I work as Vice President of a software company. Recently in a senior leadership meeting someone made the statement that we charge higher prices to new clients for our training because our training costs are higher. I asked why that statement was made and the response was “it takes us longer to train new clients.”
My response was that our training costs are fixed – based on the number of trainers we have on staff. We then did a quick “5-Why” exercise and the root cause of why are training takes longer was the complexity of our software.
This recent conversation led me to write this blog.
It’s a common held belief that the longer it takes to do something in a business, the higher the costs of the business, which leads to allocating costs based on time to understand costs. Here are a couple of simple examples:
• Product X in a manufacturing company costs more than Product Y because it takes longer to produce
• A complex tax return has higher costs for an accounting firm than a simple return.
Under this thinking, both the manufacturing company & accounting firm would seek to reduce the time it takes to process the products/services to “reduce” costs. Or prices would be adjusted to “cover” the additional costs.
In Lean Accounting, we want to stop allocating costs based on time because it just isn’t really an accurate way to understand costs. In order to make this transition, accounting people need to change thinking as follows.
1. Processing time creates value: Lean companies recognize that the time to produce a product or service is based on the value-added processing time (aka cycle time). Typically, the more value that needs to be created, the more time it will take resources (people and/or machines) to create the product or deliver the service.
2. Waste adds to costs: any of the 7 wastes of lean adds costs to the business. Some costs may be direct – poor quality in manufacturing increases material costs; and some costs are less direct – a company hires more people than necessary because waste exists in the processes.
3. Lean companies also recognize that the cost of the resources to the business is typically fixed, which means the business will incur these costs on a regular basis regardless of time. Lean companies make cost decisions based on long-term trends rather than which work must get completed today.
Labor costs are fixed based on how many people are employed. Companies hire more people based on total demand projections. Full-time, hourly employees work a 40-hour week, regardless of demand. Yes, a company may have temporary or part-time workers that they can bring in or send home based on demand, but usually these are not the primary workforce.
Purchasing a machine, equipment or IT infrastructure is a one-time cost. The utilization of this equipment is based on demand, but costs don’t increase significantly based on the particular demand each day. Many years ago, I did consulting work at a company that moved its machine-intensive manufacturing from California to Kentucky because the total cost of utilities was less in Kentucky.
It’s important for accountants to understand the flaws in doing time-based cost allocations & analysis and make the necessary adjustments to align cost analysis with lean thinking. I like to say that the primary root cause of any operating expense is usually based on operating performance. Lean operating performance measures can reveal why costs are being incurred.