Costs

Costs are simply our outlays or expenses for which we get something in return. It is most often money, but it can be anything—time, money, or even something that you trade in barter.

That expectation of getting something in return, given the assumption of a rational market, always implies a win-win situation. In a voluntary transaction (I’m leaving things like taxes and fines out of this), both sides think that they are getting more value than they are giving, or else the exchange doesn’t make sense to do.

Value is not static, however. As the seller perceives the intrinsic worth of something to change, he may change the cost. Commodity prices fluctuate as the sellers sense scarcity, for example, and beach vendors may price items higher on hot weekend days than on cool midweek afternoons.

Continuous improvement helps to keep your costs down in several ways. First, and most obvious, is that it reduces waste, so you need less of everything to create the same value to sell to your customers. Lower scrap equals lower costs. Lower inventory equals lower carrying costs. Higher productivity means lower labor costs.

Improvement efforts can also help reduce the costs of your vendors, especially if you are easy to do business with and help them get more efficient.

From the employee perspective, the simple transaction says that they get money in return for their time. But the hours they work is not their only cost. Energy and health can also be traded. Done right, Lean should also help on the worker side of an employment transaction. It should be used to reduce the intangible costs that lower job satisfaction.

“Cost” has a broad meaning. There are many sub-terms associated with it.

• Fixed Costs & Variable Costs: Fixed costs are the expenses that are the same no matter how much you are producing. (Rent, business licenses, etc.) Variable costs change as production levels change. (Materials, labor, shipping, etc.) Note that with major changes in production levels you will see changes in some fixed costs. For example, if you need to expand a factory to add in a production line, those costs will obviously change. “Fixed” refers to the costs staying stable within that production window.
• Marginal Costs (or incremental costs): This is the cost of building one additional unit at a given level of production. At some point, though, there will be a step up when a new facility is needed, or another person needs to be hired, so the marginal cost cannot be projected out very far.
• Direct Costs & Indirect Costs: Direct costs can be traced to a specific product, such as materials or labor from that production team. Indirect costs are the overhead costs of doing business—marketing, accounting, etc.—that don’t flow down to a single product.
• Cost of Goods Sold (COGS): This is the cost related to making a product. It generally includes labor, materials, and factory overhead. This is an accounting term and finds its way into income statements. It is a summary of the direct expenses associated with making a product.
• Standard Cost: Standard Costs are the established costs for a product, used for accounting purposes to determine the COGS. They are generally calculated annually, and account for the current estimate as to how much a product costs. The difference between the standard cost and the actual cost is called variance.
• Cost Center: Cost centers are organizations that have control over their costs, but do not have overall control over profitability. An IT group might be a cost center, because they do not control sales. A customer service (repair) organization might be a profit center, since they control the costs as well as the revenue they generate.
• Opportunity Costs: This is the cost related to the value you are giving up by using your resources for one option over another option.
• Sunk Costs: These are the costs that you have already paid and are perhaps the most misunderstood of all costs. The money you have already spent is irrelevant in determining the value of continuing a project. Those funds are gone no matter what. What matters is the amount it will still cost to finish a project.
• Tangible Costs & Intangible Costs: Tangible costs are the ones that you can measure—time, money, kilowatts, etc. Intangible costs are the ones that can’t be easily measured—trust, job satisfaction, morale, etc.
• Projected Savings & Actual Savings: Most projects, at the moment of completion, can only project savings. You look forward and estimate what will be saved over time. If you lower the cost of producing the WidgetMax 3000, the cost will show in all future earnings—but only a small sliver of the total gain can be felt on the day the improvement was implemented. Later, though, you can look back and point to actual savings—the ones that really materialized. Why does this matter to continuous improvement? Kaizen teams tend to overstate their projections when talking about the success of their events.
• Cost Avoidance & Cost Reduction: Continuous improvement works to lower costs in two ways. First, it actually reduces costs on an existing expense—it lowers the price of inventory, cuts floor space, or frees up employees. (Continuous improvement efforts should never result in a job loss, or employee commitment to it will evaporate in an instant.) Cost avoidance is when a projected cost is no longer needed. For example, an open position is closed, or a new factory is put on hold.

Costs and Kaizen Activity

There is a mild controversy surrounding the tracking of cost savings as a result of kaizen activity. On one hand, you know that costs move in the right direction when key metrics move. Reducing inventory, improving safety, lowering floor space, and increasing productivity all make costs drop. Plus, kaizen teams generally are not sophisticated enough to know how to account for the actual costs, so the numbers are generally not fully trusted.

The contra point, though, says that kaizen promotes using facts and data, and that you should be able to put numbers to nearly anything. Plus, using dollar figures adds a dose of reality to the discussion. The goal of kaizen is not to improve productivity. It is to improve profit. Productivity is a path to that end. And understanding costs shed light on that path.

My general observation is that it is OK to mention costs in kaizen targets/report outs, but those figures should not be used in any major decision making beyond the improvement project. And someone with authority should vet any projected costs / saving before they are distributed. Teams have a tendency to be overly optimistic.

Words of Warning:

• Be careful about how accountants track costs in a Lean operation. The two main issues are related to the consumption of inventory as levels are reduced and with the changes in standard costing for machines as batch sizes are altered.
• Be especially wary about how cost savings are reported due to kaizen Overstate the impact and you lose credibility. Understate the impact and it can be hard to convince the naysayers of Lean’s value.
• Become especially familiar with opportunity costs and sunk costs. Your projects will always have alternatives that you can be doing, so present an opportunity cost. And you will often have to abandon pet projects when alternatives are discovered. The money already spent has no bearing on the decision. Those costs are “sunk” and have no bearing on the cost/benefit analysis for two competing projects.

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Key Points:

• The term “costs” can create confusion. There are many types of costs and the way they are tracked can vary widely.
• Tracking costs serves a variety of purposes. You have to pay the bills, show investors what is happening with their money, and make sure Uncle Sam gets his cut. They all track differently.
• There is a fascination with tracking costs in a kaizen. Be careful how you do it to prevent undermining the improvement process.