes the confrontation will occur early in the lean journey, sometimes later, but it is going to happen.

My advice to the accounting people in accounting departments of lean manufacturing companies is to lead rather than react. Be the leaders of proactively evaluating how the standard costing system is being used as your lean journey begins and come up with a plan.

Coming up with a plan is not difficult, as long as you understand the issues. Fortunately, these issues happen to be very common across lean manufacturing companies that use standard costing systems. For the next few blogs, I am going to write in detail about the issues, look into exactly why these issues occur and lay out solutions.

I see 6 issues that accounting will have to deal with in a lean manufacturing company:

  1. The financial & operational impact of variances and overhead absorption
  2. The financial impact of inventory reduction
  3. Internal financial analysis & business decision making
  4. Inventory valuation
  5. Maintaining GAAP/IFRS compliance
  6. Other – such as transfer pricing or maintaining local regulatory compliance

Before we get into the issues, I think it’s important to get some background on why standard costing even becomes an issue in lean manufacturing companies.

The Root Cause

The primary root cause of why accounting will have to deal with standard costing is twofold. Accounting needs standard costing to value inventory but lean operations does not need, nor have any use for, the performance measurement & financial analysis aspects of a standard costing system.

Conflict between accounting and lean operations occurs when each side doesn’t understand each other’s reasoning.

Lean operations people don’t like the performance measurement & financial aspects of a standard costing system because standard costing systems are based on mass-production manufacturing practices and lean operational practices are 100% opposite of mass-production practices.

It’s important for accounting to recognize this and not try to force lean operations to use standard costing information to measure or manage lean operations.

Accounting needs standard costing to value inventory for GAAP/IFRS compliance. In most manufacturing companies with high inventory and many SKU’s, this is the simplest and easiest way to value inventory. And ERP systems are set up to do this, which automates the process. Accounting has another obligation, which is being able to explain the financial impact of the financial information a standard costing system produces, such as variances, absorption and margin.

It’s important for lean operations to understand accounting responsibility for maintaining GAAP/IFRS compliance and “stop using standard costing” is not a simple to do.

First Steps in Leadership

I mentioned earlier that accounting should lead the discussion on using a standard costing system in a lean manufacturing company. Here are 4 initial leadership steps accounting can take.

  • It’s a company problem not an accounting problem. Accept that your lean manufacturing company will have to deal with standard costing. Information from standard costing systems are used in all parts of a manufacturing business, and for many different reasons. The entire company will have to be part of the solution.
  • It’s a long journey not a short destination. It’s going to take time to adapt, improvise & overcome a standard costing system. Just like a Lean journey, there will be successes, and adjustments along the way. The larger to company, the longer it will take.
  • Begin communication of the issues. The CFO needs to begin talking to senior management. The controller needs to engage lean operations management. The entire accounting function needs a continuing dialogue on this topic. Begin laying out the specific issues your company is going to face over the long run.
  • Lean accounting practices & methods do provide a path & solution to resolving these issues in your lean manufacturing company. Learn about Lean Accounting.

In the next blog, we will begin discussing the issues in detail.