Challenges in product costing – 3 ways to measure improvements in productivity
Posted by Stéphane Bonutto
The previous blog looked at how finance can support resisting the price pressure in order to optimise the net revenues of the company. In parallel, on the cost side, operational leaders need to work out production efficiency improvements in order to counteract inflation. This blog explores how finance can measure their financial impact.
Overall company profit and loss (P&L) statements enable an assessment of the overall margin improvement from year to year. However, they remain at a high level and do not provide enough insights about the financial impact of productivity improvements. Operational leaders, such as plant managers, need management reporting to make the result of their actions fully transparent. Finance can support this process by selecting the most appropriate cost and profitability reporting method, based on the nature of the organisation’s type and its products.
1. Implement standard cost reporting
This method is adequate to measure actual product cost against a defined target. The value is broken down into several elements, based on the assembly sequence.
Cost variances can be associated with a particular production stage. Therefore, the efficiency of each stage, and cost saving actions taken, can be measured through the size of the variance between actual and standard product cost. Alternatively, the management P&L can be structured into separate margin levels. Firstly, reporting the margin on standard cost, then on actual cost after deduction of the actual to standard variances. I have met companies who have successfully implemented this method.
Standard product cost reporting is however, complex. For this reason, it requires an adequate enterprise resource planning (ERP) system, a list of defined standard products, established production cost centres and measured production times. The determination of standard products can be a challenge for companies producing a large variety of goods.
2. Implement production cost driver reports
In some companies, standard product costing has either not yet been implemented or is too difficult to put in place. In these cases, a production cost driver report can be an alternative way to review plant profitability.
The plant profitability may or may not include material cost, depending on the material cost intensity. I have seen examples of both. Their commonality is that they report through a limited but representative number of cost drivers. It is best to select a manageable number of drivers that cover a large proportion of the production cost. Primary candidates are staff costs, depreciation, energy and maintenance. A manageable number is between 15 and 20 drivers, since they have to be budgeted, forecasted, and reported on in actuals.
Finance can support the review of production improvements through variance analysis and reports on key performance indicators (KPI) that include the main cost drivers. Common KPI examples involve personnel ratios e.g. time per piece or sales per head.
3. Implement cost centre reports
In some situations, cost driver reporting does not offer enough insight into production efficiency. In these cases, cost centre reporting can be a good alternative. Sometimes it also represents the first step towards standard costing.
For each cost centre, resources and cost rates are defined. Ideally, the cost driver structure is held constant across factories and cost centres in order to enable an aggregation on company level.
I have seen businesses where factories are sliced into production cost centres and service cost centres. Service cost centre examples are technical services and logistics. The costs incurred by service cost centres are internally charged back to the production cost centres, based on the services provided and their cost rate. Production cost centres are organised following the production workflow. Activity types and cost rates are also defined for the production cost centres.
Finance can illustrate the value of production improvements through cost centre reporting by calculating the difference between actual and planned for both cost and activity level. The trend in the cost rate over time can illustrate the cost centre’s improvement in efficiency. Most current ERP systems should be able to support this method.
In summary standard cost, cost driver or cost centre reporting are three different ways to measure production improvements. They can be used as alternatives to one another or complementary instruments depending on the production complexity and the ERP systems in place.