Wow, simple question with profound implications. Both standard cost accounting and takt time can be thought of as the backbones of the operating/management systems which they support; each one drives management decisions, behavior, and in the end, organizational cultures. And, they couldn’t be more opposite from each other. Standard cost accounting generates rate and volume variances used to value inventory and cost of goods sold. Unfortunately it is also used for performance measurements that drive management behavior/culture and mass production thinking. Takt time on the other hand focuses on the rate of demand of the customer and uses that to determine production and inventory levels which of course drives company culture.
As someone with more than 30 years of implementing lean in a variety of companies (mostly manufacturing), I would guess that in asking me this question you would expect me to say that takt time and the accompanying lean management strategy wins out. Unfortunately, based on my experience, I would have to say that the opposite is true. I have found that more than 80 percent of the time the traditional management approach anchored to a strong standard cost system prevails. Sad, but true.
Now, having said that, let’s explore why this is true and what can be done to change this outcome. Consider first the traditional management system used by most companies today, and the type of behavior or culture that it drives. While the standard cost system is not the only contributor, it is a major driver.
I would rank the typical functional organizational structure of most companies right up there as well. This functional factory organization was driven by “the division of labor” based on the work of Fredrick Taylor and others. In my experience, this physical structure results in most traditional companies having between 25-40% excess people (even though they would never admit it), and having long lead times and many quality problems that arise from the functional disconnects. We can’t make a case that standard cost accounting is what drives the functional organizational structure in the first place (in fact it just follows it), but it certainly exacerbates the problem.
Most standard cost systems do not provide management with meaningful information. They calculate the cost of every product out to four decimal points—which sounds precise, but if you ask any organization, which I have frequently done, “How many people believe that your standard costs per SKU are accurate?”, no hands will go up. There are simply too many assumptions and allocations involved in determining these costs to have much chance at accuracy.
More importantly, the typical standard cost financial statement has so many different “variance” lines that it can’t be understood by humans. You are left to compare how you are doing against the assumptions that were used at the time of the budget, rather than seeing any clear period-to-period financial trends. Even so, this is still the system that most traditional companies use to drive everyone forward to “make-the-month”. The fact that “the month” that you are trying to make is not a real thing but just something you made up last year at budget time is somehow lost in all this. Traditional companies will do lots of stupid things in pursuit of “make-the-month”.
Despite all of these shortcomings, the biggest problem, in my opinion, is that standard cost accounting stubbornly resists any improvement. This is not surprising in that standard costing was developed for a production environment that was relatively stable, and is not therefore suited for an environment of “continuous improvement.” It in fact encourages behavior that is very un-lean in nature. For example, it encourages the building of inventory in order to make “the absorption hours” budgeted for the month. This allows overhead spending that occurred in the current period to be deferred to a later period by capitalizing it on the balance sheet to make this period’s results look better. This incentivizes functional department heads, if they are short on absorption hours near the end of the month, to make the products in their area that carry the most absorption hours in the last week of the month, even if there is no demand for them, and even if it means not producing products where there is demand but that carry low absorption hours. Yikes!
Now, absorption hours are usually based on some measurement of time, such as labor hours or machine hours. So imagine what happens when lean and takt time come along. Takt time sets the standard for lean, as it represents the “beat”, or demand, of the customer. As lean companies convert to flow, pull and standard work all of it is based on the rate of demand from the customer, i.e. takt time. It is the measurement that determines what the “sell-one-make-one” ideal for lean should be. It is in complete contrast to the traditional “sell-one, make 10,000” approach driven by “economies of scale” and measured by standard cost accounting. Producing to takt time is what drives out the waste for a lean company. As you remove waste, you shorten the time that it takes to do everything, and in the process free up resources that add to capacity and reduce lead time while improving quality.
So, if the traditional manager (especially the ones in finance) is relying on absorption hours to defer overhead and make earnings look good, and along comes the lean team that says we can show you how to reduce the number of hours needed dramatically, then you have a really big problem. For the lean company, “inventory is the root of all evil” because it hides the waste. For the traditional standard cost company, inventory is just fine as it allows costs to be deferred into later periods as it rises. So if lean can take inventory turns from 3x to 6x in the first year, cash flow and freed up space will be very positive results but (non-cash) earnings will fall as the P&L gets hit with a double dose of overhead costs. The CFO will scream like hell. “This lean stupidity is killing us.” Because the CFO is often the number two executive in the company, the CEO, who will also be a little shocked by the earnings decline, may decide to slow or even stop the lean implementation.
I have seen this over and over again. When I was CEO of The Wiremold Company, we helped many companies get started down the lean path. They often made good initial progress driving takt time and lean into their companies. Then, about a year later, they would ask if they could send their CFO and a small team to us for week to learn about lean (as these individuals were fighting the changes like mad). When I was an Operating Partner in a private equity firm we looked at a large number of companies that told a great lean story but were only turning inventory about 3-4x. That of course meant that they had in fact made almost no lean progress and the reasons were always the same, the CFO insisted on running equipment and making product even when there were no orders just to get absorption hours.
I won’t pretend that this is an easy problem to solve. There are other issues beyond just standard cost accounting that need to be solved in order to become lean. But knowing up front that this will be a major barrier should encourage you to start getting off standard cost early on. It will require a lot of resolve on the part of the CEO. The CFO will not change without a fight. You don’t need to do this on day one but you can start early by issuing a lean P&L alongside the traditional standard cost P&L. By the end of about six months no one will want to look at the standard cost P&L anymore and you can move to a lean accounting system that supports rather than fights your lean turnaround. Note: For more specifics on how to make the change see the article “Dealing with standard costing in lean organizations” by Nick Kato in this month’s “Lean accounting learning and practice” monthly newsletter published by LEI.
SUMMARY
Takt time and standard cost accounting are not good friends. While they both rely on time, absorption hours for standard cost, or the rate of demand (units per hour) of the customer for takt time, they are essentially complete opposites. Trying to become a lean enterprise while retaining traditional standard cost accounting is an exercise in futility. It was developed for a steady state environment and is obsolete once a company changes to a lean “continuous improvement” strategy.
It is therefore important to understand that one of the first things you need to do in your lean turnaround is to replace your standard cost approach with lean or “plain English” accounting. You don’t need to do this on day one but you should start parallel lean accounting statements early on and then switch when people are comfortable with the new statements and the better information they provide.
