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Contribution Margins to Cover Structure Costs

Contribution margin accounting is applicable in all industries. The procedure is described using various examples. In addition, the path from the contribution margin of a single item to the EBIT of the company is shown.

After completing the planning for proportional product costs and net revenues (see the post From Planned Sales to Net Revenue), the data to calculate the contribution margins to cover structure costs is available.

Contribution Margins to Cover Structure Costs

The proportional cost of goods manufactured includes those planned costs that are directly caused by the product (valued bills of material and work plans). All product costs are first booked as entries in the warehouse (semi-finished or finished products) at planned proportional costs (standard costs) and are withdrawn from there at the moment of delivery to the customer. The planned fixed costs remain in the cost centers.

The example of item 101060 shows how contribution margin I is created in the plan:

CMI 101060 — Contribution margin of article/item 101060

Salespeople should not get a commission based on sales or net revenue as a component of their income. Doing so often leads to rebates of all kinds being granted in order to achieve the sales targets or to increase capacity utilization. Therefore, in the example company a contribution-based commission of 2% of the achieved CM I volume is credited.

The contribution margin I (CM I) is internationally defined as the difference between net revenue and proportional product costs (see Glossary). It is easy to see that the sum of all CM I must be sufficient to cover all fixed costs and earnings before interest and taxes (EBIT) if the result is to be in line with the objective. CM I is thus the contribution to structural cost coverage. The following illustration shows its creation:

Contribution Margins to Cover Structure Costs — The interaction between production levels, warehouse positions and Contribution margins

The following planned EBIT can be shown in the example company:

This illustration is not particularly informative. In the post “Multi-Level and Multi-Dimensional CM Accounting”, more detailed insights for the management are provided.

Cross-Industry Applicability

Before that, we consider the cross-industry applicability of this profitability analysis structure. So far, the example has been developed for a manufacturing company.

- In a pure trading company, the goods purchased are usually the goods sold. The company makes no changes to the product, that is, the bills of material and the work plans remain the same, so the purchase price corresponds to the proportional cost of goods manufactured. Small adjustments can happen if purchased goods are repackaged. All other costs are fixed costs since they are the result of the organizational and capacity structure of the trading company.
- In service companies, clear product definition is a prerequisite for the installation of an integrated planning and control system. Only the structured recording of the scope of services makes it possible to record the use of purchased services or products (bill of materials) and to describe the activities to be performed in the cost centers for a product in a measurable way (work plan). In an automotive workshop, the bill of material is of relatively great importance (spare parts, additional parts, externally commissioned paint shops). In a law office it is mainly the type of case to be processed (products) and the processing times required for this in the various departments (work plan) that are decisive, rather than the use of purchased parts or services.
- Public administration companies and, to a large extent, hospitals also know the consumption of purchased goods (parts list) and the work performed by their internal departments (work plans) for the planning and control of their cases.
- In banking institutions, the market interest rates of borrowed money define the proportional cost of the money lent in a mortgage while the work steps in the process of granting the mortgage loan correspond to the work plan and thus to the proportional manufacturing costs. The trading function comes to the fore when foreign currencies or gold (coins) are involved.

With the presentation of the planning of costs, services, and revenues as well as contribution margins for a manufacturing company, a more complex case was deliberately chosen. However, as the above references are intended to show, the presented system can be applied to almost all companies.

Project Cost Planning

Projects cause investments and costs. These are to be included in management accounting in order to present the complete result. The necessary data is presented here.

Project cost planning

To release a project order its financial effects should be determined as well. Project cost planning requires a similar procedure as for product costing. As projects also generate costs and investments they also have to be represented in the management accounting system.

In the assembly cost center of the example company the material positioning (envelope and mechanism) should be automated with the help of a loading robot and at the same time enable an accurate positioning of the parts. Manager of this project is the head of the Assembly cost center. His employees will help set up the equipment and test it. An external company will be commissioned to handle the project, the in-house maintenance and repair center will ensure the availability of compressed air and electricity, and the in-house IT department will program and test the interfaces for the transmission of production order data.

The same procedure as for the manufacture of a product should therefore be provided for:

- Material consumption for testing
- Internal services of the cost centers Maintenance and Repairs and IT
- The time needed in the Assembly department to put the installation into operation (internal tasks)
- The external expenditures for the system (including installation) for testing (third-party invoices, cash out).

The project budget is created using the plan data from the simulation model (accompanying the book Management Control with Integrated Planning – Models and Implementation for Sustainable Coordination). The project budget serves as a basis for decision-making by the deciding managers when releasing the budget.

Project cost planning — Planned consumptions for the project

The internal services provided are already included in the post “Planning the Internal Services Provided”. These services, the investment, and the material consumption will be posted to the balance sheet as assets under construction. This is recommended from a management perspective, because the costs of the investment will not appear as (imputed) depreciation in the assembly cost center until the following periods. The points to be considered when determining depreciation in Management Accounting are discussed in another post.

Because projects will soon be omnipresent in companies, the working time requirements for internal tasks and for internal services provided in particular must be planned in detail. These hours have an increasing impact on personnel requirements planning.

Standard Cost Calculation of Products

Proportional standard production costs are the planned costs that are directly caused through the product or service to be manufactured. They are the value-based consequence of fixing the objectives and must therefore be applied in calculation as well as in the valuation of inventories.

Creating the standard cost calculation for an article requires the following data: bill of material and work plan, lot size, planned purchase prices for raw material, planned proportional cost rates of the cost centers.

The base plate for the locking mechanism of a 4-ring binder is calculated as follows:

Basic data and proportional planned cost of itemnr. 11

- From production planning it is known that the annual production of item number 11 should be 816,200 pieces. 11 equal lots of 74,200 units should be produced.
- The bill of materials shows that sheet metal for 50 units will be used for setup and that 200 of the manufactured units will have to be disposed as scrap. For one base plate 0.024 m² of sheet metal are required.
- Together with the requirement for setup and scrap the requirement for steel amounts to (74,200 + 50+ 200) x 0.024 m² = 1,786.8 m².
- The planned purchase price per m² is 2.00 EUR. This results in direct material costs of the lot of 3,573.60 EUR
- The work plan states that 0.25 machining minutes are required to produce one qualitatively good base plate (stockable). Added to this are 120 minutes for setup. The power requirement per batch is therefore (74,200 pieces at 0.25 min + 120 min setup = 18,670 min.
- These are multiplied by the proportional planned proportional cost rate of the stamping shop of 0.8938, which results in the proportional planned production costs of 16,686.37.
- In total, the proportional planned costs of this lot are EUR 20,259.97 or, for 74,200 good units, EUR 0.2730 per unit of inventory entry.

Valued at EUR 0.2730 / unit, the semi-finished product base plate 4-ring (itemnr. 11) is posted as a stock receipt. In the management-oriented system, this valuation approach for inventory movements applies to both planned and effective transactions. The reason for also using the planned proportional standard rates for real movements is that cost variances occur at the time of production and that the production managers are responsible for this variance. The orders that withdraw the semi-finished products for the next manufacturing level are not responsible for the variances that occurred previously and should therefore receive the products at standard cost rates.

For the same reason, the actual withdrawals of raw materials from inventory are always valued at planned purchase price. This is because if purchases are made at a higher or lower price than planned, a purchase price variance occurs in procurement. This variance can be observed by the purchasing manager and is shown in the overall result of a period. Often it is not possible to pass on purchase price variances to the production orders according to their cause, because it would then be necessary to decide which orders receive the same material at the lower and which at the higher price.

In our post “From the Sales Plan to Production and Purchase Planning” the multi-level bill of materials of item 101060 was presented. These steps from the raw materials to the various semi-finished products and to the finished product are shown in the standard cost calculation for the finished product 101060 below.

Standard Cost Calculation of Products — Standard Cost Calculation of product 101060

The proportional costs of every unit are always transferred to the next production level as standard values. Costs for setup and scrap are always included in the proportional standard costs. Although the warehouse receipts and issues are not shown, they are also always valued at these standard costs.

Charging Internal Services

The allocation of internal services to other cost centers or products using full cost rates provokes wrong decisions. Only if these services are ordered by the recipient, their proportional costs are to be charged to the receivers.

Charging Internal Services

In many companies and in literature it is strongly believed that all costs of internal service areas should be charged to end products. This is done in order to be able to see how much a certain item did cost in total until it was received in the finished goods warehouse. The subject of this post is to show to what extent this approach can be implemented in a way that is appropriate for management and thus for decision-making.

Our starting point is the plan of cost center 330 Maintenance and Repairs in the example company. Cost center manager Temmel is responsible for internal repair and maintenance work in the entire Ringbook Ltd. This also includes the operation of the energy center. Up to now, the manager was able to carry out this work alone. For larger orders, external service companies were commissioned. Their costs are planned in the receiving cost centers in the cost type “external maintenance/repairs”.

Based on the planning of the internal services provided the planned activity level of cost center 330 is 1,650 hours for the plan year. The question as to whether Mr. Temmel’s planned presence time of 1,700 hours will also be sufficient for his internal tasks was left open for the time being. If there will be some overtime it will be paid and shown as a cost center variance.

Charging Internal Services: 330 Repair center

Together with his controller and his boss, Mr. Temmel prepared his cost planning on the basis of the planned activities. His own salary including social benefits amounts to 64,496. The consumption he has planned for his cost center is listed in cost types 5 – 13. Based on the equipment installed in his cost center, the controller has calculated the imputed depreciation of 7,625. From the previous measurements it can be deduced that the cost center will consume about 400 kWh of electrical energy per year. This corresponds to 80.00 at an internal rate of 0.20 / kWh.

The splitting of the costs into their proportional and fixed parts works automatically, as shown in our previous blog “Splitting Planned Costs into Proportional and Fixed”, when the plan data has been completely entered:

- His personnel costs are 64,496 for 1,700 hours presence time. Per hour this amounts to 37.94.
- He assumed that he will need 0.56 auxiliary and operating materials per hour of repair and maintenance work in his cost center. This amount is consumed with every hour worked for other cost centers and can therefore be integrated into the proportional cost rate. The remaining 156 of this cost type are incurred for the operational readiness of his repair center and can thus not be charged to the recipients.
- He proceeded accordingly when planning the other cost types.

This results in proportional planned costs of 64,266. Divided by the planned employment (1,650 hours), the proportional planned cost rate of 38.95 results.

The cost center manager is responsible for the planned fixed costs of 11,445. The installations and capacities of his workshop are there because they are planned by him and approved by his bosses in the budget. If he can dismantle them, for example by reducing the fixed maintenance of his own processing machines, the total costs of the job will be lower. However, the proportional cost rate for the service hour performed remains 38.95.

If any share of fixed costs for the workshop building, for the use of the canteen, for IT connection and personnel administration were allocated to the workshop cost center, the full cost rate of the workshop would explode but the proportional cost rate would remain the same. If the full cost rate were to rise to 100 EUR/hour as a result of these fixed cost allocations, the internal service receivers would get the idea of procuring the repair and maintenance activities externally, because they would be available there for 70-80 EUR per hour. This would not only result in more money flowing outwards. The fixed costs of the workshop would rise massively because less internal service would be provided, but the employee and the equipment would still be there. This would result in a reduction in profits for the company as a whole.

To avoid such undesirable developments, we recommend to only charge the proportional costs of internal services provided at planned cost rates. It is the management, not the receiver of the service, that decides on the amount of structural costs.

The idea of outsourcing internal services to a separate company within the corporation must also be carefully considered from an overall perspective. After all, the spun-off company must also build up and pay for all kinds of capacities. Investments must be written off, taxes and profit transfers to the parent company are due. This often led to the total costs of a spin-off getting higher than previous internal costs. This has then led to a higher internal price for the service than before.

Proportional and Fixed Costs

The splitting of cost center costs into their activity-dependent proportional and their fixed portion is part of the annual cost center planning. This is done for each planned in the affected cost centers. Once the basic data is available, the process can be automated.

Proportional and Fixed Costs

Applying the cost cube from the previous post means that for decision support all costs have to be split into their proportional and fixed portion, since proportional is the consequence of units produced and sold, fixed is the consequence of management decisions. The point is to correctly represent the principle of cause and effect in cost center planning. This splitting is done in the planning process.

- An employee in a production center can work on production orders (setup, production, monitor quality, pack finished parts into transport containers). These are tasks that are causally necessary for the creation of a defined product. Without them, the product cannot be created. They are incurred proportionally to the quantity produced. The same employee can organize, take part in further training, attend meetings, clean up the workplace or, hopefully in rare cases, wait for work. The latter activities are determined by the organization of the cost center. They are incurred independently of the quantity produced and are therefore part of the cost center’s fixed costs.
- The consumption of electrical energy in a production cost center is mainly determined by the type of product to be manufactured and the quantity produced. Electricity is also consumed for lighting, air conditioning, and the operation of auxiliary equipment such as computers. The consumption for production is causally necessary for the creation of the product and must therefore be planned proportionally. The rest of the electricity consumption is again the part of the capability to perform.
- Maintenance work on the machines installed in the cost center can be caused by the operation of the equipment, e.g. after 200 hours of operation the rollers have to be replaced because they are no longer flat. Other maintenance work (technical inspections, functional checks) is due after a predetermined period of time, for example, annually, regardless of the quantities produced, to ensure operational readiness.

The examples show that different cost elements in a cost center must be planned with a proportional and a fixed portion. The following section shows how the necessary cost splitting can be largely automated. The example of the Stamping cost center is reused for this purpose.

Proportional and Fixed Costs in 220 Stamping

In comparison to the initial situation in the post “Planning Cost Centers”, the columns proportional, fixed and value consumption per RFU have been added.

The procedure for automated cost splitting using the example of personnel costs: The annual budget for personnel costs is 337,560. This amount divided by the normal capacity of the employees (408,000 Pmin) results in the average presence time rate per minute of 0.82735. This is the average cost per minute “been there” of any employee in this cost center. The 0.82735 are multiplied by the planned activity level of 338,855 Pmin. The planned proportional personnel costs are thus 280,353. The fixed costs are the difference to the planned amount (57,207).

For the other cost types the cost center manager considers for each of these what portion of the planned amount depends on the cost center’s activity. In the example, these are the consumption of auxiliary and operating materials, external maintenance, other expense, and energy. The manager derives this proportional share from his planning documents (maintenance contracts, consumption tables for energy, material costs that only arise from productive work). By dividing the amount by the planned activity he receives the consumption per reference factor unit (RFU, entry in last column). Since the RFU in the stamping shop is the minute, this naturally results in very low rates. The calculation method is then analogous to the splitting of the personnel costs.

Tip for practical implementation: Do not use percentages when splitting the proportional from the fixed amount. Always use the proportional rate per RFU. If the planned activity level has to be adjusted due to a changed production plan, the proportional plan cost rate of the cost center would change when using percentages. This is unrealistic because it is still the same product with the same work plan.

Cost splitting is a prerequisite for the calculation of proportional planned product costs. In order to be able to process if-then questions, the manager must know which costs are directly caused by the product (proportional planned production costs) and which cost blocks are the result of structural and capacity decisions (fixed costs). The latter change as shown in the cost cube through management decisions while the proportional product costs per unit remain the same as long as the product unit has the same bill of materials and work plan.

If the planned activity level, the planned cost amounts per cost type and the consumption per RFU are known for each cost center, cost splitting can be completely automated. Proof of this is provided in the simulation model of the book Management Control with Integrated Planning – Models and Implementation for Sustainable Coordination.

Cost splitting is not necessary in structure cost centers since these areas work for the products and not on the products. Consequently, only fixed costs can be planned in these cost centers.

Management-Relevant Cost Terms

In order to make correct cost decisions, the management accounting system must be able to present all costs in three dimensions. Because these dimensions interpenetrate each other, they can be represented with the cost cube.

Why management-relevant cost terms?

Enabling management control requires decision-relevant cost and revenue terms. Every manager is dependent on being able to identify which variables he can directly influence and therefore should also be responsible for in his area. He must be able to recognize in which time period he can change what cost and revenue parameters. Finally, he wants to be sure that only those cost items are charged to his area that can be unambiguously assigned.

This requires viewing costs in three dimensions according to their intended use and mapping them in the management accounting system:

Management-Relevant Cost Terms in the cost cube

These three dimensions interpenetrate each other, which is why they should be represented in a cube (see the cost cube in the Controller Dictionary, p. 146):

What does this mean for the design of Management Accounting systems?

Costs are to be planned by the unit whose manager is also directly responsible for them. Personnel costs and most third-party costs arise in the cost centers (except material). The same applies to depreciation. Material costs and product-related external services are incurred for the products. They are represented in bill of materials items and are therefore included in the costing of the products. The production managers are responsible for this. These costs are therefore to be planned and accounted for by cost center managers and product-responsible managers.

For all managers, it is important to know in which period of time their costs (and the procurement prices behind them) can be changed. In the case of personnel costs (they always arise in cost centers), hiring, notice periods, negotiated wages and rates for social benefit costs determine the period in which the costs can be changed. In the area of material and external service costs, order quantities and the agreed contract and delivery conditions determine the costs.

From the point of view of traceability, in Management Accounting, both planned and actual costs (or expenditures) must be assigned to the area that is directly responsible for them. The costs of the unit’s own employees are direct costs for a production cost center since each employee is permanently assigned to that cost center. For the orders processed by the cost center, they are indirect costs because an employee usually works on different orders in a given time period. The same applies to the consumption of operating supplies, external maintenance work, or depreciation. Direct costs of products are the raw materials and semi-finished products consumed (ex warehouse) and of externally procured external services. These items can be clearly assigned to a production order. The key to recording purchases and consumption in a management-oriented manner is therefore the account assignment of the documents (supplier invoices, payroll accounting, material procurement from stock).

In the third dimension, a distinction is made as to whether costs are caused directly by the units manufactured or sold (products or services) or by decisions that determine the capabilities of the organization (capacities of all types, size of the organization, training and further education or management services). The former are referred to as proportional costs, while the capability/capacity costs are mainly called fixed costs or structural costs.

Proportional costs are determined by sales and production, while fixed costs are determined exclusively by management decisions. To staff the anteroom of a member of the management board is a management decision just as much as the approval of a sales promotion campaign, the decision to convert existing production facilities, the purchase of vehicles for delivery or the introduction of an ERP system. Proportional costs are determined by production quantities, bills of material (where the planned consumption quantities are recorded), work plans (containing the planned times for the individual production steps in the cost centers) and planned purchase prices for raw materials and order-related external services. In a purely trading company, the purchase price for the product sold corresponds to the proportional costs, since nothing is changed in the product. All other costs of trading operations are structural costs.

To avoid confusion: We have replaced the term variable costs with proportional costs (see Controller Dictionary, p. 200), because in practice and science proportionality is often confused with controllability. If the activity of an employee in a production cost center is causally necessary for product creation (can be seen in the work plan), these are proportional costs. They are added with every unit produced. If the same employee has nothing to do due to a lack of orders, his wage is still paid, but becomes a fixed cost (reserved or unused capacity). How long the wage will continue to be paid despite underemployment (controllability) is a question of notice periods and the management’s decision what to do with this employee. From this it can also be concluded that everything that is not proportional becomes fixed costs.

To distinguish clearly between proportional and fixed costs is extremely important for the design of the management control system. For both operational and strategic decisions to be made, it must be known which costs are directly caused by the products and their sales and which will be the result of decisions on capacities and structures of the organization.

Plan Cost Centers

Cost center planning begins with clarifying which production-dependent activities are to be performed in the plan period and which additional internal tasks are to be performed. This activity reference forms the basis for determining the planned costs per cost element.

Plan Cost Centers

Quantity, activity, and task-related annual planning as described in previous posts generate the orders for the cost center managers responsible for implementation. Like every manager, they are responsible in their area for QQDR: qualities, quantities, dates, and results (see the post “The management cycle determines the value types”). The performance requirements arise from:

- the planned production quantities envisaged,
- the necessary internal services provided, and
- the planned internal tasks.

As a first step, cost center managers must therefore consider what services or results their area must deliver. From this, it can then be derived which staffing levels and which assets are required for this. The requirements are derived from the plans already drawn up:

- From the planned production quantities, the planned activity levels of a production cost center can be derived with the help of the work plans. From this, the personnel requirements for the production-related work are determined.
- From the internal tasks planned for the given cost center, the hourly requirements for work that is not directly production-related are derived. These are the working times for cost center management, training and education, inspection work, participation in projects, and attendance at meetings of all types.
- The machines and installations installed in a cost center largely determine how much activity will have to be obtained from internal service providers (workshops, maintenance, internal transportation, energy, and so on).

The head of the Stamping cost center has the following planning basis concerning activities, employees, and machinery:

- According to production planning, his cost center should be ready for an activity level of 338,855 personnel minutes (Pmin).
- For the stamping work and for internal tasks, 4 full-time positions are required (including the manager), as each employee is planned with a net annual presence time (vacation public holidays and other absences already deducted) of 102,000 minutes (4 x 102,000 = 408,000 minutes).
- The capacity of the installed machines is still sufficient at 435,840 minutes.

On this basis, he begins to plan the primary costs to be incurred for the planned activity. To do this, he receives a list of the plannable cost types from the controller. This is shorter than the list of the expense types in accounting as it is defined to plan the costs of this cost centers consumption:

- To do this, the personnel costs including all social welfare costs are prepared in the personnel area and reported to the cost center manager as a total amount. Since the cost center manager cannot change the rates for additional wage-dependent costs (for example, insurance, vacation), one aggregate cost category for Personnel costs is sufficient. This makes planning and control easier.
- The controller prepares the imputed depreciation amounts in Fixed Asset Accounting based on the assets installed in each cost center and reports this information to the cost center manager.
- Primary costs are characterized by the fact that they come from outside the company and, with few exceptions, are always posted in Accounts Payable or Payroll Accounting. If such costs are to be provided in the cost center (office materials, supplies, etc.), the planner consults invoices from previous years, maintenance plans and other documents to determine the planned cost amount.

This procedure is directly linked to the process of management by objectives. Once the cost center manager has prepared his cost and activity planning, he agrees on the target cost center budget with his boss. For this reason, the cost center plan may only contain amounts and cost elements that the responsible person can influence directly.

Cost center planning does not yet contain the planned costs for internal services provided. These are called secondary costs as they stem from another cost center. In the table of planned internal activities in the post “internal services provided” it was shown that in the plan year 240 service-hours are to be obtained from the maintenance and repairs cost center (330). Its hourly rate is 38.95, which results in a debit of 9,348. The planned cost for energy consumption was calculated accordingly. A total of 536 is planned for this. The complete planned costs of the stamping shop are as follows:

The detailed sequence of the calculations can be traced in the simulation model accompanying Management Control with Integrated Planning – Models and Implementation for Sustainable Coordination.

To use the cost center plans in product calculation the next post will first provide clarity about cost terms in the management control system.

Capacity Requirements for Internal Tasks

Even in typical production plants, more than 50% of personnel costs today are attributable to internal tasks. These are tasks that are performed in order to be able to start production and sales at all. Consequently, internal tasks must also be planned and tracked.

Capacity Requirements for Internal Tasks

Internal tasks are the collective term for all work to be executed in an enterprise that is not directly caused by the units produced or by internal services provided. Internal tasks are only indirectly related to the products and services produced or sold. Examples include:

- Management, planning and control work in all areas
- Work of the entire sales-oriented areas
- The entire production planning and control as well as the work preparation
- The work of the personnel department, payroll accounting and the time spent on training and further education
- Work of the functions purchasing, warehousing, forwarding
- Tasks for the further development and operation of the entire information technology as far as it is not a matter of orders of individual areas and thus internal services provided.
- Provision of buildings, company premises, installations, and machines ready for operation
- Administrative work to meet legal requirements.

What these Internal tasks have in common is that they are performed for the capability of the organization to perform at all. Managers decide how much work capacity is to be built up and made available in the form of employees or investment capacity as part of strategic and operational planning.

These capacities must always be included in the overall planning of an organization. This can be explained by the fact that nowadays in all industrial companies known to us, more than 50% of the total personnel costs are incurred for internal tasks.

The difficulty is to create a reliable capacity requirements planning for the areas of Internal tasks. One reason for this is the fact that people in these areas often perform a wide variety of tasks in parallel. On the other hand, only a few companies record time consumption for Internal tasks. This makes it difficult to plan the time requirements. In order to get a better grip on capacities and the cost pool for Internal tasks, we have therefore long recommended that work for Internal tasks should also be integrated into factory data capture. Although attendance time can be measured quite easily using time recording devices, many managers are not even required to carry out this recording for themselves. The work for which the time was spent cannot be evaluated from the presence time recording system.

Our experience showed that even the planning of task types in internal areas generates important insights for capacity planning. For this purpose, we divide the tasks into six groups, which occur in almost every cost center:

Capacity Requirements for Internal Tasks

Task 5 (subject tasks) can be subdivided by cost center. In a sales office cost center, for example, these could be tasks such as addressing potential customers, looking after existing customers, preparing quotations, negotiating contracts. In the personnel department it could be personnel recruitment and selection, wage and social insurances, personnel and illness care, documentation of management and specialist staff potential.

Capacity requirements planning is also an essential prerequisite for Activity Based Costing. For Internal tasks, the direct cause-effect relationship is missing, but capacity requirement estimates can be used to improve the planning quality of fixed costs.

Planning at the level of detail described above benefits the entire company. Since employees are usually reluctant to fill out the activity recording for the actual times incurred, a user-friendly and thus largely automated recording application should be set up.

Thanks to the Lean Production movement impressive improvements have already been achieved in the area of directly product-related services and production management, Now it is important to apply the findings to Lean Administration as well. This helps to improve the cost position towards competition.

Plan Internal Services to be provided

We speak of Internal Services Provided if a service from another cost center is explicitly ordered by the receiving cost center or if the service is directly caused by the activity of this cost center. For Internal Tasks no order exists. This is why they cannot be charged according to the cause to other cost centers. But for Internal Services Provided the direct causation link exists. This why the latter can be charged to the receiving cost centers but not the internal tasks.

Plan Internal Services to be provided

Internal services are provided when a receiving cost center directly orders services (activities) from another cost center. Such an order can be placed explicitly or be the direct consequence of the activity level of the ordering cost center. The supplying area is therefore responsible for providing the service.

Examples:

1. A car of the sales department is damaged and repaired in the company’s own garage (the order could also have been placed externally).
2. Every 100 operating hours the repair department has to check the dimensional accuracy of the rolls in the Rolling and Punching cost center for four hours and replace the rolls if necessary.
3. The maintenance group receives an order to rebuild the entrance of the reception building according to the latest safety standards.
4. The energy supply division supplies all other divisions of the company with electricity, water, and compressed air. Consumption is directly dependent on the equipment installations and on the performance of the receiving cost centers. It can be measured using meters or calculated using consumption tables.
5. Every tenth production order must be checked in the internal laboratory for compliance with all quality regulations.

In these cases, the ordering cost center is the trigger for the production of the service, either through an explicit order or through an automatic relationship between the service provided in the ordering area and the service delivered by the service area (2,4,5 above). The originator of the service procurement is always the delivering party. The ordering party should plan (in cooperation with the internal supplier) the services for a year, so that the personnel and machine capacities required by the internal supplier can be determined from this information.

In the example company Ringbook Ltd., the genuine internal exchange of services is planned in the following table:

Plan Internal Services to be provided — All planned internal services

The consumption estimates of the receiving cost centers are collected and converted to the personnel hours or kWh required. A distinction must be made between which consumption is dependent of the activities of the receiving cost centers and which is independent (mainly calendar-driven). Totaling the values in the last column gives the planned activity levels of the internal service providers.

Activity-flows and Internal Structures

Managers are the customers of management accounting. They want to know whether their services provided were performed according to plan but taking into account the actual order quantities.

Activity-flows and Internal Structures are the foundation of Management Accounting

Managers decide on the dimension of structures to be built, such as buildings, facilities, machines, fleets and software applications. This leads to investment decisions and the investments subsequently lead to (imputed) depreciation costs.

Managers also determine which employees are to be recruited, exchanged or promoted and trained in their area of responsibility. This generates the personnel costs (including all social benefit costs, sick leave, vacations and public holidays).

Purchases of external services, licenses, energy are consumed in the functional areas or directly for the manufactured products and result in material costs.
Purchases of raw materials, merchandise and auxiliary and operating materials can be stored until they are consumed. As long as they are still there, no costs are incurred, only expenditures.
Contracts were entered into for all the items described, mostly by the purchasing department. The purchasing department or the ordering managers are therefore responsible for purchase prices and conditions (also applies to investments).

For the purpose of management support, purchases must therefore be clearly separated from consumption. Consumption mostly happens subsequent to purchasing and storing. The procurement of capital goods is also initially an expenditure and only leads to costs through depreciation of the installed assets.

Personnel expenditures are also not always incurred at the same time as the consumption of employee performance. Many employees receive a fixed monthly salary. They perform their work mainly in the long months with few public holidays and in periods in which only a few take holidays. A cost center manager therefore wants to know which personnel costs were consumed in a month so that he can compare them with the activity performed during this month. If, for example, a company closes down completely in July because of company holidays, no personnel costs are incurred for this month, although wage payments are higher than in other months because vacation allowance is paid out.

Each manager is responsible for QQDR (quantity, quality, deadline and result) (see “360° Management, section 1.2″). For this reason, both in planning and control, they must be able to compare the consumption of resources (valued as costs) with the services provided in the same period.

Most consumption is caused by the units produced or sold, not by management decisions. This includes, in particular, consumption of raw materials and semi-finished goods as well as personnel activities for production orders and directly activity-dependent costs of machines (e.g. energy). For management support and for the cause-related valuation of inventories it is necessary to charge these consumptions to the production orders executed (red fields).

In the sales/distribution area, a distinction must also be made between the services provided to initiate a sale and the costs of products and services consumed when a customer places an order. The former, summarized simply by the term marketing, must be planned and controlled by the respective sales managers. These can hardly be assigned to individual customers on a cause-and-effect basis. The latter are triggered by the actual sales order and can subsequently be clearly assigned to this order.

To enable the production and administrative areas to fulfill their tasks, they are supported by internal service departments. Examples include the workshop for maintenance and repairs, other workshops or laboratories, the group for internal transports, an internal energy center (electricity, steam, compressed air). The services these areas provide to the receiving cost centers can be measured (hours, kWh). In some cases they are directly dependent on the performance of the receiving area, e.g., energy consumed per machine hour. The recipients decide or agree with the internal service areas how much activities they want to receive. The receivers are therefore responsible for the quantity of services received and the service areas for the costs incurred in their area. This makes it possible to charge the proportional costs for consumed activities to the receivers in a way that is appropriate to the cause (costing internal services provided).

Internal tasks are performed in the administrative and sales-oriented areas. The services provided there differ from those of the internal service areas in several ways:

- They are necessary to coordinate the processes (management, planning, IT applications, databases).
- They ensure the timely and cost-effective availability of materials and external services (procurement)
- Legal requirements or internal rules are the cause of their execution (personnel administration, documentation requirements, audits, legal services)
- They prepare the actual sales and handle sales (marketing, sales organization, sales promotion, product management).

These internal tasks are never directly related in a cause-and-effect manner to the products or services produced and sold. Consequently, the costs of internal tasks must not be attributed to the products, as they are caused by management decisions (especially in the budgeting process, blue fields). A production manager, directly responsible for the execution of production orders according to the plan, will correctly say that he is not responsible for the internal tasks of other areas and for their respective costs.

Although many accounting regulations (international financial reporting standards and tax law requirements) require the allocation of structural costs (blue fields), accounting for management is designed in such a way that only the costs directly caused by the production orders are assigned to the latter (red fields). Consequently, only the product costs incurred by the products sold are to be charged to the sales achieved. Variances that occurred in upstream areas have no place in sales-related evaluations.

The customers of management accounting are primarily the managers. They want to be able to recognize from the internal evaluations whether the services provided in their areas were performed according to plan but taking into account the actual order quantities. Management accounting designed for management must therefore start from the activity flows and consistently charge costs only according to their cause.