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September 1, 2010

A New Approach to Standard Cost ?

Standard costing worked in the 1920’s where mass producers could sell everything that they made and had very low product variability; but it gets impossibly complex in the modern environment where we have differing customer demands; high product variability; and competition means we rarely sell our full productive capacity.


Nevertheless, many managers and accountants seem to like the concept of standard cost and most accounting software encourages users down that route. So the challenge is to develop the concept of standard cost from one where the driver of absorption is the labour (or machine) content of a product (which tells us nothing about the efficiency of the production process as a whole) to a cost driver that, at least, gives us some link to the production process and encourages improvements to that process.


I suggest that that new cost driver might be process lead time. Process lead time (also called manufacturing lead time)is the time between initiating a production order and completing it. This applies equally well in a service environment being the time taken to plan and deliver the service involved to the customer’s satisfaction.


Basing the “standard” unit cost on process lead time – with labour and overhead absorbed according to the lead time – would encourage operational managers to work to reduce the overall lead time in the process. This means working on bottlenecks, delays and quality issues to improve the throughput of a process and, thus, reduce the total process lead time. Such improvements in the process increase the capacity of the process, meaning that we can produce more products (or service more customers) with existing resources within a given timeframe.


So reducing process lead time is a good thing: removing inefficiencies in the whole business process and leading to improvements in delivery performance, quality and customer service. By using a “standard cost” that absorbs labour and overhead according to the process lead time, we would encourage such process improvements and would genuinely reduce costs. This is in contrast to current standard cost systems based on labour content, where reducing the labour minutes in a product rarely actually reduces cost because most process costs are fixed, and taking a few minutes out here and there may not actually improve the throughput of the process or its overall efficiency.


Of course using a “Process Lead Time Standard Cost” to encourage operational managers to reduce the process lead time could have some unintended consequences. By reducing the process lead time for a product or service family we are creating the capability for the process to do more work in a given timeframe. However, unless we can actually sell that increased capability (capacity) we will not realise much financial benefit. The labour costs and overheads of the process will be pretty much fixed (with some efficiency savings by reducing the need for overtime, or by reducing material wastage etc). This means that reducing the “Process Lead Time Standard Cost” as the process lead time reduces will lead to under-absorption variances, since labour and overhead costs will probably not be fully covered. These under-absorption variances should not be put back in the operational accounts as that will remove the incentive to reduce process lead time (and may encourage the production of stock to reduce under-absorption, eating up cashflow).


Such under-absorption variances reflect the additional capacity we have created in the process, but not yet sold. They should be kept in an overhead account to highlight the issue of capacity, and reflect the need to develop new customers and new products to fill the capacity we are creating through process improvements. Indeed, in my view, it would be useful to develop a performance measure of the capacity of the process to use in conjunction with the “Process Lead Time Standard Cost” and reflect the operational improvements that are reducing the process lead time.


“Process Lead Time Standard Cost” could help incentivise process improvements that would boost delivery, quality and customer service performance and, thus, support business growth. This new model of standard cost may not be ideal, and should be used in conjunction with other measures of process performance, but it may be a stepping stone between traditional standard cost (which does nothing to encourage process improvement), and full direct costing of the process. It might be a stepping stone that makes the transition to more modern process orientated methods of costing and business improvement easier.