Bad Accounting Costs You Very Dearly

In my kind of work I get to meet up with a lot of good people in manufacturing, healthcare, financial services and other companies. Often we get into a discussion about how accounting systems need to change for companies on the lean journey – or LSS or TOC or BPI or CI or TQM or …..  Usually it is fun to talk about these issues because I have a passion for it and most companies are grappling with these problems. But sometimes it goes the other way. They say to me that their accounting system uses standard costing and this gives them great information.

Here’s a recent story from Todd Atkinson that shows the fallacy of this. Mr. Atkinson has years of experience in manufacturing and currently works for company making memorialization products in Tennessee. When you read the story, ask yourself why the manager thought the pre-cut steel had a higher cost than the uncut steel.

In my youth I wSaw Blades 3elded band-saw blades for industrial OTC and mail-order customers. The established practice was to wait for the order ticket, then cut the prescribed length(s) of blade from the roll stock, weld & dress and take it up to the counter for sale.

It didn’t take long to realize that there were a limited number of end-article permutations for each variety of roll stock, and typically with very predictable consumption patterns. So I broke tradition and started to make-ahead the most common sizes, capitalizing on the same efficiency as making two pizzas instead of one. I was way ahead of Little Caesar, but way behind Ray Kroc.

Everything was going great: sales volume increased, customer wait times decreased, conversion cost went down due to touch-labor efficiency improvement, quality improved due to consistency of short-series instead of one-off production, and I got to do proactive production planning including buying an expanded quantity of roll-stock to serve increased demand, instead of just being a reactive weld-monkey. Until one of the managers got tired of noticing the increasing number of pre-made blades in stock and decided to calculate this (I believe his actual term was ‘do some cipherin”). Holy cow – that’s thousands of dollars worth of end article sitting on the shelf, that if it were left un-converted roll stock would only be hundreds of dollars. Can’t have that… I

I was instructed to go back to the old way, since we had so much money tied up in roll stock in the first place and shouldn’t run up that cost even further by converting it ahead of time. I told him that if inventory valuation was his concern he didn’t need to value it as end-article, it’s WIP until I do the ‘final inspection and packaging’ prior to delivery to the customer. No dice.

Band sawHis fears were realized when within a couple of months customer wait times increased, sales volume decreased, and now the additional volume of roll stock I had accumulated over the last few quarters languished due to lower sales volume. See – he told me it was a bad idea and look – it ended poorly. Look at all this excess roll stock inventory! No duh…

Did the pre-cut steel cost more than the un-cut steel. Of course not. The man did not work any extra time to cut the steel – no additional labor cost. Did the overhead costs go up? Of course not. Overheads are fixed. Material costs, the same. The pre-cut steel had no additional cost than the un-cut. Yet, the manager’s decision was based upon traditional cost accounting and it cost him badly. It also bankrupted GM and Chrysler in 2009.

Sadly, in my line of work, I see this kind of thing rather frequently. Fortunately there are some simple and compliant ways to prevent this madness.

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2 Responses to Bad Accounting Costs You Very Dearly

  1. BMaskell says:

    Steve:

    Thank you for your thoughtful reply. I do of course see this rather differently from you. I only have a few minutes to reply.

    1. Your observation that the people do not understand the accounting is THE issue. By and large people in manufacturing (and other) industries do not understand the accounting because it is complicated, specialized, and very unhelpful to run a lean operation. The spurious product costs, meaningless gross margin against standard, and the baffling absorption and other variances. IMHO the people deserve something better and more helpful to run their business.

    I have listed below, some blogs and other information that will shed some more light on this.

    Standard Costing issues: http://blog.maskell.com/?p=927 http://blog.maskell.com/?p=292 http://www.maskell.com/lean_accounting/mindmaps/subpages/do_we_need_product_costing.html

    I do not have a blog on inventory valuation because it is rather straightforward, but we do address the various methods in our book “The Lean Business Management System”. http://maskell.com/

    http://www.amazon.com/Business-Management-Accounting-Principles-Practices/dp/0978976010/ref=sr_1_1?ie=UTF8&qid=1372284031&sr=8-1&keywords=Lean+business+management+system

    One method is of course to continue to use standard costing, but use it only for what it was designed for – valuing inventory. Do not use it for anything else. Companies making progress with lean however, can use much simpler and more intuitive methods.

    Good to hear from you. I would be glad to continue dialogue, if you are interested.

    All the best,

    Brian

  2. Steve Madison says:

    I am not sure this is a good example of an accounting system creating the problem. Perhaps it is not understanding the accounting system that is a problem. By all measures – your improvement in performance would have been noticed as a favorable manufacturing variance in a standard cost system. To complain about an increase in inventory valuation is often the result of outdated MBA education as opposed to standard cost accounting or even lean accounting. Standard cost accounting and indeed lean accounting would look at a measure of how this impacts the value stream – inventory turns. If inventory turns has increased or remained the same then an increase in inventory value is not really a bad thing. Obviously there is a potential impact on cash flow being if you are cash “poor”. You want collections from customers to coincide as closely as possible to cash payments to your vendors. But even this can often be mitigated as long as borrowing costs are less than the improved production gains.

    I understand your point about measures and what is important to measure. Telling a production worker to reduce waste by 10% and throwing up a waste chart is meaningless. Unless you can communicate to that person how to reduce waste and a measure that supports reducing waste then you will fail. So I agree that all “measurables” in manufacturing should be non-financial (unless you are the mint printing money perhaps).

    What intrigues me is how you eliminate inventory valuation based on a “standard” without wreaking havoc on short-term planning, actual inventory valuation (even standard cost systems require capitalized variance calculations to align with actual costs). The reason I bring up the actual inventory valuation is that it is quite simple to calculate standard costs and then do a capitalized variance. Allocating overhead rates for inventory valuation can indeed be quite tricky especially if you have different value streams in your company. I am guessing that you would value inventory at actual by determining actual costs each month. This would imply “pooling” of inventory costs and being able to recognize different margins on sales of the same product.

    So I await your next blog to detail how some of this is accomplished.

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