Internal Accounting

Implementation of Internal Accounting

An Analysis Made for the Internal Accounting Structure
By Emanuel Schwarz

Previous articles featured on Pro2Net have emphasized the importance of separating the financial accounting structure (the external chart of accounts), from the internal accounting
structure.

This new Internal structure will be developed in accordance to managerial information needs.

A basic structure is necessary to arrive at an internal system that will be perfect for cost accounting purposes. Here we will discuss the basic classes of accounts that are necessary in internal accounting:

Cost Elements

Just as in general accounting, all expense accounts must be analyzed and matched to the sales-revenue accounts.

The same basic procedure must be realized in the creation of an internal accounting structure. However, cost is not matched to the amount of sales, but to the production activity volume of the company.
It is important to recognize that within a company’s internal accounting system, we are not interested in the amount of the sales and revenues. The sales accounts correspond to general accounting (external accounting) and not to internal accounting.

Internal Accounting must shift its focus away from traditional Financial Accounting terminology and instead emphasize internal value movements. Instead of merely categorizing costs based on inventory or income statement relevance, the goal is to track the true flow of cost absorption and allocation within the organization—reflecting operational efficiency rather than external reporting requirements.

By structuring accounts around functional activities, direct and indirect cost distribution, and responsibility accounting, Internal Accounting provides decision-useful financial insights that traditional cost frameworks overlook. This perspective ensures costs are accurately assigned based on usage, optimizing transparency in production costing, lease transactions, and departmental financial structures.

Would you like an example of how value movements should be recorded within an Internal Accounting structure?

Internal Accounting determines true production costs, which then transition to Finished Goods Inventory within External Accounting. This ensures accurate cost valuation for financial reporting.

Once goods are sold, the Cost of Goods Sold (COGS) is derived from these production cost records, ensuring expenses align with revenue recognition. This structured approach provides financial clarity, maintains cost integrity, and supports effective pricing strategies.

Would you like assistance in refining transaction entries for the sales activity phase?

All costs within the Cost Elements class should be categorized into two fundamental groups:

  1. Direct Costs – Expenses that can be directly traced to a specific product, project, or production unit. Examples include:

    • Raw materials

    • Direct labor

    • Machine usage cost (allocated per unit of production)

    • Specific manufacturing supplies

  2. Indirect Costs – Costs that support overall operations but cannot be directly linked to a single product. These are allocated systematically across departments. Examples include:

    • Factory overhead (utilities, rent, insurance)

    • Maintenance and repairs

    • Administrative expenses

    • Depreciation on equipment

By structuring costs within these groups, Internal Accounting gains clarity in responsibility allocation and cost absorption, ensuring accurate financial tracking for managerial decision-making.

Group 1 – All cost elements that are identified as directly related to production will be allocated from this cost element class directly to the production class of accounts. These direct costs are also identified as variable costs because these costs vary proportionately with the changes in the activity level.
Group 2 – All cost elements that cannot be identified as directly related to production will be allocated from this cost element class directly to the cost center class of accounts. These indirect costs are also identified as fixed costs because these costs do not vary proportionately with the changes in the activity level.
These two groups help us to allocate all cost elements to the right accounts. We identify these costs with their association to the final cost objective of production. This is very helpful to fulfill the next two important steps of configuring an internal accounting structure. There must be a clear identification and structure of a responsibility accounting system and production cost accounts.

The responsibility accounting system refers to all departments and cost centers in a company.

The term departmental operating cost provides greater clarity and aligns with the structured nature of a Responsibility Accounting System. By categorizing costs based on functional departments and cost centers, businesses enhance financial transparency and ensure more precise allocation of indirect expenses.

This approach shifts the focus from broad, ambiguous “overhead” classifications to specific departmental financial structures, making cost tracking more effective for managerial decision-making.

Indirect costs are distributed across departments, and within each department, specific cost centers—such as individual machines—are identified for precise expense tracking.

This approach ensures that every machine operates as a distinct cost center, allowing businesses to analyze its actual operating cost per hour and optimize financial allocation. By structuring costs at this granular level, manufacturers achieve greater transparency in machine efficiency, resource utilization, and production expense distribution within their Internal Accounting framework.

The graphic depicts to the basic structure of Internal Accounting. Internal accounting starts with the cost elements, which must be:
  • Allocated to the different departments as indirect cost;
  • Allocated to the different production cost accounts as direct cost; and
  • Allocated to the different cost of goods sold as production cost.

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