Tag: direct cost

Management-Relevant Cost Terms

In order to make correct cost decisions, the management accounting system must be able to present all costs in three dimensions. Because these dimensions interpenetrate each other, they can be represented with the cost cube.

Why management-relevant cost terms?

Enabling management control requires decision-relevant cost and revenue terms. Every manager is dependent on being able to identify which variables he can directly influence and therefore should also be responsible for in his area. He must be able to recognize in which time period he can change what cost and revenue parameters. Finally, he wants to be sure that only those cost items are charged to his area that can be unambiguously assigned.

This requires viewing costs in three dimensions according to their intended use and mapping them in the management accounting system:

Management-Relevant Cost Terms
Management-Relevant Cost Terms in the cost cube

These three dimensions interpenetrate each other, which is why they should be represented in a cube (see the cost cube in the Controller Dictionary, p. 146):

What does this mean for the design of Management Accounting systems?

Costs are to be planned by the unit whose manager is also directly responsible for them. Personnel costs and most third-party costs arise in the cost centers (except material). The same applies to depreciation. Material costs and product-related external services are incurred for the products. They are represented in bill of materials items and are therefore included in the costing of the products. The production managers are responsible for this. These costs are therefore to be planned and accounted for by cost center managers and product-responsible managers.

For all managers, it is important to know in which period of time their costs (and the procurement prices behind them) can be changed. In the case of personnel costs (they always arise in cost centers), hiring, notice periods, negotiated wages and rates for social benefit costs determine the period in which the costs can be changed. In the area of material and external service costs, order quantities and the agreed contract and delivery conditions determine the costs.

From the point of view of traceability, in Management Accounting, both planned and actual costs (or expenditures) must be assigned to the area that is directly responsible for them. The costs of the unit’s own employees are direct costs for a production cost center since each employee is permanently assigned to that cost center. For the orders processed by the cost center, they are indirect costs because an employee usually works on different orders in a given time period. The same applies to the consumption of operating supplies, external maintenance work, or depreciation. Direct costs of products are the raw materials and semi-finished products consumed (ex warehouse) and of externally procured external services. These items can be clearly assigned to a production order.  The key to recording purchases and consumption in a management-oriented manner is therefore the account assignment of the documents (supplier invoices, payroll accounting, material procurement from stock).

In the third dimension, a distinction is made as to whether costs are caused directly by the units manufactured or sold (products or services) or by decisions that determine the capabilities of the organization (capacities of all types, size of the organization, training and further education or management services). The former are referred to as proportional costs, while the capability/capacity costs are mainly called fixed costs or structural costs.

Proportional costs are determined by sales and production, while fixed costs are determined exclusively by management decisions. To staff the anteroom of a member of the management board is a management decision just as much as the approval of a sales promotion campaign, the decision to convert existing production facilities, the purchase of vehicles for delivery or the introduction of an ERP system. Proportional costs are determined by production quantities, bills of material (where the planned consumption quantities are recorded), work plans (containing the planned times for the individual production steps in the cost centers) and planned purchase prices for raw materials and order-related external services. In a purely trading company, the purchase price for the product sold corresponds to the proportional costs, since nothing is changed in the product. All other costs of trading operations are structural costs.

To avoid confusion: We have replaced the term variable costs with proportional costs (see Controller Dictionary, p. 200), because in practice and science proportionality is often confused with controllability. If the activity of an employee in a production cost center is causally necessary for product creation (can be seen in the work plan), these are proportional costs. They are added with every unit produced. If the same employee has nothing to do due to a lack of orders, his wage is still paid, but becomes a fixed cost (reserved or unused capacity). How long the wage will continue to be paid despite underemployment (controllability) is a question of notice periods and the management’s decision what to do with this employee. From this it can also be concluded that everything that is not proportional becomes fixed costs.

To distinguish clearly between proportional and fixed costs is extremely important for the design of the management control system. For both operational and strategic decisions to be made, it must be known which costs are directly caused by the products and their sales and which will be the result of decisions on capacities and structures of the organization.

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.

Management Accounting

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.