Tag: CM I Contribution Accounting

Management Tasks and Management Accounting

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

Management Tasks and Management Accounting

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

Decision support and responsibility for results

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

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

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

Objectives and plans belong together

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

The management cycle requires plan, target and actual data

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

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

Requirements from strategic and medium-term planning

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

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

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

Adjustments at the beginning of the new year

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

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

Forecasts

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

Controllers check the right system application

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

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

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

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

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

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.