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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.

Pizza Dough and Management Accounting

Bills of material and work plans are necessary to calculate product costs. They are mainly found in production companies, but increasingly also in service and trading companies.

A central task of any management accounting system is to calculate the cost of a product or service. Product costing is necessary for planning, for recording the actual costs incurred, for analyzing variances and for accounting.
To be able to cost a product, the product must be clearly defined. This includes the raw materials, semi-finished products and external services to be used as well as the company’s own work and the quality specifications to be met.

Pizza Dough and Management Accounting — Preparation of a pizza dough

For the preparation of a pizza, a finished dough can be purchased or one can be made at home. If it has to be very quick, a visit to a pizza shop should be planned. Three versions are therefore to be distinguished:

1. Purchase of a finished rolled out pizza dough: weight, raw materials, quality, production method and price are determined externally.
2. Produce the pizza dough yourself: Procure raw materials at market prices, set up and then clean the workplace, process raw materials, mix and knead the dough, check the rising of the dough, roll out, check quality, cut to sheet size.
3. Buy finished pizza in the shop: Type of pizza and ingredients to be selected, pizza dough and size are given by the shop, selling price according to price list (other product).

Purchase or own production of the pizza dough are easy to compare since the end product is more or less identical. If a finished pizza is purchased, it is a different product in which the dough is “only” a semi-finished product. The ingredients and the production of the finished product “Pizza Napoletana” are included in the offer.

A closer analysis of the process “Making your own pizza dough” shows that technical information is required for its calculation, namely the bill of materials (ingredients), the work plan (how you do it) and the lot size (for 4 round pizzas with a diameter of 20cm each).

Bill of materials:
This table contains the material consumption required by the recipe. It also includes the flour that must be sprinkled on the table to knead the dough.

This simple example shows that the quantity- and activity-structure of a product must be known as a prerequisite for costing. The purchase prices and the hourly rate for the working hours can change. The quantities and times are given by the currently valid production process. Consumables are procured from the warehouse (cellar, refrigerator), and services are performed in the cost center “kitchen”. The consumptions recorded in the quantity- and activity-structure are objectives that must be achieved if one is to master the process. In technical terminology they are also called “standards”.

Bills of materials also occur in trading companies, for example, when several products are packed together as a set and sold as one unit. Bills of material and work plans also form the basis for costing in service companies. The main difference from a production company is that the quantity and activity structure can only be determined when the exact customer requirement is known or the product to be delivered is clearly defined. Some examples:

Custom Tailoring: The planned costs of an order can only be calculated once it is known what materials are required in what quantities and which operations with what time requirements will be needed to fulfill the customer’s request.

Hospital: From a processing point of view in a hospital, the “case” is the container for the consolidation of all services provided for recording patient information, diagnosis and therapy (discussions, operations, therapies, care) and the resulting consumption (drugs, implants, medical consumables, accommodation, meals). The treatment pathway describes in detail the services to be provided and the items to be consumed. It thus corresponds to the work plan and the bill of materials in industry.

Public administration: “A product is created in public administration when a service is provided for an external customer (e.g., issuing of a passport, granting of a permit) or when new public assets are created by the service (e.g., construction of a district road) (see Rieder, Kosten-/ Leistungsrechnung für die Verwaltung, p. 66). Only when the product with its content and its scope of services has been defined can it be determined which internal administrative services are causally necessary for the creation and which purchases of materials and external services are to be provided. The quantity structure is documented in product-specific BOMs and work plans.

Bills of material and work plans are omnipresent. Management accounting takes the data for costing from the production planning and scheduling system (PPSS). It is here that the master data regarding input material, external services, process flows, machines, cost centers, standard times and planned purchase prices are maintained and the orders are planned and processed according to that data.

Please note: The use of the complete kitchen equipment was not included in the calculation of the pizza dough. The equipment must be available in an operational and efficient condition so that any products can be produced. If the kitchen is not used, electricity costs are still incurred for the operation of the refrigerator/freezer. The kitchen must be cleaned periodically so that it remains operational. It is also necessary that equipment such as cutlery, bowls, plates, cake trays, etc. be available. From a business point of view, the kitchen, whether used or not, loses value every day because it becomes outdated. This circumstance is taken into account through depreciation. All these cost elements are not caused by the meals produced, but by the decision as to how the kitchen should be equipped and maintained. They cannot be attributed to the manufactured product, i.e., the pizza dough, according to their cause and therefore do not appear in the calculation.

In accounting for management, only those costs are attributed to a product or service that are directly incurred by its creation. The corresponding proportional planned costs are also used to value the inflows and outflows of inventory, because in this way the inventories are always valued at standard costs and the variances are charged to the reporting period. Management accounting is used for internal planning and control. It can only provide orientation data for the calculation of the sales price.

The cost of the product and of the infrastructure tell the pizza baker if he can survive with the possible sales prices. The shrewd pizza baker determines his sales prices based on the sales prices of his competitors and his own estimate of the superiority of his offer. His cost is only of secondary importance.

Management&Controlling&Controller

Controlling means to keep the business under control. This is managers’ task. Controllers enable managers to do the controlling.

Management&Controlling&Controller

Management Control is defined as the process by which managers at all hierarchical levels ensure that their (strategic) intentions are realized.

Managers do the controlling, controllers empower them to do so. Controllers are enablers. “As management partners controllers make a significant contribution to the sustainable success of the organization” See the controller mission statement of the International Group of Controlling (IGC) and of the International Controller Association (ICV). “Controllers

1. design and accompany the management process of goal fixing, planning and controlling, so that every decision-maker can act in an objective-oriented manner,
2. ensure the conscious preoccupation with the future and thus make it possible to take advantage of opportunities and manage risks,
3. integrate an organization‘s goals and plans into a cohesive whole,
4. develop and maintain all management control systems. They ensure the quality of data and provide decision-relevant information,
5. are the economic conscience and thus committed to the good of an organization as a whole.” See https://www.igc-controlling.org/“

Controllers are thus responsible for the design, operation and content of the management control systems.

Management-Controlling-Controller — Management, Controlling, Controller

Controllers do not practice controlling. Controlling is done by managers when they perform their planning and control tasks. A department with the designation “Controlling” is therefore a contradiction in terms. Controllers work in a controller department or in controller services. This distinction is important to avoid disputes about responsibilities and competencies.

In other words: To prepare the various budgets and to integrate them in the overall plan is the controller’s task. Preparing, approving and releasing budgets is just as much a management task as the realization of the factual and financial objectives.

10 Principles for Decision Relevance

Management accounting has decision relevance when it can quantify objectives in plans, compare the results achieved with the plans, document the differences that arised and offer leverage points for improvement. In addition, it should provide support for the assessment of forecasts.

10 Principles for Decision Relevance

Implementing this uncompromising management orientation in the design of the management accounting system requires application of the following principles:

1 Work with standards:

Management means goal-oriented proceeding. This requires that all objectives be transformed into a measurable format. As far as management accounting is concerned this requirement can be met with a standard costing system. It can be applied to prices, services, cost and revenues. Standards and the standard cost system are not new. They are often described in literature and installed in practice (see Horngren, et al., 1999, p. 575 ff.).

New is the importance these methods gain in a management-oriented design of a planning and control system. A planned purchase price for a raw material determines for the plan year the expected average purchase price to be paid for raw material or supplies. For the responsible purchaser, this value is the yardstick against which he can measure the achievement of his price objectives. By displaying purchase price variances, procurement can see how well it succeeded in realizing the target prices.

For the users of an item (for example, production), the internal standard purchase price remains unchanged during the whole year. This equally applies for merchandise in the sales organization.

2 Plan and record direct costs:

A manager will rightly insist that his area of responsibility only be charged for services, consumption and revenues that he or his employees can influence directly and thus for which he should be held responsible. That includes withdrawals from inventory (raw material, semi-finished and finished goods), external purchases directly for one’s own cost center (area of responsibility), services from other cost centers (if the consumption can be determined directly by the receiver, i.e., real internal activity charging), as well as costs that can be clearly assigned to an item/product.

3 Distinguish consistently between proportional and fixed costs:

Proportional costs are those costs caused directly by the production of units, as opposed to fixed or structural costs which result from decisions by management concerning capacities or the structure of the organization. Decisions regarding fixed costs are always made by managers. Proportional costs can be clearly compared with the units produced and the sales achieved. Proportional costs are driven by quantity and product structure. Fixed costs are the result of management decisions and are the responsibility of the deciding manager.

4 Plan and record sales deductions according to source:

Bonuses and reimbursements are usually granted retrospectively based on sales achieved in a given period. Whether cash discounts were taken can only be determined after receipt of payment. All sales deduction items should be subtracted monthly from the monthly billings. This has the advantage of not overstating a company’s profits during the year. As the actual amounts of many sales deductions are not yet known at the reporting date, standard rates should be applied and deducted from sales. These standard rates should thus be used in preparing the monthly reports.

5 Always valuate stock receipts and issues with proportional standard costs:

Similar to the valuation of raw material issued to production at the planned purchase price, standard rates (based on proportional costs) should also be applied to the valuation of receipts to and issues from the semi-finished or finished goods warehouse as well as to the valuation of goods in production, WIP. This means that all production activities performed on production orders are always valued at proportional standard cost (proportional planned cost rate of the respective performing cost center). Additions to the semi-finished goods warehouse are valued at the planned proportional product cost, as are withdrawals of finished products for sale.

This principle results from the management orientation. If in a cost center the actual costs deviate from plan, the cost center manager is charged with taking corrective action so that the variances disappear in future reporting periods. He must ensure that these deviations are rectified by means of corrective measures. Recipients of his services, be they a person responsible for production orders or a cost center manager who receives internal services, cannot directly influence these variances. From a management point of view, it is appropriate that variances are always reported at the point of origin and not passed on to the purchasing or consuming units. They are only to be presented in the overall result of the operating unit. In any case, the allocation of variances to subsequent cost centers or to products is inappropriate as there is no direct causal link between the cause of the deviation and the actions of the recipients.

6 Present contribution margins after deducting proportional standard product costs:

The planned and the realized revenues (gross and net) should always be compared to the proportional standard cost of goods sold. Production managers and their cost center managers are responsible for variances on the manufacturing side; sales is responsible for the realized net revenues.

7 Revalue year-end inventories:

The application of the standard system for the calculation of proportional standard costs requires that, in the transition from the old to the new year, all inventories must be valued with the planned proportional unit cost for the new year. If, for example, an item becomes more expensive in the new year due to price increases in purchasing or due to higher proportional cost rates (e.g., higher wages), the inventories available at the end of the year are to be revalued with the new standard rates. This prevents “comparing apples to oranges” in the planned year.

This revaluation at year end is to be implemented without affecting net income. The assessment of net income for the current year is based on the standard rates for the current year, while the assessment for the following year is based on the new rate.

8 Value fixed assets at replacement value and use imputed depreciation:

It is advisable to value fixed assets at replacement value. This gives the responsible managers a more realistic feeling about the investment needed to produce and sell their products. Replacement value is estimated with the question: “How much would have to be paid today if the asset in question were bought and installed newly and what is the planned useful life of this new asset? From these specifications, one can calculate imputed depreciation for each asset and therefore also for each cost center.

Imputed depreciation is a fair guess of the cost of use of the currently invested assets and should be deducted whenpresenting the internal EBIT to management. The total of all replacement values minus the cumulated imputed depreciation roughly shows management the necessary net investment in fixed assets to run the business.

9 Do not allocate fixed costs:

Fixed cost should neither be passed on from one cost center to another nor allocated to manufactured or sold items. The amount of fixed costs is determined by the decisions of the respective cost center manager and his superiors. They are therefore responsible for these amounts.

Since there is no direct “cause-effect-relationship” between fixed cost and units produced and sold, any allocation of fixed cost to other cost centers and from there to product units is not appropriate.

The so-called “as realistic as possible causal relationship” does not actually exist. It can only be constructed with an arbitrary allocation basis. Because of this, neither full manufacturing costs nor cost-prices per unit should be calculated in accounting for management. Fixed costs are passed on as cost blocks in the step-by-step contribution margin accounting.

10 Include in reports only revenue and cost figures that can be directly influenced by a manager:

A manager should only be held responsible for what he can directly influence himself. All plans and reports about revenues and cost should be presented in a performance-related way so that the addressee recognizes the connection immediately. Items that cannot be influenced (e.g., allocations) are not to be shown. Input services from other areas should always be valued at proportional standard rates, as the influence is exerted through the service provider. Additionally, the receiver of the report should be able to derive the time-period in which he can change individual items from the report.

Insofar as external reporting requirements, local tax law, or the determination of transfer prices require the disclosure of full manufacturing costs, these calculations should be performed outside the management accounting system. External financial statements should only be shown to those managers who bear (co-)responsibility for these so that the different valuation approaches do not create confusion within the company.

Overall, the decision- and responsibility-oriented design of the management accounting system should always be structured in a way that each manager can immediately recognize for his area which items he is directly responsible for and thus has to react to if actual results do not proceed according to plan and requires corrective measures.

While these 10 principles contradict in many ways those used in common accounting practice, they are essential for developing and implementing effective management control systems. Most ERP-systems can be rearranged to reflect this management orientation without requiring a change of software.

Full product costs are always wrong!

Fixed costs can only be charged to a product unit with the help of an arbitrarily chosen allocation key.

Full product costs are always wrong!

An engineer and board member wanted us to develop a costing system that shows the profit before deduction of interest and taxes (EBIT) by product (item number). This would require calculation of the full manufacturing cost and the cost price per item number (net revenue – cost price = EBIT).

We did not accept this engagement!

Scientifically and empirically it has been shown that full production costs or even cost prices cannot serve as reliable decision-making information. Nevertheless, the methodology of the “cost distribution sheet” is still being taught at many schools and is extensively used in practice. Even for a simple trading company that only sells one single product, the inadequacy of using total cost (EBIT) per unit for decision-making is clear. While the purchase price per unit is agreed with the supplier and can be clearly assigned to the sold unit, that is not the case with other costs:

- The procurement costs (packaging, freight, insurance) depend on the quantity ordered. They are caused by the purchase order (decision), not by the individual piece.
- The costs of the purchasing department (personnel and material costs) are determined by the size of the department (decision) and only indirectly by the quantity purchased.
- Advertising and sales promotion costs are also the result of decisions on selling activities. These costs are also decided before sales are made. These cannot be related in a direct cause-effect-relationship to the quantity of units planned or actually sold.
- This also applies to infrastructure and to the costs of managerial functions.

The following example shows how the full production cost and the cost of goods sold change when planned and actual quantities or other structural costs differ (method: simple fixed cost allocation):

Full product costs are always wrong! — Changing profits per unit due to fixed cost allocation

Although the costs directly incurred by the product sold are always the same, each situation presented gives rise to a different full manufacturing cost or cost price per unit. This is due to the fact that the structural costs (fixed costs) determined by management decisions were allocated to the product unit based on sales volume.

If the example is extended to a company offering several products and possibly also producing semi-finished products, additional cost allocation keys would have to be used. This is because the parts delivered to inventory would have to bear a proportionate share of the fixed costs of procurement and production readiness (full production costs). The fixed costs of sales and marketing, of the remaining internal functions, and of overall management would have to be allocated to the units sold in order to calculate the cost of goods sold per unit. Whatever allocation factors are used to achieve these allocations is therefore always wrong. This is because all fixed costs are a result of management decisions (budget) and are only indirectly dependent on the units produced or sold.

Only the costs caused by the actual production of a product unit can be clearly assigned to a product unit. Behind these costs are the consumption of raw materials, external services, semi-finished products, and own production activities. These are determined by bills of material, workplans, and recipes (technical cause-effect chains). These are the proportional (planned) manufacturing costs. There is never a direct causal relationship between the fixed costs of the support functions and the units manufactured or sold.

In other words:

There is no such thing as a doubt-free profit per unit before interest and taxes (EBIT), because it is calculated based on arbitrarily chosen allocation factors.

There is also no such thing as “as far as possible cause-based allocation” because, due to the lack of a direct cause-and-effect chain, an allocation factor must be used anyway.

This insight must be taken into account when designing decision-relevant management accounting systems. Managers correctly argue that they should only be responsible for cost elements they can directly influence themselves.

Management Accounting

The purpose of Management Accounting is to support all managers in decision-making and responsibility taking.

Planning and control instruments must be management oriented in order to be relevant for decision-making. The purpose of Management Accounting is to support management. Information provided by the system should be presented in a planning and control-compliant manner up to the balance sheet, so that managers can plan and control their areas of responsibility and coordinate them mutually.

The Focus of Management Accounting

The focus is always on the self-reliant management of a given area. Customers, sales, products, cost centers and projects are in the center. For a cost center the following questions arise:

- Which and how many activity units should we provide and what should be their performance-related costs (planning of proportional costs)?
- Which structures must be available to be ready to generate the requested output and how much should these cost (planning of fixed costs)?
- What was the actual activity level in a given period of time and how much should this perfomance have cost (flexible budget of the actual performance)?
- Which costs directly attributable to our area have actually been incurred (actual cost recording)?
- What differences between the flexible budget and actual costs have arisen for which we are responsible (variance analysis)?
- What further development do we expect by the end of the year or project, taking into account what has been achieved and the corrective measures already planned (forecast)?

Overall, Accounting for Management is a support for decision-making in planning, implementation, control, correction and expectation (i.e., the management cycle). This requires the inclusion of services, revenues and inventories, represented in quantities and values. A consistently designed management-oriented activity, cost, revenue and profit accounting system that can represent plan, target, actual and forecast is a prerequisite. The underlying data comes from the dispositional systems (ERP) and from the accounting system.

Controllers are responsible for the design, implementation and operation of this overall system.

Valuation requirements from laws and accounting standards are of secondary importance for the design of Management Accounting, because internal and market-related planning and control are the main focus.

Accounting for Management can only do justice to its purpose if it shows the person responsible in each case the variables in plan, target, actual and forecast that can be directly influenced by him and his employees.