This is a great question because you can’t really become a lean enterprise without making the shift from traditional standard-cost accounting to lean (i.e. plain English) accounting.
There are several powerful reasons for this. First of all, the traditional standard-cost accounting system doesn’t provide good information—in fact, the information it does provide is often misleading. This makes it very difficult for management to make good decisions. More importantly, standard cost encourages many of the things you are trying to eliminate with lean, which is why I like to call it the anti-lean. On top of all that, running a standard-cost accounting system is much more expensive.
Let’s start with poor information. The standard cost system expresses results in the form of a long list of variances:
- Purchase price variance;
- Material usage variance;
- Labor efficiency variance;
- Labor rate variance;
- Overhead volume variance;
- Overhead spending variance
Etc., etc. These are all variances from the assumptions made during the budgeting process, which was itself just a guess in the first place. As a result, when there is a problem, no one can really tell if this problem is actually in operations, or shows up as a result of flawed assumptions made while putting the budget together. In many cases, the finance guys don’t understand what is going on – and even if they do, they have a hard time explaining it to humans.
The traditional standard-cost company believes in having a product cost for each product, in detail, out to four digits. Every one of these is based on various assumptions and estimates that get so complicated that in the end no one outside of finance believes they are accurate. Even so, finance insists that product pricing be set on these inaccurate costs. This leads to either overpricing certain products, or underpricing them and leaving money on the table. After all, the price for any product is really set in the marketplace and not by an arbitrary cost estimate that the finance department comes up with…at great expense, I might add.
There are many ways standard cost accounting is anti-lean; one of the worst is that it incentivizes the building of inventory. Of course in lean, inventory is seen as the root of all evil because it hides waste. With lean a major thrust is to reduce inventory to eliminate waste; not build it. The standard-cost absorption approach, on the other hand, allows you to defer a certain amount of the overhead costs into inventory and thus a future period as long as inventory stays the same or goes up. The more inventory you build, the more costs you can defer and the better this month’s results will look. In fact, many standard-cost companies keep a keen eye on the number of absorption hours created during the month as they see this as a key measure of how they will do vs. the budget at the end of the month. If they are running behind after, say, the third week, the various functional managers will switch to making the products in their areas that have the highest absorption hours, even if there is no demand for them, as they know this will make the month look better and no one is going to bother them about building a little extra inventory.
Another benefit of the lean accounting approach is that it will help you gain visibility on your costs at a higher level. As you organize into cells, you will develop a clear idea of the labor and material for the products being made in each cell. Then at the product family or value stream level you will also see the overhead for all the products in the family. It will only be down to the gross margin line as a family, as trying to allocate all your overhead on a product-by-product basis is an exercise in futility. Even so it will be a more accurate view of profitability than you have now. In fact, the production cells will know which particular products are causing problems and as a result the people will work to remove the waste from them long before any standard-cost system will identify the problem (if in fact it ever does). You can set your prices based on the market.
Don’t expect that making the transition will be easy, as your finance team will likely fight the change. At Wiremold, we helped a number of companies get started down the lean path. Many of them called us a year later and asked if they could send their CFO and a couple of their staff to spend a week with us to understand lean accounting. Their resistance was one of the biggest obstacles these companies faced in making the transition to lean. You will want to run the lean P&L in parallel with the standard-cost system, but before you know it, no one will want to look at the standard-cost numbers anymore. Then you will know you are on the right track.
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