Performance Measurement In A Cost Center Considering Production Lead Time

Abstract:     
This paper studies the design of the performance evaluation system in a decentralized firm where units are organized as cost centers and lead time has an important effect on demand or cost. The paper has two conclusions. First, performance measurement systems exist and lead the firm to a profit maximum if correct weight is assigned to a cost centers' lead time performance. However, computation of the proper weight requires that general managers have specific knowledge of the cost centers' tradeoff between cost and lead time. Second, an iterative procedure leads to a profit optimum if accurate estimates of marginal cost, which include opportunity costs, are available. Two potential difficulties cause suboptimal profits under decentralization: the cost center's performance measurement system is not optimal, and inaccurate estimates of marginal cost are used by general managers when setting production levels.The first problem is solved if general management knows customers' value of lead time and the tradeoff of cost and lead time. Different types of investments can be used to gain this knowledge, such as engineering studies about the technical relationship between cost and lead time, marketing research studies, cycle time reduction programs, just-in- time programs, quality improvement programs and customer satisfaction surveys. The second problem can be solved by using lead time measures to estimate marginal cost.

JEL Classification: L22

working papers series