Measure what matters

This takes us back to the idea of a standard cost system. At the risk of oversimplifying, I will oversimplify. Here’s how it works. The standard cost system is an accounting system that has been in use for many years in manufacturing companies. When a product is developed, a cost is calculated for that product.

A list of all the materials in the product is created, and this is called the bill of material (BOM). This materials cost is assigned to the product and usually updated once a year. The number of labor and/or machine hours needed to make this product is also calculated, and these standard labor/machine hours are assigned to the product, again updated once a year.

In addition, since all company costs must be paid for by-products that are sold, overhead costs are spread over the products that a company sells and paid for in proportion to the standard hours required.

This includes all factory costs and the salaries of sales, engineering, accounting, personnel, supervisors, and such. In short, overhead is the cost of all the people and items that are not directly associated with the product.

In a standard cost environment, when a product is made and reported to accounting, the producing department earns credit for these ‘‘standard hours,’’ and a percentage of the overhead cost is absorbed; hence the term absorption (you have absorbed, or paid for, a portion of the overhead). So, if Product  A has 4 standard hours of labor and gizmo B has 6, and you produced 100 units of gizmo A and 200 units of Product B in a day, you would earn 400 (4 x 100) standard hours for gizmo A and 1,200 (6 x 200) standard hours for gizmo B, for a total of 1,600 standard hours for the day.

If your employees actually worked 1,600 hours to produce these products, your labor efficiency for the day would be 100 percent. If your employees actually worked 3,200 hours to produce these products, your labor efficiency for the day would be 50 percent.

In addition, whatever amount of overhead was allocated to 1,600 hours would be paid for (absorbed). Since these standard costs are usually locked in for a year, if your actual work hours are greater or less, the difference goes into a labor variance (this can be positive or negative) line on the financials. The same thing is done with materials costs: if you pay more or less than standard cost for a particular batch of materials, the difference goes into a material variance line on the financials.

As you may imagine, people managing production and materials areas spend a great deal of time explaining these variances to their bosses if the actuals are more than the standards. If you have no orders for the product being produced and you send it to the stockroom to be stored, you still earn standard hours for this product. Accounting logs this production activity on the financials as if the product has been sold—regardless of whether it ships to a customer or goes to stock.

Any production supervisor worth his salt will quickly learn how to be successful in this game: Keep people busy producing (direct labor efficiency and machine utilization), regardless of where the product is going, and your department will be extremely efficient—on the books. Your boss will love you, you’ll get raises and promotions, and you’ll become very visible within your company as a real manufacturing go-getter.

In theory (and in reality), a department could be the most efficient area in the company and be sending all its production to the stockroom for storage. As you can see, this system will lead managers to perform unnecessary work just to make the numbers look good. Now here’s the kicker: If you do not send a product to a customer, who in return sends you money as payment, you may be headed for a difficult experience. So, what should we measure and how should we measure it? That’s a complicated question with a number of reasonable answers. For the day-to-day decisions, measure what’s important, and keep it real-time and ruthlessly simple.

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