The Fundamentals of Value Stream Costing – Part 1 of 3

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.