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Purchase Price Variances are topical again

Show purchase price variances in financial accounting per period and in management accounting per product.

As a result of the Corona pandemic and supply chain challenges, increasing inflation rates can be observed worldwide. As a result, the questions of how quickly and comprehensively rising costs can be passed on to customers and what consequences can be expected for the company’s own results are coming to the fore.

To determine the extent to which price variances in purchasing could be passed on to customers and whether price increases are leading to increased spending variances in the cost centers, it is necessary to record purchase price variances in management accounting for short-term planning and control.

In the example below, the real price development for the purchase and consumption of sectional steel is the starting point for determining the company’s own material acquisition costs. Data origin: cf. https://www.d-a.ch/da/da-home/services/dienstleistungen/preisentwicklungen/stahl-metalle/kbob/kbob-preisindizes-baugewerbe.pdf) .

Purchaseprices sectional steel — Purchase prices sectional steel

Row 7 of the table shows the monthly purchase price variances based on the standard price of EUR 120.- per ton.

- These variances should be recorded as part of the monthly cost of materials in financial accounting, since the purchase price variance arose in this period.
- In management accounting, however, the planned standard purchase price should be used throughout the whole year, since otherwise production would have to create a new standard cost calculation every month, which would be too late for sales, since new price increases have already occurred in the meantime.
- The purchasing manager should include the expected average inflation when setting the standard purchase price for the plan year. Since he is not a prophet, he can only estimate the price. This estimate goes into the planned product costing and consequently is also applied in the planned contribution margin calculation. The advantage of this is that the standard cost estimate remains the yardstick and the monthly variances can be calculated automatically.
- Stock receipts of semi-finished and finished products are also consistently valued in Management Accounting at proportional standard manufacturing costs, which in turn facilitates the preparation of contribution margin accounting.

This approach also makes sense because raw materials from deliveries with different real purchase prices can be consumed in the same production order. The table highlights consumption and costs:

- Order 1 (row 8) consumes in January the 100 tons of sectional steel purchased in December of the previous year at a price of 100.00/ton, plus 20 tons from the January delivery at a price of 117.30 (row 3 in the price development table).
- Due to its volume of 320 tons the production of order 4 (row 11) has to be distributed over the months March to May. Because 100 tons are purchased each month and charged by the supplier at the applicable price, 3 different purchase prices would also have to be used for the calculation.
- If the smaller order 5 (row 12) were processed before order 4 in early March, it could still benefit from the more favorable purchase price in February of 134.20 per ton at the expense of order 4, but this would increase the cost of order 4.

This complexity of evaluating order-specific consumption cannot be expected of neither the production managers nor the salespeople. In addition, as can be seen from rows 16 – 18, the valuation rule to be applied would still have to be determined:

1. All purchases are valued at the standard purchase price throughout the year (row 16).
2. The real withdrawals from the warehouse are valued at the current purchase price of the month of purchase (Last-In-First-Out, row 17).
3. The real purchases are valued at the weighted average purchase price of the current inventory (weighted average purchase price, row 18).

It can be seen that price variances in purchasing are period costs. They can only be clearly allocated to a product if the material was purchased directly for a specific production order.

As a result, especially in inflationary times, order and product costing should be carried out using standard purchase prices. Otherwise, those responsible for production will lose their orientation with the use of rapidly changing prices. In addition, they are held responsible for variances for which they are not responsible.

As mentioned, purchase price variances are period costs. In stepwise contribution accounting they can usually not be clearly assigned to a specific sale. Consequently, they are to be reported where unambiguity is given, e.g. per product or customer group or, as in the example, the assortments (cf. Management Control with Integrated Planning, p. 231).

Management Tasks and Management Accounting

Corner stones for the implementation of the decision-relevant Management Accounting System covering revenue, activities, capacities, cost and earnings.

Management Tasks and Management Accounting

The design of the management accounting system outlined in this blog and in the book “Management Control with Integrated Planning” is based on generally accepted management principles and the resulting behaviors.

Decision support and responsibility for results

All managers make decisions and are responsible for their implementation. This applies to all individuals who manage an area and are accountable for its results to their superiors or to the company. Managers of all levels are thus the main customers of the management accounting system. Consequently, such systems must be structured to provide decision support to all managers at all management levels and to delineate responsibilities in a manner that is appropriate to the organization.

To fulfill its purpose, results must be achieved by a company. Objectives are results to be achieved. Each manager should be able to plan, measure and control the achievement of his objectives in accordance with his responsibilities.

As far as monetary targets are concerned, they are to be described in the management accounting system. From this it can be deduced that planning in management accounting should run in parallel with the process of agreeing on objectives. If, for example, the activity quantity of a cost center is determined as a target, but the headcount required for this objective is not approved, it cannot be achieved.

Objectives and plans belong together

When planning, it is necessary to make and prepare the decisions regarding personnel, material and financial resources required to meet the strategic and the operational goals. Since this process is time-consuming, ways are often sought to simplify and shorten the planning process. Despite the large amount of work involved, however, practice shows that it is worthwhile to plan all areas, products and management levels once a year in terms of performance and value and in conjunction with the objectives of an area. This provides the benchmark for the plan to target and plan to actual comparison and thus the basis for determining corrective actions. Planning for a fiscal year also proves useful in “short-lived” times, because personnel and management decisions as well as objectives are usually also agreed for a fiscal year.

The management cycle requires plan, target and actual data

In order for the management cycle to work properly the plans that are created together with the objectives must be stored in the system in all their detail, so that they can be compared with the results achieved. The comparison of planned, target and actual data makes it possible to also measure the actual extent of achievement of the objectives in monetary values. It is recommended to prepare the plan to actual comparison on a monthly basis, so that the real events are still present for the evaluation of the results. It also enables faster reaction in the case of unfavorable variances. For projects, the plan to actual comparison should also be set up for each milestone, because at each milestone meeting a decision has to be made as to whether the project should be continued or terminated (a go/no-go decision).

Managers at all levels usually decide on quantities, activities and times. The value consequences of implementation then become known in cost accounting. This requires that the management accounting system be designed as a cost-, activity-, revenue- and earnings system (CARE). Management-oriented CARE is therefore clearly distinguished from purely money-based financial accounting.

Requirements from strategic and medium-term planning

Strategic planning defines the intended positioning in the markets. For this purpose, product/market positions to be achieved are specified with quantities and revenues for several years.

Medium-term operational planning has the task of preparing the implementation of the strategies. Since the managers must record quantities, services and prices for this purpose, the CARE structures must also be set up in the multi-year planning.

In annual planning, the planned purchase prices, the planned personnel costs, and the bills of materials as well as the work plans for the planned year are set. This results in new planned cost center rates and new planned product costs.

Adjustments at the beginning of the new year

To enable managers to compare their achieved results with the planned values at any time during the year, the inventories of materials, semi-finished and finished products in CARE must be revalued using the new approach at the beginning of the next year.

If, for example, a product can be manufactured at a lower cost in the new year due to a process improvement, the previous year’s ending inventory must be revalued internally with the new cost rates. If this revaluation of the year-end inventory is not carried out, variances will occur in the new year which still belong to the old year. This revaluation is only carried out in management accounting and can be automated. Inventory valuation for financial accounting continues to follow the applicable commercial law regulations.

Forecasts

Because the preparation of forecasts ties up a lot of management capacity, it is advisable to schedule two forecast dates. When the fiscal year corresponds to the annual calendar, the first forecast should be prepared on the basis of the planned and actual data from January to April (Easter days are then always included). Based on the accumulated actual values as of the end of August (major vacation period mostly completed), the second forecast should be prepared. This forecast also serves as the input for the subsequent planning of the next business year. Stock-listed companies are usually forced to prepare quarterly forecasts. However, practice shows that especially forecasts based on the actual data as of the end of March is not very meaningful, and its preparation usually causes a lot of hectic activity in the organizations.

Controllers check the right system application

As designers and operators of the management accounting system, controllers have the task of monitoring the correct application of the planning and controlling system. This results from the controller mission statement (see Management, Controlling, Controller). Once the planning results or forecast data have been entered into the management accounting system, a sufficient period of time must be provided during which the controllers can check compliance with the system rules and, if necessary, ensure that corrections are made on time. Unfortunately, there are always “specialists” who try to abuse the planning system or valuation rules in their favor by circumventing content-related or process-related rules:

- In a company known to us, a business unit manager massively manipulated the planned net attendance times of the employees in order to be able to calculate lower unit costs in the plant he wanted to erect. On this basis, the investment in the plant was approved by the group’s management. In the first year of operation it already became apparent that the actual attendance times did not correspond to the planned ones, which led to the loss of the planned cost savings. In retrospect, the desision to make the investment had to be judged as wrong, but the money had already been spent.
- In multinational companies, there is a great risk that decisions about the profitability of a subsidiary are made on the basis of transfer prices between group companies. However, the latter are driven by international transfer pricing regulations obeying legal requirements and leaving out the overall group view (each country wants to generate taxes locally for the value produced, making it difficult to properly charge group services back to the producing and selling individual companies).
- From a controllers’ view, planning for an individual company must therefore be based on local conditions, but must also take into account the group’s internal planning and control requirements (those parameters which the local managers can actually influence themselves and therefore also take responsibility for). From this it can be deduced that controllers must set up the management accounting system in such a way that the entire business can successfully be managed locally. The finance department at corporate headquarters, on the other hand, must use transfer pricing to ensure that the overall corporate tax burden remains as low as possible (tax optimization). From a management perspective, these two areas must be kept separate if local planning and management are to be carried out correctly and the group result optimized.

Design of the decision-relevant Management Accounting System

To design a comprehensive management accounting system that can meet the requirements resulting from the management process, we have been observing the scientific developments as well as their practical implementations at our customers for several decades. According to our findings, the following sources and systems are of decisive importance for the design of CARE:

- Marginal costing according to Hans-Georg Plaut (Grenzplankostenrechnung GPK)
- Standard costing with flexible budgets according to Wolfgang Kilger
- Contribution margin accounting according to Albrecht Deyhle
- Sales and turnover planning according to the lived market cultivation structures
- Extension to multi-level and multi-dimensional contribution margin accounting (mainly described by Lukas Rieder)
- Three dimensions for the management-oriented structuring of costs and revenues in the controller dictionary of the International Group of Controlling (IGC)
- Activity Based Costing (ABC) according to Robert Kaplan and Peter Norton, but without allocation of fixed costs (including capacity costs) to product units. This mainly corresponds to Resource Consumption Accounting (RCA)
- The Costing Levels Continuum Maturity Model by Gary Cokins
- The IMA (Institute of Management Accountants) Conceptual Framework for Managerial Costing.

References to these publications can be found in the bibliography of this blog.

Multidimensional Contribution Accounting

A truly helpful management accounting system must deliver its figures in plan and actual according to market dimensions and internal structures. Only then it enables correct decision-making. Multidimensional and multi-level contribution accounting is the instrument for this.

In accordance with the goal orientation in the entire management (see the post “Integrated Management System”) it is also necessary to record values to be achieved for specific persons in the income statement. Multidimensional contribution accounting can make a significant contribution to this.

Multidimensional contribution accounting

Contribution accounting must be structured according to the structures in the company. For the example enterprise, the following plan results: We start with the sales and the sales deductions. The proportional standard product costs are deducted from these, which results in the Plan CM I. The planned sales commissions are subtracted from this. This in turn results in Plan-CM I after sales commission of 3,668,723.

The two assortments and the product group structure are shown horizontally. In this way, the CM I for each product group is visible. In the simulation model, this observation is possible at the individual item level.

This means that all proportional costs of sales are included (withdrawal from the finished goods warehouse at standard). Vertically, the fixed cost center costs are assigned to those areas where they can be clearly influenced and thus justified. The entire process of showing directly controllable fixed cost blocks is based on this responsibility without using any keys for fixed cost allocation:

- The company plans the costs for sales promotion in the cost centers “Sales Promotion Own Products” and “Merchandise”. These are fixed product range costs that can be assigned uniquely to the assortment, but not to the product groups or even the individual articles.
- The sales area consists of the three cost centers for the sales areas and those for sales management and internal sales. As these organizational units sell all articles of Ringbook Ltd., the fixed sales costs can only be assigned to the total of all contribution margins.
- The total fixed costs of the production area (995,112) can only be clearly assigned to the range of own products, since the employees take care of all own products.
- The remaining cost centers from the warehouse to management and administration work for the entire company, which is why they are only presented in the “Total company” column.

The result is the planned EBIT (earnings before interest and taxes). Assuming that the EBIT of 201,058 also corresponds to the profit objective for the year, the following responsibilities can be derived:

- The company manager is responsible for achieving the planned EBIT.
- The cost center managers are responsible for keeping to their target costs. These are the planned costs of the activity actually performed (explained in detail later). In all cost centers that are not directly involved in product creation (that is, they do not appear in any work plan), the target costs correspond to the planned fixed costs.
- The head of procurement is responsible for realizing the planned (standard) purchase prices.
- The top sales manager is responsible for the complete sales-CM. This includes the net revenues, sales commissions, planned proportional cost of goods manufactured, and the fixed costs of the entire sales organization. This responsibility can be partially delegated to sales area managers, since they are responsible for the CM achieved in their area and their own fixed costs. It can also be delegated to assortment managers or heads of promotion areas. If there is responsibility for both, regions and assortments, this results in a “crossed responsibility” (more to this at the end of this post).

These explanations are intended to show that the structure of the multilevel contribution accounting system allows obtaining financial targets that fully correspond to the ideas of Management by Objectives. It is important that the multilevel CM-calculation is designed according to the conditions and structures of the company (not according to the textbook).

If the sales, turnover and net proceeds are planned in all relevant dimensions of sales as described in the post “Planning from the Market into the Company”, the CM calculation can be created not only multilevel but also multidimensional. The prerequisite is that both product and customer structures are structured and planned bottom-up.

Contribution margin accounting for the sales areas is created by evaluating sales planning according to sales areas and the cost centers assigned to them. Each area manager has his own cost center for which he plans the fixed costs, which he can directly influence and therefore be responsible for. These are fixed costs because they have nothing to do with product manufacturing, but with the sale of all items. If this cost block is subtracted from CM I after commissions, the area CM (sales region) is the objective to be achieved.

Planned contribution margin for sales regions and sales management

No fixed costs were directly assigned to exports because the sales manager together with his office staff wins and handles all foreign sales in addition to his management task. According to this organization, the fixed costs of exportations are included in the cost center sales management and internal sales support. Using an appropriate allocation basis, these fixed costs could be distributed between export and sales management. But the consequence would be that nobody would be responsible for the fixed costs of internal services neither for exportation. This example shows why the structure of the database and of the profitability analysis always has to be set up according to the organizational circumstances.

The sales contribution of 2,495,958 is the same as the one in in the dimension of product groups. All the fixed costs below remain the same since the cost centers for production and the other areas work for all sales areas. This again results in the same EBIT.

The salespersons planned sales volumes and revenues per product group and sales area, but not by sales channel. Therefore, in planning, CM-accounting cannot be created according to sales channels. In the actual view, however, this will be possible, since the customer number in the invoices indicates the channel to which the customer belongs.

Today it is common practice in many companies to cultivate the market along various dimensions (for example, territories, sales channels, product groups). For each of the dimensions, the same total sales and contribution margin totals are to be achieved. As mentioned, the top sales manager is responsible for the complete sales CM. In order to achieve it area managers must coordinate with product managers. A sales promotion campaign for certain products (or product groups) should result in salespersons specifically recommending the respective products in their presentations and making targeted use of any available advertising material.

This coordinated approach can be supported by cross-referencing the results targets. The columns show the contribution margins planned in the individual sales areas for each product group. In the rows, the sales promotions planned for the product groups are compared with the target CM. It can be seen that the budget for the promotion of the still small merchandise area is almost as large as that for the own products. The intention here is to promote the merchandise area. This requires salespeople making their customers more aware of the advantages of the merchandise assortment.

Contribution accounting in two market dimensions

Contribution margin accounting is a powerful tool to support objective-oriented approaches and, in particular, for promoting coordination between all areas of an organization. It can be adapted to changing corporate structures. This also applies to strategic planning. Because there it has to be decided with which products the company wants to reach which market positions in the future and thereby make the profit targets become reality. To do this, it is necessary to know which sales volumes and net revenues will be added and which will be eliminated, which costs will be incurred by the products (proportional) and which capacities and structures will have to be rebuilt for the necessary success potential (fixed).

In operational terms, contribution margin accounting helps to enable management by achieving agreement on objectives. It provides the tools for agreeing on targets for sales and net revenues down to the individual order or customer. Cost targets are mapped in such a way that they correspond to the direct influence of the holders of the objectives. The proportional manufacturing costs of an item are the target value for consumption in production. Finally, the planned fixed costs are the budgets for maintaining performance, whether in one area or in the entire company.

Contribution Margin or Full Cost

Full cost accounting leads managers to take wrong decisions because fixed costs are allocated to the costs per unit. Here is the proof.

Contribution Margin or Full Cost? What is decision-relevant?

Thanks to good negotiating of the CEO of Pekka Heating Systems Ltd., his company was able to acquire and realize a large installation order for a university building and a smaller conversion order for the heating system in a house with 6 apartments in the last period. Now the question is what kind of orders should be increasingly won in the future. A consultant was commissioned to calculate whether it would be more likely to win conversion orders or large installations of new systems. The consultant explained that, using the method he knew from school, he had first distributed the full manufacturing costs over the orders according to the number of hours worked. The costs of sales and administration were then allocated to the orders in proportion to the full manufacturing costs.

He presented the following calculation:

Contribution Margin or Full Cost — Full cost accounting

The verdict is clear: it is not advisable to accept large orders.

The project manager of the large installation project was, on the one hand, proud that Pekka Heating Systems Ltd. was able to successfully implement this large order and, on the other hand, frustrated by the massive loss of the order. Therefore he asked a friend if the consultants’ calculation was correct. The friend presented the following table:

Without order 1 the company would be bankrupt

With the following example, the friend showed him that the application of different cost allocation bases (allocation keys) leads to different order results every time, despite the same initial situation. None of the results can be correct because costs are distributed that are incurred for the whole organization.

Different fixed cost allocation keys lead to different order profits

The conclusion remains that full cost accounting is not suitable for management control, because managers need to compare both in planning and in the concrete case of application the additional net proceeds of an additional order to the direct costs incurred with this order.

Precisely because various accounting standards and tax laws require the preparation of full cost accounting, management accounting requires the courage to not allocate fixed costs from one to other cost centers, orders, and products because otherwise managers will make wrong decisions.

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.