The Limitations of Standard Costing: Why Lean Accounting Can Take You Further
Nick Katko
As more companies search for ways to stay viable in a lightning-fast, global economy, lean thinking has become an increasingly successful way for companies to adapt more quickly and remain competitive. However, many organizations have attempted to implement lean thinking without moving to a lean accounting model. Accounting departments are trying to reconcile a lean organization with standard costing and running into significant difficulties. Lean accounting represents a shift in how companies use collected data to make essential decisions around quality, production, and more. We'll start with the basics to understand why and how lean must translate to accounting.
This blog was written based on a webinar presented by Mike De Luca and Nick Katko.
What Is Lean Accounting?
Quite simply, lean is the principle of creating maximum value with as few resources and as little waste as possible. It is a method of problem-solving that centers around the customer. Organizations successfully implementing lean practices understand it is a process often involving several iterations before achieving targets. Lean means identifying where companies can improve quality and ease the flow of products in the work process while reducing production time and effort. By approaching production processes this way, companies can vastly increase adaptability and move toward processes that meet customers' needs on time.
In the last three decades, many organizations have moved toward lean practices, but not all have implemented lean in the accounting department. Standard costing is still the default approach for many, even though there are many instances where lean practices and standard costing come into conflict.
A Refresher on Standard Costing
Standard costing is when manufacturers create an estimate of expense for a particular production process. It allows manufacturers to plan costs in several areas, including overhead, labor, or product material, and make decisions based on the estimates. Many manufacturers have in the past and continue to benefit from standard costing because it can allow managers to make decisions more quickly than waiting for actual cost figures. However, many manufacturers are creating monthly reports based on standard costing, which are not always timely enough to be useful.
What Is Wrong with Standard Costing?
It's not that standard costing is inherently terrible, it's that it doesn't fit lean thinking. Standard costing has been the typical set of tools for about 100 years for most manufacturers. It provides an estimated cost, not an actual cost for profitability. Standard costing works very well for what it was designed for—mass production manufacturing. However, lean organizations struggle to hang on to standard costing because lean thinking promotes very different behaviors. Problems arise in this conflict, as difficulty reconciling lean thinking and standard costing can lead to poor financial and operating decisions that impact profits.
Standard costing motivates non-lean behavior. For instance, if a company is dealing with purchase price variance, excessive buying to get a good price helps the supplier, but doesn't help a lean operation team because it opposes the strategy of buying only what you need. Standard costing can also lead to manipulating profits by overproducing, which goes against the make-to-order environment of lean. Holding onto standard costing in a lean organization can also negatively impact production variances and product costs.
What Are Lean Performance Indicators?
Moving toward lean accounting means shifting the types of performance indicators a company utilizes for decision-making. Lean performance indicators include:
Productivity: Identifying revenue—output—divided by resources required (input)
Delivery: Targeting on-time delivery to the customer on their requested date
Inventory: Reducing the impact of inventory by measuring the days
Quality: Quantifying defects and rework—SafetyChain's software solutions target waste reduction in plants
Cost: Most costs are fixed, so it's important to look at long-term cost reduction
Lead Time: The length of time it takes to fill an order
With a standard costing perspective, manufacturers might prioritize data for total labor time and labor costs, and overhead and material costs. A lean accounting perspective would instead focus on improving quality, throughput, and lead time with the goal of making better use of people resources and physical assets. SafetyChain's software provides a customizable dashboard that can track these data and create automated reports.
What Are the Benefits of Lean Accounting?
Shifting mindsets to lean manufacturing accounting can be a long process. As manufacturers move away from solely utilizing standard costing, lean accounting can open doors and allow much better flow and faster responsiveness to the market and customers' needs. Some key benefits include:
Using value streams to examine productivity holistically. Production costs may not be necessary—the goal is to simplify the data.
Producing plain English reports that are more concise and understandable for anyone in the company. Reports can describe profit and loss clearly and provide the actual costs.
Identifying what customers value and making that the target with waste reduction in mind. Lean performance measurement systems can work on monthly and weekly or even daily to hourly cycles, allowing for faster pivoting for customer solutions. Manufacturers can also address quality issues much more quickly and make smaller, less drastic course corrections.
Using the Box Score tool to make decisions more quickly and efficiently. The Box Score is a critical tool for lean accounting manufacturers and allows them to understand the true impact of their decisions on the value streams in question.
How Lean Manufacturing Accounting Can Solve Standard Costing Problems
The critical thing to remember is that solving the standard costing problem is a process and isn't meant to happen overnight. Each company will apply and move through the lean accounting process differently. How a manufacturer was using standard costing is also a factor. It can also take time for those at the enterprise level to understand that it is okay to work toward lean accounting in steps, but it will take discipline.
With lean practices, manufacturers can reduce labor, overhead rates, and work order reporting by reducing the number of reporting steps, which lessens the chances for mistakes. Manufacturers can cut down on human error by cutting back on transaction reporting. Lean also drives less inventory, opening up the opportunity for simplified inventory valuation. The lean strategy is about finding ways to improve customer value, delivery, quality, and cost from the customer's perspective and ensuring the organization can grow profitably and get better financial results.
To learn more about how your company can integrate lean accounting, register here for access to SafetyChain's informative webinar that takes a deeper dive into solving standard costing problems with lean accounting.
