Cost Accounting Strategies for Multinational Corporations

Introduction

Strategic Sources, Inc. is a multinational organization that operates in 20 countries around the world. It offers a wide variety of products and services to its customers. Its extensive business portfolio includes portions of the organization that serve as suppliers for other parts of the organization. In an effort to increase profit margins, the Chief Financial Officer has been appointed the task of presenting options for cost accounting that will help maximize profit margins not only in individual units, but in the organization as a whole.

The following sections present options for achieving this goal, addressing three different approaches to cost accounting: making individual managers cost center managers, profit center managers, or investment center managers. Additionally, three different approaches to costing products or services are examined — marginal or variable costing, full or absorption costing, and activity-based costing.

Cost Center Management

Companies may choose to classify their divisions as cost centers when the divisions of the company are clearly defined and costs are easy to measure. Establishing business units as cost centers simplifies accounting for both the unit and the parent company. However, cost centers can create incentives for managers to reduce operating costs within their unit in ways that benefit themselves at the expense of the broader organization. This can negatively impact the parent company by creating poor customer experiences, which ultimately results in lost sales and diminished brand equity. Cost centers can also become easy targets for layoffs and downsizing when budgets are cut.

Operational decisions in a cost center are often driven by cost considerations. Indirect costs are frequently difficult to translate into their effect on profitability. For instance, new equipment purchases might not realize a profit until sometime in the future. Cost centers may not appreciate the benefit of such long-term purchases and therefore may not make the decision to acquire them. Cost centers tend to seek profit quickly and in easily measurable ways, and must be able to immediately justify expenditures — which is not always possible.

A cost center does not necessarily generate revenue directly, but it does contribute to revenue generation within the company as a whole. Some cost centers do not generate revenue at all — for example, a personnel department or a customer call center. These services are paid for by the company's sales, but they do not directly create sales themselves. Yet without them, sales for the entire company would decrease. An IT department is a common example of this type of cost center (Bahel, 2010).

In a cost center, profitability is usually determined by subtracting only those costs that the manager can control and directly attribute to their unit from the revenues. When costs are shared between several divisions, one unit may receive a disproportionate benefit from an expenditure while still sharing equally in its costs. Cost centers often experience disproportionate costs and benefits relative to their use of capital. This arrangement generally works best for companies that are fairly centralized.

The more assets and overhead that can be shared, the greater the success with the cost center management approach. For instance, in a manufacturing facility where all units are located under a central roof and share utilities and personnel, the cost center approach can be very effective. In this case, all cost centers share equally in operational costs and each receives some benefit from them as well. One key disadvantage of the cost center approach is that managers must absorb costs they did not control and that were handed down from above — yet they must still find ways within their department to absorb those costs and remain profitable. Power and control in the cost center approach is weighted toward the company as a whole, and individual cost centers may struggle to meet their own goals.

Profit Center Management

A profit center differs from a cost center in that it is treated as if it were an entirely separate business entity. Profits and losses at each center are calculated separately, and the manager of a profit center is responsible for both revenues and expenditures. The manager must drive sales so that cash inflows outpace cash outflows — an arrangement similar to running an independent business. This differs from the cost center model, where the manager is only responsible for keeping costs down and activities are limited to those producing tangible, measurable results.

Management can easily track how much each profit center contributes and compare it against the contributions of other centers. The profit center approach is easier to monitor in terms of performance, and it has the advantage of quickly identifying which divisions are profitable and which are not, allowing resolutions to be implemented swiftly. However, a disadvantage is that one manager's decisions can have a detrimental effect on the rest of the business.

Profit center approaches are typically applied to decentralized businesses. Each unit must often maintain its own facility and assume its own operational costs — utilities, personnel, physical premises, and administrative and maintenance staff. Unlike cost centers, profit centers cannot share centralized services, but they receive direct benefit from their own expenditures. Managers operating under the profit center approach are often under considerable pressure to meet goals because they bear direct responsibility for them. With the adoption of activity-based costing, the definitions of cost and profit centers are evolving (Kaplan, 2006), and there is a growing trend toward transforming cost centers into profit centers (Leonard, 2006).

Marginal or Variable Costing

Variable costing takes into account costs that vary from a fixed amount. Many of these variations involve relatively small fluctuations that occur over limited periods. The marginal cost of a product refers to its variable cost. Typical variable costs include labor, materials, and a portion of overhead. Marginal costing incorporates the principle that as output increases, the cost per unit normally decreases as costs are spread over more units. If output decreases, the cost per unit typically increases.

Variable costing is typically used in manufacturing. For example, if a factory produces 100 toasters at a total cost of $300 and then produces one additional unit, bringing total cost to $302, the marginal cost of that additional toaster is $2.00. This is sometimes referred to as Cost-Volume-Profit (CVP) Analysis. Managerial decision-making in areas involving cost-per-unit analysis, such as manufacturing, is well suited to variable costing methods.

Variable costing is also applied in managerial decisions involving stock and inventory valuation. Profit measurement is valued at the marginal cost per unit of stock. This has become an important costing method for companies that operate warehouses associated with online storefronts. Variable costing is most suitable for situations where revenues and profit margins are dependent on a certain level or volume of activity. However, several assumptions must be considered in the valuation process: constant sales price, constant variable cost per unit, constant total fixed costs, and a constant sales mix. It is not appropriate for businesses that frequently change the types of inventory they carry. In a company where unit costs are critical, full absorption costing can result in inaccurate pricing schemes, as it does not link directly to unit cost. Activity-based costing is similarly not appropriate in this context, because it is difficult to divide variable overhead costs into unit cost. For unit-based manufacturing, variable costing is typically the most appropriate method.

Variable costing can also be used when a company manufactures many different product lines, particularly when production occurs at a set, predictable rate. For instance, a manufacturer may have several product lines and know precisely how fast each line produces units and the exact cost of producing each unit. A cereal company, for example, might have separate lines for several different brands and know the inputs required to produce a given number of units on each line. Variable costing would give the most accurate picture of the costs associated with each unit in this scenario, especially when labor costs are approximately equal across units and production runs at a steady, constant pace.

Variable costing would not be the best choice if several different products were produced on the same line, with intermediary setup time between runs, or if those products ran at different rates and produced varying numbers of units. In such cases, absorption costing, activity-based costing, or a combination of both would be more appropriate.

Conclusion

The appropriate costing method depends on the nature of the business being conducted. Activity-based costing is becoming more popular in many areas where traditional variable costing was previously used exclusively. Many manufacturers and service providers now use a combination of direct and indirect cost approaches combined with activity-based costing methods. Organizations are not required to adhere rigidly to a single method; many accountants develop a system specifically designed for their particular business or industry.

For a large multinational corporation such as Strategic Sources, Inc., the recommendation is to implement a layered approach: a centralized corporate headquarters functioning as an investment center, country-level units operating as profit centers, and functional units within each profit center managed as cost centers. Similarly, no single costing methodology will serve all units equally well. Variable costing may be appropriate for high-volume, steady-rate production units; absorption costing for units with constant production and fluctuating sales; and activity-based costing for units with complex, multi-step, or variable-volume production processes. A carefully designed combination of these approaches will most accurately reflect the true costs and profitability across the organization.

References

Bahel, J. (2010). IT departments can be profit centers. The National Law Journal, 4 May 2010.

Kaplan, R. (2006). The demise of cost and profit centers (Working Paper 07-30). Harvard Business School.

Leonard, S. (2006). Turning your CRA program from a cost center into a profit center. Community Banker.

Portz, K., & Lere, J. (2010). Cost center practices in Germany and the United States: Impact of country differences on managerial accounting practices. American Journal of Business, 25(1).