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Management Accounting for Service and Transportation Companies

Service providers in general

The focus is on the individual work performed by the company’s own employees for a customer order. The main task is to charge the performance-related cost center costs to the customer orders according to cause. To do this, it is often necessary for employees to record their working hours per order on a daily basis. Based on this activity recording, these times are multiplied by the planned proportional cost rate per hour of the cost center providing the service and charged directly to the customer order. This procedure is the prerequisite for determining the contribution margin I of a customer order, as well as the absolute contribution margins achieved by a service group.

Material taken from the warehouse is charged to the customer order at standard purchase price. If material for a customer order comes directly from an outside supplier, the bill is recorded at actual price in the accounts payable department and charge directly to the customer order.

This applies above all to workshops and craft businesses of all kinds (e.g. car repair shops, heating fitters, plumbers, tailors). The costs of inventory management and procurement cannot be allocated to the individual sales order according to cause.

If other providers procure services for the execution of the customer order, these are order-specific external services (e.g. software licenses, design drafts, expert opinions, transportation services, laboratory tests). Also such positions are recorded in accounts payable and assigned directly to the customer order.

As in industrial operations, also service providers need to cover their fixed costs and to generate profit. The main focus here is on the customer order, rarely on an individual item. The sum of all contribution margins has to cover all fixed costs plus the EBIT needed.

If new products are developed in service companies that are subsequently made available to customers for use over several years, it should be considered from an operational perspective whether the project costs incurred should be capitalized, i.e. added to fixed assets and depreciated in subsequent years. These considerations are mainly necessary when developing application programs (software for sale) and consulting modules if the development costs are to be covered by the contribution margins of the subsequent years of use. In financial accounting, an attempt may be made to write off the total expenditure for such a project in the year in which it is created in order to save taxes in the short term.

Transportation companies

In airlines, railroad companies, local public transport and direct transportation from the supplier to the recipient, the following cost types are the most important:

- Personnel costs
- Fuel and energy consumption
- Maintenance of the means of transportation
- Distance or time-dependent imputed depreciation.

Only in the case of direct transportation for a single client from the point of departure to the point of arrival is it possible to determine the proportional costs and thus the contribution margin I of a transport order according to the origin. The time spent by drivers and attendants as well as the miles driven can be measured and evaluated, which makes it possible to determine the proportional costs and the contribution margin I of the transport.

In air, sea, rail or bus transport the transportation options are usually offered according to a timetable or flight plan. The proportional costs arise when the transportation offer is executed. Whether the seats on the train, flight or public transport are well or moderately utilized has little influence on the proportional costs as the personnel deployment remains largely the same and energy consumption changes only insignificantly.

However, if the proportional costs of the unit produced (a flight or a train) remain more or less the same, the net revenue can be increased without significant additional costs by increasing the utilization of the available seats or transport areas. On trains that run between 0900 and 1130 and between 1400 and 1630, a large proportion of seats are often unoccupied. In particular American airlines and railroad companies in Europe recognized this and therefore advertise time-restricted offers at lower than usual prices (see the real examples in “Customer profitability, seller productivity, p. 76”. This approach is known as Revenue Management. On one hand the lower sales prices can increase the absolute contribution margin volume and on the other hand they reduce capacity bottlenecks on flights or trains with a high “Load Factor”.

Like in production also service companies should thus know the proportional costs of their services. This is the only way to determine which services contribute how much to covering fixed costs and profit.

Management Accounting for Industry, Construction and Trade

Industrial production

The main trigger for the development of management accounting was industrial production. Their managers want to know the net revenue of a product or order and compare it with the costs directly caused by the product. The difference is the contribution margin I (CM I).

To achieve this, management accounting is to be set up that it can calculate the proportional production costs in planned and actual values, based on the quantity and activity structure of the manufactured product. The bills of materials and routings with consumption quantities and working times are used for this purpose (see the post “Pizza Dough and Management Accounting“).

Net revenue less proportional production costs results in the CM I per product unit, as described several times in this blog. Based on this, the contributions to the coverage of fixed costs and profit for product groups, customers, customer groups, regions or sales channels can be determined in planned and actual in various levels and dimensions (see the post “Multidimensional CM-Calculation“). After deducting all fixed costs, the top level of summarization is the EBIT achieved by the company as a whole.

Construction Companies

In construction companies the focus is on the contribution margin of a specific customer order. The person responsible for implementing the order (construction manager) is assessed according to how well he succeeded in realizing the planned contribution margin for the order. As in industrial operations it is important to adhere to the planned costs of the bills of materials and subcontracting, as well as to avoid higher actual time consumption by employees compared to the projected target times.

In both industrial and construction operations, the splitting of cost center costs into their proportional and fixed costs is necessary for cost planning and control (see the post “Cost splitting”). Even the best financial accounting software cannot fulfill this requirement because it can only record values, but not quantities and times per order.

Pure Trading Companies

A pure trading company sells its products as they are purchased. Customers usually receive the products directly from the warehouse or from the rack in the store. Packaging for shipping is determined by the size of the order, rarely by the individual item. This usually also applies to online retailers.

Because in trading companies the purchased product is not changed, no routings are required and bills of materials are only needed if the items to be sold consist of product bundles. Therefore, in the cost centers of a pure trading company, all cost center costs, from purchasing to warehousing, sales and administration, are fixed costs. There is no need to split costs into proportional and fixed costs in the cost centers because the proportional production costs correspond to the stock withdrawals for the sales executed.

Management Accounting for Different Types of Companies

Private companies, many foundations and associations as well as public organizations and their administrative units manufacture products and services. All these organizations must be able to cover at least the costs of a period under review with the revenue of this period (year) and, where appropriate, to achieve a profit in line with the market. (See the post “Profit in Line with the Market“).

Consumption-related disbursements usually happen before customers pay. Therefore, it must be ensured that sufficient cash and cash equivalents or open credit lines are available at all times to pay the amounts due. For this, financial accounting is the appropriate instrument in all organizations. However, financial accounting is not suitable for planning and controlling an organization as it cannot process neither quantities nor services and relate their costs to the revenues according to cause.

Management accounting is the only way to charge costs and services to individual service and product units in line with causation. It calculates the planned and actual costs directly caused by the manufacturing of a product or service unit and deducts them from the net revenue generated. The result is the contribution margin I. This is used to cover all costs of the organization that are not directly product-related (fixed costs) and to achieve a profit in line with the market.

For decision-relevant management accounting this results in the requirement to split costs into proportional and fixed when planning cost centers and to charge only the proportional costs of the manufactured units to products or other cost centers. This is because there is only a direct cause/effect relationship for the proportional cost center costs. The fixed costs remaining in the cost centers are period costs. They are the responsibility of the cost center managers. They are transferred as cost blocks to the stepwise contribution accounting.

According to current knowledge, only Resource Consumption Accounting (RCA, see L. White, Resource Consumption Accounting) fulfills this requirement. In German-speaking countries, Grenzplankostenrechnung GPK combined with contribution accounting correspond to RCA. RCA shows which costs are caused directly by the manufacture of the individual product unit produced. These costs are to be recorded per unit as inventory receipts and can be charged to the units sold according to their origin. The costs not incurred directly per unit remain in the cost centers. They are to be understood as fixed costs for the period under review. They are fixed costs because they are incurred for the cost center’s readiness to perform.

How to plan cost center costs and to calculate proportional cost rates for product costing is a main topic of this blog. The application of the methodology in different kinds of companies as well as in corporations with many daughter companies or in public administration are discussed in more detail in the following posts. The focus is on:

- Production and sale of physical products, e.g. industrial and construction companies
- Pure trading companies
- Service companies, e.g. consulting companies, auditors, law firms, software developers
- Transportation companies
- Banks and insurance companies
- Healthcare facilities such as hospitals, retirement homes, laboratories
- Public administrations and educational institutions.

What these types of companies have in common is that they

- work for several customers,
- can process several orders for a particular customer, each with several order items,
- offer different products or services,
- can divide their organization into cost centers, each of which is the responsibility of one manager,
- should charge activities between cost centers according to their origin (Charging Internal Services, no allocation of fixed costs),
- want to know which customers, products and services generate how much contribution margin.

For the planning and analysis of results by the managers concerned, the contribution margin I per product and per customer is always relevant for decision-making in the various types of companies. Because the fixed costs cannot be allocated to an individual order item according to their origin, the evaluations must always be based on CM I per order item.

The following data model shows that for aggregated reports always 1:n relationships (1 < —>> n) are needed:

Management accounting for different kinds of companies

Reading method: On a specific date, a customer can purchase one or more products or services. The proportional product costs are defined per unit, customer and date, the CM I is the difference between the net revenue agreed with the customer and the proportional cost. Based on the customer, the product and the date, net revenue, proportional product costs and CM I can be summarized according to all higher-level dimensions.

Calculating imputed depreciation

Entrepreneurs want to know what existing and additional investments will be required to generate the planned profit (EBIT) in the coming years. The amounts originally paid for the fixed assets are only partially relevant for this because inflation and technological developments often lead to higher replacement values and therefore higher imputed depreciation. If the replacement value of an asset increases by 20% compared to the previous year, the imputed depreciation for this asset must also be increased by 20%. This reduces the (distributable) profit, but also ensures that the money remains in the company to finance replacement investments.

The annual business plan must therefore determine which and how much fixed assets will be required in the planning year in order to achieve the planned profit. For this purpose, it is necessary to estimate by how much the replacement value of an existing and still used asset will increase in the year to plan. The replacement value is divided by the useful life planned by management and results in the imputed depreciation of the asset in the year to plan.

By stipulating that the imputed depreciation is charged to the income statement each year, the owners ensure that the money for replacement or renewal investments remains in the company’s current assets or is used to reduce interest-bearing loans. The funds for maintaining the company’s ability to perform are thus available because less has been distributed to the owners or been given away through lower sales prices. External cash inflow for the further expansion of the company is only necessary to finance growth.

Replacement value and imputed depreciation

Using the example of cost center 100 (sales management) at Ringbook Ltd., the following steps are required to determine the replacement value and the imputed depreciation:

- The fixed assets of cost center 100 amounted to EUR 96,000 at the end of 2020.
- The management of Ringbook Ltd has determined that machines, equipment and software can be used for 8 years until they need to be replaced. This results in a depreciation of 12.5% of the acquisition or replacement value (EUR 12,000, column j) for 2021.
- The replacement value therefore amounts to EUR 84,000 at the end of 2021.
- In 2022, an online store was set up for cost center 100. Project costs of 86,602 (column f) were incurred for this. These were capitalized so that the replacement value of the fixed assets in cost center 100 amounted to EUR 182,602 at the end of 2022.
- In addition, a general inflation rate of 3% (inflation rate, column g) had to be taken into account in 2022. This had an impact on the replacement value of the original investment of EUR 96,000 at the beginning of 2022 (EUR 2,880, column h).
- In total, 12.5% of the replacement value of 185,482 (column i), i.e. 23,185 (column j), was to be charged as imputed depreciation for 2022.
- In the years 2023 – 2025, the new investments (column e) are added to the existing assets of the cost center. They must also be taken into account in subsequent years.
- The effects of the annual inflation rates (column g) increase the replacement value of the existing investments in cost center 100. Depreciation of cost center 100 also increases (column j) and thus also the balance sheet value to be reported in the internal reporting at the end of the year (column k).

Estimating the replacement values of existing investments is often difficult, as quotations have to be obtained from potential suppliers. For this reason, many companies use the index method to calculate the replacement value of an asset. The question is how much an acquisition will increase in the planning year if it is multiplied by the current inflation rate (columns g and h).

Imputed depreciation is a cost type of cost center costs because the operating resources (assets) are assigned to cost centers and are used in these cost centers to produce services. For large assets that are used by several cost centers often a separate cost center is set up. An example is a factory building in which various cost centers are housed.

Imputed Depreciation

“Imputed depreciation is a cost equivalent for the devaluation of long-term usable operating resources (see Wolfgang Kilger, Flexible Plan Cost Accounting and Contribution Margin Accounting, 9th Improved Edition, Wiesbaden, 1988, p. 398).”
Imputed depreciation amounts are intended to lead to corresponding amounts of money being “reserved” in the financial assets for replacement investments, in order to procure replacement assets if necessary and thus be able to continue to meet the operational purpose. The devaluation equivalents mentioned by W. Kilger are to be calculated on the basis of the replacement values of the investments from the point of view of value retention.

It follows that imputed depreciation should not be calculated on the basis of the historical acquisition value of long-term working assets, but on the amount to be paid at the end of the year for equally efficient assets. From our point of view, a company’s profit potential is only preserved when the equally efficient operating resources can be procured again. As a consequence, there is no distributable profit for the owners/shareholders until the imputed depreciation calculated from the replacement value has been deducted. Only the residual amount can be distributed with a clear conscience if the company is not to suffer a loss of substance.

In order to determine replacement values and imputed depreciation, it must be clarified annually what changes in the purchase prices are to be expected for the various fixed assets. There are many reasons for imminent purchase price increases or expenses for updates:

- Inflation in procurement markets
- New technical or legal regulations to be complied with
- Changed safety regulations for the operation of the facilities (and buildings)
- Adaptation of computer programs, program extensions and release changes
- Switching to another machine supplier because the previous one no longer exists.

It also happens that equipment to be replaced becomes cheaper to purchase because physical plant components are replaced by electronics or metal by plastic.
In the event of expected increases as well as reductions in the purchase prices of fixed and intangible assets, imputed depreciation for the plan year must be recalculated and taken into account in management accounting. Like all other costs they determine the annual internal profit.

Imputed depreciation should not only be calculated for long-term assets such as buildings, facilities, machinery and vehicles. Increasingly, the resources also include rights and potential benefits of a non-physical nature such as ERP- and CRM-systems, rights of use and sales, purchased customer addresses, time-limited licenses of use. If such potential benefits lose their value over time and require new investments to preserve their benefits, the corresponding estimated amounts have to be taken into account in the replacement value, which in turn leads to higher imputed depreciation.
Sustainably successful corporate management requires the inclusion of imputed depreciation and amortization in the income statement. This prevents funds from being distributed to the owners, which will be necessary to maintain the company’s potentials for success and thus its continued existence.

Depreciation of Fixed and Intangible Assets

Buying a car privately

If private individuals want to buy a new car, they first determine how much they will have to pay for the desired vehicle including all equipment features. This results in the gross purchase price of the vehicle, which is then also shown in the purchase contract. If her used car is traded in, the trade-in price is deducted. She may prefer a leasing contract with monthly payments. When making the decision, the private individual mainly considers the cash outflows at the time of purchase and the ongoing annual expenses. Such an investment calculation only takes cash flows into account.

Why write off?

A company, on the other hand, must present a financial statement with a profit and loss account every year. To determine the annual profit for the period, it must deduct the annual loss in value of the car, i.e. depreciation, from the revenue generated and show it in the income statement and in the balance sheet.

Depreciation is the value-based expression of the annual loss in value of physical and intangible assets. External reporting and the calculation of taxes payable are governed by legal regulations. These regulations are intended to ensure that all taxable companies report according to the same rules and are therefore treated equally by the state. The management approach, on the other hand, focuses on the loss in value of an asset or right due to its use and the expected remaining useful life of it. These different purposes can lead to different depreciation amounts being included from an operational perspective than those permitted under tax law.

External or internal valuation

In order to treat all their taxable companies equally, many countries issue commercial and tax regulations on the valuation of assets, the depreciation methods to be applied and the useful lives permitted for the calculation. In Germany, for example, these are the depreciation rules (depreciation for wear and tear), cf. the depreciation table of the German Federal Ministry of Finance (Bundesfinanzministerium – AfA-Tabelle für die allgemein verwendbaren Anlagegüter (AfA-Tabelle “AV”)). For internationally operating and reporting companies, the rules of international reporting standards such as IFRS or US GAAP are applied.

For the managers controlling a company or a group these external valuation and depreciation rules are of secondary importance. They want to be able to assess whether the depreciation and amortization charged to the internal financial statements will be sufficient to maintain the company’s performance potential in the future so that it can continue to generate profits in line with the market. Distributions (dividends) to owners and shareholders should therefore only be decided once it has been ensured by means of imputed depreciation and amortization that funds that will be required to maintain the profit potential will not be distributed.

“Management control plans, controls and measures the implementation of guidelines, strategies and operational objectives, see the management control definition.

From this understanding of management control it can be deduced that management accounting must take into account imputed depreciation, not financial depreciation. This is because it is about shaping the future of the company and only to a limited extent about external profit reporting.

Depreciation of fixed and intangible assets

Cost plan for the IT-Cost Center

The company’s IT department is responsible for the installation, operation and further development of all applications used throughout the company. In the example company these are: ERP (production planning and control, purchasing and inventories, projects), PLM (product life cycle management), CMS (customer acquisition and support, quotation preparation and tracking, sales orders, analyses), payroll administration, financial and management accounting, internal and external communication (mail, internet presence).

In most cases, several functional areas of a company use these applications. They collect data, analyze content and create evaluations.

The IT department is responsible for the operation, extension and maintenance of the existing applications as well as for the necessary hardware and communication installations. It is also planned that its employees will work 800 hours in the planning year on development projects that can be capitalized and amortized in subsequent years.

For this purpose 7 employees (full-time positions FTE) are employed: (1 IT manager, 4 persons to operate the applications, create evaluations and maintain the hardware and software installations, 2 persons to further develop the applications and work on (capitalizable) projects.

The following cost center plan was defined for the planning year:

Notes:

If the plan is approved as presented, the head of IT is responsible for adhering to the planned costs of 1,242,000 (line 13).

If IT department services were directly dependent on the actual performance of the receiving cost centers, they would have to be charged to the receiving areas at proportional costs. However, there is rarely a direct cause/effect relationship between the recipient’s activities and those of the IT department.

If the costs of further IT developments are to be capitalized, i.e. written to fixed assets, the proportional personnel costs (45,000, line 13) are included because these directly performance-related costs are causally necessary for the creation of fixed assets. All other cost types of the IT cost center are not directly caused by the IT services purchased. They are period costs.

The calculation of imputed annual depreciation in accordance with lines 5 and 12 depends mainly on the valuation rules applied in the respective company (what is capitalized and what is charged directly to the annual financial statements?)

The IT cost center performs various internal tasks. The costs incurred for these are to be planned and accounted for in this cost center.

Conclusion:

Cost planning and the control of internal tasks take place in the cost centers that perform them, because this is where the personnel and systems work, but their costs can rarely be clearly assigned to an individual internal task.

Internal tasks generate period-related fixed costs. This is because their amount is only indirectly dependent on the services produced or sold. Consequently, the costs of internal tasks cannot be charged to the cost centers consuming them or even to the units produced. They are the result of the company’s willingness to perform and the associated management decisions.

Internal tasks can rarely be measured in units, as they usually comprise a bundle of tasks and are not directly related to sales or production quantities.

The costs of an Internal task can usually only be estimated as often several cost centers contribute to an Internal task. However, it is important to continuously record the working time consumption per Internal task. This is because personnel costs carry the most weight and cause the readiness to perform costs to swell.

The costs of all Internal tasks must be covered by the contribution margins.

Costs of Internal Tasks

In the glossary Internal Tasks are defined as “all work performed in the cost centers that is neither directly caused by the quantity of products manufactured and sold nor requested by other cost centers directly depending on their own output”. The post “Internal tasks” in the Management Control blog lists the types of tasks that count as Internal tasks.

The fulfillment of these tasks leads to readiness to perform costs (fixed costs). They are incurred so that production and sales can take place at all. The fixed costs are incurred in the cost centers, but cannot be allocated to products and services according to cause. Readiness to perform costs are planned and approved by the managers. Consequently, the cost center managers and their superiors are also responsible for their amount.

Cost planning for Internal tasks

Cost center budgets must be prepared so that the costs of internal tasks can be assessed and approved for implementation. This requires the following considerations:

1. Time requirements, time consumption of cost center employees per internal task and year, planned services for project orders, time required for cost center management and further training, training.

2. Costs and usage licenses to be paid externally, per internal task or cost center

3. Services from other companies, external costs to fulfill the internal task

4. Services from other cost centers, genuine internal services, e.g. from energy, maintenance, repair, laboratory, transport or IT cost centers (ordered and measurable).

5. Investments and resulting imputed depreciation, acquisition of machinery, equipment, hardware and software; management decision for the planned useful life, calculation of annual imputed depreciation.

The procedure to plan costs for internal tasks is shown in detail in the post “Planning the costs of the central IT-department”.

Valuing Inventories at Standard

Decision-making and responsible management accounting require that variances from plan are reported where they occurred. This is where corrective actions must first be determined and implemented if the targeted result is to be achieved (see the post “Management Cycle“). This can be achieved if all stock receipts and issues are valued at proportional planned production costs and if the cost center activities are only passed on to products and other cost centers valued at the proportional planned cost rate.

The following rules must be observed:

- All purchased material is valued at the planned purchase price (according to annual planning) during the entire year at warehouse entry or exit
- The difference between the planned purchase price and the actual price paid is disclosed as a purchase price variance in the monthly reporting and can thus also be reported on time in financial accounting. Purchasing is responsible for this.
- Withdrawals from stock of raw materials and supplies are also debited to the production orders and the consuming cost centers at planned purchase prices Purchase price variances remain with Purchasing.
- Manufactured semi-finished and finished products are valuated at proportional planned production costs of the respective item at the time of stock receipt (variances remain in the production orders or in the cost centers performing the work).
- Fixed costs are period costs and consequently cannot be allocated to an individual manufactured unit according to the cause.
- Stock withdrawals of semi-finished products for processing in further production stages are valuated at proportional planned production costs, i.e. at standard. This is because any variances were already disclosed in the preliminary stage.
- Stock withdrawals for sales are also made at proportional planned production costs of finished products (variances were already disclosed in the semi-finished products and in the cost centers). In addition, the sales department is rarely responsible for production variances.

This consistent passing on of the services rendered at proportional production costs or at proportional planned cost rates of the cost centers shows all variances from the plan or from the flexible budget where they originally occurred. This is where corrective actions mainly must be found. The respective managers always have the comparison available between the services rendered at standard and the costs for which they are responsible. Variances from preliminary stages remain there because they also have to be eliminated there. All production and cost center managers can thus assess whether they have complied with their planned costs, taking into account the actual activities performed. This is because they are responsible for the costs they can influence directly.

At the turn of the year, the planned purchase prices and the proportional planned costs of the following year must be applied. This is because the processes and thus the production costs can change in the cost centers and other purchase prices must be provided. Although this requires a revaluation of inventories at the beginning of the year (can largely be automated), it also produces the figures in the following year to be able to present target to actual comparisons relevant for decision-making.

Accounting for Management means providing all managers with the systems and data to enable them to plan and control in a target-oriented manner in their area of responsibility and for the company as a whole. The focus is always on decision-relevant internal reporting and the successful management of the individual divisions.

What about external reporting?

The decision and responsibility-based approach pursued here often does not comply with the valuation rules of accounting standards such as IFRS, US GAAP or national tax law requirements. These rules mostly require the presentation of results in the form of full cost accounting and an externally oriented valuation of inventories.

We compiled the legally binding rules and analyzed their impact on the design of corporate accounting for many countries. In particular, we wanted to know whether legal requirements or accounting standards prohibit or prevent the design of a management accounting system that is uncompromisingly focused on decision making and internal accountability.

This analysis was revised and updated several times. Download the 2019 version with the link below (sorry, until now only available in German): Lukas Rieder, Markus Berger-Vogel: “Fixed Cost Allocations: one or none?”

Here we anticipate the key findings from this analysis:

There are no statutory accounting requirements or international reporting standards that prohibit or otherwise prescribe the structure of the decision- and responsibility-driven management isaccounting system recommended in this blog.

In management accounting, the starting points are the individual item, the processes and cost centers and the people working in them. These elements must be planned and controlled in detail if a company is to remain successful in the long term. Evaluations are mostly condensations on higher observation levels, which deny the view of the control-relevant details.

With reference to the valuation of inventories and thus the determination of the externally reported annual result, it makes sense to always value all inventory receipts and issues at proportional planned production costs. It is easy to adjust inventory valuations to accounting rules in an automated side-by-side calculation to generate external reports. However, financial success is generated in the market and internally, not through external reporting.

Cost price is irrelevant for decision-making

Cost price is the total cost of a company in a period, adjusted for changes in inventory. According to Wikipedia.org, this includes material costs, manufacturing costs, research and development costs, administrative costs and distribution costs. as well as imputed interest for assets required for operations (see German Guidelines for Price Determination on the Basis of Cost of Goods Sold (Annex to Regulation PR No. 30/53 of November 21, 1953, Notes 43 – 45)). If the net revenues exceed the cost price, the company starts to make a profit.

This statement is true for the company as a whole but it misleads when it comes to management control. Who wants to calculate the cost price of an article, a customer or a subdivision of the company, has to break down the fixed costs to product units. But as there is no direct cause-and-effect relationship between the company’s fixed costs and the individual product unit sold, this can never be done properly

To calculate the profit contribution of an item, the cost price per unit of a product or service unit sold must be calculated. All fixed period costs must therefore be allocated to the product units sold. For this purpose, an overhead rate is determined for the calculation of the unit cost of goods sold. If the sales quantities or the fixed cost blocks change, the cost price per unit unit also changes. This affects inventory valuation and, even more important, the management of sales and production.

As long as neither the bill of materials nor the routing and neither the material purchase prices nor the proportional planned cost rates of the cost centers involved in production change, the proportional costs incurred per unit produced remain the same. However, distributing the fixed costs to a different production or sales quantity, results in different cost prices per unit. Neither production nor sales are responsible for this, only the capacity utilization.

Cost price is irrelevant for descision-making

In the example, the monthly cost price per unit of goods sold changes because the fixed costs are divided by the production quantity of the period under review. If inventory receipts and issues are valued monthly at full productions costs, they include a portion of the period’s fixed costs. The value per unit thus changes every month. The fixed costs of other functional areas of a company are usually added as percentages to the full production costs. Although cost of goods sold is necessary in external reporting, it is not useful for corporate management purposes:

- If the really paid purchase prices deviate from the planned ones, first the purchasing department is responsible for the variances.
- If in the production processes more direct material is consumed per unit produced than planned (or more semi-finished products), the production management is responsible.
- If the standard times for the manufactured product units are not adhered to in the production cost centers, it is up to the respective cost center managers to take corrective action.

The data required for this can only be obtained if the splitting into proportional and fixed costs has been set up in the management accounting system. This can be achieved with marginal costing (flexible standard costing), see the posts “Full product costs are always wrong” and “Complete variance analysis“).

Since the demand, respectively the customers and the ability of one’s own sales organization determine the net revenues, it is necessary to compare the latter with the proportional product costs of the services and products sold. Our experience shows that most companies sell their items at different contribution margins per unit. The sum of all contribution margins achieved must be sufficient to cover all fixed costs and the targeted profit. An item that does not cover its calculated cost price can still make a considerable contribution to covering fixed costs.

The aim is always to cover all fixed costs and all variances with the contribution margins from the units sold, while at the same time achieving a profit in line with the market.