Category: Management Accounting

Precalculation of a Strategy Implementation

A product/market strategy should help to increase company value. The calculations in the post “Quantifying the draft strategy” are not sufficient for the strategic decision because

• • the estimated quantities and the net revenues per sales area and product for the intended strategy period are still missing,
  • information on proportional material and external service costs for the new products or services to be offered is missing (bill of materials of the items to be assessed),
  • for the new products or services it has not yet been determined  in which cost centers which unit-related processing steps are to be carried out (work plan per new service or new product),
  • it is not clear yet for the new products which additional fixed costs will be required for the sales, production and support areas (cost center plans),
  • the necessary investments in buildings, equipment, vehicle fleet or rights and licenses are not yet taken into account.

This data is preferably created in the ERP-system and in the management accounting system because the data structures and historical values are already available there:

• • If customers, products, sales quantities, prices and sales deductions as well as bills of materials and routings are stored in the ERP-system, the new products can also be created in these data structures.
  • In management accounting the cost center plans with their personnel and machine capacities, the proportional cost rates and the fixed cost blocks are available. This allows to calculate the proportional production costs of the new products or services.
  • The deciding managers must be able to build on this database because they will be responsible for the success of the strategy.

The procedural steps for quantifying the implementation project of a strategy are developed in the example below. It must be shown whether the production and sale of individualized bookends for private or public libraries can increase the value of the company.

Intended manufacturing process

The starting material for the standard bookends are 1 mm thick and 12 cm wide steel coils. Sheet metal plates with a length of 24 cm are punched from the coils and are bent into a 12 cm wide and 12 cm high bookend.  The bookends are then painted black, white or red and individually wrapped in a transparent protective film.

For the intended front flap bookend 18 cm wide steel coils are required because the front flap should be 6 cm high and 12 cm wide. Punching a front flap bookend will result in sheet metal waste of 6 x 12 cm per piece. The coil supplier can recycle this waste.

The area to be painted increases by 12 x 6 cm per unit compared to the standard version, i.e. by 25%. The front flap bookend can be punched, coated and packaged on the existing machines.

The front flap is customized using an image template of the customer’s choice submitted electronically. The “image processing” cost center is to be set up for this purpose. It should take on the following tasks:

• • Checking the images submitted by e-mail for the front flap and sending the order to the external printer of the self-adhesive images
  • Gluing the returned foils onto the bookends front flap.

It is advisable to create the bill of materials and the work plan for the intended front flap bookend in the ERP system, as almost all the materials to be used and the processing cost centers are already available in the system. Based on this data the planned proportional costs of the existing and of the new front flap bookend can be calculated:

With this calculation the strategy deciders recognize which costs are directly caused by the production of the bookends. The planned proportional costs per unit are a key prerequisite for assessing whether the introduction of the new product will lead to higher company profits.

The annual fixed costs of the production and image processing cost centers were estimated (excluding depreciation and interest) and recorded as a planning basis in management accounting:

These fixed costs are also relevant to the strategy assessment.

Net revenue planning

Together with product management, the sales organization considered how many units per product could be sold annually in the sales channels (direct sales, sales via dealers in Germany and exports). In doing so, they did not focus on the manufacturing costs, but tried to estimate the sales prices that potential customers would be willing to pay for the individualized front flap bookend by means of competitor comparisons.

They also estimated how the life cycle of the products might develop. The experience curve shows that both the sales quantities and the net revenue per unit decrease towards the end of the life cycle due to market saturation and the market entry of imitators.

The expected quantities per sales channel (columns a-c, yellow boxes) and the expected net revenue (columns e-g) were estimated for an expected product life of 7 years and entered in the table. It had to be taken into account that domestic and export dealers will require a margin share of gross sales to cover their own efforts (columns f and g). The expected net revenue of Bookend Ltd. is shown on the right-hand side of the table (rows h-k), BE = Bookend, BEF = Bookend with front flap.

Planned development of absolute contribution margins

The proportional production costs of the two types of bookends were deducted from the planned net revenue (column k above). To simplify matters, it was assumed that the proportional product costs per unit will not change over the strategy horizon. This resulted in the absolute contribution margins I per item to be expected annually.

In the following graph the expected annual absolute contribution margins I from bookends BE and front flap bookends BEF are highlighted in yellow. These must cover the additional fixed costs, the investments and the target profit of the strategy.

These annual contribution margins must cover the additional fixed costs and investments listed below:

• • Additional fixed personnel costs of EUR 100,000 are expected annually and beginning in year 3 in bookend production because more production orders will have to be processed and more operational personnel will have to be supervised.

Increasing production volumes will require investments in production facilities:

• • Year 0 (before the start of production of front flap bookends): Adaptation of the punching and bending system, approx. EUR 90,000.
  • Year 0: Installation of the system for positioning and gluing the front flap images, approx. EUR 60,000.
  • Year 2: Addition of a heating tunnel to the paint shop for approx. EUR 80,000. The heating tunnel reduces the drying time and thus increases the capacity of the paint shop by 40%. The processing times per unit will remain the same as before.

As these cash outflows for additional fixed costs and investments are expected in different years, the time value of money must be considered when deciding on a strategy. This is done in the next post with the help of the dynamic investment calculation.

Is it worthwile to do this detailed planning?

Definitely! If the described clarification of the strategic project were to cost EUR 100,000 in personnel costs (3-6 months of work) but would lead to a rejection recommendation, this amount would be much smaller than the outflow of funds that would result from an unsuccessful strategy implementation.

 

 

 

 

Quantify the Draft Strategy

Bringing a strategic plan to decision-making maturity requires the cooperation of many people who are often already heavily burdened with the execution of their usual tasks.  It is therefore advisable to make a rough estimate of the expected financial impact of the draft strategy. Only when this rough assessment is positive is it worth starting an implementation project.

A quantified estimate should be made for the following items:

• • How much additional net revenue (quantity x expected net sales price) could the proposed strategy generate annually?
  • What will be the expected unit-related material and external service costs per unit to be sold?
  • How many manufacturing hours will approximately be required to produce the proposed products or services? The hours estimated are multiplied by the personnel cost rate of the respective activity cost center. The proportional personnel costs per unit result.
  • With this information the expected contribution margin I per unit can be calculated.
  • New product/market combinations usually lead to additional fixed (mainly personnel) costs in sales, production, purchasing and administration. These are also be taken into account.
  • Finally, strategic plans often lead to investments in fixed assets (capacity expansions) as well as to external service expenses, which are necessary for the realization of the strategy and must therefore be covered by the proceeds of the strategy.

The net cash inflow from the market is estimated in lines 1 – 3. The sales quantity is to be assumed for an average product of the strategic idea. It also forms the basis for calculating the volume- and the  hourly costs. Only the net amounts to be invoiced will lead to cash flow. For this reason, expected discounts and expected margins for intermediaries must be deducted.

Changes in inventory are not taken into account in this first estimate. For this reason, the material and external service costs per unit can be multiplied by the sales volume in lines 4-6.

The proportional production costs are estimated in lines 7 – 11. The assumed processing time per unit  includes all cost centers directly involved in production. The personnel costs per hour as well as the other direct hourly costs are multiplied by the processing time. This results in the estimated proportional production costs per unit (line 10) and for the planned sales quantity (line 11).

The absolute contribution margin I to be expected from the project can then be calculated in line 14.

Insofar as the strategy will require an expansion of management capacities for production, procurement and sales, estimated additional fixed personnel and other costs must be entered in line 15.

If the intended strategy will lead to capital expenditures for new equipment (machinery, buildings, vehicle fleet, IT) and for externally commissioned feasibility studies, the corresponding estimated amounts should be entered in line 17.

This rough estimate of the average expected annual sales volumes, net revenue and proportional production costs per unit is sufficient to calculate the contribution to fixed cost coverage and profit generation (CM I = 330,000 per year). After deducting the additional annual fixed costs resulting from the strategy, the expected annual cash flow is calculated.

The payback period of this strategy design is calculated in row 18. In the example, it will take around 4.5 years for the investments to be paid for by the annual cash flows.

This rough quantification of the draft strategy is worthwhile, as only a few quantities, consumptions and values need to be estimated. With few figures it is possible to assess whether further development of the project is promising.

If the payback period is longer than 4 years, there is little chance of achieving a higher company profit with the project. This is because interest must be paid on the investments and the net cash flows will result in additional taxes on profits.

If the draft strategy clears the payback hurdle, an implementation project can be applied for.

Decision-Making, Responsibility and Causality

CZSG Controller Zentrum St. Gallen/Switzerland introduced many decision-relevant planning and control systems mainly in German speaking countries. The basis was always “Grenzplankostenrechnung GPK” and the further developments arising from it. The applied management accounting principles correspond almost 100% to the recommendations for the design of “Resource Consumption Accounting RCA” according to Larry R. White and of the Profitability Analytics Center of Excellence PACE.

Who decides what?

Many chief financial officers and cost accountants see the purpose of management accounting primarily as presenting an organization’s financial results in accordance with the requirements of local accounting laws, IFRS and USGAAP, local tax laws and regulations for setting transfer prices between related companies, and other regulations.

In our eyes the purpose of management accounting is first and foremost to provide decision support for managers at all hierarchical levels. After all, they are responsible for the results to their superiors. The focus is on management support, not on external reporting.

Customers decide whether they want to place an order and at what price. In this way, they also indirectly decide the proportional manufacturing costs of the products or services to be sold and manufactured. Managers at all levels decide how the necessary offers are to be made and what personnel and machine capacities will be required to process the orders won and, in doing so, to achieve a profit with the company in line with the complete market.

In strategic and operational planning, managers at all levels must define activities, quantities and capacities. Consequently, consumption according to bills of materials and work plans as well as activity-based cost center budgets are required for planning and subsequent control. Only when these quantities and activities are known can they be valued in monetary terms. A management accounting system that is suitable for decision-making must therefore provide those quantities, activities and valuations which a responsible manager can control himself and thus take responsibility for. This also requires that the manager can always compare the planned values with the actual values of his area.

This starting position applies to manufacturing companies, service providers, hospitals, retailers as well as banks and government institutions.

No financial accounting system can provide this data, as it only represents values. Valuation regulations from tax law, from accounting standards (US GAAP, IFRS) or from specifications for the determination of international transfer prices are also irrelevant in accounting for management, because cost center managers, product managers and salespersons cannot change these values themselves.

Responsibilities of different managers

(usual period of consideration is one month).

Since managers are responsible for achieving their objectives, it is useful to list their responsibilities.

Production manager:

• • Timely processing of dispatched production orders
  • Ensuring stock receipts of semi-finished and finished products (valued at proportional standard production costs)
  • Adherence to target consumption rates for materials and cost center activities in accordance with the precalculation of released production orders, valuation of consumption at planned purchase prices and proportional planned cost rates
  • Compliance with the planned costs of its own cost center(s)
  • Notify other areas when capacity constraints become apparent.

Cost Center Manager:

• • On-time completion of manufactured work
  • Adherence to the precalculated times in the production orders to be processed
  • Adherence to target costs (flexible budget) of own cost center, taking into account precalculated times and work performed.

Sales Manager:

• • Achievement of planned net revenues per period (invoiced).
  • Compliance with the planned costs of his own cost center(s)
  • Meeting the agreed delivery dates to the customers.

Purchasing Manager:

• • Procurement and on-time availability of all goods and services to be purchased.
  • Determination of planned prices (standard prices) for raw and auxiliary materials as well as services to be purchased (on this basis the standard cost calculations are prepared)
  • Informing sales and production in the event of major variances between actual and planned purchase prices.

Who is responsible for depreciation?

• • The manager in whose cost center the asset is located,
  • the managers who determined the planned useful life of an asset on the occasion of the investment decision,
  • the financial manager or the controller who determines the depreciation method (preferably fixed depreciation from the replacement value of an equally efficient asset)
  • Depreciation is mainly a period cost, since most assets do not need to be replaced because they no longer function, but because they are technologically obsolete.

In the stratified presentation of the origin of results and profit, the contribution of the individual responsibles and their employees becomes apparent:

Who is responsible for idle capacity?

• • The managers who bought too large a plant,
  • the salespeople who sold too little
  • possibly cost center managers, if they do not point out idle capacity to their colleagues.

From this it can be deduced that it makes little sense to allocate costs of idle capacity (especially personnel and depreciation costs) to cost centers or product groups. As mentioned, imputed depreciation and personnel costs are charged to cost centers because they are observed there.

Strong and weak causalities

In our opinion, a strong causality is given if the consumption of an input good, e.g. the output of a cost center or an employee, is directly caused by the storeable or saleable product. This is the case if a routing or/and a bill of materials can be created for the product or the service unit performed.  In Grenzplankostenrechnung GPK, therefore, only proportional costs are charged to products or services, and the remaining fixed costs are transferred to stepwise contribution accounting. This is because fixed costs can only be changed by management decisions, such as firing an employee or purchasing a machine.

Weak causalities do not show a direct dependency between output and input.

Example 1: Because the headcount has increased, the human resources department needs an additional employee for everyday personnel support. There is no rule how many employees one person in the personnel department can supervise. It is a management decision whether to hire the person or not. The costs directly attributable to a manufactured product do not change as a result of the increase in staffing levels, since no changes are required in either the bills of materials or the routings. But the fixed costs of the company increase.

Example 2: A company fills gas cylinders and delivers them to customers by trucks (see the case study “Le Petomane Gas in the PACE homepage“). Delivering to a remote customer requires an additional hour of travel time, resulting in corresponding fuel and labor costs. These could be saved if the customer is no longer served. On the other hand, the net sales minus the proportional costs for the delivered gas cylinders, i.e. the contribution margins I of this customer would be eliminated. This results in:

+ omitted transport costs – omitted contribution margins.

The proportional product costs per filled gas cylinder in the finished goods warehouse can be clearly determined since material consumption and work schedule for filling are defined in the technical bases (strong causality).

Example 3:  Most companies have a central IT cost center for the implementation, operation and maintenance of applications and data. The resulting data and evaluations are used (to varying degrees) by many cost centers.  In cost accounting, therefore, a search is often made for cause-effect chains by means of which the IT costs could be charged to the receiving cost centers. Mostly this search is unsuccessful because both the data sets and the applications are used by a wide variety of cost centers (very weak causality).

Nevertheless, many financial managers and cost accountants try to allocate the fixed costs of the IT department (including depreciation) to the various cost centers and from there to the manufactured products by means of one or more allocation keys. After all, according to the widespread opinion that each product must bear its share of the total fixed costs. However, the IT manager plans and controls the costs of the IT department and is consequently also responsible for them to the management. There is no need to allocate costs to individual cost centers and products. The contribution margin from sales must be sufficient to cover all fixed costs plus the target profit.

Insight:

In Grenzplankostenrechnung GPK, only proportional costs are charged to manufactured products because they were directly caused by the products (only strong causalities). Therefore, in management-oriented cost and revenue accounting, inventories should also be valued only at proportional (standard proportional product costs). This is because fixed costs are period costs and, as such, should be shown as blocks in the contribution margin accounting. They are to be controlled in the cost centers.

To put it even more clearly:

In GPK and in Resource Consumption Accounting RCA, fixed cost allocations have no place because these allocations are an attempt to delegate cost responsibility to units that have no direct possibility of influencing the costs at the point of origin.

Of course, it makes sense to include fixed costs in pricing for individual customers. However, in our view, this is activity-based pricing, not costing. Therefore, considerations about setting offer prices and conditions should be made outside the management accounting system, especially in the sales organization.

If in the Costing Levels Continuum Maturity Model from Gary Cokins the  levels 11 and 12 are to be reached, all allocations of fixed costs must be eliminated, because otherwise no useful simulations are possible.