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Standard Cost: Setting Stretch Performance Targets

February 28, 2012 | Comments: 0 | Views: 253

When setting performance targets, is it best to stretch the target so that everyone has a lofty, almost unattainable goal. Many would say that this is the best way to drive quantum leaps in performance management.

Others would tell us that the best performance is only somewhat better than current performance. They would argue that when a stretch target seems unattainable to many employees, they stop trying.

Yet others argue for loose standards. They would say to enjoy all the favorable variances that result from then beating the standard for performance.

Who is right? All make great arguments; tell great stories; and cite numerous examples to support their position.

But when it comes to setting standard costs, I recommend using standards that are as close to projected actual performance as possible. I can hear the howls of protest already. What about improving performance? What about incentivizing employees to do better? What about the greater profits resulting from tight standards?

Let's take a step back and look at what standard costs are usually intended to do. Their first task is to facilitate transactional systems and related inventory valuation and reconciliation. I maintain that standard costs can do this task very well. However, when standard costs are used as a foundation for performance management, they fall short.

Standard costs are poor performance measures because they have secondary implications and potential adverse motivations. Remember that when a standard cost is evaluated, it is usually compared to an actual cost; this results in a variance. If performance measures focus on standards, then variances can get out of control. If performance measures focus on variances, then standards can get out of control.

So, rather than focusing performance measures on standards and variances, use actual costs as performance measures. Actual costs afford fewer opportunities for manipulation. Current financial systems are focused and optimized for external financial reporting. For internal performance management, we need measures that enable us to discern internal operating realities. External reporting systems fall far short of providing information suitable for internal management decisions.

Are actual costs perfect measures? There are no perfect measures. However, a good cost measure will consider capacity measurement and responsibility. When a company is operating at 50% capacity, holding operating personnel responsible for an actual cost that includes all capacity costs is a farce. Operating personnel are not responsible for sales volumes. Rather, they are responsible for efficiently fulfilling customer orders. Sales and upper management are responsible for "selling" excess capacity.

So, what to do about cost based measures? The first task is to recognize the proper role of standard costs and not to stretch them over to a role in performance management. They will not fulfill this role well. The second task is to understand cost. This understanding is more than looking at externally oriented financial statements. This understanding requires considering cause and effect relationships inside the organization. It requires understanding capacity. It requires understanding the real work and real processes going on inside the organization. Activity-Based Cost and Capacity modeling expedite this understanding.

There is a big difference between reading about standard cost and actually using standard costs. Alan Stratton has real experience managing standard cost systems in variety of companies and has consulted with many others on cost issues including Activity-Based Cost. Understanding cost is critical to understanding profitability and to management decision making. Come to for more tips and useful information.

Source: EzineArticles
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Standard Cost


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Activity Based Cost




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Performance Management

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