Lean Management and Standard Costing

Lean Management has been around for the past 10 to 15 years. While I believe that it can have a positive effect in all companies, I will limit this discussion to manufacturers. In most cases it identifies the primary benefit as reducing costs, maximizing productivity, and satisfying customer requirements. However the greater benefit is Cash Flow improvement. This is also a process that does not occur quickly in a single financial period, but rather is a journey lasting many years, with some significant accounting issues in the early periods. This is another reason why companies need to focus on the long term objective and not instant gratification.

My concern today is: Can Lean Management and Standard Costing Coexist

Most manufacturing companies have been using full absorption standard cost accounting since the beginning if the 20th Century. These systems are designed using a number of accounting routines that attempt to determine the cost of a discreet product. In this process the cost includes: material, direct labor, and overhead. It is also based on the allocation of overhead on the amount of direct labor that is required to produce the product. Commonly known as the overhead or burden rate.

This method of costing was developed in the early days of mass production where it was the norm to have large volumes of a few products, with long life cycles, very few configurations, and customers that were accustomed to having long lead times.

I am sure that most of us can agree that this is not the environment that we find our companies in today. Today we find the opposite. Small lot sizes, short life cycles, a variety of configurations, and lead times as short as 24 hours or less. With these constraints and more companies developing self directed work teams, cellular manufacturing, one piece production, and implementing lean management techniques one can see that the current methods of looking at cost accounting has to change.

Another flaw with this system is that it rewards managers for false efficiency, as these systems create an environment where it is considered good to have all labor and overhead fully absorbed in the cost of the product. This can only be accomplished by producing products. Lots of products up to the capacity of the standard direct labor and plant equipment.

This term “standard” is the amount of direct labor that was determined through a process of time study and actual labor reporting. This combination suggests that the standard labor “approximated the actual cost” of the labor component.

This all seems to work fine as long as we have constant demand for products from our customers.

What happens when that demand changes or even reduces?

Early in my career, I was a user of standard cost accounting. I worked for a manufacturer that used full absorption cost accounting to not only determine the cost of the products and establish selling prices, but also to manage the plant. The system was designed to calculate variances which were deviations from standard for: purchase price, labor efficiency, labor rate, and spending. Management was rewarded on positive variances, and criticized for the negative variances. We also believed that to be a low cost producer we must maximize our efficiency by having all manufacturing resources producing 24/7.

What would result was a very competitively priced product and that may have been true as long as we had customer orders to produce. However when customer demand was reduced, in order to maintain our efficiency we would put “stock” orders into the system. These were based on an expected future order form our customers. If these orders did not materialize we would hold these in inventory. This was considered good management for a number of reasons: maintaining high efficiency, increasing inventory which was good as inventory was an asset and more assets are good.

It didn’t take long for the warehouse to become full and cash to become tight. When this happened we would have the sales department sell the products in inventory at a discount in order to make space available in the warehouse and generate some positive cash flow.

This situation created a fair amount of friction in the company because manufacturing made their numbers and were rewarded, while sales was criticized because they couldn’t forecast their customers purchasing cycles or patterns.

As my career continued, the word “forecast” was used many times. It seemed that the budget cycle needed a sales forecast to determine the financial budget for the company and manufacturing needed a forecast to plan their production using a system known as MRP. This complex system was based on having in addition to an accurate forecast, an accurate Bills of Materials, Routings, labor and material standards.

I believed that it was not only possible, but also necessary to maintain accurate Bills of Material, Routings, and material standards, as well as accurate sales forecasts and labor standards. Accurate forecasts became the larger issue, because like many companies we implemented a complex system of labor reporting and tracking. This enabled us to validate the standard and make adjustments as needed.

But the elusive FORECAST. If the forecast was accurate everything worked fine. If the forecast was inaccurate, we increased inventory, missed customer delivery dates, increased the number of set ups due to machine changeovers, incurred non productive direct labor, and generally (with the exception of building inventory which was an asset and was considered good) became inefficient.

The truth is, all inventory is not equal. Every manufacturer has three types of inventory. Raw Materials, Work In Process, and Finished Goods, and all are valued for financial purposes at cost. When the forecast changed, the inventory that had the greatest impact on it was Work in Process. This is because work stopped and operations were incomplete. In many cases unless they were included in an upcoming forecast, and assuming there was no engineering change, they may never be completed or sold in the future. This resulted in the designation of Obsolete. Raw Material had the next highest impact as unless it could be consumed by another product or included in another forecast, it too would fall into the Obsolete category, unless it could be returned to the supplier for full credit. Finished Goods may have the lowest impact, but only if they can be sold at full price. Otherwise it becomes Obsolete as well.

Consequently full absorption costing and MRP have a significant effect on the amount of inventory that a company carries and the longer it is held, the greater financial risk.

How does Lean Management change this?

The simple answer is by eliminating waste. Lean Management focuses on what is important. In most companies the answer is: To satisfy my customers needs at the least cost.

This means that a company will transition away from building products to a forecast, and build only to customer demand. In order to do this a company must consider the following:

• Have complete Buy In and 125% support from the CEO and all of senior management.
• Identify an internal champion or hire a consultant to form teams, provide training and direction, and be responsible for the successful transformation. Remember this is a continuing process that will become the culture of the company.
• Provide support and training for all company employees.
• Implement aNo Lay Off policy as the result of process improvements realized from Lean.
o Employees need to believe in and trust the process.
• Expect Lead Time reduction
o Reduce the amount of time it takes from the receipt of a customer order to delivery to the customer.
o Look for ways to reduce set up from hours to minutes.
o Consider one piece production and produce only the quantity required by the customer.
• Eliminate Waste (non value added activities)
o Quality Control
o Labor Reporting
o Overhead Allocations
o Develop process diagrams and work to eliminate or rethink steps in the process.
o Eliminate meaningless reports and develop new relevant reports that are useful to the reader.
• Supply Chain buy in
o Suppliers need to understand that the will be producing to actual demand, so initially orders may be smaller and deliveries more frequent.
• On time delivery

All of these activities will have a dramatic effect on the company, and it all sounds like it relates to manufacturing and operations, but there are also many issues that Accounting needs to deal with and prepare for.