“It is not necessary to change. Survival is not mandatory”, W.E. Deming
Kaizen is much more than a costing method. It represents a transformative philosophy of Operations Management, supported by all encompassing Human Resource Policies and Practices, resulting into Continuous Improvement aligned with Corporate Strategy. This is the first out of two articles, dedicated to Kaizen.
In order to understand how Kaizen works, it is worth juxtaposing it with the more traditional Variance Analysis of Cost control. Organizations invest in order to render services or develop products. A cost must be attached to the output, based on which decisions will be taken, e.g. regarding profitability, growth potential, micro and macro market share, to name but a few. Irrespective of the method used to determine the price of a product or service, it is essential that the cost attached to them reflects true and accurate consumption of (mainly) scarce resources. Even if a resource is not per se scarce (“we have more Direct Material ‘C’ available that necessary to produce the projected Quarter quantities”), we are all familiar of the resource that is always scarce and this is money. Therefore accurate costing should enable decision makers make optimum decisions in terms of allocation of any resource in order to generate profitable, sustainable products / services.
I will briefly review the method of determining Cost structure and control of products as these are more tangible in nature, although the pattern described is equally valid for rendering of services.
Manufacturers traditionally identify the quantities of Direct Material & the time of Direct Labour that is is needed in order to produce 1 unit of output. Let’s assume Direct Material costs $10 per kg and Direct Labour is paid at a rate of $25 per hour. A unit of production requires 1.5 kg of Direct Material and 0.5 hours of Labour. On top of this, manufacturers would add the Variable Overhead, for example energy consumption to produce 1 unit, let’s assume this is $6.5. Based on the amounts given we may proceed with the generation of the Cost card of our product:
Direct Material 15
Direct Labor 12.5
Prime Cost 27.5
Variable Overhead 6.5
Total Variable Cost 34
Fixed Overheads are an integral part of the manufacturing process, these may be for example lease costs of plant or the fixed element of energy costs, etc. Depending on the Cost method applied, manufacturers will treat differently the incorporation of the Fixed Costs in the Cost structure.
Marginal Cost method
Should they choose a Marginal Cost approach, they will “ignore” Fixed Costs in the Cost card. Pricing decisions will be based on the Marginal Cost of each unit of output. Assuming the cost accountant applies a mark-up, e.g. 25%, on the marginal cost described above, this will result into a Sales price of $ 42.5.
The difference between the sales price and the total variable cost, i.e. $8.5 is called contribution and it reflects the amount of money generated by selling one additional unit, which will be used to contribute to covering the fixed costs.
The main inherent weakness with this approach is that management obtain no transparency with regards to the generation of the fixed costs. They are taken to be indisputable and management aims at covering them by applying a sufficiently high mark up and ensuring sufficient quantities are sold to generate contribution and profit. Depending on the total period output and sales, Fixed Costs incurred in the period may or may not be covered.
Absorption Cost method
Alternatively, should the management accountant choose a Full Absorption Cost approach, she will decide on an Overhead Absorption Rate (OAR) in order to absorb Fixed costs in the Cost card on a per unit basis. The management accountant will decide on an absorption tool, which is more likely to reflect generation of Fixed costs. Let’s assume there is a correlation between total Fixed costs and labor hours and that total budgeted labor hours are 100,000 in the month and total budgeted Fixed Overheads are $ 1million, then the OAR is $10. This Fixed Cost per unit would be added to the Total Variable Cost of $34 calculated above and result into a Total Cost of $ 39 ((34 + (10*0.5)). The inclusion of Fixed Costs in the Cost card ensures that as each unit is sold, the budgeted level of fixed costs apportioned are considered before deciding on the price of each unit. Applying a mark-up of 25% to the total cost would result into a price of $48.75.
The main inherent weakness with this approach is again the fact that the drivers for generating the fixed costs are not challenged. This may result into inefficiencies not being challenged and loss of opportunities for economies, inappropriate cost structure, pricing and loss of market share. Consumers will not be prone to accept a price at which no value is deemed to exist. Think for example that you are being asked to pay $42.5 for a unit when the competition offers the same model for $38. The entity asking for $42.5 base pricing on inappropriate cost base and pass on inefficiencies to the consumer who declines the offer and the entity consequently suffer from loss of market share, contribution and profits.
Once the Cost card is decided upon, then manufacturers set budgets/targets for the month, quarter, etc. and these budgets are used as the yardstick to measure performance, by means of “actual vs. budget”. Based on this comparison managers investigate differences between budget and actual, assign responsibilities, hold people accountable, reward them for achieving the budget, etc. The thorough investigation of differences between budget vs. revised budget and revised budget vs. actual is a process called Variance Analysis, where all elements of costs/ sales/ mix/yield are identified one by one with the aim to get an insight into the performance of the period at stake. I am not advocating in favor of any of the 2 methods described above (Marginal – Absorption), neither will we get into the details of Variance Analysis as this is beyond the scope of this article.
Although this process of deciding on a unit Cost card, pricing a unit, setting targets and investigating variances seems to be straightforward, it has serious shortcomings. I will highlight these shortcomings and contradict this process with the Kaizen philosophy and the resulting cost approach.
Creating a Cost card, with the multiple aims to:
Set the tone of the expected performance,
Decide on the price of a unit of production,
Hold employees accountable and decide on their rewards based on achievement of results,
Compare actual with the budget and investigate a range of Variances,
denotes that the following assumptions are held to be true by manufactures:
Data produced are valid for a longer given period and can therefore be used for the purposes mentioned above. It is safe to assume that staff will spend time and effort to create a Cost card per unit only if it is taken to be useful and provide accurate information, for a longer period of time.
It follows that the focus upon the creation of a Cost card is cost control of predetermined levels and not process improvement.
The system therefore does not provide insight into the Activities/Processes that generate costs and only initiates action towards Cost Control and Variance Analysis (feedback control) as briefly outlined above. There is very little transparency as to if the related activities/processes are value adding or not. In simple terms, we take an activity to be value adding if the consumer will accept a price covering the costs related to this activity as it resulted into a product feature/condition that the customer appreciates.
Employees are involved to a limited extend in the target setting process. Management decide how to cost and price the units of output and employees are expected to achieve those targets.
Little attention is paid into the way the results will be achieved. Management set the tone on the “what” and not on the “why” or “how” of performance.
When results are not achieved, people are considered to be the source of problems, being unable to follow methods and processes as expected (dogmatic approach in Job description, methods and processes).
Meaning of Kai-zen in English:
Kai = to change.
Zen = the virtue of being good.
The etymology reflects a much deeper meaning, than a simple short-term, repetitive, cost control process.
I briefly outline the core elements of the Kaizen philosophy:
The aim of Kaizen is to ensure employees at all levels of the organization develop the necessary skills to become better problem solvers, decision makers and innovators. It is expected they continuously eliminate non-value adding activities, enhance value adding ones and improve processes.
Consequently, the organization will be able to realize many small incremental changes on a continuing basis. Management stimulate a proactive stance with the focus on process improvement that will result into major innovations and economies.
Cost reductions and innovation will be the result of active Process Optimization performed by empowered employees turned innovators and problem solvers.
The environment within which employees operate tolerates errors as a result of experimentation to optimize processes at the actual workplace (at the “Gemba”).
The focus on Process optimization implies that the current status quo of service or manufacturing processes is not seen as the infallible and unique way of production, from which Standard costs are derived, the achievement of which is checked with the aim to control them (see beginning of Article).
The current status quo is rather the object of fact verification and eventual change and improvement. Simply put: the current processes should serve the purpose of delivering continuously improved products based on actual client specification and anticipated changes due to technology development.
Even if the current processes do result into production of output according to specifications in terms of both features and costs, then they are still subject to verification. Case in point: Kaizen philosophy compels the organization to verify whether the achievement of the target performance was due to circumstantial factors (e.g. luck) or because the process was followed as expected and it did deliver the target results. Even if we get what we want, we need to ensure this is because the process is both adequate and cost efficient and was followed as expected.
If the process did not result into production of output according to specifications in terms of either features or costs, then either one or both of the above mentioned factors does not hold true. It follows that inevitably the process will be subject to substantial scrutiny to eliminate non-value adding activities, improve, and cut out muri (waste).
It should be evident by now, that Kaizen is a continuously proactive philosophy that is fact driven. Its proponents are not advocating that financial competitiveness is subordinate to process improvement. On the contrary, the argument is that process improvement that is based on facts that confirm better products are manufactured at a lower cost or with enhanced features, will lead to increase in the wealth of Shareholders. In order to achieve this process optimization people centered Human Resource Policies and Practices must be put into practice.
Candidates sometimes struggle with seemingly conceptually complicated areas as Kaizen, especially as to “how can I apply this in practice”. Truth being told, everyone daily adopts (subconsciously) either Kaizen or anti-Kaizen practices.
Individuals that continuously seek self-improvement by:
Discontinuing habits and practices that hinder them from achieving their goal of enhancing their performance, improving their social relationships, or advance their career;
Redirecting their career path in anticipation of developments in the job market, and learn new skills in order to enhance their employability;
Being open to learn from individuals they look up to and especially focus on the “why” and “how” these individuals are better than themselves, not just “what” they do better;
Not seizing to apply ethical practices in their business and personal relationships;
Being eager to help others improve themselves, in a sense gain fulfillment from seeing others grow, too;
Seeking to shape the future;
Not shying away from aspiring a leadership role for themselves;
…are indeed applying in practice the basic Kaizen principles.
In my second article, I will analyze how Kaizen is further applied into practice.
Date: July 2014
By: Chris Ragkavas, BA, MA, FCCA, CGMA
StudySmart management consultant, senior finance & accounting tutor, IFRS technical expert