Management Accounting

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.

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.

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.