Note: This is a continuation the Marginal Accounting post describing a dialog between a manufacturing executive and me.

M: So you want to simplify how you manage costs, while at the same time provide accurate cost information to support decision making. Like most manufacturing companies, you’re now using a cost accounting scheme that uses some sort of allocation process for assigning indirect costs to individual units or batches of product. There’s an underlying assumption with cost absorption that all expenses must be allocated to individual product – an assumption that I encourage you to challenge. Instead of spending resources to calculate individual product cost, focus on your total cost. Recognize that most of your expenses – including labor - are fixed costs, and then report them that way.

This means that you’re left with a simple cost accounting model that reports fixed costs as line items – and not allocated – while variable costs which are mostly material costs are reported as variable costs. This model is vastly simpler to maintain since there are no burden rates to maintain and no cost allocation. To adhere with GAAP, you’ll need a way to value inventory and we can help you put a simple process together to do that.

Since the distinction between fixed and variable costs remains clear, this model also supports decision analysis. The marginal revenue and marginal costs of decisions are easy to determine, and the impact to cash flow to a specific change is easier to determine.

E: What’s the reaction by CFOs with this type of model?

M: Well, a trait of most CFOs is they are open to decisions based on a rational argument. We’ve found that if we get them on board with this project early and take them through the thought process, they often become a strong advocate for a simplified cost accounting model. We can also put them in touch with other companies who have been through this.

For more information about this, don’t hesitate to contact us. You can also browse the Lean Accounting page of our web site.

E: Thanks Mark.

Note: Those of you who have already read Real Numbers: Management Accounting in a Lean Organization by Jean E. Cunningham, Orest Fiume and White Lisa Truit can skip this post.

Several times a year, I’ll have a conversation with a manufacturing executive or business owner that goes something like this:

Executive: We don’t even know what our product cost is!

Me: What do you mean by product cost?

E: Well, for example, we’re building 15 widgets today. Our cost accounting report says that our total unit cost is $120,000 which means we’re losing money on these since revenue per unit is only $100,000.

M: Has this product always shown a loss?

E: No. Direct labor for this product has gone up, which has increased the allocated overhead expenses for this product.

M: Why is direct labor higher for this product?

E: Because of our ongoing efforts with lean, we had some excess capacity earlier this year. So we decided to do sub-assembly in-house rather than outsourcing it like we were. Consequently hours went up.

M: So your cost accounting system is allocating more overhead to this product because you shifted some assembly work from a vendor to your plant. Has overhead costs for the company really increased because of this action?

E: Of course not. In fact, building more in-house has simplified our supply chain and manufacturing process, resulting in less work for purchasing and procurement engineering.

M: So you made a good business decision resulting in lower overall cost. Yet as a result your cost accounting system is now arbitrarily allocating more fixed costs to the product, making it look unprofitable.

E: Right. And you can imagine the time I’m spending with our CFO explaining why this was really a good decision. Not to mention the time spent by cost accounting, finance, and engineering trying to “fix” this problem by adjusting overhead burden rates and their variance reports.

M: Now you’re describing real waste that’s avoidable. Would you be interested in learning about how to greatly simplify the way you manage costs, while also providing you with the accurate cost information you need for decision making?

E: I’m all ears.

M: Great; let’s talk later this week about this.

[To be continued]

Your people are smart, and they soon learn that optimizing their metric of performance is what counts during their evaluation.

Here are examples we run across showing how measuring the wrong thing can lead to unintended results:

• Measuring “recordable injuries” sometimes results in more unrecorded injuries.
• Measuring machine or labor “utilization” sometimes results in overproduction.
• Measuring customer complaints may discourage documenting customer feedback.
• Measuring “available to promise” delivery performance sometimes results in quoting longer lead times, while not tracking what your customers really need.
• Measuring “throughput” sometimes creates overproduction and impacts quality.
• Measuring “overhead burden rates” may only institutionalize some costs as fixed, while distorting make versus buy decisions.

Is your performance management process encouraging the behavior you intend?

Is your management team focused on the vital few measures that will result in your company’s success?

Do all of your employees clearly understand what they must do today, this week, this month, and this year to achieve your business objectives?

These are the questions that Policy Deployment addresses. To learn more see www.leanaffiliates.com/policy_deploy.htm.

Today I went to the local post office to buy holiday stamps and Priority Mail boxes. (An aside: Priority Mail for gift parcels is a great deal – you can cram as much stuff as possible into your free “flat rate” box that will arrive in about 3 days – all for about the price of the box alone at the UPS Store.)

After waiting in line for 20 minutes, the clerk motioned me forward. (Note to self: avoid the PO at lunch time; half the clerks go on break just in time for their noon customer rush.)

“I’d like to buy some Christmas stamps, please.”

“I’m sorry sir, we’re out of holiday stamps.”

“When will you get some more?” I asked hopefully.

“They’re backordered now, but we should have them by the end of the month.”

“But the end of the month is after Christmas.” I said lamely.

“We have these salsa dance stamps – they have some nice holiday colors in them.” the clerk suggested.

I appreciated the unexpected empathy; maybe the Post Office really does care. I pictured salsa dance stamps on my Christmas card envelopes and wondered if anyone would notice. Dancing is part of the holidays, isn’t it?

With so much of this customer facing process broken, and the salsa dance suggestion thrown in by an earnest postal worker, my mind went tilt.

Yet another example of a good employee coping as well as possible with a broken process.

“Well, how about some flat rate Priority Mail boxes?” I needed to ship some Christmas gifts.

“I’m sorry, we’re out. You can just use your own boxes and put Priority Mail stickers on them.”

She didn’t understand. Call me thrifty, but I like using the free Priority Mail boxes. Especially the flat rate variety that you can cram full with the heavy stuff for no extra charge. Besides, did I mention the price of boxes at the UPS Store?

I left empty handed. I was an eager customer thwarted from spending money.

The US Postal Service is experiencing monumental market shifts: email, on-line bill pay, FedEx Ground, UPS Stores, Google adwords. Their market share is shrinking all around.

All that’s left for them is neighborhood junk circulars and…holiday mail.

A good first step might be for the post office to stock stamps and boxes so I can do business with them. Maybe if the Postmaster General read Womack’s new book Lean Solutions, it would make a difference. I’ll get their lean transformation started and just mail him a copy myself…damn, I don’t have any Priortiy Mail boxes.

See you at the UPS Store.