Most manufacturing companies have a standard cost system. Their first motivation for this system is to simplify inventory valuation and tracking. Then with all the resulting information available from this system, it seems only logical to use it for key performance indicators or KPI’s. One indicator could be a product’s total standard cost; others could be variances recorded for material prices, scrap, labor rates, labor efficiency, and overhead. Variances are the differences between a standard and the actual costs or usage.
The problem with standards as key performance indicators is that they are interrelated and may trigger unintended consequences.
For a simple, yet classic, example, let’s assume that purchasing has a purchase price variance performance indicator and that purchasing is rewarded for a favorable variance. A purchase price variance is the difference between the standard cost and the actual price of materials purchased. However, purchasing also has a role in setting the cost standard for materials. With all else equal, purchasing would drive for higher standards for materials. Then when they negotiate a lower price, the resulting more favorable variance contributes to their performance evaluation.
This performance indicator may also drive purchasing to consider substandard materials or less qualified vendors offering a lower price. In this case, the purchase price variance may be favorable but additional cost is incurred in reworking materials, dealing with poor quality issues, or in manufacturing downtime.
For another classic example, a product manager has product cost as a performance indicator. He complains that his product is over costed and sends a team of engineers to fix it. The team examines the labor routing for the product and adjusts the labor standard. This lowers the standard cost for labor. And, since many companies use labor for the basis to calculate overhead, the overhead standard is reduced also. However, since the adjustment is done for one product and does not take all other products into consideration, the net effect may only be to shift cost from one product to all others. Then may trigger a snowball effect as other product managers then complain that their products are now over costed.
Does this mean that standard costs should never be used as key performance indicators? Not necessarily. There is no single magical key performance indicator. Any measure always has consequences whether intended or unintended. What gets measured gets managed. Too much focus on one indicator may well lead to improvements in that measure but then be an overall detriment to the company. The key is to understand the interrelationships of standards, variances, and actual costs with their potential consequences then set key performance indicators accordingly.
My recommendation is to consider actual costs as key performance indicators rather than standards and variances. Actual costs are more difficult to manipulate. However, as there are always consequences, calculating an actual cost is extremely dependent on understanding overhead. Understanding overhead is a topic by itself. My additional recommendation is to consider Activity-Based Cost methods to understand and manage overhead. Stay tuned.