Traditional Standard Cost Systems Incompatible with Lean
One major obstacle of a Lean business system implementation has been traditional cost accounting systems. Typical standard accounting reports are too complex, difficult for non-accountants to understand, and do not appropriately reflect Lean journey improvements. There has been a disconnect between accounting and operations managers; with the latter generating their own internal performance reports that also generally failed to document the financial implications of shop-floor improvements. A system perspective has not existed.
Having an appropriate accounting system in place is especially vital as firms need performance measurements that reflect the benefits of continuous improvement arising from the Lean journey. Too often those benefits are hidden in outdated accounting reports filled with archaic jargon. The need for a clearer, simpler, more strategic performance measurement system in Lean companies is long past due. While many on the shop floor perceive this need, senior leadership, including finance and accounting, has been slow to understand this need for change in accounting measurements and reporting.
Traditional Standard Cost Accounting Systems
Without going into an in depth study of the origins of cost accounting, we should be aware that standard cost systems were originally developed for a totally different type of operating environment. Despite the fact that the world has changed significantly, and that cost structures of the typical organization today bear little resemblance to the labor intensive organizations of seventy plus years ago, we continue to use the same cost management systems.
Figure 1: A Depiction of Cost Structure Changes over Time
As shown in Figure 1, in the first half of the twentieth century, “labor” was the most significant cost component for manufacturing companies.
Over time, companies migrated to lower cost labor markets and focused more heavily on substituting capital for labor. As the use of computers became commonplace, labor expenditures shifted from direct labor to overhead, as a greater emphasis was placed on sophisticated MRP and ERP systems to manage more complex internal operations as well as national and global operations.
Overhead and Direct Labor Costs Considerations
Use of a traditional standard cost system, where overhead expenses are determined as a multiplier of direct labor costs, was appropriate in the early 20th century when overhead was the smallest piece of the cost pie, direct labor was the largest piece, and a batch and queue philosophy was universally accepted. Overhead rates of ten, twenty, or thirty percent of direct labor were not that significant and did not distort costs a great deal. However, in today’s typical cost system, where direct labor has continually declined and overhead has increased dramatically, we typically have overhead rates of three hundred to six hundred percent of direct labor. The practice of allocating overhead via a multiple of direct labor, or having overhead “ride the backs of direct labor” becomes more and more meaningless as the numerator of the ratio grows (or at least remains constant) and the denominator declines. The combination of a diminishing role for direct labor and the transformation from batch-and-queue production to one-piece flow renders the standard cost approach inappropriate or even detrimental in a world-class operation.
An interesting offshoot of this discussion is an analysis of the current reports emanating from the accounting department and the intense focus on labor analysis. When labor constituted the lion’s share of an organization’s cost of goods sold, it made sense to track it very carefully. The problem is that in today’s environment, we still have the same intense focus on all sorts of direct labor reports despite the fact that direct labor is usually the smallest component of a firm’s production costs and continues on a downward trend.
Lean and Financial Variances
A traditional standard cost system cannot coexist with Lean because it motivates behavior which is actively hostile to a Lean transformation. In particular, the intense focus placed by a standard cost system on the generation of a multitude of variances as a means of assessing operational performance is highly questionable. These variances are extremely complex, require significant resources and associated transactions to maintain, and usually are distributed long after the activity has taken place. Very few people outside the accounting area truly understand how the variances are generated. Furthermore, since all variances are financial in nature, they distance everyone from the underlying physical activity that generated these variances, which contradicts the desired behavior in a Lean organization. A true understanding of activity can occur only in gemba (the place where the work is done) by observing the work, not by an end of the month financial report.
Lean Accounting Practices
If your company has or will be embarking on a Lean Transformation journey, then it is critical to adopt Lean accounting practices that encompass value stream costing, box scores, and a “Plain English” Profit and Loss Statement to enable all employees to fully understand exactly what is happening on the shop floor as well as be able to report Lean improvements.
If you are ready to start your transformational journey, please join us Thursday, June 11th in Hartford, CT for our Symposium for Manufacturing Excellence. Click on the link to see the agenda or to register… www.b-wi.com/symposium
The author of this blog, Jerry Solomon and other Thought Leaders will be leading dicussions on topics including:Lean Accounting Practices, Cultural Transformation, Technology's Role in Transformation and others. Check out the link and the agenda using the link above. Hope to see you there!
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If you would like to talk about your current lean and business transformation initiatives, please reach out to me or our team of consultants here at Barry-Wehmiller International. Contact me at Pat.McGrath@B-WI.com . Wishing you success in all of your endeavors!
About B-WI: At Barry-Wehmiller International (B-WI) we are proud of our remarkable journey, a journey we began 20 years ago to become who we are today – a trusted, global, people-centric, ‘Total Solutions’ provider with a rich heritage in manufacturing. We take particular pride in our people-centric culture and values.
We have built a strong foundation, we are here to lend a hand and be a guide to our customers with our specialized consulting, technology, engineering and manufacturing talent. We were there then, we are here now and we will be there with you into the future. Welcome to Barry-Wehmiller International.
About the Author: Jerry Solomon, Retired VP of Operations, MarquipWardUnited. Jerry has over 35 years oJf experience working in a variety of industries where he has held the CFO & Vice President of Operations positions. He led Lean transformations achieving dramatic improvements in inventory turns, lead-times, customer service, income and cash flow.
He has authored 3 Lean books, two of which won the prestigious Shingo Award: Who's Counting? Accounting for World Class Operations and Leading Lean. His books focus on bridging the gap between Lean Ops and Lean Accounting. He was the Maryland Lean Leader of the Year in 2013 and is a founding thought leader and subject matter expert in Lean Accounting. Jerry is a long time board member of the Maryland World Class Consortia and a frequent speaker at industry conferences.
Jerry conducts two day workshops on Lean and Lean Accounting. He also offers private classes and is a frequent speaker at industry events and corporate gatherings.