Contribution Margin Accounting

Contribution margin accounting is an umbrella term for different variants of multilevel gross income calculations. There are two basic types. The relative calculation of direct costs and contribution margins according to Riebel distinguishes between direct costs and overhead, whereas other types, such as direct costing, base the analysis of fixed-cost allocation or marginal costing on a separation of fixed and variable costs.

Direct costs is a relative term, since it can refer to costs on many items, including products, product groups, or units of capacity in which only certain products or product groups are manufactured. An example of product-related direct costs would be leasing costs for special-purpose machines that are only used for a single product, such as a chromium plating machine. Costs for advertising that relate to a whole product group (such as flat screen televisions) are an example of product group direct costs. Distinguishing between direct costs and overhead costs is based on the principle of identity. According to this principle, it is only possible to definitively align costs and revenues for calculating a contribution margin if they can be traced back to the same decision.

The relative calculation of direct costs and contribution margins primarily focuses on decision-making. Its main purposes are:

1. Preliminary costing

2. Control of the effect on net income of different alternatives for action

3. Profit planning related to orders, projects, and specific periods as well as across periods, and analysis of the source of profit by multidimensional evaluation objects (Riebel 1994)

Contribution margin accounting therefore offers significant support in deciding whether products should be added or removed from an existing product line. For example, less complex products in the product line may be suffering from adecline in prices, while products at the upper end may be suffering from a lack of demand, making the lot sizes too small.

Instruments for Operational Enterprise Management

Target Costing

The traditional product development path consists – in very simplified form – of the following stages:

1. Design

2. Calculation of costs

3. Determination of price as a function of costs

Unlike this forward-thinking approach, target costing employs “backward thinking.” The starting point is the decision to position a product in a given market segment, for instance a coupe version of a sedan. The market prices of the competition’s similar (neighboring) products are known, so management has a basis for determining the price segment in which the new product will be positioned.

In the second step, the company determines what customers want regarding the attributes of the product, particularly its features. Depending on the industry, this could encompass not only the attributes of the product in the most narrow sense,but also such things as the expectations placed on customer service or financing terms (financial engineering). Collecting this data demands professional field research, since imprecise and amateurish questions give potential customers too much leeway for expressing impossible wishes: “The car should combine the performance of a Ferrari, the interior space of a large Mercedes, the passive safety potential of a tank, the noise level of a sewing machine, and the fuel consumption of a lawn mower.” It is also extremely important to estimate the customers’ willingness to pay for above-average performance and quality features, as well as for additional equipment. Conjoint analysis is a method that determines the level of consumers’ willingness to pay for certain product attributes.

All of this information contributes to the decision regarding the target price, which usually involves intense participation of corporate management or area management. Now you subtract the desired profit from the target price. The amount of desired profit is also dependent on the strategic ideas of the company, as reflected in value-based management (see section 2.2). The result is the target value for the costs.

The responsibility then shifts to the functional area for product and process development. This is where the particular transformation problem of target costing arises. Revenue normally depends on the functionality of the product. Costs, on the other hand, are determined by the parts needed to build the product. Therefore, it is important to specify what part of the manufacturing costs can be assigned to the design engineers in the different assembly groups (bodywork, chassis, drive chain, and so on) as a kind of budget. Within these areas, it is possible to break down the budgets even further, having a separate cost budget for seats and one for upholstery, for instance. The design engineers now have to try to keep their designs within the cost budget.

Complications arise through technical interactions, but an elegant target cost system takes these into account, similarly to a product configurator. For example, when the total power requirements of optional equipment exceeds a threshold value for the electrical system, the next-largest generator or the next-largest wiring harness is selected. The reverse effect occurs if the level of optional equipment is reduced.

The procedure described up to this point is referred to as the top-down approach. If the product is a variant or successor of a known product, then a bottom-up approach can be applied: the construction elements of the existing product are changed one after the other. For example, you replace old materials with new ones or mechanical elements with electronic ones, and calculate whether these variations meet certain cost limits. Generally, these phases have to be repeated more than once.

One of the challenges for the method is to output not only average prices and average costs, but also changes over time. For example, in the automobile industry, development and warranty costs usually fall in an early phase of the product lifecycle (see section 3.3.5); revenues from repairs and sales of replacement parts, however, are usually earned in later phases. The present value of the decision is affected accordingly, similar to a dynamic investment analysis.

Another interpretation of target costing is to set allowable costs as a new, lower maximum limit. The current actual costs are compared to this limit. If the actual costs are above a level based on the market price, the firm has to take cost reduction measures. In making these decisions, the customer benefit related to individual parts of the product, as determined by market research institutes, serves as a criterion for distributing the cost reduction burden.

An even less methodically influenced development in target cost calculation correlates the expected additional benefits of modern features with the increased costs. You then try to find the optimal point in this correlation. In doing so, it has to be considered that the benefit curve for the customer declines slightly if a product is weighed down with extras. For example, the operating instructions become too long and complicated which makes it difficult to learn all the functions, or the optica signals (such as from the onboard electronics of an automobile) are more than the customer can handle. However, the costs function increases progressively due to the more expensive chips required by the electronics, for instance.

Scorecard Hierarchies

It makes sense to employ a Balanced Scorecard not only at the level of the entire company or in units that plan strategically. Instead it is beneficial to make communicating strategic objectives possible at all operational levels by setting up a scorecard hierarchy. Cascading scorecards are instrumental in making strategies transparent even at the lower levels of the organization, so that all business processes have a strategic direction.

The question of the number and integration of Balanced Scorecards is especially significant in large companies with complex structures. If we assume that companies unite multiple strategic business units (SBU) and subsidiaries under one roof in order to benefit from synergies, then cascading Balanced Scorecards are an appropriate instrument for bringing the strategies of the individual business units in line with one another. Corporate management provides a framework containing the general objectives, and these are translated into individual objectives. This enables the strategic business unit to have an individually formulated Balanced

Scorecard, with contents that are in agreement with the corporation-wide objectives and that therefore allow analyses of common objectives across all areas. In practice, there are even certain cases in which scorecards are broken down as far as to the level of individual employees, and these scorecards are then used in evaluating the employee’s performance (see section 7.1).

Procedure

First the overall strategy is divided into substrategies that consist of objectives. Very often there is also a further division into four perspectives: Financials, Customers, Internal Processes, and Innovation and Learning (see figure 3.7). However, you can also make divisions that suit your individual needs. For example, you can add a supplier or product perspective, if procurement or product development are critical success factors for the company (see section 7.1).

The use of various perspectives ensures that, along with the financial objectives and key figures, other areas are also included. At the same time this means that both long and short term aspects are considered.

At regular intervals, the responsible persons analyze the development of their objectives, initiatives, and key figures in the BSC. Statuses can either be set automatically using threshold values for key figures and aggregation rules, or they can be set manually. In many cases, the company links the attainment of given statuses of key figures, objectives, strategies, perspectives, or entire scorecards with variable, performance-based compensation of employees.

All persons and departments involved are connected to each other by a status reporting system, which allows them to exchange comments on the status and assessments. These may be called directly in the BSC. Experiences of BSC users substantiate the advantages of this openness. In contrast to traditional reporting systems, they find the benefit lies in an interpreted view of the strategy, with figures, facts, judgments and comments entered by the directly responsible persons. Kaplan and Norton also refer to this as "strategic learning by management" (Kaplan/Norton 1996b).

Elements

A Balanced Scorecard system is comprised of the following elements:

Perspective: Perspectives are the various viewpoints from which it is possible to consider the modeled connections. Usually there are four perspectives. However, the number of perspectives can vary depending on the business requirements.

Scorecard: Scorecards assist in monitoring the success achieved in making the overall strategy a reality. They encompass both current and planned key figures, as well as initiatives that are tied to objectives, and therefore also to strategies.

Strategy: A strategy is the top element of a scorecard. It is a part of the overallenterprise strategy, which is divided into sub-strategies for the sake of modeling.

Strategy category: Strategy categories are a means of classifying the defined strategies into groups. The basis is a one to many relationship: one strategy category groups together multiple strategies. Strategy categories help a user keep an overview when modeling. Objective: An objective describes a strategic goal within the framework of a perspective. Objectives are joined together into an overall strategy by means of cause-effect chains. The extent to which objectives are reached is determined by comparing the actual and planned values of the key figures that are assigned to the objective. Initiative: Initiatives are a set of activities that share the realization of one or more objectives as their purpose. A responsible person, a timeframe, and specific resources are allocated to each initiative.

Key figure: Key figures assist in measuring the degree to which the strategy has been put into effect. They are assigned to objectives and also receive a status thatallows a qualitative pronouncement to be made on the current value of the key figure as compared with the plan value (unsatisfactory, satisfactory, good, excellent, and so on). In addition, a firm may organize the key figures in a Value

Driver Tree (see section 5.2.3.2).

Risk: Risk can be seen as a completing factor to the other elements. There is the option of assigning risk to the key figures of a Balanced Scorecard and of quantifying the effects of key figures on risk. This opens up the possibility of integrated management of opportunities and risks. Certain companies have a legal obligation to set up a risk management system (see section 2.5), and these are thereby assisted to that end. Along with its verbal definition, a risk receives any number of value fields for a comprehensive and qualitative description of the risk situation.

Balanced Scorecard

The concept of the Balanced Scorecard (BSC), developed by Robert S. Kaplan and David P. Norton, links enterprise strategy to operational business processes, forming a framework for the distribution of resources in a firm. The BSC is often misunderstood as simply a grouping of key figures in four perspectives, where purely financial figures are augmented by non-financial ones. Key figures are certainly an important component of the BSC, but they do not comprise its backbone. Kaplan and Norton see the BSC as a strategic management system with the following aspects (Kaplan/Norton 1996a, also refer to the interview with David P. Norton in section 7.1):

1. Transparently formulated strategies

2. Communication of the strategy throughout the whole organization

3. Alignment of the strategy with the goals of employees

4. Linking objectives to the annual budget

5. Pinpointing of and agreement on strategic initiatives

6. Regular Performance Measurement with confirmations, and any strategy

changes

Benchmarking

Benchmarking is closely related to the analysis of competitors. By continuously comparing products, services, processes, and methods with those of other businesses, benchmarking attempts to ascertain the performance gap separating the firm from the “best in class.” At the same time, it should help to find ways of reducing this performance gap. The central figures here are productivity figures, turnaround times, costs, and quality. Benchmarking is not limited just to competitors. The following variants have been identified:

Internal benchmarking: Internal benchmarking compares functions and areas within the company. Data collection in this case is relatively simple. However, there is a danger of organizational blindness.

Benchmarking of competitors: Here the comparison is made with the strongest competitors. Usually it is extremely difficult to obtain the necessary data about the competition. In addition, limiting benchmarking to a particular branch or market can sometimes make it impossible to identify world class performers. This puts the company in danger of simply copying methods or processes within a branch of industry, thereby merely gaining equal footing with competitors rather than surpassing them.

General benchmarking: General benchmarking lifts the focus from an individual industry and instead seeks out top performers in all segments of the economy. Gathering data in this case is usually less difficult than for benchmarking of competitors. However, identifying suitable objects for comparison can be problematic.