Spring 2007 issue of Horizons

INDUSTRy u

MANUFACTURING AND DISTRIBUTION

Here is an example of a typical standard cost income statement:

Cost Accounting in a Lean Environment Many companies have implemented lean practices into their manufacturing processes, and most of us have heard of the success of the Toyota Production System. Lean manufacturing principles focus on eliminating waste and producing only enough product to meet customer demand. This system is in sharp contrast to traditional mass production or “batch” manufacturing, which typically concentrates on efficiency and machine utilization to produce the lowest “per unit” cost possible. As companies begin to implement lean processes, they find that traditional standard costs fall short in providing them with the information they need to continue their lean initiative. Instead, companies that implement lean manufacturing are finding it necessary to simplify the cost accounting process to provide timely information to continue their lean transformation. TRADITIONAL STANDARD COSTING Since the early 1900s, the accounting for the cost of inventory has been accomplished via a standard costing system. Standard costs typically include material costs, direct labor and allocated indirect costs, typically referred to as overhead. In most cases, the allocation of indirect costs is based on the amount of labor or machine hours required to produce the product. It follows that the lowest per unit cost can be achieved by producing more units, thereby reducing the amount of overhead costs per unit. This costing system induces many companies to build in large batches in order to keep machines running and people busy to absorb overhead costs.

Standard Cost Income Statement Current Year

Prior Year

Net Sales

$150,000 100.0% $100,000 100.0%

Cost of Sales at Standard Cost

98,000

65.3% 66,100

66.1%

Gross Margin at Standard Cost

52,000

34.7% 33,900

33.9%

Material Variance Labor Variance Overhead Variance

2,200

1.4% 2,600

2.6% 7.1% 4.5%

(7,200) <4.8%> (5,000) <3.3%>

7,100 4,500

Total Variances from Standard

(10,000) <6.7%>

14,200

14.2%

GAAP Gross Margin

$42,000

28.0% $48,100

48.1%

Although sales revenue has increased 50 percent, gross margin decreased by $6,100. Examining the detail of the income statement does not provide much insight into the reasons for this decline. What it does not explain is why gross margin has fallen so drastically. Based on the variances from standard, it appears the decline might be due to additional labor and overhead costs not anticipated when the standard cost was established. However, reviewing this statement and arriving at reasons for the decline in financial position are not easy! STANDARD COST IN A LEAN ENVIRONMENT In a lean environment, overproduction of inventory is the ultimate sin. Inventory is produced to meet customer demand. As a result, when companies implement lean, they normally reduce the volumes produced as they work down inventories to meet customer demand. Under a standard cost system, these lower volumes of production result in: • Highest per unit overhead costs. • Net income declines as negative variances are expensed on the income statement. • Deferred labor and overhead costs previously included in inventory on the balance sheet are moved to cost of goods sold on the income statement.

23 u summer 2007 issue