Category: Cost Accounting

Management Accounting is a Prerequisite for Financial Accounting

Many companies base their choice of software modules to be used for ERP and accounting on legal requirements. Financial accounting must be kept because profit or loss as well as assets and liabilities must be reported at least once a year. At the same time, accounting regulations must be complied with (local commercial and tax law, internal settlements between companies of a group).

In addition, the rules of the international accounting standards (IFRS, US GAAP and the like) mostly assume the following basic structure of the income statement:

This is the usual form of the profit and loss account presented externally and very often internally. It can be created with auxiliary calculations from financial accounting. All consumptions incurred in a period for the plant (material, personnel, external services, depreciation and even pro rata interest costs) are debited to the plant cost center (simplified all costs incurred within the fence of the plant). This results in the full cost of goods sold after accrual of inventory changes. Similarly, all marketing and sales costs are concentrated in the collective cost center for marketing and sales. Also, the costs for administration and management and possibly for research and development are added as a percentage of the full costs of products sold. This presentation mostly meets the requirements of the mentioned external standards of financial accounting.

However, the executives of a company, especially the product and cost center managers plan and decide quantities, activities and prices and create new products and services by means of input factors such as working time, material or energy. Corporate management expects all managers of lower levels to take responsibility for the costs of their area. To this end, it must be ensured that there is a causation-based relationship between costs and the units created and sold.

Cost, performance, revenue and profitability accounting

The relationship to quantities, consumption and values can only be established in a management accounting that presents cost, activity, revenue and earnings. This system calculates how much the consumed quantities and services did or should have cost per product or service unit. Accounting for management is a matter of calculating the plan, target and actual of the units produced and sold. Because both the cost and the revenue side are included, the term management accounting became established.

The figure below shows that in the various auxiliary accounts and in the summarizing general ledger accounting, the focus is on the period view for the company. In the right-hand management accounting section, on the other hand, the order or unit view is decisive. Managers at all levels want to know how much it cost to manufacture a product or service unit in their management area. In order to calculate the result for the period, it must also be known by how much the inventory quantities of raw materials, semi-finished and finished products have changed per item. Costing per product unit is a prerequisite for this valuation.

In the accounting-based full cost structure of profitability analysis, both unit and period costs are deducted from net revenues to arrive at Gross Profit. Example:

In month 1,100 pieces were produced and sold. This resulted in full production costs of 500, taking into account the cost center costs of production,warehousing and purchasing. In month 2, 120 pieces were produced and sold at the same material purchase price of 2.00 per piece. According to accounting, the personnel costs remained at 300 (the existing employees had enough capacity for the additional production). As a result, the full manufacturing cost per piece dropped from 5.00 to 4.50.

Questions:

• • Is the finished goods inventory receipt to be posted at a different valuation each month (moving average)?
  • If yes, does the gross profit per unit change each month because the capacity utilization is different? What is the correct valuation approach for planning and managing sales?
  • The differing full costs of goods sold per unit are the result of the utilization of the production cost centers. The staffing and machinery of these cost centers is determined by production managers, not by sales.

Planned and actual costing are core functions of management accounting.

The calculated values are not only used for inventory valuation but above all are compared with the net revenues generated by sales. As the sales organization is not responsible for variances in production and procurement this requires that direct material consumption is valued at planned purchase prices and work plan positions are valued at the planned proportional cost rates of the cost centers. Splitting cost center costs into their proportional part (driven by the products) and their fixed part (driven by the dimensions of the cost centers) is a key requirement for decision-relevance.

Controllers and management accountants must therefore set up their system in such a way that a distinction can already be made in the standard cost estimate between proportional costs directly caused by the products manufactured and fixed costs that are mainly the result of management decisions. This is because the net revenue from a sale to a customer must first be compared with those costs that can be allocated to this order in a manner that reflects their cause. In the absence of a direct cause-and-effect relationship, fixed costs can only be allocated to a product or a customer by applying allocation keys that are arbitrarily chosen by the majority.  Only small proportions of marketing and selling costs and other cash out costs can be allocated to an individual product or customer on the basis of causation.

In Accounting for Management  rules such as IFRS, US GAAP or tax laws do not apply. They lead to incorrect decisions.

Example: A product with a high proportion of material or external activity costs must bear a higher proportion of the fixed costs of purchasing and the warehouse cost centers, even if its procurement is uncomplicated and can be handled with a telephone call or an e-mail. This increases the full manufacturing costs of this product, with the result that the markups for marketing and sales costs and for other cash costs and depreciation also increase. This is because such surcharges are calculated on the basis of the full manufacturing costs. The product then no longer looks particularly worthy of promotion because it is “broken” by surcharges.

Conclusion: A management accounting system is built to support all managers of a company in their decision-making so that they can achieve an overall improvement in the company’s results. Fixed cost allocation does not help in this optimization process. According to the current state of knowledge, it is recommended to set up management accounting as marginal costing, combined with multi-level contribution margin accounting .

The Institute for Management Accounting IMA still trains and propagates the “full cost structure of profit and loss accounting”. The focus is still on external reporting, not on internal decision making. These non-decision-making guidelines led  to the establishment of the Profitability Analytics Center of Excellence (PACE). Find  practical examples and technical papers on how management accounting can increasingly fulfill its mandate to show executives ways to improve results on their homepage.

Variators for Cost Splitting

In many textbooks and partly also in cost accounting software the variator method is recommended to split  cost center costs into their proportional and their fixed part. The planned proportional costs are given as a percentage of the planned costs of a cost type in a cost center and the complement is the fixed costs of this cost type. Using variators for cost splitting should be omitted because it generates incorrect cost rates. The example explains this:

Initial situation in annual planning

The annual production plan shows that the cost center to be planned should work 14,400 hours on production orders. The cost center manager plans, including himself, a staff of 10 persons, each working 1,600 hours per year. The planned yearly personnel costs will amount to 480,000 EUR, the average rate per presence-hour and employee thus to 30.00 EUR. 90% of the planned 16,000 presence time hours are to be used for manufacturing (14,400 hours) and 10% for organization ant training.  Thus the variator of 90% results (row 6).

The planned non-personnel costs (including depreciation) amount to 100,000, of which it is estimated that 5.00 are to be used per hour of planned employment. This corresponds to proportional non personnel costs of 72,000 and thus a variator-rate of 72% (rows 9 and 10).

Comparing the variator method and direct activity-based planning shows (still) the same planned cost rates, e.g. 35.00 proportional hourly cost rate.

But the executives and the cost center manager expect stronger fluctuations of the production quantities in the plan year. They decide to equip the cost center with an eleventh employee (security variant). This increases the installed capacity to 17,600 hours and the planned personnel costs to 528,000. But the planned employment remains at 14,400 hours per year. Due to the variator of 90% the higher personnel costs raise the proportional hourly rate from 35.00 to 38.00, although the same number of hours is worked for the products to be manufactured.

It is the fixed cost-rate that has to change from 5.61 to 8.61 as more fixed costs are included in the products. The proportional planned costs per unit remain the same. This is appropriate, since the costs of the additional employee only become proportional costs when his hours are used for  manufacturing.

Variators belong to the master data of cost accounting and it is not intended that they be adjusted by cost element each time there is a change in normal capacity or planned employment. The variant with 11 employees results in incorrect cost rates. This is because also in the second variant, 30.00 personnel costs and 5.00 material costs are incurred for each hour worked on order; it is the same people with the same wages who perform this work. If, as a result of a revised sales plan, plan employment were increased, each variator would also have to be adjusted.

If in the subsequent plan year, non-personnel costs increase from 100,000 to 120,000 because fixed depreciation and non-personnel costs increase, a portion of the fixed costs will be “shifted” to the proportional plan cost rate if the 72% variator remains the same. As a result, period fixed costs are understated.

Conclusion: Variators are unsuitable for the design of a flexible budget costing and a real contribution margin accounting. They have to be adjusted cost type by cost type in the master data with every activity change. Flexible budgeting produces the correct values. In addition, it ensures that the proportional planned cost rate remains the same even with changes in the production program and thus with other planned activities.

Order Variances

Only a few variance types can clearly be assigned to the individual production order:

A lot size variance occurs when the production lots ordered deviate from the planned lot size in the annual plan. If the quantity ordered in a production order is larger than the quantity planned in the standard cost estimate for the article in question, the setup costs are spread over more units. As a result, the item produced costs slightly less per unit.

Yield variances occur when more or fewer “good quality” pieces result from the production order than planned. This happens primarily in process manufacturing, e.g. in the production of chips for processors or in chemical processes.

Material quantity variances occur when the input material did not fully meet the specifications or when the processing machines were not precisely adjusted. They lead to cost overruns in the respective production order.

Work time variances occur in the cost centers of production when more or less process time has been used than in the plan-calculation of the order. These over- or under-consumptions can be assigned to the individual order if the processing cost centers record their output per order.

Purchase price variances occur when the really price paid for raw materials and purchased services does not correspond to the planned price (especially in the case of inflation). They can be calculated in purchasing when the supplier invoice is recorded. Because the purchasing department negotiates the contracts with the suppliers, it is also responsible for purchase price variances.

As the same material can be used for different products and in many production orders, most purchase price variances can neither be assigned to an individual production order nor to a cost center according to cause. Direct assignment is only possible when materials or services are procured directly for a production order or a cost center.

Usually, raw materials and supplies are first stored in inventory and are only assigned to the production orders or cost centers when they are taken from the warehouse (material withdrawal slip). If actual purchase prices are used to value the inventory, the same material is in stock at different purchase prices. As a result, production would encounter a different average purchase price for the material each time they use this material.

If the production orders are debited according to the first in – first out principle, the order processed earlier still benefits from the lower-priced material, while the subsequent order is charged the higher prices. Valuing inventories with moving average prices does not help either. This is because each production order delivered to inventory results in new (proportional) unit costs and thus different valuation approaches in the warehouse for the same finished item.

If all warehouse receipts and issues are valued at standard purchase prices, this dilemma can be avoided. Production and sales can then (internally)  purchase the materials throughout the year at the standard purchase price, and purchasing can determine the purchase price variance at the moment of purchase, i.e. when it occurs.

In the cost centers, the flexible budget costs, i.e. the planned costs of the actual activity performed, must be adhered to. The cost center managers are responsible to avoid negative differences between target and actual costs, i.e. spending variances, and for ensuring that these variances disappear in subsequent periods.

The example below has already been presented in a similar form in the post “Complete variance analysis“. All variances from the target are presented at the lowest hierarchical level to which they can be clearly assigned. This is also the place to intervene if these variances are to be avoided in the future.

This illustration only shows internal variances within the company. Changes in net sales are analyzed in  contribution accounting.