To: The CEO of Folt Manufacturing (Folt)
From: An Accountant
Date: September 20X5
Subject: Performance measurement and outsourcing of manufacturing at Folt
This report recommends a set of key performance indicators (KPIs) for the identified critical success factors (CSFs) associated with the new strategy and evaluates these as a set of measures of the strategic performance of Folt. Further, in preparation for the negotiation of the outsourced manufacturing contract, advice is given on the use of target costing; the attribution of responsibility for areas of quality and the information required to monitor the quality of production.
(i) Recommended KPIs for CSFs
The chief executive officer (CEO) has identified three critical success factors (CSFs) for the medium term. Performance towards these requires to be measured and so KPIs are recommended as follows:
1. Keep capital providers satisfied
There are two capital providers, the debt is all provided by the venture capitalist (VC) and the equity is provided by the management team and the VC combined with the management team taking the majority. A widely used and understood metric for performance would be return on capital employed (ROCE) which measures the returns to all capital providers as a group. It is defined as operating profit/capital employed. In order to properly understand performance, a target measure should be set for this, possibly by using an industry average as benchmark.
To break this down further would probably require return on equity and cost of debt measures and would, therefore, break the desire to keep the performance information brief. As there are only two capital providers and ROCE neatly summarises this, no other KPIs are suggested.
2. Build a world-class software development team
This is a difficult factor to measure with precision. Building a team could be measured by an increasing number of employees or number of projects undertaken. However, the important element in this CSF is the ‘world-class’ quality of the team. This could be measured by the input cost of the team, provided that they are recruited at competitive market rates, since higher wages would imply higher skills. Alternatively, it could be measured by the team’s output in terms of commercial success (sales) or technical achievement (industry design awards).
Overall, therefore, being led by the output of the team, it is recommended that we use growth in number of projects undertaken and the number of industry design awards won as the KPIs for this CSF.
3. Ensure that quality of the imaging devices meets market standards
Again, this is a difficult factor to measure. Financial measures of quality are possible by looking at the effect on sales volume and profitability (both likely higher for higher quality). However, these are lagging indicators where quality effects can take some considerable time to trickle through to customer perceptions.
A more direct measure of the quality of current manufacturing would be through customer returns and product failure rates on factory testing. However, it can be difficult to obtain benchmarking information which will allow judgement of whether this is meeting market standards. Given that the company already does manufacture successfully, it should have historic data which, if products are selling at the required margins, would suggest that these data on failure rates and returns would be acceptable to the market. As the business is moving to outsourcing its manufacturing, it is the external failure rate data of the customer returns which will be more appropriate as Folt will retain the key contact with the customer.
Overall, it is recommended that gross profit (a measure of both volume and profitability) of products and value of customer returns be used as KPIs. Both of these will need to be benchmarked to historic values in order to judge the maintenance of standards.
Performance measurement system
The KPIs suggested are:
– ROCE
– growth in number of projects undertaken
– growth in number of industry design awards won
– gross profit and
– value of customer returns.
The question of whether this is a suitable set of metrics to measure strategic performance really asks, does this measure the achievement of Folt’s overall objective ‘to provide an adequate return to its capital providers while growing the business into a world-class supplier in its areas of expertise’.
This objective can be broken down into:
– to provide an adequate return to its capital providers
– growing the business
– being a world-class supplier in its areas of expertise.
These KPIs do address the first part through ROCE and the second part partly, through building the software team. However, the overall growth of the business is not measured financially through sales or profits and its target of being world-class is not measured through the number of markets which it has entered and is considered a leader. The final two KPIs have a more supporting role to play for the overall objective and these could be replaced by others measuring the concepts of growth and world-class supplier in order to provide a strategic view for the board of whether the company’s mission is being achieved.
[Tutor note: Credit is given for suitably justified metrics and then a consistent discussion of this in relation to the objectives of Folt.]
(ii) Outsourced manufacturing: target costing
Working (per unit):

[Note: It is assumed that it is the total design costs which are relevant to pricing the product although it would also be possible to consider the original design costs as sunk and so only include the redesign element.]
The target cost is calculated as the estimate of a competitive product price less the desired profit margin.
The illustrative calculation above shows that the current estimated cost is $2 per unit too high and so the product or the manufacturing process will need to be redesigned to cut these costs in order to meet the desired margin.
The costs will be split under the contract between the two parties. Therefore, Folt could press Xela to make cuts in its costs to meet the cost gap as the gap is not large (2·3% of the total costs for manufacturing [i.e. excluding software, design and packaging and delivery]) and it is stated that Ceeland is a lower cost environment than Beeland for manufacturing. However, it may be dangerous to Folt’s strategy if these cuts adversely affect product quality.
(iii) Responsibility for quality areas within outsourced manufacturing
This discussion relates to the quality of the manufactured device and should exclude issues with the software, packaging and delivery which remain Folt’s responsibility. Taking each of the four areas of quality costs in turn, the cost area is defined and the appropriate treatment under the contract discussed:
– Prevention costs are incurred to prevent the production of products which do not conform to specification (e.g. design of the product and manufacturing process). The product design costs will obviously lie with Folt and the costs for design of the manufacturing process will lie with Xela, although it would be sensible for Xela to replicate Folt’s current process and indeed this may be required in order to maintain quality. However, Xela may want autonomy on this in order to make further gains from streamlining processes. There will need to be liaison between Folt and Xela to ensure that process designs are acceptable to both parties.
– Appraisal costs are costs to ensure that the products output by the manufacturer conform to standards. These costs will mostly lie with Xela as it will be the manufacturer. However, Folt will have to oversee this appraisal by checking on the quality data which Xela will supply under the contract.
– Internal failure costs arise when poor products are identified before despatch. These costs will remain the responsibility of the manufacturer (Xela) as they have control of the manufacturing facility and the appraisal operation there.
– External failure costs arise when poor products are identified after despatch to the customer. Where these costs relate to repair or replacement of faulty hardware products, they should lie with the manufacturer. It is worth noting in price negotiations that there are additional costs for Folt from these failures beyond immediate reworking costs, such as the impact on Folt’s brand.
There may be reasonable argument from Xela that Folt should bear some of the non-conformance costs (internal and external failure) if the faults can be attributed to faulty product design work.
Obviously, all of these matters are subject to negotiation before the contract is finalised.
(iv) Impact of sources of quality information
The maintenance of quality standards is a critical success factor for Folt. The ability to ensure this is based on the SLAs in the manufacturing contract with Xela. The monitoring of these SLAs will be done through information systems and so the quality and reliability of the information is critical to Folt’s success.
The outsourcing contract must stipulate agreed quality metrics and also the targets for performance. These will have to be measured and reported by Xela to Folt. Xela does not at present have information systems which are capable of capturing the non-financial data which is likely to be required by the SLAs. It must therefore be a condition of the contract that suitable systems are put in place by Xela.
In fact, a simple solution would be for Xela to duplicate the existing systems at Folt. This would avoid the need for Folt to authorise (under the contract) any new system as it would then have a familiar one. It will also mean that the format of the reports is familiar and this too will ease the handover of operations.
However, this new system will be owned and operated by Xela and so Folt will need to have access to it in order to verify that data is being input, processed and reported accurately. The detailed type of system audit work may be new to Folt. However, again by using the same system as currently exists, it should be possible to identify managers who monitor quality at Folt’s existing manufacturing operation, to perform this task.
In summary, it will be important that any metrics and targets for these which are used under the contract are unambiguous. It will also be important to stipulate in the contract that Folt be given access to verify that this information is being produced accurately. This will help to avoid the possibility of gaming the contract by Xela.
Ultimately, customer complaints and returns will represent an external source of information on the quality of the products manufactured. However, it would be more effective to identify and address problems before they reach customers.