proportional cost - Decision-relevant Management Accounting

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.

Standard Cost Calculation of Products

Proportional standard production costs are the planned costs that are directly caused through the product or service to be manufactured. They are the value-based consequence of fixing the objectives and must therefore be applied in calculation as well as in the valuation of inventories.

Creating the standard cost calculation for an article requires the following data: bill of material and work plan, lot size, planned purchase prices for raw material, planned proportional cost rates of the cost centers.

The base plate for the locking mechanism of a 4-ring binder is calculated as follows:

Basic data and proportional planned cost of itemnr. 11

- From production planning it is known that the annual production of item number 11 should be 816,200 pieces. 11 equal lots of 74,200 units should be produced.
- The bill of materials shows that sheet metal for 50 units will be used for setup and that 200 of the manufactured units will have to be disposed as scrap. For one base plate 0.024 m² of sheet metal are required.
- Together with the requirement for setup and scrap the requirement for steel amounts to (74,200 + 50+ 200) x 0.024 m² = 1,786.8 m².
- The planned purchase price per m² is 2.00 EUR. This results in direct material costs of the lot of 3,573.60 EUR
- The work plan states that 0.25 machining minutes are required to produce one qualitatively good base plate (stockable). Added to this are 120 minutes for setup. The power requirement per batch is therefore (74,200 pieces at 0.25 min + 120 min setup = 18,670 min.
- These are multiplied by the proportional planned proportional cost rate of the stamping shop of 0.8938, which results in the proportional planned production costs of 16,686.37.
- In total, the proportional planned costs of this lot are EUR 20,259.97 or, for 74,200 good units, EUR 0.2730 per unit of inventory entry.

Valued at EUR 0.2730 / unit, the semi-finished product base plate 4-ring (itemnr. 11) is posted as a stock receipt. In the management-oriented system, this valuation approach for inventory movements applies to both planned and effective transactions. The reason for also using the planned proportional standard rates for real movements is that cost variances occur at the time of production and that the production managers are responsible for this variance. The orders that withdraw the semi-finished products for the next manufacturing level are not responsible for the variances that occurred previously and should therefore receive the products at standard cost rates.

For the same reason, the actual withdrawals of raw materials from inventory are always valued at planned purchase price. This is because if purchases are made at a higher or lower price than planned, a purchase price variance occurs in procurement. This variance can be observed by the purchasing manager and is shown in the overall result of a period. Often it is not possible to pass on purchase price variances to the production orders according to their cause, because it would then be necessary to decide which orders receive the same material at the lower and which at the higher price.

In our post “From the Sales Plan to Production and Purchase Planning” the multi-level bill of materials of item 101060 was presented. These steps from the raw materials to the various semi-finished products and to the finished product are shown in the standard cost calculation for the finished product 101060 below.

Standard Cost Calculation of Products — Standard Cost Calculation of product 101060

The proportional costs of every unit are always transferred to the next production level as standard values. Costs for setup and scrap are always included in the proportional standard costs. Although the warehouse receipts and issues are not shown, they are also always valued at these standard costs.

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.

Proportional and Fixed Costs

The splitting of cost center costs into their activity-dependent proportional and their fixed portion is part of the annual cost center planning. This is done for each planned in the affected cost centers. Once the basic data is available, the process can be automated.

Proportional and Fixed Costs

Applying the cost cube from the previous post means that for decision support all costs have to be split into their proportional and fixed portion, since proportional is the consequence of units produced and sold, fixed is the consequence of management decisions. The point is to correctly represent the principle of cause and effect in cost center planning. This splitting is done in the planning process.

- An employee in a production center can work on production orders (setup, production, monitor quality, pack finished parts into transport containers). These are tasks that are causally necessary for the creation of a defined product. Without them, the product cannot be created. They are incurred proportionally to the quantity produced. The same employee can organize, take part in further training, attend meetings, clean up the workplace or, hopefully in rare cases, wait for work. The latter activities are determined by the organization of the cost center. They are incurred independently of the quantity produced and are therefore part of the cost center’s fixed costs.
- The consumption of electrical energy in a production cost center is mainly determined by the type of product to be manufactured and the quantity produced. Electricity is also consumed for lighting, air conditioning, and the operation of auxiliary equipment such as computers. The consumption for production is causally necessary for the creation of the product and must therefore be planned proportionally. The rest of the electricity consumption is again the part of the capability to perform.
- Maintenance work on the machines installed in the cost center can be caused by the operation of the equipment, e.g. after 200 hours of operation the rollers have to be replaced because they are no longer flat. Other maintenance work (technical inspections, functional checks) is due after a predetermined period of time, for example, annually, regardless of the quantities produced, to ensure operational readiness.

The examples show that different cost elements in a cost center must be planned with a proportional and a fixed portion. The following section shows how the necessary cost splitting can be largely automated. The example of the Stamping cost center is reused for this purpose.

Proportional and Fixed Costs in 220 Stamping

In comparison to the initial situation in the post “Planning Cost Centers”, the columns proportional, fixed and value consumption per RFU have been added.

The procedure for automated cost splitting using the example of personnel costs: The annual budget for personnel costs is 337,560. This amount divided by the normal capacity of the employees (408,000 Pmin) results in the average presence time rate per minute of 0.82735. This is the average cost per minute “been there” of any employee in this cost center. The 0.82735 are multiplied by the planned activity level of 338,855 Pmin. The planned proportional personnel costs are thus 280,353. The fixed costs are the difference to the planned amount (57,207).

For the other cost types the cost center manager considers for each of these what portion of the planned amount depends on the cost center’s activity. In the example, these are the consumption of auxiliary and operating materials, external maintenance, other expense, and energy. The manager derives this proportional share from his planning documents (maintenance contracts, consumption tables for energy, material costs that only arise from productive work). By dividing the amount by the planned activity he receives the consumption per reference factor unit (RFU, entry in last column). Since the RFU in the stamping shop is the minute, this naturally results in very low rates. The calculation method is then analogous to the splitting of the personnel costs.

Tip for practical implementation: Do not use percentages when splitting the proportional from the fixed amount. Always use the proportional rate per RFU. If the planned activity level has to be adjusted due to a changed production plan, the proportional plan cost rate of the cost center would change when using percentages. This is unrealistic because it is still the same product with the same work plan.

Cost splitting is a prerequisite for the calculation of proportional planned product costs. In order to be able to process if-then questions, the manager must know which costs are directly caused by the product (proportional planned production costs) and which cost blocks are the result of structural and capacity decisions (fixed costs). The latter change as shown in the cost cube through management decisions while the proportional product costs per unit remain the same as long as the product unit has the same bill of materials and work plan.

If the planned activity level, the planned cost amounts per cost type and the consumption per RFU are known for each cost center, cost splitting can be completely automated. Proof of this is provided in the simulation model of the book Management Control with Integrated Planning – Models and Implementation for Sustainable Coordination.

Cost splitting is not necessary in structure cost centers since these areas work for the products and not on the products. Consequently, only fixed costs can be planned in these cost centers.

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 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.

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.