The focus is on the individual work performed by the company’s own employees for a customer order. The main task is to charge the performance-related cost center costs to the customer orders according to cause. To do this, it is often necessary for employees to record their working hours per order on a daily basis. Based on this activity recording, these times are multiplied by the planned proportional cost rate per hour of the cost center providing the service and charged directly to the customer order. This procedure is the prerequisite for determining the contribution margin I of a customer order, as well as the absolute contribution margins achieved by a service group.
Material taken from the warehouse is charged to the customer order at standard purchase price. If material for a customer order comes directly from an outside supplier, the bill is recorded at actual price in the accounts payable department and charge directly to the customer order.
This applies above all to workshops and craft businesses of all kinds (e.g. car repair shops, heating fitters, plumbers, tailors). The costs of inventory management and procurement cannot be allocated to the individual sales order according to cause.
If other providers procure services for the execution of the customer order, these are order-specific external services (e.g. software licenses, design drafts, expert opinions, transportation services, laboratory tests). Also such positions are recorded in accounts payable and assigned directly to the customer order.
As in industrial operations, also service providers need to cover their fixed costs and to generate profit. The main focus here is on the customer order, rarely on an individual item. The sum of all contribution margins has to cover all fixed costs plus the EBIT needed.
If new products are developed in service companies that are subsequently made available to customers for use over several years, it should be considered from an operational perspective whether the project costs incurred should be capitalized, i.e. added to fixed assets and depreciated in subsequent years. These considerations are mainly necessary when developing application programs (software for sale) and consulting modules if the development costs are to be covered by the contribution margins of the subsequent years of use. In financial accounting, an attempt may be made to write off the total expenditure for such a project in the year in which it is created in order to save taxes in the short term.
Transportation companies
In airlines, railroad companies, local public transport and direct transportation from the supplier to the recipient, the following cost types are the most important:
Personnel costs
Fuel and energy consumption
Maintenance of the means of transportation
Distance or time-dependent imputed depreciation.
Only in the case of direct transportation for a single client from the point of departure to the point of arrival is it possible to determine the proportional costs and thus the contribution margin I of a transport order according to the origin. The time spent by drivers and attendants as well as the miles driven can be measured and evaluated, which makes it possible to determine the proportional costs and the contribution margin I of the transport.
In air, sea, rail or bus transport the transportation options are usually offered according to a timetable or flight plan. The proportional costs arise when the transportation offer is executed. Whether the seats on the train, flight or public transport are well or moderately utilized has little influence on the proportional costs as the personnel deployment remains largely the same and energy consumption changes only insignificantly.
However, if the proportional costs of the unit produced (a flight or a train) remain more or less the same, the net revenue can be increased without significant additional costs by increasing the utilization of the available seats or transport areas. On trains that run between 0900 and 1130 and between 1400 and 1630, a large proportion of seats are often unoccupied. In particular American airlines and railroad companies in Europe recognized this and therefore advertise time-restricted offers at lower than usual prices (see the real examples in “Customer profitability, seller productivity, p. 76”. This approach is known as Revenue Management. On one hand the lower sales prices can increase the absolute contribution margin volume and on the other hand they reduce capacity bottlenecks on flights or trains with a high “Load Factor”.
Like in production also service companies should thus know the proportional costs of their services. This is the only way to determine which services contribute how much to covering fixed costs and profit.
The main trigger for the development of management accounting was industrial production. Their managers want to know the net revenue of a product or order and compare it with the costs directly caused by the product. The difference is the contribution margin I (CM I).
To achieve this, management accounting is to be set up that it can calculate the proportional production costs in planned and actual values, based on the quantity and activity structure of the manufactured product. The bills of materials and routings with consumption quantities and working times are used for this purpose (see the post “Pizza Dough and Management Accounting“).
Net revenue less proportional production costs results in the CM I per product unit, as described several times in this blog. Based on this, the contributions to the coverage of fixed costs and profit for product groups, customers, customer groups, regions or sales channels can be determined in planned and actual in various levels and dimensions (see the post “Multidimensional CM-Calculation“). After deducting all fixed costs, the top level of summarization is the EBIT achieved by the company as a whole.
Construction Companies
In construction companies the focus is on the contribution margin of a specific customer order. The person responsible for implementing the order (construction manager) is assessed according to how well he succeeded in realizing the planned contribution margin for the order. As in industrial operations it is important to adhere to the planned costs of the bills of materials and subcontracting, as well as to avoid higher actual time consumption by employees compared to the projected target times.
In both industrial and construction operations, the splitting of cost center costs into their proportional and fixed costs is necessary for cost planning and control (see the post “Cost splitting”). Even the best financial accounting software cannot fulfill this requirement because it can only record values, but not quantities and times per order.
Pure Trading Companies
A pure trading company sells its products as they are purchased. Customers usually receive the products directly from the warehouse or from the rack in the store. Packaging for shipping is determined by the size of the order, rarely by the individual item. This usually also applies to online retailers.
Because in trading companies the purchased product is not changed, no routings are required and bills of materials are only needed if the items to be sold consist of product bundles. Therefore, in the cost centers of a pure trading company, all cost center costs, from purchasing to warehousing, sales and administration, are fixed costs. There is no need to split costs into proportional and fixed costs in the cost centers because the proportional production costs correspond to the stock withdrawals for the sales executed.
Management Accounting for Different Types of Companies
Private companies, many foundations and associations as well as public organizations and their administrative units manufacture products and services. All these organizations must be able to cover at least the costs of a period under review with the revenue of this period (year) and, where appropriate, to achieve a profit in line with the market. (See the post “Profit in Line with the Market“).
Consumption-related disbursements usually happen before customers pay. Therefore, it must be ensured that sufficient cash and cash equivalents or open credit lines are available at all times to pay the amounts due. For this, financial accounting is the appropriate instrument in all organizations. However, financial accounting is not suitable for planning and controlling an organization as it cannot process neither quantities nor services and relate their costs to the revenues according to cause.
Management accounting is the only way to charge costs and services to individual service and product units in line with causation. It calculates the planned and actual costs directly caused by the manufacturing of a product or service unit and deducts them from the net revenue generated. The result is the contribution margin I. This is used to cover all costs of the organization that are not directly product-related (fixed costs) and to achieve a profit in line with the market.
For decision-relevant management accounting this results in the requirement to split costs into proportional and fixed when planning cost centers and to charge only the proportional costs of the manufactured units to products or other cost centers. This is because there is only a direct cause/effect relationship for the proportional cost center costs. The fixed costs remaining in the cost centers are period costs. They are the responsibility of the cost center managers. They are transferred as cost blocks to the stepwise contribution accounting.
According to current knowledge, only Resource Consumption Accounting (RCA, see L. White, Resource Consumption Accounting) fulfills this requirement. In German-speaking countries, Grenzplankostenrechnung GPK combined with contribution accounting correspond to RCA. RCA shows which costs are caused directly by the manufacture of the individual product unit produced. These costs are to be recorded per unit as inventory receipts and can be charged to the units sold according to their origin. The costs not incurred directly per unit remain in the cost centers. They are to be understood as fixed costs for the period under review. They are fixed costs because they are incurred for the cost center’s readiness to perform.
How to plan cost center costs and to calculate proportional cost rates for product costing is a main topic of this blog. The application of the methodology in different kinds of companies as well as in corporations with many daughter companies or in public administration are discussed in more detail in the following posts. The focus is on:
Production and sale of physical products, e.g. industrial and construction companies
Pure trading companies
Service companies, e.g. consulting companies, auditors, law firms, software developers
Transportation companies
Banks and insurance companies
Healthcare facilities such as hospitals, retirement homes, laboratories
Public administrations and educational institutions.
What these types of companies have in common is that they
work for several customers,
can process several orders for a particular customer, each with several order items,
offer different products or services,
can divide their organization into cost centers, each of which is the responsibility of one manager,
should charge activities between cost centers according to their origin (Charging Internal Services, no allocation of fixed costs),
want to know which customers, products and services generate how much contribution margin.
For the planning and analysis of results by the managers concerned, the contribution margin I per product and per customer is always relevant for decision-making in the various types of companies. Because the fixed costs cannot be allocated to an individual order item according to their origin, the evaluations must always be based on CM I per order item.
The following data model shows that for aggregated reports always 1:n relationships (1 < —>> n) are needed:
Management accounting for different kinds of companies
Reading method: On a specific date, a customer can purchase one or more products or services. The proportional product costs are defined per unit, customer and date, the CM I is the difference between the net revenue agreed with the customer and the proportional cost. Based on the customer, the product and the date, net revenue, proportional product costs and CM I can be summarized according to all higher-level dimensions.
“Imputed depreciation is a cost equivalent for the devaluation of long-term usable operating resources (see Wolfgang Kilger, Flexible Plan Cost Accounting and Contribution Margin Accounting, 9th Improved Edition, Wiesbaden, 1988, p. 398).”
Imputed depreciation amounts are intended to lead to corresponding amounts of money being “reserved” in the financial assets for replacement investments, in order to procure replacement assets if necessary and thus be able to continue to meet the operational purpose. The devaluation equivalents mentioned by W. Kilger are to be calculated on the basis of the replacement values of the investments from the point of view of value retention.
It follows that imputed depreciation should not be calculated on the basis of the historical acquisition value of long-term working assets, but on the amount to be paid at the end of the year for equally efficient assets. From our point of view, a company’s profit potential is only preserved when the equally efficient operating resources can be procured again. As a consequence, there is no distributable profit for the owners/shareholders until the imputed depreciation calculated from the replacement value has been deducted. Only the residual amount can be distributed with a clear conscience if the company is not to suffer a loss of substance.
In order to determine replacement values and imputed depreciation, it must be clarified annually what changes in the purchase prices are to be expected for the various fixed assets. There are many reasons for imminent purchase price increases or expenses for updates:
Inflation in procurement markets
New technical or legal regulations to be complied with
Changed safety regulations for the operation of the facilities (and buildings)
Adaptation of computer programs, program extensions and release changes
Switching to another machine supplier because the previous one no longer exists.
It also happens that equipment to be replaced becomes cheaper to purchase because physical plant components are replaced by electronics or metal by plastic.
In the event of expected increases as well as reductions in the purchase prices of fixed and intangible assets, imputed depreciation for the plan year must be recalculated and taken into account in management accounting. Like all other costs they determine the annual internal profit.
Imputed depreciation should not only be calculated for long-term assets such as buildings, facilities, machinery and vehicles. Increasingly, the resources also include rights and potential benefits of a non-physical nature such as ERP- and CRM-systems, rights of use and sales, purchased customer addresses, time-limited licenses of use. If such potential benefits lose their value over time and require new investments to preserve their benefits, the corresponding estimated amounts have to be taken into account in the replacement value, which in turn leads to higher imputed depreciation.
Sustainably successful corporate management requires the inclusion of imputed depreciation and amortization in the income statement. This prevents funds from being distributed to the owners, which will be necessary to maintain the company’s potentials for success and thus its continued existence.
If private individuals want to buy a new car, they first determine how much they will have to pay for the desired vehicle including all equipment features. This results in the gross purchase price of the vehicle, which is then also shown in the purchase contract. If her used car is traded in, the trade-in price is deducted. She may prefer a leasing contract with monthly payments. When making the decision, the private individual mainly considers the cash outflows at the time of purchase and the ongoing annual expenses. Such an investment calculation only takes cash flows into account.
Why write off?
A company, on the other hand, must present a financial statement with a profit and loss account every year. To determine the annual profit for the period, it must deduct the annual loss in value of the car, i.e. depreciation, from the revenue generated and show it in the income statement and in the balance sheet.
Depreciation is the value-based expression of the annual loss in value of physical and intangible assets. External reporting and the calculation of taxes payable are governed by legal regulations. These regulations are intended to ensure that all taxable companies report according to the same rules and are therefore treated equally by the state. The management approach, on the other hand, focuses on the loss in value of an asset or right due to its use and the expected remaining useful life of it. These different purposes can lead to different depreciation amounts being included from an operational perspective than those permitted under tax law.
External or internal valuation
In order to treat all their taxable companies equally, many countries issue commercial and tax regulations on the valuation of assets, the depreciation methods to be applied and the useful lives permitted for the calculation. In Germany, for example, these are the depreciation rules (depreciation for wear and tear), cf. the depreciation table of the German Federal Ministry of Finance (Bundesfinanzministerium – AfA-Tabelle für die allgemein verwendbaren Anlagegüter (AfA-Tabelle “AV”)). For internationally operating and reporting companies, the rules of international reporting standards such as IFRS or US GAAP are applied.
For the managers controlling a company or a group these external valuation and depreciation rules are of secondary importance. They want to be able to assess whether the depreciation and amortization charged to the internal financial statements will be sufficient to maintain the company’s performance potential in the future so that it can continue to generate profits in line with the market. Distributions (dividends) to owners and shareholders should therefore only be decided once it has been ensured by means of imputed depreciation and amortization that funds that will be required to maintain the profit potential will not be distributed.
“Management control plans, controls and measures the implementation of guidelines, strategies and operational objectives, see the management control definition.
From this understanding of management control it can be deduced that management accounting must take into account imputed depreciation, not financial depreciation. This is because it is about shaping the future of the company and only to a limited extent about external profit reporting.
Cost price is the total cost of a company in a period, adjusted for changes in inventory. According to Wikipedia.org, this includes material costs, manufacturing costs, research and development costs, administrative costs and distribution costs. as well as imputed interest for assets required for operations (see German Guidelines for Price Determination on the Basis of Cost of Goods Sold (Annex to Regulation PR No. 30/53 of November 21, 1953, Notes 43 – 45)). If the net revenues exceed the cost price, the company starts to make a profit.
This statement is true for the company as a whole but it misleads when it comes to management control. Who wants to calculate the cost price of an article, a customer or a subdivision of the company, has to break down the fixed costs to product units. But as there is no direct cause-and-effect relationship between the company’s fixed costs and the individual product unit sold, this can never be done properly
To calculate the profit contribution of an item, the cost price per unit of a product or service unit sold must be calculated. All fixed period costs must therefore be allocated to the product units sold. For this purpose, an overhead rate is determined for the calculation of the unit cost of goods sold. If the sales quantities or the fixed cost blocks change, the cost price per unit unit also changes. This affects inventory valuation and, even more important, the management of sales and production.
As long as neither the bill of materials nor the routing and neither the material purchase prices nor the proportional planned cost rates of the cost centers involved in production change, the proportional costs incurred per unit produced remain the same. However, distributing the fixed costs to a different production or sales quantity, results in different cost prices per unit. Neither production nor sales are responsible for this, only the capacity utilization.
Cost price is irrelevant for descision-making
In the example, the monthly cost price per unit of goods sold changes because the fixed costs are divided by the production quantity of the period under review. If inventory receipts and issues are valued monthly at full productions costs, they include a portion of the period’s fixed costs. The value per unit thus changes every month. The fixed costs of other functional areas of a company are usually added as percentages to the full production costs. Although cost of goods sold is necessary in external reporting, it is not useful for corporate management purposes:
If the really paid purchase prices deviate from the planned ones, first the purchasing department is responsible for the variances.
If in the production processes more direct material is consumed per unit produced than planned (or more semi-finished products), the production management is responsible.
If the standard times for the manufactured product units are not adhered to in the production cost centers, it is up to the respective cost center managers to take corrective action.
The data required for this can only be obtained if the splitting into proportional and fixed costs has been set up in the management accounting system. This can be achieved with marginal costing (flexible standard costing), see the posts “Full product costs are always wrong” and “Complete variance analysis“).
Since the demand, respectively the customers and the ability of one’s own sales organization determine the net revenues, it is necessary to compare the latter with the proportional product costs of the services and products sold. Our experience shows that most companies sell their items at different contribution margins per unit. The sum of all contribution margins achieved must be sufficient to cover all fixed costs and the targeted profit. An item that does not cover its calculated cost price can still make a considerable contribution to covering fixed costs.
The aim is always to cover all fixed costs and all variances with the contribution margins from the units sold, while at the same time achieving a profit in line with the market.
Initial situation: In the annual plan derived from strategy and medium-term plans, it is determined which items (services or physical products) are to be manufactured at what cost. For this purpose, the planned proportional production costs per unit are to be calculated in the costing system. In the sense of Management by Objectives the responsible persons have the task of adhering to these planned proportional product costs in each production order. This requires that each responsible person (e.g., production managers and project managers) must be able to track which costs were directly caused by an order. This is because they can only take responsibility for the cost elements that they can directly influence.
Three types of costing are distinguished because they serve different purposes:
Standard costing: Determination of the planned costs of a unit of an item (physical product or service) as part of annual planning. This costing results in the (annual) planned costs per unit produced.
Precalculation: On the basis of the planned costs and the actual quantities ordered, the planned costs of an order to be actually executed are calculated. This is because the actual incoming orders rarely match the planned quantities. Precalculation forms the basis for the target to actual comparison of a production order that has been placed.
Post-calculation: Comparison of the costs incurred in the actual order compared to the precalculation.
With this target to actual comparison managers are enabled to identify the order items that have deviated from the plan. With this information they can intervene in the next periods and find measures that will lead to achieving the target costs again in the following periods. In addition, it must be ensured that cost variances are not passed on to subsequent levels. This is because these are only responsible for their own variances.
Cost center-managers as well as production- and project-managers are responsible for variances in the production area. In decision-relevant management accounting the variances of production and all cost centers should not be charged on, neither to the warehouse nor to the sales organization, since the latter cannot be responsible for such variances. For management-relevant Profitability Analysis (step-by-step contribution accounting), it follows that during the year all warehouse receipts should be valuated at proportional planned production costs and the variances should be shown in the (monthly) Profitability Analysis. This is because the variance types mentioned can neither be allocated to the products nor to the sales organization nor to the individual customers according to their cause.
The next two posts show how the various types of variances are shown in Profitability Analysis in a way that is appropriate to the levels and responsibilities, where they are to be shown, and how inventories are to be valued.
Useful Management accounting systems must provide the data relevant for decision-making.
Decisions – Responsibility – Causality
CZSG Controller Zentrum St. Gallen/Switzerland introduced many decision-relevant planning and control systems mainly in German speaking countries. The basis was always “Grenzplankostenrechnung GPK” and the further developments arising from it. The applied management accounting principles correspond almost 100% to the recommendations for the design of “Resource Consumption Accounting RCA” according to Larry R. White (Journal of Corporate Accounting & Finance, Volume 20, Issue 4) and of the Profitability Analytics Center of Excellence PACE.
Who decides what?
Many chief financial officers and cost accountants see the purpose of management accounting primarily as presenting an organization’s financial results in accordance with the requirements of local accounting laws, IFRS and USGAAP, local tax laws and regulations for setting transfer prices between related companies, and other regulations.
In our eyes the purpose of management accounting is first and foremost to provide decision support for managers at all hierarchical levels. After all, they are responsible for the results to their superiors. The focus is on management support, not on external reporting.
Decisions – Responsibility – Causality
Customers decide whether they want to place an order and at what price. In this way, they also indirectly decide the proportional costs of the products or services to be sold and manufactured. Managers at all levels decide how the necessary offers are to be made and what personnel and machine capacities will be required to process the orders won and, in doing so, to achieve a profit with the company in line with the complete market.
In strategic and operational planning, managers at all levels must define activities, quantities and capacities. Consequently, consumption according to bills of materials and work plans as well as activity-based cost center budgets are required for planning and subsequent control. Only when these quantities and activities are known can they be valued in monetary terms. A management accounting system that is suitable for decision-making must therefore provide those quantities, activities and valuations which a responsible manager can control himself and thus take responsibility for. This also requires that the manager can always compare the planned values with the actual values of his area.
This starting position applies to manufacturing companies, service providers, hospitals, retailers as well as banks and government institutions.
No financial accounting system can provide this data, as it only represents values. Valuation regulations from tax law, from accounting standards (US GAAP, IFRS) or from specifications for the determination of international transfer prices are also irrelevant in accounting for management, because cost center managers, product managers and salespersons cannot change these values themselves.
Responsibilities of different managers
Since managers are responsible for achieving their objectives, it is recommended to list their responsibilities.
Production manager:
Timely processing of dispatched production orders
Ensuring stock receipts of semi-finished and finished products (valued at proportional standard production costs)
Adherence to target consumption rates for materials and cost center activities in accordance with the pre-calculation of released production orders, valuation of consumption at planned purchase prices and proportional planned cost rates
Compliance with the planned costs of its own cost center(s)
Notify other areas when capacity constraints become apparent.
Cost Center Manager:
On-time completion of manufactured work
Adherence to the pre-calculated times in the production orders to be processed
Adherence to target costs (flexible budget) of own cost center, taking into account pre-calculated times and work performed.
Sales Manager:
Achievement of planned net revenues per period (invoiced).
Compliance with the planned costs of his own cost center(s)
Meeting the agreed delivery dates to the customers.
Purchasing Manager:
Procurement and on-time availability of all goods and services to be purchased.
Determination of planned prices (standard prices) for raw and auxiliary materials as well as services to be purchased (on this basis the standard cost calculations are prepared)
Informing sales and production in the event of major variances between actual and planned cost prices.
Who is responsible for depreciation?
The manager in whose cost center the asset is located,
the managers who determined the planned useful life of an asset on the occasion of the investment decision,
the financial manager or the controller who determines the depreciation method (preferably fixed depreciation from the replacement value of an equally efficient asset)
Depreciation is mainly a period cost, since most assets do not need to be replaced because they no longer function, but because they are technologically obsolete.
In the stratified presentation of the origin of results and profit, the contribution of the individual responsibles and their employees becomes apparent:
Decision-Making, Responsibility and Causality
Who is responsible for idle capacity?
The managers who bought too large a plant,
the salespeople who sold too little
possibly cost center managers, if they do not point out idle capacity to their colleagues.
From this it can be deduced that it makes little sense to allocate costs of idle capacity (especially personnel and depreciation costs) to cost centers or product groups. As mentioned, imputed depreciation and personnel costs are charged to cost centers because they are observed there.
Strong and weak causalities
In our opinion, a strong causality is given if the consumption of an input good, e.g. the output of a cost center or an employee, is directly caused by the storable or saleable product. This is the case if a routing or/and a bill of materials can be created for the product or the service unit performed. In Grenzplankostenrechnung GPK, therefore, only proportional costs are charged to products or services, and the remaining fixed costs are transferred to stepwise contribution accounting. This is because fixed costs can only be changed by management decisions, such as firing an employee or purchasing a machine.
Weakcausalities do not show a direct dependency between output and input.
Example 1: Because the headcount has increased, the HR department needs an additional employee for everyday personnel support. There is no rule how many employees one person in the personnel department can supervise. It is a management decision whether to hire the person or not. The costs directly attributable to a manufactured product do not change as a result of the increase in staffing levels, since no changes are required in either the bills of materials or the routings. But the fixed costs of the company increase.
Example 2: A company fills gas cylinders and delivers them to customers by trucks (see the case study “Le Petomane Gas in the PACE homepage“). Delivering to a remote customer requires an additional hour of travel time, resulting in corresponding fuel and labor costs. These could be saved if the customer is no longer served. On the other hand, the net sales minus the proportional costs for the delivered gas cylinders, i.e. the contribution margins I of this customer would be eliminated. This results in: + omitted transport costs – omitted contribution margins.
The proportional product costs per filled gas cylinder in the finished goods warehouse can be clearly determined since material consumption and work schedule for filling are defined in the technical bases (strong causality).
Example 3: Most companies have a central IT cost center for the implementation, operation and maintenance of applications and data. The resulting data and evaluations are used (to varying degrees) by many cost centers. In cost accounting, therefore, a search is often made for cause-effect chains by means of which the IT costs can be charged to the receiving cost centers. Mostly this search is unsuccessful because both the data sets and the applications are used by a wide variety of cost centers (very weak causality).
Nevertheless, many financial managers and cost accountants try to allocate the fixed costs of the IT department (including depreciation) to the various cost centers and from there to the manufactured products by means of one or more allocation keys. After all, according to the widespread opinion that each product must bear its share of the total fixed costs. However, the IT manager plans and controls the costs of the IT department and is consequently also responsible for them to the management. There is no need to allocate costs to individual cost centers and products. The contribution margin from sales must be sufficient to cover all fixed costs plus the target profit.
Insight:
In Grenzplankostenrechnung GPK, only proportional costs are allocated to manufactured products because they were directly caused by the products (only strong causalities). Therefore, in management-oriented cost and revenue accounting, inventories should also be valued only at proportional (standard proportional product costs). This is because fixed costs are period costs and, as such, should be shown as blocks in the contribution margin accounting. They are to be controlled in the cost centers.
Precisely: In GPK and in Resource Consumption Accounting RCA, fixed cost allocations have no place because these allocations are an attempt to delegate cost responsibility to units that have no direct possibility of influencing the costs at the point of origin.
Of course, it makes sense to include fixed costs in pricing for individual customers. However, in our view, this is activity-based pricing, not costing. Therefore, considerations about setting offer prices and conditions should be made outside the management accounting system, especially in the sales organization.
If in the Costing Levels Continuum Maturity Model from Gary Cokins the levels 11 and 12 are to be reached, all allocations of fixed costs must be eliminated, because otherwise no useful simulations are possible. IFAC-Evaluating-the-Costing-Journey_0.pdf
Target to Actual Comparison shows the difference between the should be-costs and the actual costs in a cost center
Target to Actual Comparison
The great benefit of comparing the flexible budget with actual costs is that cost center managers can see every month how well they succeeded in implementing the plan, taking into account the orders processed. The financial goal of a cost center is to meet the cumulative flexible budget costs for the year. If the flexible budget and the actual costs are determined as described in the post “Flexible Budget”, corrective measures can be sought quickly. These should bring the cumulative spending variances back to zero in the next periods, if possible. Theoretically, a target to actual comparison could be made “real time”, i.e. daily. But because the real personnel costs and other cost types can only be calculated after the end of each month, it is recommended to create monthly comparisons per cost center.
The example shows the monthly target to actual comparisons of the cost center Stamping:
Target to Actual Comparison
The spending variances show how well the cost center manager succeeded in keeping to the planned costs adjusted to the effective performance in the individual months. A positive spending variance means a productivity gain compared to the plan, a negative the contrary. These variances are corrections of the planned fixed costs.
In the month of July, Ringbook Ltd. is on vacation. Therefore, no activity is listed there, but parts of the fixed costs, especially depreciation, are also incurred in this month. The flexible budget costs are calculated according to the formula “actual output times proportional planned cost rate + planned fixed costs”, the actual costs according to the real charges.
For the year as a whole, the flexible budget was undercut by 6,164.
Actual costs
The costs charged to a cost center for a reporting period (usually a month) are recorded in various subsystems:
Invoices from external suppliers: Recording of the invoice receipt in accounts payable with specification of the consuming cost center.
Consumption of auxiliary and operating materials from the warehouse: Recording by means of material consumption slips by multiplying the purchased quantity, valuated with the planned purchase price of the auxiliary or operating material. The planned purchase price is used for valuation because the purchase price variances are reported to the purchasing department, since this department triggers the purchase orders.
Personnel costs: Debit of the presence hours of the month of the employees of the cost center, valued in each case with their planned presence hour rate (data source is the personnel cost plan).
Charging of activities of other cost centers: Units consumed during the reporting period (mostly hours, kWh, km) valued at the proportional planned cost rate of the providing cost center. As a result, neither the fixed costs of the issuing cost center nor the variances incurred there are passed on.
Overall: The fixed costs and the purchase price variances remain in the sender cost centers, since they can only be recorded and accounted for there. In this way, target to actual comparisons are created in the receiving cost centers without including price or cost-rate changes from serving areas. The resulting variances are the responsibility of the respective cost center manager.
Calculating the planned costs of the actual services provided.
Flexible Budget
When performing a target to actual comparison, cost center managers should be able to check monthly as to whether or not costs they can manage themselves are “under control”. Given that the annual plan is approved by the organization’s management who releases the cost center budgets, the budget must be adhered to. However, during the year various factors can deviate from the plan, including:
Sales and production quantities,
Purchase prices,
Manufacturing processes efficiencies, and
Employees retention rate.
A simple comparison between planned and actual costs does not help cost center managers in their search for possible corrective measures because they lack a reference to the actual performance of the period under review. As a benchmark the flexible budget of the cost center should be calculated:
Flexible budget costs =
actual activity x proportional planned cost rate + planned fixed costs.
The flexible budget shows the planned cost of work actually performed in a period. If the activity performed in the period under review deviates from the planned activity, the proportional costs of the cost center will change, but the planned fixed costs should not. In the example below, actual employment is slightly less than planned employment. Therefore, the proportional plan costs is less than the annual plan, but the planned activity capacity (fixed) costs remain the same.
Flexible budget
The flexible budget cost is thus the cause-related yardstick for assessing the total costs actually incurred by the cost center. If the cost center managers keep to their flexible budget, they will have achieved their cost target. If negative variances from the target costs occur, ways must be found to cumulatively reach the flexible budget again in the following months.
If cost centers perform activities that are not directly caused by a production order, a customer order, or by internal projects (e.g. research and development), they also have no planned or actual activity and consequently only fixed costs. In these cases, the flexible budget corresponds to the planned costs.
For the wire bending cost center in the example company the annual plan is as follows:
Cost Cetner Wire Bending
The installed capacity of the production equipment is 7,264 hours, which is sufficient for the planned production time.
The cost center has a planned workforce of 4 people who are planned to work a total of 6,800 net hours. This includes the working time of the cost center manager for planning and controlling the cost center.
The complete planned personnel costs of the cost center totals 387,600. The average hour worked (including the cost center manager) will thus cost 57.00 per hour (presence time).
According to production planning 5,870 employee hours will be necessary to execute the planned activity. This means that 5,870 hours at 57.00 per hour will “slip” into the products to be manufactured. This corresponds to 334,590 planned proportional personnel costs. The 53,010 difference between the planned personnel costs represents the costs for work not directly related to the products, i.e. the planned fixed personnel costs for the year.
In line with this, the other planned costs were divided into their proportional and fixed portions. Dividing the proportional budgeted cost of 363,940 by the planned activity of 5,870 hours yields a budgeted hourly proportional cost rate of 62.00 for wire bending. This rate is used to calculate the proportional costs of all products that will be processed in this cost center (see the post “Standard Cost Calculation of Products”).
If the activity of the issuing cost center is caused by a direct order of the receiving cost center or by its activity, there is a direct cause-and-effect link between the serving and the receiving centers. The planned proportional cost-rates can thus be charged to the receiving cost centers. The issuing cost center has its own planned and actual activity. The activities it performs for other cost centers can be measured. (Examples include repair and maintenance shop, laboratory, and energy cost centers). Thus, the respective cost center also has a proportional plan cost rate and its flexible budget is dependent on the activity performed for others during the period.
If the activities of a cost center are performed for the entire company, there is no direct cause-and-effect relationship between the producer of the activity and the users of the output. Therefore, the costs of such cost centers cannot be allocated to other cost centers according to their cause (e.g. reception, personnel administration, internal training, sales, production planning, finance, the majority of IT costs and top management). The IT costs for the ERP- or for the management accounting system are incurred for all cost center managers who use ERP data. The costs of generally used services cannot be charged to the users according to their origin (forced consumption). Due to this lack of causation, the allocation of fixed costs to other cost centers makes no sense. In other words, fixed costs should not be allocated to other cost centers, cost center managers should assume responsibility for their own flexible budget.
Flexible budgets are thus a prerequisite for the introduction of a Resource Consumption Accounting system RCA and for Contribution Accounting.
