Cost allocation - Decision-relevant Management Accounting

Maturity Level of Your Management Accounting

Gary Cokins from North Carolina, USA, developed the “Costing Levels Continuum Maturity Framework 2.0”. Its version 2.0 was reviewed by the International Federation of Accountants IFAC in 2013 and published as a guide to good practice in cost accounting (IFAC-Evaluating-the-Costing-Journey_0.pdf).

This framework is designed to help management accounting professionals assess the maturity of their own system. How well does the system work in providing managers with data that is relevant to their decisions and their responsibilities?

It also helps organizations align the maturity level of their management accounting system with the decision-making needs of their managers.

12 maturity levels of your own management accounting

Cokins structures the Costing Levels Continuum Maturity Model into 12 maturity levels, ranging from simple accounting analysis to a comprehensive simulation model:

- Levels 1-8 cover the systematics from financial accounting to internal accounting, activity-based full-cost accounting (also known as standard full-cost accounting), cost allocation using activity-based costing (ABC), the comparison of revenues and costs per customer, and the quantification of unused capacities.
- Levels 9 and 10 compare plan to actual comparisons and attempt to allocate fixed costs to products and customers based on activities.
- Level 11 requires the implementation of Resource Consumption Accounting (RCA). RCA corresponds almost completely to Grenzplankostenrechnung according to H. G. Plaut, Flexible Budgeting according to W. Kilger and the multi-level and multi-dimensional Contribution Accounting as described in this blog.
- Level 12 is reached when simulations from the product and customer level to the entire company are possible on the basis of level 11 data.

Maturity Level of Your management Accounting

Description of the 12 levels

- Level 1 is pure financial accounting (general ledger, payroll accounting, purchasing)
- Level 2 also assigns the expenses to cost centers and cost types
- Level 3 posts the direct material and labor costs per product group (also fixed labor costs)
- Level 4 allocates the indirect costs of the service areas to the cost centers that work directly on the products with the help of a single allocation factor.
- Level 5 looks at individual manufactured units for the first time. This requires links to bills of materials and the work schedules (ERP). The manufactured quantities are generated from historical data. In expanded versions, the costs are also recorded per production order or per project.
- Level 6 attempts to allocate fixed costs to individual products on the basis of estimated or measured consumption using Activity Based Costing (ABC) (this still corresponds to an unfair allocation of fixed costs).
- Level 7 includes sales and net revenues for the first time. It attempts to allocate the costs of marketing, sales and promotion, as well as the entire administration and management, to customers and products using allocation keys. These allocations are shown in the period statement for each customer or product but are not included in the inventory values.
- Level 8 calculates the costs of unused capacities (personnel, machinery, IT, other equipment) of the cost centers and attempts to allocate these to the customers and sales channels.
- From level 9 onwards, planned and actual values for revenues and costs are used to support decision-making and thus planning. This brings the splitting of costs into their proportional and fixed portions to the fore. In addition, planning is based on the needs of existing and potential customers, rather than just on the people and equipment available.
- Level 10 only uses planned quantities and times derived from target-oriented planning to calculate products. These form the standards. However, fixed costs continue to be allocated to products and customers via the cost rates of the cost centers.
- Level 11 brings the comprehensive application of the causation principle as described in this blog and being used since many years in Grenzplankostenrechnung (GPK) and Flexible Budgeting in German-speaking countries. These two systems are largely consistent in terms of methodology. In the US this method is known as Resource Consumption Accounting (RCA). RCA also wants to answer the question: How much should the produced or sold products and services have cost, if they had been provided exactly according to plan?
- Level 12 is reached when simulations can be run based on level 11 (GPK or RCA) and on the ERP and CRM data. The aim of simulations is to determine and implement programs that optimize results on the basis of current order backlogs and management accounting data.

Background and purpose of the continuum

The Costing Continuum Model was developed based on knowledge of the application of different cost accounting systems in the English-speaking world, particularly in the United States. The model is indirectly a consequence of the famous book by Robert Kaplan and Thomas Johnson entitled “Relevance lost. The rise and fall of management accounting” (Harvard Business School Press, 1987). This book also criticized the fact that most cost accounting departments focus on meeting reporting standards (US GAAP / IFRS) but that hardly any suitable systems are used to support managers’ decision-making. From 2004, it was recognized that Marginal Cost Accounting (Grenzplankostenrechnung GPK) and Flexible Budgeting can largely cover these needs. In the USA, this led to Resource Consumption Accounting (RCA, level 11).

In German-speaking countries the software developments by the Plaut group and SAP, as well as many other software providers, led to many companies that reached level 11 in their management accounting. However, in our practical experience, compliance with accounting standards and statutory accounting and transfer pricing regulations still takes precedence over decision support for managers at all levels and in all functions.

The Continuum is designed to help controllers and finance professionals assess the extent to which the systems and processes they have installed provide relevant information for management decision-making. This applies to both operational and strategic management.

Application of the Maturity Model

Organizations using Flexible Budgeting or GPK are at level 11. For this they need to have access to ERP-data as well as sales and revenue planning and to link those to Management Accounting. This is a prerequisite to reach levels 11 and 12. For running simulations quantities and services must be available as planned and actual figures for each item number and customer and for each cost center. Flexible Budgeting is to be set up in the cost centers so that the actual costs can be compared with the planned costs of the services provided.

Even if artificial intelligence is used to plan and control success, it derives its suggestions from the available plans and the actual data. It cannot develop new plans.

In the simulation model of our book “Management Control System”, it is possible to change prices, sales deductions, quantities, services and proportional cost rates. The Excel-model immediately calculates the consequences of changes in the basic input variables through to the internal profit and loss statement and the internal balance sheet.

This is not artificial intelligence, but it allows decision-makers to follow the consequences of each change step by step.

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.

Contribution Margin or Full Cost

Full cost accounting leads managers to take wrong decisions because fixed costs are allocated to the costs per unit. Here is the proof.

Contribution Margin or Full Cost? What is decision-relevant?

Thanks to good negotiating of the CEO of Pekka Heating Systems Ltd., his company was able to acquire and realize a large installation order for a university building and a smaller conversion order for the heating system in a house with 6 apartments in the last period. Now the question is what kind of orders should be increasingly won in the future. A consultant was commissioned to calculate whether it would be more likely to win conversion orders or large installations of new systems. The consultant explained that, using the method he knew from school, he had first distributed the full manufacturing costs over the orders according to the number of hours worked. The costs of sales and administration were then allocated to the orders in proportion to the full manufacturing costs.

He presented the following calculation:

Contribution Margin or Full Cost — Full cost accounting

The verdict is clear: it is not advisable to accept large orders.

The project manager of the large installation project was, on the one hand, proud that Pekka Heating Systems Ltd. was able to successfully implement this large order and, on the other hand, frustrated by the massive loss of the order. Therefore he asked a friend if the consultants’ calculation was correct. The friend presented the following table:

Without order 1 the company would be bankrupt

With the following example, the friend showed him that the application of different cost allocation bases (allocation keys) leads to different order results every time, despite the same initial situation. None of the results can be correct because costs are distributed that are incurred for the whole organization.

Different fixed cost allocation keys lead to different order profits

The conclusion remains that full cost accounting is not suitable for management control, because managers need to compare both in planning and in the concrete case of application the additional net proceeds of an additional order to the direct costs incurred with this order.

Precisely because various accounting standards and tax laws require the preparation of full cost accounting, management accounting requires the courage to not allocate fixed costs from one to other cost centers, orders, and products because otherwise managers will make wrong decisions.

Charging Internal Services

The allocation of internal services to other cost centers or products using full cost rates provokes wrong decisions. Only if these services are ordered by the recipient, their proportional costs are to be charged to the receivers.

Charging Internal Services

In many companies and in literature it is strongly believed that all costs of internal service areas should be charged to end products. This is done in order to be able to see how much a certain item did cost in total until it was received in the finished goods warehouse. The subject of this post is to show to what extent this approach can be implemented in a way that is appropriate for management and thus for decision-making.

Our starting point is the plan of cost center 330 Maintenance and Repairs in the example company. Cost center manager Temmel is responsible for internal repair and maintenance work in the entire Ringbook Ltd. This also includes the operation of the energy center. Up to now, the manager was able to carry out this work alone. For larger orders, external service companies were commissioned. Their costs are planned in the receiving cost centers in the cost type “external maintenance/repairs”.

Based on the planning of the internal services provided the planned activity level of cost center 330 is 1,650 hours for the plan year. The question as to whether Mr. Temmel’s planned presence time of 1,700 hours will also be sufficient for his internal tasks was left open for the time being. If there will be some overtime it will be paid and shown as a cost center variance.

Charging Internal Services: 330 Repair center

Together with his controller and his boss, Mr. Temmel prepared his cost planning on the basis of the planned activities. His own salary including social benefits amounts to 64,496. The consumption he has planned for his cost center is listed in cost types 5 – 13. Based on the equipment installed in his cost center, the controller has calculated the imputed depreciation of 7,625. From the previous measurements it can be deduced that the cost center will consume about 400 kWh of electrical energy per year. This corresponds to 80.00 at an internal rate of 0.20 / kWh.

The splitting of the costs into their proportional and fixed parts works automatically, as shown in our previous blog “Splitting Planned Costs into Proportional and Fixed”, when the plan data has been completely entered:

- His personnel costs are 64,496 for 1,700 hours presence time. Per hour this amounts to 37.94.
- He assumed that he will need 0.56 auxiliary and operating materials per hour of repair and maintenance work in his cost center. This amount is consumed with every hour worked for other cost centers and can therefore be integrated into the proportional cost rate. The remaining 156 of this cost type are incurred for the operational readiness of his repair center and can thus not be charged to the recipients.
- He proceeded accordingly when planning the other cost types.

This results in proportional planned costs of 64,266. Divided by the planned employment (1,650 hours), the proportional planned cost rate of 38.95 results.

The cost center manager is responsible for the planned fixed costs of 11,445. The installations and capacities of his workshop are there because they are planned by him and approved by his bosses in the budget. If he can dismantle them, for example by reducing the fixed maintenance of his own processing machines, the total costs of the job will be lower. However, the proportional cost rate for the service hour performed remains 38.95.

If any share of fixed costs for the workshop building, for the use of the canteen, for IT connection and personnel administration were allocated to the workshop cost center, the full cost rate of the workshop would explode but the proportional cost rate would remain the same. If the full cost rate were to rise to 100 EUR/hour as a result of these fixed cost allocations, the internal service receivers would get the idea of procuring the repair and maintenance activities externally, because they would be available there for 70-80 EUR per hour. This would not only result in more money flowing outwards. The fixed costs of the workshop would rise massively because less internal service would be provided, but the employee and the equipment would still be there. This would result in a reduction in profits for the company as a whole.

To avoid such undesirable developments, we recommend to only charge the proportional costs of internal services provided at planned cost rates. It is the management, not the receiver of the service, that decides on the amount of structural costs.

The idea of outsourcing internal services to a separate company within the corporation must also be carefully considered from an overall perspective. After all, the spun-off company must also build up and pay for all kinds of capacities. Investments must be written off, taxes and profit transfers to the parent company are due. This often led to the total costs of a spin-off getting higher than previous internal costs. This has then led to a higher internal price for the service than before.

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.