Tag: Cost Management

Shared Value Stream Costs

Shared value stream costs exist because resources or consumption of goods & services may be shared by value streams. Shared value stream costs are operational in nature and each value stream can influence the total cost through operational practices and decisions, however the actual spending decisions and management of the costs are outside of any one value stream.

Shared value stream costs are typically assigned to value streams when creating a value stream income statement in order to understand value stream profitability. Assigning shared costs to value streams should be done using the simplest method possible, based on how the value stream influences the shared cost.

The 3 primary types of shared value stream costs are facilities & warehouse; production monuments and operational support functions. Let’s look at each in detail.

Facility & Warehouse Costs

Facility and warehouse costs consist of the rent, interest, utilities, repairs, maintenance and depreciation. Value streams can influence total facility and warehouse costs by reducing the amount of space needed. Therefore, assigning facility and warehouse costs to value streams is best done based on space (square feet or meters).

Production Monument Costs

A production monument is a value-added process step shared by value streams.  Production monument costs consist of the direct costs of labor, material, machine and other costs. Value streams can influence production monument costs based on demand for the parts the monument must produce. Therefore, product monument costs should be assigned to value streams based on percentage of parts produced for each value stream.

Operational Support Costs

Operational support functions consist of purchasing, planning, engineering, quality, maintenance, receiving and material management. In the early stages of a lean transformation, operational support functions may exist as separate departments, which would mean these costs need to be assigned in some fashion to value stream income statements.

In the middle stages of a lean transformation, you may see some operational support work move into value streams, either by moving operational support people directly into specific value streams or moving the work into the value streams to use available capacity. The result is more direct value stream costs and less shared costs.

This process will continue as the lean transformation matures and the organizational structure moves towards more of a value stream organization, at which point there would be minimal shared costs.

Determining how to assign operational support costs to value streams can create a lot of interesting discussion, so it is best to go back to the standard explained earlier: Assigning shared costs to value streams should be done using the simplest method possible, based on how the value stream influences the shared cost.

For operational support functions that consist of primarily labor costs, it’s best to assign costs based on ratio of full-time equivalent operational support employees that work in each value stream to total employees in the function (whole numbers only). Don’t overthink this or attempt to create a complex tracking system in an attempt to be “precise.”

For example, use the 80/20 rule to determine “full-time equivalent”: If on average a certain number of employees in an operational support function spend 80% of their time in one value stream, use this number as full-time equivalent. And if this cannot be done simply and easily, don’t try to assign the costs because over time, it may get easier due to the maturity patch of shared operational support costs.

Value Stream Costing Categories

In value stream costing, we like to categorize value stream costs either as direct costs; shared costs or business support costs.

Direct value stream costs are the costs that a value stream controls through operational activities and decisions. Direct value stream costs are rather easy to identify once value streams have been identified and mapped. From an accounting perspective, value stream direct costs can easily be charged to one value stream when posting to the general ledger. The cause – the spending decision and the effect – the expense posted to the general ledger, are quite clear, direct and natural. The 4 primary types of direct value stream costs are material, labor, machine/equipment costs and other direct costs. Each of these will be discussed in detail later.

Shared value stream costs exist because resources or consumption of goods & services may be shared by value streams. Shared value stream costs are operational in nature and each value stream can influence the total cost through operational practices and decisions, however the actual spending decisions and management of the costs are outside of any one value stream. The 3 primary types of shared value stream costs are facilities & warehouse; production monuments and operational support functions. Each of these will be discussed in detail later.

Business support costs are all the other traditional organizational costs that would be considered selling, general and administrative costs. These costs are typically not assigned or allocated to value streams.

In manufacturing organizations, there could possibly be a 4^thcategory of costs – product development. Lean manufacturing organizations consider product development a separate value stream, beginning with product concept and ending with product launch and there would be applicable direct value stream costs for the product development value stream.

Material

Value stream material cost is the actual cost of material consumed by a value stream, and can be identified either at the point of purchase or the point of issuance. Purchased material is used when the 100% of the material goes into one value stream.

If purchased material is shared by multiple value streams, then the material cost would be based on material issued to a specific value stream.

Using material consumed to establish direct cause and effect relationships between material entering a value stream and the 3 operational outcomes – produce and sell (which is the desired outcome); scrap or stock.

Labor

Value stream labor cost is based on the employees assigned to work in specific value streams. Through the process of value stream organization, value streams become the primary unit of operational organization, replacing operational departments.

Once these employees have been identified, the simplest method to assign the costs are through a company’s payroll system. Payroll systems have fields such as cost centers or departments, and this allows companies to assign employees and auto post labor costs to the general ledger. Auto posting of labor costs to value streams can be accomplished by modifying the proper field in your payroll system.

If this level of detail poses an issue due to the confidential nature of salaries, it is possible to assign labor costs based on ratio of full-time equivalent employees in a value stream to total employees in all value streams. If this method is preferred, it is recommended to only use whole numbers of full-time equivalent employees and avoid fractions or percentages.

Machine & Other Costs

Value stream machine/equipment costs consist of the depreciation, repairs/maintenance, tooling and utility costs. Value stream maps identify the specific machines in each value stream, and actual costs can be recorded into the general ledger through accounts payable process.

Any other cost which can naturally be charged in the general ledger to one specific value stream can be considered a direct value stream cost. Avoid creating allocation systems in accounting to try to be precise. It’s also important to consider the materiality of any other costs because in most cases labor, machine and material costs make up the majority of direct value stream costs.

In the next blog we will look at shared value stream costs.

Lean is a multi-faceted business strategy, with a primary focus on employees and learning. Through the use of various lean tools, practices and methods, employees learn to master their work, solve the right problems and help an organization learn how to doing things tomorrow it cannot do today. That’s why we should always talk about “lean thinking” as opposed to “doing lean”.

In the broadest possible context, lean accounting is a financial learning system for the entire organization, not just the accounting function. Because the economics of Lean changes the relationships between operations and financial numbers, the whole business must learn the new relationships and incorporate the dynamic context of these relationships in their financial analysis.

Deeply rooted paradigms exist about understanding and managing costs, usually based upon traditional financial management practices, industry practices or external financial reporting requirements. Many of these paradigms conflict with lean thinking, and if these paradigms are not changed, then eventually there will be conflict between the lean strategy and cost management & analysis practices.

The solution to this problem is value stream costing, which is a set of new paradigms based on the true cause & effect relationships between lean operating practices and costs. In this series of blogs, you will learn:

• The lean thinking cost paradigms which must be established in lean organizations
• The difference between direct value stream costs and shared value stream costs
• How lean organizations define fixed and variable costs
• Examples of typical value stream direct & shared costs

Lean Thinking Cost Paradigms

Value stream costing makes a lot of sense if it is viewed through the lens of lean thinking cost paradigms, so this is the first step toward establishing value stream costing in a lean organization. As you read through the following paradigm comparison, ask yourself 3 questions:

• Which traditional cost paradigms are present in my organization?
• At what organizational levels are these traditional cost paradigms entrenched?
• What level of discussion should be established to begin changing thinking towards lean cost paradigms?

Labor

For financial reporting, labor is an expense and because of this reporting requirement, it has created traditional thinking paradigms that conflict with lean thinking. Traditional financial thinking says expenses must be managed & controlled and possibly reduced due to business conditions. This leads to managing headcount, controlling salaries and when necessary reducing the number of employees in an organization.

Lean thinking organizations view people as their most important asset. Through the use of various lean tools, practices and methods, employees learn to master their work, solve the right problems and help an organization learn how to doing things tomorrow it cannot do today. That’s the idea behind the phrase “lean thinking”. Continuously improving productivity is what matters the most to a lean organization, and as a result labor expense will be controlled.

Time & Costs

Another traditional cost management paradigm is the perceived relationship between processing time and costs: the longer it takes to produce a product or deliver a service, the higher the costs. The genesis of this paradigm is based on the desire to understand the cost of individual products or services.

Lean thinking organizations view time as their second most important asset and develop a deep understanding of value-added activities and non-value added activities. The never-ending goal is to eliminate non-value added activities (“eliminate waste”), free up capacity (time) and apply this capacity to value-added activities. The cause-effect relationship is between revenue and value-added activities: the more time resources (people and/or machines) spend on value-added activities, the more revenue will increase. Sure, eliminating waste may achieve some direct cost savings, but it will not be to the degree that revenue will increase.

Cost Analysis

Traditional cost analyses are usually based upon complex allocation schemes in order to understand costs from many aspects, such as product/service costs, business unit costs and the cost of serving customers. The primary issue with cost allocation schemes is they try to allocate as many costs as possible and the allocation bases can be quite subjective.

Cost, or an expense on an income statement is an outcome, due to operating practices or managerial decisions. Lean organizations apply “lean problem-solving methodology” to cost analysis through understanding the dynamic relationships between operating practices and spending decisions, which results in preventing costs from being incurred.

Cost Management Objectives

The two primary traditional methods to manage costs are “actual-to-budget” analysis and requiring costs to be reduced. Both are “top-down” methods where the organization sets the goals and the rest of the organization must “make it happen”.

Contrary to what some people think, lean organizations are very concerned about costs. The general goal is to reduce costs over time through:

• Continuous improvement
• Clearly understanding the dynamic cause-effect relationships between operating performance, capacity requirements and actual costs.

Fixed & Variable Costs

Traditional definitions of fixed and variable costs are usually based on conventional cost accounting systems in manufacturing, where labor, material and overhead are assigned to products. In this environment, direct labor is often considered variable and in some systems a portion of overhead is considered variable.

Lean organizations tend to shy away from using these traditional definitions of fixed and variable costs. Variable costs are defined as costs that vary with volume in the short term. Fixed costs do not vary with volume in the short term and are typically influenced by management decisions.

In the next blog we will look in detail at value stream costing.

The purpose of a value stream income statement is to analyze current value stream costs compared to current value stream performance measures to determine root cause analysis of current costs.

Actual production costs for any value stream include the labor costs for people that work in the value stream, costs to own, lease, operate and maintain machines in the value stream, a portion of the facility/factory costs and any other production cost that can be directly attributed to the operation of a value stream.

It’s important for the entire accounting function in a lean manufacturing company to learn & understand the relationships between value stream performance measures and actual production costs on a value stream income statement. Understanding the root causes of value stream performance measurements reveals direct insights into the current state of production costs and also what improvements can be made operationally to reduce and/or better control production costs. Let’s look at some examples.

The cost of labor & machines in any value stream can be explained by understanding value stream productivity. A typical lean productivity measure is output / resources to produce the output. The output numerator is usually related to revenue. The resource denominator is usually based on number of people, actual hours worked by people or machines.

The primary root cause of low productivity is the resources are spending too much time on wasteful activities, rather than the activities that generate revenue. Eliminating the waste frees up capacity, increasing revenue without a corresponding increase in costs.

Labor and machine costs increase when additional capacity is needed.

Machine maintenance costs can be understood better by understanding the root causes of downtime. Reducing downtime will reduce these costs, as well as increasing productivity.

On a typical value stream income statement, actual material, labor and machine costs will account for the overwhelming majority of value stream costs, possibly up to 80% of total costs. Accounting should concentrate all efforts understand the root causes of these 3 costs using lean performance measures to create value-added financial analysis.

In the world of Lean Accounting, you will hear that a value stream income statement needs to show “actual material cost”, and is typically defined as actual material purchased. This confuses accounting professionals because it appears to be in conflict with the matching principle of accounting. So here is my attempt to clear up this confusion.

If a lean manufacturing company has about 30 days of inventory, then actual material cost will be what is purchased in the period. But in many cases, especially early in the lean journey, manufacturing companies have more than 30 day of inventory. In this case, material purchased is much different than the material cost of goods sold. This is the reason accountants think a value stream income statement is not compliant with GAAP.

What is important for accountants to remember is a value stream income statement for internal use only. The purpose of a value stream income statement is to explain the financial impact of lean progress. The accuracy & precision of a value stream income statement is not based on GAAP but on how it represents the current state of lean progress.

So, I’d like to clarify the definition of actual material cost, based on where a company is in its lean journey.

I believe a good starting point in creating a value stream income statement is to define actual material cost as “actual material consumed” by each value stream. This would be the actual cost of material released into the value stream.

I use this definition because there are three operational stages for material after it enters a value stream:

1. Sold – material can be processed through the value stream and sold
2. Scrapped – material is defective and scrapped during operations
3. Stored – material can be stored as inventory, and subsequently either sold or scrapped

At the beginning of the lean journey, material in most value streams will likely be in all 3 stages. Then as quality & flow improves, the quantity of material scrapped & stored will reduce. Eventually if a company can reach 30 days of inventory, actual material cost will be what is purchased & sold within period.

Accounting’s responsibility is to financially analyze material cost its impact on value stream profitability based on what happens to the material as if flows through a value stream. Let’s look at this in more detail.

Obviously, any financial analysis involving changing sales volume would have a corresponding change in material cost.

As lean manufacturing operations improves quality, value stream material cost will decrease because less material is being consumed. Using a standard lean performance measure such as First Time Through or scrap rate, it’s not difficult for accounting to calculate the financial impact of better quality.

As lean manufacturing operations improves flow, it will also lead less material being consumed. Using a standard lean performance measure such as inventory days or inventory turns, accounting can calculate the financial impact. This is very important to show on a value stream income statement, because the external financial statements will not show this as reducing inventory only has a balance sheet impact – improving cash.

One financial analysis accounting needs to move away from in a lean manufacturing company is simply analyzing material price. Don’t get me wrong – the logic of lowering material prices does have a positive impact of profits. But in lean manufacturing operations, material price is balanced with supplier quality, delivery & lead time.

The price of anything is a reflection of value. Lean manufacturing operations values short lead times, high quality and on time delivery from its suppliers because this type of supplier performance will increase flow, and thus increase revenue. Suppliers that provides the best overall performance with lowest price usually become preferred suppliers.

The danger of focusing financial analysis simply on lowering material prices is the only short term solution is large volume purchases from suppliers that offer volume price discounts. But this is “anti-lean” because it increases inventory.

Accounting’s financial analysis of material costs based on “actual material consumed” will provide real time financial information to management to clearly show the impact of lean operations on material costs.

Value Stream Costing (VSC) is often misunderstood when it’s introduced into a business.

First reactions to VSC often are based on incorrect or incomplete beliefs about VSC.  The purpose of value stream costing is to get all employees focused on the root causes “actual costs”. Because VSC is so different from analyzing product costs, employees believe falsely that a VSC-based income statement is not GAAP compliant.  This is based on the false belief that standard costing must be used for GAAP-compliant financial reports. Another typical reaction is “These numbers can’t be right!” because the numbers look different from what they are used to. The result is a lot of stress.  It’s just human nature.

So, when I am helping a company introduce VSC, I consciously make myself aware of that these reactions may occur and look for ways to reduce this stress.

In my experience, what really helps is training.  The Lean company introducing VSC will get on board faster, once they understand two key facts about VSC, namely:

1. It’s the best way to identify the root causes of your costs.
2. All we are doing with VSC is applying standard Lean problem solving methodology (Plan-Do-Check-Act) to managing the costs of the business.

Once I get people to understand these facts, I invariably see the lights go on in peoples’ minds and feel the stress go down.

Here’s how you can understand this:

Let’s start with a fact that binds everyone together. Every company has a goal to be a low-cost producer.  Many companies, however, struggle with reducing costs in an effective manner.  For example, we can mostly agree that a management edict like “10% across the board cuts” is not effective way. Nor is strictly adhering to an annual budget going to work, because it is impossible to predict everything in an annual budget.

Now, let’s consider how Traditional companies differ in their approach from Lean companies.

Traditional (non-Lean) companies have problems cutting costs because they are going about cost analysis in the wrong way, looking at the wrong indicators, and not understanding what’s really driving their costs.

Lean companies understand that the most effective way understand costs, is to analyze any variability using root cause analysis. Once they identify the root cause, then they take corrective action to eliminate it. Eliminate the root cause, eliminate the variability. This is how Lean companies eliminate waste from processes.

Lean companies recognize there are two primary root causes of costs in a value stream (whether it is a production value stream or an office value stream). One root cause is the amount of production capacity required (people, machines, and facilities) to meet demand. The other primary root cause is the amount of variability in the value stream processes, such as quality problems, lack of flow, too much inventory and other wastes. And these two root causes are related because the more waste that exists in a value stream creates need for more capacity.

VSC makes the path to understanding how to improve costs more direct. It puts real power in the hands of the value stream manager because he or she gets critical actual cost information faster.

I like to use the following diagram as a handy way to contrast the two approaches.

VSC reports actual spending; a value stream manager can identify the decisions or events which were the root causes of the spending. Countermeasures go into effect quicker, and costs go down.

VSC is a much easier and more direct method for managing costs than any form of product costing. The traditional product costing process requires subjective allocations of fixed costs to products. It is quite difficult for a value stream manager to understand these allocations and they are useless to get to the actual root cause of the cost.  Please note: knowing the allocation method used is not the same as knowing the root cause.

So when introducing VSC into your company, first have a discussion on these topics:

• Is your company meeting its cost management objectives?
• What are the weaknesses of your current cost management/analysis system?

Then you can see Value Stream Costing as a method to achieve your Lean goals.

 

Continuing my discussion about what I call “Lean Cost Management:”  I’ve been making the case for a Lean Cost Management System vs. using  “traditional” cost management methods.  Management methods differ widely between the two approaches when it comes to keeping track and reducing spending  on labor and machines, as I covered in my last blog.

Now it’s time to think about some types of spending that may not directly contribute to customer value, but which are nevertheless crucial to delivering it.  I’m talking about activities your company has to do and do well. We have to do them so well in fact, that we keep our costs as low as necessary while making sure that production flows unimpeded.  All companies everywhere have to solve these issues.  But looking at these subjects  through the Lean Management lens can give you a fresh approach and perhaps help you make changes that move your lean efforts in the right direction.  We’ll start with quality.

Spending on Quality

Traditional companies make an attempt to calculate the Cost of Quality. The most popular method to do this is to use the standard costing system to track the total material cost scrapped or the total product cost scrapped (including the materials, labor & overhead.) Companies do this primarily to be able to report summary information to senior management and answer this question: How much is poor quality costing the company?

Lean companies go about this another way.

A colleague of mine related a story she heard at a meeting of lean accountants.  A CFO (from a very large lean company) was telling about how his company did not track scrap cost.   A bunch of hands shot up; a lively back-and-forth  followed about how you get scrap off the books, why report it, how you manage it etc.  The CFO laughed and answered patiently.  It turns out he did not care about the standard cost of scrap because tracking it and telling upper management about it (himself, in this case) did not help.  What he really cared about was that lots of scrap represented lots of waste, and it meant there was more lean work to do.

This CFO understood that fixing the real “Costs of Quality” from a lean viewpoint should focus on the waste:  the lost productivity, the possibility of poor quality products being shipped to customers and the hidden root causes of poor quality.  Notice, none of this information is directly financial.  And that’s the point!  Fixing scrap cost involves fixing the “who what where why and how.”  Fixing scrap cost comes from fixing  quality at the source.

Lean companies measure quality incidents at every production step (cell)  daily and overall in every value stream weekly. Performance measures such as First Time Through or First Pass Yield help identify the true root causes of quality failures.  Then the cell or value stream can put countermeasures in place promptly and new standard work will emerge. Such improvements  will  reduce spending on bad quality while maintaining production flow. Lean companies will work to eliminate quality inspection entirely  (as a separate department) and instead incorporate it directly into the value stream through a series of kaizen events.  Overall quality spending goes down.

Spending on Maintenance

 

Many times what I see regarding traditional ways of tracking and controlling maintenance costs goes something like this:   the company uses a work-order system to track the time and material spent by the maintenance department.  The department manager  knows down to the gnat’s eyebrow exactly what the financial impact of maintenance spending is.  This is all good information to have,  but it does little to focus on the root causes of maintenance issues and how they impact the pull of value to the customer.

As I discussed in my earlier blog  ( https://maskell.com/?p=418 ) there’s a better Lean way to manage maintenance, namely finding a way to FLOW maintenance work

Flowing maintenance  work actually improves productivity in the long run and reduces spending for unplanned problems.  Plus, existing maintenance staff can handle more work.  Incorporating maintenance flow into the value stream produces better flow over all and saves money.

Spending on Material Management

 

LEI’s[i] Lean Lexicon[ii] makes the point nicely:  moving materials through a production facility is much more than just getting stuff to the line, “wrestling with dunnage, and finding parts.”  You still have to do it, but doing it well, and in a planned way that is integrated into the flow of production is the Lean way.

A lean company will establish pull systems throughout production as inventory management activity is absorbed into the value stream;  spending on it will be reduced overall and inventory levels will go down.  Implementing various lean ways of managing inventory visually, having  point-of-use stocking locations, etc. will not totally eliminate the costs, but they be reduced to the minimum necessary for maintenance of flow, and  (for the CFO best of all!)  they will render obsolete a bunch of spending on dragging materials around the production floor, cycle counting, and the like.

Spending on Receiving Inspection

 

Here is where a Lean approach can result in major savings.

Having a receiving inspection department or designated function usually exists because traditional approaches don’t focus specifically on ensuring that your suppliers consistently deliver quality where and when you need it and are rewarded for doing this well.

Similarly to material management functions, the ultimate goal in the Lean company is to incorporate the receiving function into the value stream flow. Lean companies do this by setting into place such practices as:

1. Supplier certification  (where you establish relationships with your key suppliers in terms of price, delivery, quality and lead-time)
2. Kanban pull between value streams & certified suppliers, who deliver directly to the point-of-use.

Using Lean methods may render the receiving inspection function obsolete, thus saving money, and freeing up that resource for value-added work.

Wrap Up

Spending money involves making business operating decisions or taking some other type of action.  If the decisions and actions can be changed, spending can be changed. This is the foundation of a Lean Cost Management System.  As a Lean CFO your first priority is to help focus the efforts of your value streams on controlling spending, understanding how and why it fluctuates, period-to-period and how it ties directly revenue

A weekly value stream income statement will do this.  You can then give  the value stream manager what he/she needs to understand root causes that affect spending.  Waiting ‘til after month end and trying to tease information out of financial variances does not help.

With this focus, your company can begin using kaizen events specifically targeted  to reduce spending.

I strongly recommend that you  create and use a weekly value stream income statement. Make the Value Stream Income Statement the only income statement your managers us to analyze the business.   This is how you “put everyone on the same page.”   You will soon see the conversation shift from “what happened?” to “what do we do about it?”

Also start using weekly value stream cost reports with income statements.  Use them along with your box scores when doing kaizen events.   Your company will grow many more “financial analysts” who are in the gemba taking a proactive role in controlling spending.

Here’s a sample cost report for a lean value stream that breaks out information in an actionable way.  [iii]

Continuing my discussion about Lean Cost Management: last blog, I made the case for a Lean Cost Management System vs. using “traditional” cost management methods, focusing on Materials Spending.

Today, I’ll tackle two more topics: Labor and Machines.

Labor Spending

 

The CFO’s traditional approach to managing labor costs is deceptively simple – try to keep reducing it. When you look at it from a “total labor cost perspective,” you naturally get into measuring headcount and overtime hours.  And, because traditional costing methods are always focused on standard product cost, reducing direct labor cost becomes important to reducing the cost of your products; typically, you will do this by examining your variances and making sure that production resources are used as efficiently as possible.

From our discussion last time, about materials spending, we saw that this leads to big batches and more waste. [i] The same goes for labor resources.  Seems sensible, right? Having people standing around idle is bad; having them making something is good.  But Lean teaches us that making too much, making the wrong stuff, or making poor quality is a bad way to keep busy.

By now, we should be able to guess the traditional approach to labor cost will not be effective because it doesn’t address the real root causes of how much a company spends on labor.

We have to change the discussion from “How much did we spend?” to “How well did we spend?” on labor.

The Lean CFO will look at labor as an operating expense, not as a component of product cost.  We see labor is a resource; labor provides the capacity to create the value your customers will buy from you.  The Lean CFO will be very interested in how well our labor spending met customer demand.

This leads us to a discussion of root causes.  I believe the two primary drivers of your labor cost are 1) the total amount of labor required to make the all products your customer buys and 2) how productively our labor resource was used.

By this approach, the total amount of labor is the aggregate cost of all the people that are assigned to your value streams.  The Lean value stream is the “engine” that produces our revenue, and maximizing FLOW within the value stream is how Lean companies make more money.

Truly Lean companies quickly understand that traditional departments create barriers.  Barriers separating front-line production operations and traditional manufacturing support functions (such as quality, maintenance and engineering) are especially harmful; they actually impede flow and make it harder to improve it.   This is exactly why Lean companies work to destroy these impediments by assigning as many people to work full-time in value streams as possible.  Value stream costing recognizes this as labor expense on the value stream income statement.

Lean CFO’s understand labor spending best in the context of the Value Stream and how the labor cost is being spent. They are not as concerned with the total amount of labor spending, as long as productivity continues to increase. This is the reason why lean CFO’s simply charge the actual cost of labor to value streams. They want value stream managers to focus more on measuring and improving productivity while meeting customer demand.

In this context, productivity is the ratio of output to input of the entire value stream. Lean companies define output as demand or shipments, not production volume. Input is the total labor, such as hours worked. If productivity is improving, then output (demand/shipments) is increasing at a greater rate than input (hours worked). This means that the rate of spending on labor is increasing at a lower rate than the rate of revenue growth, which means profits are increasing.

What matters most is consistently improving productivity by 10-20% annually.

What will keep people from these productivity gains?   If the processes they work in, which have been designed by the company, are not Lean they will not see improvements in productivity.  Low productivity is generally not the fault of the people doing the work.   It’s caused by poorly-designed or poorly -performing processes.

Using traditional measurements like labor efficiency or total headcount sends the non-lean message that poor productivity is the workers’ own fault.   But the Lean CFO knows that productivity will only increase when waste is eliminated from the value stream and the people are focused on delivering value.

In a Lean environment, productivity in increased by perfecting the process; adding more people means that demand is increasing. As long as productivity improvement is maintained when people are hired, it doesn’t matter how large your headcount. You will be making money.

Machine Spending

 

The traditional approach to managing machine costs focuses on maximizing utilization.  It seems sensible, right?  You make maximum use of an expensive resource to get maximum pay back. This usually means long production runs with fewer change-overs.  This typically results in large batch sizes and too much inventory.

The Lean CFO thinks about machines pretty much like labor:  they are a component your capacity.  The focus should be on improving productivity, not maximizing the use of the machine.  This means thinking about root causes.   To improve machine productivity, lean companies focus on identifying the drivers that cause machine-related problems that impede flow.   The question becomes: “Why can’t the machine run if customer demand is present?”

One area of focus is downtime. Lean companies want to minimize unplanned downtime, as that disrupts flow. Total Preventative Maintenance (TPM) practices will minimize unplanned downtime and because PM is planned, flow will not be disrupted.

Other drivers of poor productivity will focus on quality problems related to making the product and the rate of production of the machine. If a machine is producing poor quality, costs go up. If the machine is producing at a lower rate than customer demand, then costs go up as well.

Changeover is another driver that the Lean CFO will address. To improve machine productivity, changeover must first be stabilized and standardized, then reduced.  Continuous improvement activities will address on-going changeover time.  If changeover cannot be avoided, then it must be managed using level scheduling techniques.

In summary:  Lean managers will use an analysis that shows the “How Well” they are spending their resources.  The following illustration shows one way to analyze this in a manner that us really useful and supportive of lean improvement. [ii] The data that underlies a report like this comes right out of the value stream map coupled with aggregated monthly costs of employees and machines, broken out by the cells and processes that belong to the value stream. A report such as this does not have to include money.  It could also be done in time units,  In either case, it is useful.  [iii]

Next time: spending on Quality.

Last blog, I laid out my CFO experience (and probably yours) using what I’ll call “traditional” cost management methods.    In this blog, I will lay out an alternate (and I believe much better) way for Lean companies to manage costs.   As the Lean CFO Job # 1 for you is to transition your company away from traditional types of cost management and create a lean cost management system.

I call it: Lean Cost Management

Why do it? The short answer is:  the five Principles of Lean (which form the foundation of a Lean Enterprise) demand it.

Continuing to use traditional cost management systems in a lean company will create conflict.  A management “conversation” based on traditional cost management systems will invariably lead to discussing the wrong things – and traditional solutions which conflict with lean will be the result.

For the Lean CFO (and for you too, Reader!) “it’s about spending, not costs” must be your mantra.  By word and deed, the Lean CFO needs to send this message constantly and consistently.

Furthermore, I maintain you don’t need to concern yourself with trying to calculate the cost of anything!   Be it a product, customer, process, product line, etc.  – it’s all worthless information.   Focusing retrospectively on costs (as traditional methods do) leads to thinking about allocations and discussing the basis of allocations, and so on.    This ends up in a conversation that has nothing whatsoever to do with the root cause of the costs.  The truly Lean enterprise ought to be focused on creating customer value through Lean operational processes.  The truly Lean enterprise will foster a culture where the work of empowered people, who actually can get at the “Who, What Where Why and How,” use Lean continuous improvement to control costs and reduce spending.

Spending money involves making a business decision or taking some specific action. If decisions or actions can be changed, then spending will be changed. If spending can be changed, costs ultimately will change. This is the basis for having a Lean performance measurement system.  In operations, for example, you create simple, relevant measures that identify where lean processes deviate from or reinforce your Lean strategy. Then you use Lean improvement events to remove root causes and improve performance.

It’s the same for understanding spending.  The “simple, relevant measure” in Lean Cost Management is Value Stream Costing. Identifying issues and removing root causes is based on the weekly reporting of spending to the value streams.

How does this work?

The first component of a Lean Cost Management System is what we call “Value Stream Costing” (VSC for short.) VSC assigns actual, direct costs to value streams. All costs are assigned to the value stream where the spending actually occurs.  This means that costs that are traditionally allocated under a product costing system are no longer allocated.  You do this so lean problem-solving methods can be applied directly to where they can be acted on and can produce the right result. This is an example of what is meant by “Lean Pursuit of Perfection.”

Effective Lean problem-solving depends on identifying root causes.  Once a root cause is understood, it can be changed, eliminated or managed.   This is how continuous improvement is supposed to work in Lean manufacturing operations and likewise,   from a cost perspective, the root cause of the cost comes from some kind of decision or action.  By assigning actual costs where the spending decision occurs; and by not allocating these any further, we can get everyone in the company involved in root cause analysis of spending. This means “Empowering” the people to do what is necessary.

Then by increasing the frequency in which costs are reported, from monthly to weekly, it becomes easier to identify root causes and to change or reduce spending. Let’s look at some examples of how it becomes much easier to manage spending with VSC.

Material Spending

In financial accounting, there are components of inventory on your balance sheet.   In a Lean enterprise, using VSC, these are treated as expenses when incurred.  I know right now many of you are screaming “But that is not GAAP!”

Keep calm, and read on.  Remember what we are trying to do operationally is to reduce spending on materials.   For this we do not need a discussion about GAAP.  Instead, material spending needs to be analyzed by its components – price and quantity.  Bottom line here, we are looking at the Lean principle of FLOW.

In traditional product cost systems, typically all that matters is the lowest material price. Unfortunately, this leads to non-lean behavior like buying way too much material in order to secure the largest purchase price discount.  On the other hand, Lean companies recognize that price is just one component of the entire supplier relationship which also includes lead-time, delivery and quality. All four components must be considered in terms of specific performance required of suppliers to maintain and improve material flow within your value streams.  Lean companies understand the price they pay for materials is based on the value received from the supplier. In general, unless you can dictate all terms to your suppliers, it’s best to concentrate on developing excellent relationships with your suppliers based on the value you require from them.

Material quantity is where a real difference can be made in material spending. By reporting actual material spending on a weekly value stream income statement, the company can drive value streams to reduce material spending by using the following lean practices:

1. Single piece flow: You establish single piece flow within your value streams by putting lean practices such as pull systems, kanban, and level scheduling.   When these systems are working well, you reduce the quantity of material purchased because you have limited it to actual demand plus some (small) buffer stock. Pure single piece flow may be difficult to achieve, but it should be your goal.  Use the right amount of materials in the right time frame and costs will take care of themselves.
2. Reduced scrap and rework: By doing this, you will also reduce material spending. For this to work, you need to measure quality incidents at every production cell daily and in every value stream weekly.  Notice:  I said nothing about trying to figure out the cost of these incidents. The cost of failures is NOT relevant!  What actually happened in the value stream to cause the scrap and rework is what you are looking for.  Lean performance measures such as First Time Through or First Pass Yield will help you get at the true root causes of quality.   From this you can take corrective action.   The right corrective actions will take care of the cost.
3. Product design: A Lean company also reduces material spending in product design.  They redesign products to use less material or they substitute less expensive materials when possible.   In all cases, Lean companies consider design changes in terms of customer value, not simply on material cost.

You will notice, throughout the discussion above, I have always tried to tie the actions taken back to the guiding Lean principle.    This same approach applies to managing spending of all other material costs within a company, such as manufacturing supplies, spare parts and office supplies.

Next time, we’ll tackle Labor Spending.