Dealing with Standard Costing in Lean Organizations

If you are in the accounting department in a lean manufacturing company, and your company uses a standard costing system, it is inevitable that the accounting department will be faced with confronting how its standard costing system is being used.

I stress the term inevitable, because based on my own experience both as a CFO and a consultant, I have seen it happen consistently. Sometimes the confrontation will occur early in the lean journey, sometimes later, but it is going to happen. 

My advice to accounting departments of lean manufacturing companies is to lead rather than react. Be the leaders of proactively evaluating how the standard costing system is being used as your lean journey begins and come up with a plan.

Coming up with a plan is not difficult, as long as you understand the issues. Fortunately, these issues happen to be very common across lean manufacturing companies that use standard costing systems. 

Variance Analysis

?A standard costing system generates rate & volume variances by design. Because standards are used to value inventory and cost of goods sold, actual variances are reported on the income statement to bring the financial statements back to actual. In a “traditional” manufacturing company these variances are often used as performance measures by operations itself, senior management and/or accounting. 

Using variances as performance measurements in a lean manufacturing company will not work, period. Variances are designed to drive mass production manufacturing behavior – building inventory, long production runs and buying lots of raw material to get a lower price. Accounting must understand this and be the primary communicator throughout the organization of the weaknesses of variance analysis in lean organizations.

Accounting must give unconditional support to the deployment and use of  lean performance measures. Lean performance measurements should be used to understand the root causes of operational issues which are driving financial performance. This work should be done jointly by accounting and operations. The variances will still appear on the external financial statements, but should no longer be used to try to understand operational performance. 

Inventory Reduction

Most manufacturing companies begin their lean journey with high levels of inventory. Through the deployment of lean practices and methods, inventory will be reduced. The financial impact of inventory reduction, due to how a standard costing system operates in an ERP environment, is overhead absorption will be unfavorable (“under-absorbed”) and profitability will likely be understated. 

Accounting can provide leadership in two ways. First is to create Plain-English Income Statements for internal use (I will explain these in more detail in a few paragraphs). Second, accounting can project the financial impact of inventory reduction by working with operations to estimate the inventory reduction over time using days of inventory or inventory turns. After calculating this estimate, accounting can convert the change in the measure into the dollar value of inventory reduction flowing through the income statement used for financial reporting. 

Accounting can use the Plain English income statement and projections to explain to all levels of management what will happen financially as inventory is reduced.

Decision Making

In lean manufacturing companies, continuing to use standard costing for business decision-making will create conflict and confusion throughout the organization because standard costing information drives mass production thinking. It’s also possible decision makers can draw incorrect conclusions using standard costing information in lean organizations. 

Accounting must lead the company through the process of eliminating standard costing in business decision making. This may take some time depending on how ingrained standard costing information is in your company’s decision making process. This is also a learning process. Decision makers must learn how to use new information to evaluate business decisions. 

The first step is to develop a lean-based decision making framework based on “lean financial thinking” principles, as opposed to standard costing. I call this framework the Economics of Lean. Jean Cunningham calls it the Lean Profit Model. The idea behind such a framework is for an organization to understand how lean works financially by linking lean principles and practices to their actual financial impact.

Here are a few examples. “Creating value” can be translated into improved revenue growth. “Improving productivity” can leads to cost reduction over time. “Continuous improvement” creates capacity. “Flow and Pull” manages costs. 

The next step is to begin using Plain English financial statements broken down by value streams. Plain English financial statements are internal management reports. They are designed to show the actual revenue earned in a period  and the actual costs incurred for the period being reported. 

The general rule for understanding the financial impact of a decision is to calculate a future state value stream income statement, rather than looking at individual product costs, individual material prices or other standard costing information. 

The final step is to incorporate the impact of capacity in decision making. Improvement activities eliminate waste and the primary outcome is to create capacity. Creating capacity is creating economic value for the organization because that capacity can be utilized in many ways which will have a positive financial impact. Capacity needs to be measured and the impact of utilizing capacity incorporated into all financial analyses. 

Inventory Valuation

The primary purpose of a standard costing system is to value inventory for GAAP/IFRS compliance. In most manufacturing companies with high inventory, this is the simplest and easiest way to value inventory. Most ERP systems are set up to do this, which automates the process. 

Inventory reduction in lean organizations creates a tremendous opportunity for accounting to move away from standard costing for inventory valuation to simpler, “leaner” methods. When inventory levels reach 30-60 days of inventory, the financial risk of inaccurate inventory valuation decreases significantly, and the risk of material misstatement of profit is reduced. 

The primary opportunity is to move away from capitalizing production costs on a part-by-part basis (using labor and overhead rates) to capitalizing production costs in total. There are different methods which can be used, all of which are based on calculating average actual production costs (which are on value stream income statements) and using a simple ratio, such as units on hand to total units produced, to calculate the portion of production costs which need to be capitalized. A simple journal entry is then made to capitalize the proper amount of production costs on the balance sheet every month.

The primary benefit of lean inventory valuation is the elimination of unnecessary work. Much of accounting’s work required in conventional inventory valuation is no longer required because labor and overhead rates are set to zero in ERP systems. The time and effort of setting detailed labor and overhead rates is eliminated. The time spent analyzing, explaining, and reconciling product cost information, variances, and absorption is also eliminated. 

Lean inventory valuation also provides benefits to operations through the elimination of production-reporting transactions. Many transactions required under conventional inventory valuation methods are not required under lean inventory valuation, which frees up capacity that can be reassigned to productive activities.

Moving to lean inventory valuation methods is dependent of the rate of inventory reduction, so it’s best to think of this as a medium to long term objective. This opportunity needs to be recognized by accounting early in the lean journey to develop a two-phased plan. The first phase is to simply standard costing through the elimination of reporting transactions to fewer labor and overhead rates.  The second phase is to understand the specific issues which need to be dealt with to create a lean inventory valuation methodology. 

How Accounting can Lead

I mentioned earlier that accounting should lead the discussion on using a standard costing system in a lean manufacturing company. Here are 4 initial leadership steps accounting can take.

·       It’s a company problem not an accounting problem. Accept that your lean manufacturing company will have to deal with standard costing. Information from standard costing systems are used in all parts of a manufacturing business, and for many different reasons. The entire company will have to be part of the solution.

·       It’s a long journey not a short destination.  It’s going to take time to adapt, improvise & overcome a standard costing system. Just like a Lean journey, there will be successes, and adjustments along the way. The larger to company, the longer it will take.

·       Begin communication of the issues. The CFO needs to begin talking to senior management. The controller needs to engage lean operations management. The entire accounting function needs a continuing dialogue on this topic. Begin laying out the specific issues your company is going to face over the long run.

·       Lean accounting practices provide a path to solutions to resolving these issues in your lean manufacturing company. Begin the lean accounting transformation.