Breaking from Standard Cost – A Must for Lean Companies

A standard costing system is typically used in 3 ways in a manufacturing company:

  1. Performance measurement
  2. Decision-making
  3. Inventory valuation

From an accounting perspective, performance measurement and decision-making are part of a company’s management accounting system. A management accounting system is the internal information used by management to measure, manage, control operations and also to make business decisions.
Inventory valuation, on the other hand, is part of financial accounting. Companies must comply with accounting principles related to inventory valuation for financial reporting.

What’s the Problem?
imagesA primary weakness of a standard costing system is that all of the information created & used is based on some combination of product cost information and production reporting information. In general this information comes from bills of material and in routings, as well as standard rates for material, labor and overhead. Typically an ERP system does mathematical calculations and creates different types of variances, absorption numbers and the actual inventory valuation.

Conventional performance measurement focuses on improving rate, volume and overhead absorption variances. These variances are created because inventory & cost of goods sold are valued at standard cost, but actual costs never match standard. In order for the financial statements to be correct, these variances appear on the income statement and impact profitability.  So this type of performance measure also has a direct impact on reported profits.

Performance measurements are supposed to drive behavior. These measures drive one type of behavior, which is to make the variances as favorable as possible since favorable variances have a positive impact on profits. But the real operating behavior is “anti-lean”: build inventory, long production runs, fewer change-overs, produce in anticipation of future demand and large batch sizes. Any behavior that results in good product being produced improves these variances.

To be blunt, these measures simply will not work in a lean company†. Lean companies must stop using these measures.

Every effort should be made to stop using these measures as soon as possible on the lean journey. The solution is simple – develop and deploy lean performance measurements that focus on such things as improving productivity, quality, flow, delivery, cost and lead time.

A lean company must also work to eliminate these variances from even being created because these numbers are on the income statement and as long as they appear on the income statement, they will impact profits and have to be analyzed. I’ll address how to eliminate these variances later.

images-1We Need Better Decision-Making
Decision making using standard costing is based on the standard cost of each product. Decisions on the profitability of products, customers, business units and orders is usually based on comparing the projected margin to the standard margin. Sourcing decisions are usually based on the comparison of the standard cost to the purchase price. There is motivation to try to reduce a product cost to improve profitability.

The weakness of using standard costing in decision making in a lean company is that a standard cost doesn’t reflect the actual costs involved in the decision being make. Every business decision must stand on its own financial analysis, based on the actual revenues, costs and investments required. Lean companies must eliminate the use of standard costing for all business decisions. A Box Score can be used to evaluate a business opportunity’s impact operational performance, capacity and materials, which will drive the financial analysis.


What is a Box Score (4 min video)

imagesInventory valuation is based on the standard product cost of each item in inventory. This creates a tremendous amount of complexity and work because the database used to create these product costs (all the information on bills of material and in routings, as well as all standard rates for material, labor and overhead) must be maintained. Standards must continuously be compared to actual in order to keep standards up to date.

What’s the Solution?
Lean companies take a different approach to inventory valuation. Lean Accounting is concerned primarily with the total value of inventory on the balance sheet, rather than the specific value of each individual item held in inventory. From a financial reporting view (and also an external audit view) what is important is that total inventory is correct. Lean Accounting uses the average cost method to value inventory and cost of goods sold.

Material can be valued at average cost per unit, either for each specific item (if a company has many SKU’s) or a simple average of all materials (if a company has few raw materials). Product costs (labor and overhead) are capitalized onto the balance sheet in total by a simple journal entry, rather than item by item.

Since capitalized production costs calculated at a macro level, all labor and overhead rates can be set to zero, as they are no longer needed. Setting labor and overhead rates to zero immediately eliminates most rate, volume and overhead variances because any number multiplied by zero equals zero. Purchase price variance can be eliminated by moving to average cost instead of standard cost.

Lean Accounting is Simple
images-3 Lean Accounting breaks the link of using production-reporting information and product cost information for inventory valuation, reporting profits and performance measurement.

Lean Accounting recognizes that the weakness of using variances and overhead absorption to measure performance. The behaviors required to achieve good performance measures with directly conflicts with lean principles (e.g. build inventory to absorb overhead vs. make-to-order). Lean Accounting:

  1. Creates a set of lean performance measurements that are typically process-based non-financial measures used to control and improve operations.
  2. Lean Accounting uses a value stream income statement to report & analyze profitability internally.
  3. Lean Accounting uses a value stream income statement which reports actual revenue and actual costs by value stream.  No standard product cost information appears on a value stream income statement.
  4. Lean Accounting simplifies inventory valuation because it is concerned with the total inventory value, rather than each individual item. This makes the process of inventory valuation is simpler & easier and much waste is eliminated.

Lean Accounting Takes Much Less Time
There is much less maintenance of costs as compared to conventional product costing schemes.  The average material cost is relatively simple to calculate and probably doesn’t need to be updated too often unless the material is a commodity. Labor and overhead rates can be set to zero, as they are no longer need to calculate individual product costs.Setting standards and the practice of analyzing “actual-to-standard” can also be eliminated. This will free up a tremendous amount of time in accounting.

Finally, shop floor reporting can be simplified. It’s no longer necessary to track actual costs by work order since analysis of individual product costs no longer occurs. Most work order reporting transactions can simply stop. The only real necessary transaction to report to a work order is completed production, which moves raw material into finished goods in an ERP system.

Early in a company’s lean journey it is necessary to outline a plan to eliminate standard costs from your business. This is true whether the company is a privately held family business or a publically traded international company. The larger the company, the longer it may take to eliminate standard costing. But it must be done.

Footnotes:

† The use of overhead absorption bankrupted General Motors and Chrysler in 2007. Both company claim to be “doing lean” but their traditional accounting methods and incentives bankrupted the companies, and gave US tax payers an opportunity to see their money used to prop-up failed organizations. Read more.

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Succeeding With Lean When You Don’t Know Nuffin’

Keep Calm PDCA (1)It is vitally important for lean people to know nothing when working on improvement. This sounds like a crazy idea!! But it is another 100% turnaround from traditional management thinking.

This is the third article of a series that shows how to develop a truly Lean Management System. We are still on the fundamentals of Lean Thinking.

This time we will look at:

  • how lean thinkers go about radically improving their business
  • engaging everybody to make improvement
  • increase and capture knowledge

Here’s the big-picture diagram:

Lean Mgmt System Diagram-2 Click here for Lean Management System information

If a traditional company has a significant business problem they call in the experts. The experts study the problem and work out how to solve it. They then develop a project plan with a Gantt chart to show how they will implement all the changes needed to get to their solution†. This same team will parachute into various parts of the company and implement the changes required to solve the problem. Sometimes  these projects are very successful, but often they fail or they fail to sustain over time. These projects usually do not get finished on time.

There are two fundamental assumptions at work here. The first is that the experts know what must be done. The second is that the solution can be implemented successfully. Lean thinking rejects these assumptions and the problem-solving approach starts from a position of knowing nothing. There are a variety of lean-style problem-solving methods, and the most common is called PLAN-DO-CHECK-ACT (PDCA).

All lean thinking and change is based on data, rather than expertise. We never go into an improvement event with a plan of how to achieve the improvement. We know what problem must be solved, and we know how much improvement we want to achieve. We then step through the PDCA process and make the changes that the team has proven to be the most beneficial.

PROBLEM SOLVING PDCA

  •  Click diagram for PDCA video
  • The PLAN step identifies the problem, specifies the level of required improvement, and gathers data related to the problem.
  • The DO step is where the team analyses the data, identifies root causes, and develops multiple solutions.
  • During the CHECK step the team experiments with the most promising solutions, measures the results, more deeply understands the process, and decides which changes will be implemented.
  • The ACT step formalizes the changes through standardization, ensures sustainment, and identifies the next needed improvement. There is also a reflection time where the team reviews their work and identifies what new knowledge has been created during the improvement.j
  • The process is then repeated to build on the knowledge. People learn through repeat practice. Many small projects built around data, analysis, and experimentation.

Companies using PDCA make faster and better improvement progress and they formally capture learning/knowledge that can be applied throughout the business. Companies that do NOT rigorously use PDCA (or similar methods) soon revert to the traditional “expert driven” method of improvement††.  This results in slower improvement, fewer successful projects, lack of formal knowledge capture, and the same old top-down projects that do not empower the people in the company†††.

While PDCA is a superior method of problem solving, the more important issue is that lean companies do not start off with a plan of what changes to make. They know clearly what they need to achieve as a business but they do not prescribe solutions. The important changes develop through the PDCA approach based on data, experiment, and standardization. The work is NOT done by distant “experts” but by the people working day-to-day in the processes. These may be sales processes, production processes, child care, patient treatment, accounting, administrative, and all other processes within lean organizations.

IT IS ESSENTIAL FOR LEAN TO BE APPLIED EVERYWHERE ACROSS THE COMPANY

The methods of lean and the PDCA process must be used throughout the organization. Many companies  approach lean half-heartedly and only use lean methods in the operational processes; the factory, the clinic, the construction site, the software developments, etc.. True lean includes the use of lean thinking and methods in every process and every location throughout the company.

Lean Everywhere

I sometimes work with companies where only some of their locations are “going lean”. Equally common is for the lean work to be happening in the factory but sales (for example) are not involved. This leads to dysfunctional flows and a focus on cost-cutting instead of growth. Similarly, if the factory people are working with lean thinking but the accounting and measurements are traditional, the performance reports will push back against lean improvement because the measurements will drive anti-lean behaviors††††.

Lean thinking requires a broad application of lean across the entire organization using a formal PDCA for problem solving and improvement.

LEAN LEADERSHIP AT EVERY LEVEL

All important things take leadership, and lean is no exception.  Lean thinking is entirely the opposite of traditional management. It takes leadership to change the deeply engrained paradigms.

Lean Manager (3)

When lean first came to the West in the 1980’s it was largely run by leaders in the factory. As time went by and people recognized that there was something far deeper going on than just different manufacturing practice, the pressure came to make lean a process that is led and managed by the company’s most senior leaders. There are many lean failures when the people “in the trenches” pursue lean without the understanding or support from their senior leaders.

Recently it has been seen that for lean to prosper ALL company leaders need to be actively leading lean. Everybody from the executive team, the front line workers, and the middle managers at every level must be fully aligned. Alignment with lean means consistent understanding and lean thinking across the entire organization.

Now, life is not as clear cut and simple as this suggests. But the companies that become lean powerhouses are the ones with full focus and alignment on lean thinking and methods.

SO ………..LEAN MANAGEMENT STARTS HERE:

This article and the previous one set the scene for the lean thinking needed for our Lean Management System.

  • True lean starts with the Five Principles of Lean
    • Focus on Customer Value.
    • Work by Value Streams, not Vertical Departments.
    • Make Everything Flow without Stopping, at the Pull of the Customer.
    • Everybody Works On Lean Improvement.
    •  Pursue Perfection. Lean is a Long Term Strategy.
  • All lean improvement succeeds from data, analysis, experimentation, and control. No one knows in advance what to do; the PDCA process takes us there.
  • All our leaders must be trained, aligned, and focused on lean thinking at every level and position.
  • Lean must be on-the-go at every part of the company, all the time.

Now that we have address the fundamental Lean Thinking, we can move on to the Lean Management System.  In the next article we will go deeper into how lean organizations set up value streams and prosper their companies and their customers.

Coming Soon !!

HELPFUL CHECKLIST: Does your company approach lean by leadership, lean everywhere, and PDCA continuous improvement.

Footnotes:

†  Project management Gantt charts usually can not be read by people over 40 years of age. Is this a conspiracy against us?? Is it “ageism”?

†† This “expert-lead improvement” goes back to Frederick Taylor and the Scientific Management movement of the 1920’s.

††† Dan Jones focused on two primary issues at his keynote for the Instituit Lean Paris Conference 2014. “Engage everyone to do things they could not previously do” and “Learning through problem solving and repeated practice.”     http://www.youtube.com/watch?v=xqceUgpIKOg

††††  These traditional measurements and accounting methods were designed for 1950’s mass production-style management that, in turn, was developed from Taylorism. They are NOT bad or wrong. They are just designed for a management system that is the opposite of lean.

Keep Calm PDCA (1)

Posted in Lean Culture, Lean Management System, Lean Management System Series, Lean Manufacturing, Value Streams | Tagged , , , , , , , , , | 3 Comments

What I Learned About Lean at a Theological Conference

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I attended a conference this week where academics from the U.S., Canada, Europe, and other countries addressed thorny theological issues within a lively and growing church movement. I was there to support my son who was one of the organizers. Most of the sessions were way over my head, and included lots of very long words :-)) * But the Saturday morning session relating to “Multi-Ethnic Church” issues struck a LEAN CHORD with me.

Lean discussion groups are often populated with blogs and comments bemoaning the fact that most companies largely fail at making significant lean change. One of the common responses is the need for the executive leadership to be fully committed and knowledgeable. Many company leadership teams have taken this very seriously and have made strides to approach lean strategically.

What I learned at the conference was this; real lasting change requires active alignment of the leaders at every level.

The multi-ethnic church research was presented by an experienced professor. She has researched a number of U.S. churches with specific multi-ethnic strategies. She reported that the church senior leaders always have clear alignment with their strategy and policies. But the local pastors and other church workers surveyed show less than 30% alignment. The local people are of course at the front end of these much needed changes and, while they are fully on-board with the desired results, they do not have the band-width of time, understanding, and expertise to effectively make and sustain these crucial changes.

These same issues are rampant among lean manufacturers, healthcare organizations, construction companies, and many others pursuing radical lean improvement. These companies often have well thought-out lean strategies replete with X-Charts, A3’s, training programs, and initiatives that are driven down from corporate through to the groups, divisions, and plants. The local leaders are trained in lean tools and methods, but often they do not have the skills or the time to change the fundamental culture of their local operations. Similarly, the lean changes are often restricted to the primary operations so that sales & marketing, product development, finance and accounting, etc. are not aligned or involved.

What is the solution? The professor explained that policies and training are not enough to change paradigms. She also recognized that these changes are not easy. There needs to be a lot of small group interaction. Cross cultural meetings. Deliberate building of multi-ethnic teams. Leveraging current success even when it’s nascent. Adjusting the approach to local situations. And – most importantly – local leaders having personal ownership, clear but flexible plans, and the time available to nurture the changes. It’s a messy business.  It’s long term. It’s challenging; and it requires skill and patience.

Aligned Managers (1)Many companies just load their local people with more and more “programs”. These programs are often top-down initiatives. Most people recognize that for a local plant or division to have successful lean transformation there must be changes to the business culture. (New wine can not be stored in old wine skins).This includes such issues as measurements and their frequency, how people’s work-time is assigned, the role and behaviors of local leadership (as well as corporate leaders), new financial management, organization around value streams, active empowerment in every area of the work, and a clear change of focus toward the customer. Also needed is a “let’s go do it” atmosphere where people feel safe to make changes, experiment, review success and failure, change course, and learn from each other.

This kind of change can only be fully achieved when the local leaders have the authority and ability to shed the traditional thinking and develop new, lean ways of working. These are not slogans on powerpoints. They are real daily changes in what we do and how we work.  Like the churches seeking ethnic harmony, a well-meaning, top-down strategy will only be successful when the local leaders are aligned through the training, the tools, the time; and undivided focus to make it happen day by day.

I like the phrase a “Living Daily Practical Alignment to Lean Strategy and Action”. It’s a mouthful, but it does recognize that everyone has a part to play, and the work of lean transformation is done every day by every body. It’s a human process. It’s messy. It has it’s victories and it’s dismal failures; but out of both comes the knowledge needed to turn your piece of the company into a powerhouse of customer value and profitability.

__________________________

*  The Hermaneutics of Relational Eschatological Anthropology. Mmmmm.

Posted in Continuous Improvement, Economics of Lean, Lean Culture, Lean Management System, Respect for People, Strategy, Team Work, Uncategorized, Value for Customers | Tagged , , , , , , , | 6 Comments