Most standard costing systems measure the efficiency of the use of machinery and people using what are known as a "Volume" variance. A volume variance simply compares the cost of the labor or machines actually incurred by a production operation to make a given number of items with the amount of cost that would have been incurred at the "standard," or planned volumes. If fewer items are made than planned, then the actual cost per item will exceed the planned for the period and the amounts of labor and overhead consumed are less than exceed the amounts that were planned. The so-called "negative" variance indicates that the production process produced at less than full capacity during the period, usually a month. Negative volume variances are very undesirable in a mass production environment as the goal of this philosophy is to achieve economies of scale and lowest per unit cost by using machines and people to the max.

Of course the mass production mentality is completely contrary to lean. When companies begin the lean journey, they normally reduce the volumes produced as they work down inventories and seek to produce only the amounts demanded. These lower volumes create significant negative variances and lower profits as these variances hit expense. In addition lower volumes cause higher per unit overhead cost allocations. Executives, conditioned to expect lower costs from lean, ask, "If lean is so great, why don't we show lower costs?" Sales people scream that they can't sell the product and make money at the higher cost per unit created by the lowered volumes. And manufacturing managers, unable both to make their budget numbers and implement lean, are heard to complain, "Just give me one set of measures. Don't tell me that I'll lose my job if I don't hit my budget numbers and also expect me to implement lean manufacturing! I can't do both!" Pressure by management to "fix" the negative variances has signaled the death of more than one good lean implementation.

While on the shop floor lean is seen as a great success, in the management ranks lean is often seen as making results worse, not better.

What is the Reason for the Problem?
The reason why standard costing doesn't work in a lean company is that it is based upon a contrary model of how companies make money in manufacturing. The model which traditional costing is designed to support is the traditional mass production model that seeks economies of scale to create the lowest unit cost for items produced. Using this model we want to encourage a highly automated factory capable of producing large production runs top amortize the cost of these expensive resources. Companies make money by reducing the per unit part cost.

Lean on he other hand seeks to make products one at a time promoting the flow through the production process. Companies make money by flowing greater volumes of production through the same resources.

The difference in performance measurement using these two models is striking.

The behavioral consequences of applying these two measurement systems in a factory reflect the differing assumptions regarding how money is made in these two worlds.

From the above it should be clear that performance measures created to support the traditional manufacturing world motivate behavior that is contrary to lean. Trying to manage a lean plant using these measures will have serious negative consequences for your lean program.

So we need to create a system of performance measures and cost accounting that is compatible with a lean business model if we want to be a lean company.

Introducing a Lean Approach to Costing
We want to have costs to measure the efficiency of the value stream process, for understanding product costs and for making management decisions. Before launching our discussion it will pay us to discuss some major differences between a lean value stream and a product routing for a traditional manufacturer.

A lean value stream is the set of processes through which a group of products pass. It extends from the receipt of the customer order to the delivery of the product and posseses unique characteristics compared with a traditional product routing:

In the traditional routing calculating a product cost entails adding up the unit costs of production at each of the operating steps through which the product passes. In the lean value stream this is not necessary inasmuch as all products passing through the value stream have the same routing. And because products flow through the value stream very rapidly, very much like liquid through a pipeline, the costing process can be treated in a manner similar to other flow operations. In this "flow" model the cost of the product equates to the total cost of operating the process (a value stream in this case) divided by the number of items shipped from the process. The product cost is therefore equal to the average cost per unit shipped.

What costs do we charge to the value stream? We charge all costs required to operate it as they are incurred. That means we ignore work-in-process inventories to the extent that they are low, level and under kanban control. "All costs" include payroll costs for production labor, production support, operations support, engineering support, machinery and equipment, materials used in production, and facilities cost. Because the value stream is comprised of a group of people who work as a team to improve the production flow of a group of similar products, the payroll costs charged should be limited to those people who work on that team for most of their time. There should minimal apportioning of people's time, and no overhead allocations. All costs are directly charged.

Having calculated the total costs of the value stream, the "average cost per unit shipped" is a simple and reliable way to measure value stream efficiency. Unlike traditional performance measures, it supports lean behavior. It is reduced as the units shipped increase and/or as inventories decrease, and vice-versa. It has the advantage of being simple to calculate, easy for people to understand and a reliable financial measure of lean progress.

How do We Make Management Decisions without Standard Costs?
We don't need standard costs to make management decisions. In fact, value stream costing provides a more reliable way to make management decisions, such as whether to take new business, introduce a new product, outsource or insource a process, etc. than using standard costs. Using value stream costs a decision turns on whether or not the action contemplated increases the cash flow profitability of the value stream. If it does, then from a financial point of view, it is a good thing to do. The critical question is whether capacity exists in the bottleneck resource to do whatever is contemplated, since the bottlenect limits the capacity of the value stream. If there is capacity then the only additional costs are the truly variable costs such as materials used in production.

Standard costing, on the other hand, does not usually take available capacity into account. Decisions made using these costs assume that the company is at full capacity already. Where this is not the case, companies may turn away profitable business even though they have the available capacity because the new business won't cover the full standard cost of production.

How do We Cost Difficult-to-Make Products?
The question often arises how to use value costing to calculate a product cost in cases where some products in the value stream are more difficult to make than others. We usually answer that those products using more of the value stream's bottleneck resource, and thereby limit the volume of products that can be shipped from the value stream, should assume proportionally more of the value stream's total costs. How much of the cost assumed by any product can be determined by studying the relative cycle times of products through the bottleneck and apportioning the total value stream costs based upon how their cycle times compare with the average for all products.

A more elegant approach is to identify the features of the product that cause bottleneck usage and apportion total costs based upon how the characteristics of these product features cause usage. This method has the advantage of creating the basis for evaluating feature cost against its value to customers. So if you need a product cost you don't require an expensive system and masses of data as you do with standard costing. You simply try to understand how products using the value stream affect its flow, and apportion costs accordingly.

Summary
If you want to be successful as a lean company, sooner or later you will have to deal with the adverse effects of your standard costing system. Rather than trying to "fix" a system that cannot support lean, we recommend a different approach--one that supports the goals of lean and provides better information for making management decisions.

Bruce L. Baggaley is a senior partner in BMA, Inc., specializing in the development and implementation of management processes that incorporate Lean Accounting and lean performance management systems. His functional expertise includes the development of management information for operational and financial planning and control, in implementing financial accounting control systems, and in applying activity-based management principles to reengineering operating processes. He has extensive experience in aerospace and defense, public utility, telecommunications, semiconductor manufacturing and service industries. Prior to forming his own firm Mr. Baggaley was a Accounting and Audit partner at KPMG responsible for strategic planning for the firm and a managing associate in the management controls consulting practice of Coopers & Lybrand in New York, and was a Presidential Interchange Fellow at the Securities & Exchange Commission.

Mr. Baggaley received an AB in Economics from Dartmouth College and an MBA in Finance from Columbia University Graduate School of Business, where he was a member Beta Gamma Sigma honorary society and is a Certified Public Accountant. Mr. Baggaley is a frequent speaker on lean accounting and the management of lean companies.

You can contact Mr. Baggaley at 203/656-3527, or email him at bbaggaley@maskell.com. Be sure to visit the BMA, Inc. website at http://www.maskell.com/