Accounting is one of the cornerstones of the modern economy. Cost accounting in particular helps in decision making with the goal to maximize profit. Many decisions are based on these numbers. Unfortunately, cost accounting usually does a really poor job of capturing the essence of manufacturing in general and lean manufacturing in particular.
The Historic Development – Where Did It Go Wrong?
Accounting itself can be dated back to the beginning of civilization. The beginning of modern accounting and also cost accounting is usually attributed to Luca Pacioli (1447–1517). He was inspired by Venetian merchants, who were also the primary customers of his books.
For merchants, cost accounting is rather useful. The idea behind it is simple: buy cheap, sell expensive. To maximize your profits, you should use your limited resources (money) for activities that give you the best return on your investment.
Manufacturing, on the other hand, was usually less concerned with bookkeeping. With the different materials coming in and products going out, tools needed, and time used, it would have been difficult to keep track of it all. Historic manufacturers probably used more of a gut-feeling approach and experience to set their prices. Besides, their goal was often not profit maximization, but merely to have a good life. As Daniel Defoe observed: “There’s nothing more frequent, than for an Englishman to work till he has got his pocket full of money, and then go and be […] drunk, till, tis all gone.”
With this attitude, it is no surprise that merchants became wealthier than craftsmen. Soon, merchants started what we would nowadays call a vertical integration: they included craftsmen in their supply chains through a putting-out system. Merchants contracted craftsmen for creation of products. They provided the craftsman with raw materials, and often also with the tools and even the workshop, and the craftsman labored for the merchant.
Hence, the merchant had little knowledge of the manufacturing process. He did not know and did not care about the details of the process, its efficiency, and the possibilities for improvement. He was merely interested in the cost and quantity of the raw materials, the value and quantity of the finished goods, and the expenses for the craftsman. And that is even nowadays still a fitting description of the relation between manufacturing and cost accounting.
What is Cost Accounting?
Cost accounting aims to understand the cost of the products or services of the company. It is used to help with decision making. It uses a number of different KPI, based on input values like direct labor cost, direct material cost, sales price, quantity, overhead ratio, etc.
- Variable cost: Costs that change in proportion with the number of products made (i.e., labor cost based on the wages and the time to make the part, material cost, etc.).
- Fixed cost: Costs that are independent on the number of products (i.e., the cost to purchase a machine).
- Profit Margin: How much more the customer pays you compared to your own expenses. Should obviously be positive, and for manufacturing usually up to 10%, although there are lucky companies that get more out of it.
- Return on Investment (ROI): How long it takes to get your money back. Anything less than two years is usually desired.
Ideally, cost accounting helps managers decide where to invest and where to save money. The quite valid goal is to the the biggest bang for the buck.
The Flaws of Cost Accounting Approach
However, cost accounting reduces the process of manufacturing to a few simple numbers to make decisions. Even if the numbers were correct (see Lies, Damned Lies, and KPI), it misses out on a lot of information. A lot of things cannot be reliably determined using accounting. Below is an incomplete list of important factors in manufacturing that are ill-covered in accounting.
Speed: Everybody knows that speed gives you an advantage over the competition. No matter if you are first in a market or deliver a product faster, it will improve your competitiveness and hence your revenue. However, it is nearly impossible to determine this advantage quantitatively. How much does it get you to be in the market 7 days earlier?
Fluctuations (Mura): One big thing in lean manufacturing is to reduce fluctuations, or at least to have the flexibility to handle these fluctuations. The more even your system works, the more profitable you will be. However, it is difficult to measure these fluctuations, even more difficult to determine the impact of an improvement on fluctuations, and hence nearly impossible to calculate the monetary benefit of reducing fluctuations. For example, do you know what it costs you if your customer always orders at the end of the month rather than throughout the month? Pretty much the only thing that can be calculated are inventory costs, and even these are usually flawed (see The Hidden and not-so-hidden costs of Inventory). Yet, inventory is only a small aspect of the benefit of reduced fluctuations. Overall, cost accounting usually considers a static situation.
Overburden (Muri): Often overlooked in Western-style lean is overburden. What are the costs associated with overworked employees? What is the monetary benefit of training? How much additional cost is caused by each frustrated worker, and how much would it cost to un-frustrate them? What is the quantitative advantage of having clean and well-maintained toilets on the shop floor rather than the biohazards I often see?
Customer Satisfaction: Yet another thing in lean is customer satisfaction, often described as value to the customer. But again, what is the monetary damage if a delivery is delayed, if a product breaks, if service is slow, or if your people are unfriendly? It is nearly impossible to know. Even more difficult to determine is how improvement measures will actually influence the above. How much does it cost you to provide a better service, how will this influence customer satisfaction, and what is your benefit from this?
In the above examples, the investment expenses are usually known rather well. The monetary benefit, on the other hand, is incomplete and fuzzy at best, and often even completely unknown.
On a side note, above I listed Mura (unevenness) and Muri (overburden). You may have wondered what happened to Muda (waste). Out of the The Three Evils of Manufacturing, waste is probably the one that can be calculated best. Inventory costs, transport costs, etc. are still difficult to determine, but often you may have a rough idea what these will cost you. Maybe this is the reason that waste reduction is found everywhere in Western lean, whereas the much more important (in my view) reduction of unevenness and overburden rarely pop up.
How This Leads to Bad Decisions
Bad decisions where to put the money
Industry is driven by profit. Cost accounting helps with the decisions to maximize this profit. There is an understandable tendency to prefer decisions that have a defined cost benefit over decisions that give an unknown return on investment. Even if the cost benefit is incomplete and fuzzy, having a number gives a false sense of security.
Hence, investments often happen where there are accounting numbers. In my experience, to invest in machines is an easy decision. You calculate if the machine is worth the money and then decide if you buy one. Same applies to shop floor workers. Based on quantity and time, you can determine how many you need and what they will cost you.
Investments that have a cost but lack a calculated benefit often get overlooked. Customer service is often understaffed. Toilets are only renovated if a higher-up visits the plant. Health and safety are based on legal requirements. Training for shop floor workers is often lacking. Yet, having no calculated benefit does not mean these measures have no benefit.
Bad decisions where to take money out
Similarly, an incomplete picture of the cost and benefits leads to savings that end up costing more than what they saved.
For example, while the cost of maintenance is well known, the benefit is hard to calculate. As a result, maintenance cost is often reduced more than what would be good for the plant. Same goes for internal support. For example, reducing or centralizing IT support clearly reduces labor cost. On the other hand, the cost of delayed or incorrect troubleshooting is clearly there but usually unknown.
Similarly, since work is measured in time, a young, unskilled worker or temp is usually cheaper than an older, experienced worker. Hence, replacing older workers with younger ones reduces costs. But how does that influence quality or reliability? A robot can also produce cheaper than human workers, but humans can learn and will become better. A robot does not learn. Using only robots, Improvement will slow down. (Toyota sometimes reduces robots and also trains master craftsmen (called Takumi 匠) to learn how to become better.)
How to Make Better Decisions
There are many more examples where a lack of hard numbers leads to one-sided savings or skipped investments. The question is: How can it be done better?
Why we make bad decisions
Before we go into that, I can’t really blame modern managers. Every decision includes the risk of failure. In Japan, a failure causes problem solving and learning from mistakes. In the Western world, a failure all to often causes a search for someone to blame. Understandably, managers are often risk averse, seek security in numbers, and are trained not to stick their neck out.
Of course, it does not necessarily help if the person in charge has an economics background only. To manage a process, it is necessary to understand the process.
There is something called lean accounting, which aims to rectify these problems and help to make better decisions. But, as far as I can tell, I am not impressed by lean accounting. It tries to include lean considerations in the cost benefit accounting. While it has some advantages over traditional accounting, I strongly believe that many of the benefits of lean cannot be reliably calculated. For example, I cannot possibly see how anybody can reasonably determine the monetary value of a happy employee or customer.
Besides, for my taste it includes too many buzzwords and fancy acronyms. But maybe that’s just me. But, also read the comment by Brian Maskell below, with an insider view of lean accounting.
Common Sense and Right Direction
There is one crucial fact important for decision making in lean manufacturing: Some things are beneficial even if you cant quantify the benefit! Not all decisions can be based on numbers. Some numbers may be wrong. Others may be missing completely. Nevertheless, a lack of quantitative numbers does not mean the idea is bad. In my view, there are a few things needed to make better decisions and to avoid the traps of cost accounting. While by no means a complete set of guidelines, the following may help:
Use common sense: Decisions should not be made based on numbers alone. Try to keep the big picture in mind. If a decision feels wrong, it probably is. Just because you cannot measure the benefit does not mean there is none.
Try to move in the right direction. Lean is a good guideline here. If it reduces fluctuations, leads to happier workers or customers, or generally goes toward a “true north,” it may be worth the effort.
Make small steps: Big measures can fail big. Small measures may have smaller failures. By doing lots of little steps you are less likely to have catastrophes. Besides, even with small mishaps you can learn from mistakes.
Avoid the blame game: People make mistakes. It is not important who made the mistake, but that the organization learns from it. Removing the person that made a mistake does not remove future mistakes; it actually increases them.
In my view, better decision making is still one of the big potentials in manufacturing. Yet it is difficult to change the management process and the decision making. Toyota is known for its excellent manufacturing system, but in my view, its excellent management is more important. Without this management, the Toyota Production System would have never happened. “Not everything that can be counted counts. Not everything that counts can be counted!” (often attributed to Einstein, but probably more likely William Bruce Cameron ). But it was definitely Taiichi Ohno, who said that “It was not enough to chase out the cost accountants from the plants. The problem was to chase cost accounting from my people’s minds”. So, keep your head up, use common sense, try to go in the right direction, and learn from your mistakes. Now go out and organize your industry!
This post was inspired by a recent short German book, Lean auf gut Deutsch: Band 1 Einführung und Bestandsaufnahme, by Mari Furukawa-Caspary. She is a bilingual German-Japanese lean expert, and in her short book she talks, among other things, about the failures of cost accounting in lean manufacturing.
A second inspiration was a question by O. H. on how to use traditional cost calculation in lean manufacturing.