Management Accounting | Introduction to Basic Concepts
Introduction and definition
Management gurus often say that when all is said and done, accounting is really about investigating where scarce financial resources are really going, so that their allocation and their use can be improved.
Business managers are almost always caught in a dilemma over which of their company activities show the most promise and deserve to be provided funds, and which do not.
Management accounting provides them the answers to these questions, equipping them with information that helps them decide what products to develop and sell, and how, where, and when to sell them.
Management accounting, or managerial accounting, is, by definition, the process of identifying, analysing, recording, and presenting financial information that can be used internally by managers for planning, decision-making, and operational control.
Scope of management accounting
Management accounting provides answers to typical questions that managers seek answers to. Here are examples of such questions:
- Which products bring in the maximum revenues and which products are the most expensive to produce?
- What is the increase in the labour wage component in the price of a particular product?
- What should be the ideal initial retail price of a new product?
- How much in sales does each rupee spent on marketing bring?
By facilitating planning (or strategy formulation), decision-making, and operational control, management accounting tells them what products to manufacture, where to manufacture them, and when.
It helps managers to predict future events in the light of past experiences and evolve short- and long-term policies.
It enables them to determine the resources, including labour, raw materials, and equipment, required for making their products successful in the marketplace.
It assists them in calculating the profit margins of products and even in finding out which departments and which managers have performed effectively and which have not.
In a nutshell, management accounting adopts crucial accounting, finance, and management approaches required to take a successful business forward.
In practice, management accounting increase knowledge within a business entity and, by doing so, reduces risks in decision-making.
Managers study the details of accountants’ reports on costs and revenues, and see whether specific, individual targets have been met. If not, they can take corrective action.
They can also compare overheads, productivity figures, hourly labour costs, and wastage, between departments and between time periods, for example.
Managerial accounting, therefore, is concerned primarily with many basic functions such as management planning, cost determination, cost control, and performance evaluation.
Comparison with financial accounting and cost accounting
We have already seen that financial accounting differs from management accounting mainly in the fact that while it (see the post “Financial accounting”) is aimed at external stakeholders of a business, such as creditors and investors, management accounting is meant for internal use by business managers.
While financial accounting provides information for decisions such as how to allocate funds and human resources among companies, management accounting provides data for decisions about how to allocate resources within a company. There are other differences, too, as follows.
- While financial accounting is legally mandatory for companies, they may or may not go in for managerial accounting, depending on their requirements.
- Financial accounting follows the Generally Accepted Accounting Principles (GAAP) or other norms standardised in the country where the business is operating, whereas management accounting does not follow any set rules but are specific to the company and its strategies.
- Financial accounting is “historical,” as it processes information from past events; management accounting, however, is futuristic, as it interprets data to predict future business situations.
- Because financial accounting is historical and draws data from events that have already occurred, there is more objectivity in it than there is in management accounting, which involves prediction and is forward-looking, and can, therefore, be subjective.
- Management accounting tends to be confidential and restricted to internal circulation, whereas financial accounting serves external stakeholders.
- Management accounting is a more complex exercise than financial accounting as managers require more specific information than external stakeholders.
- Management accounting reports are prepared more frequently—monthly, weekly, or even daily—than financial accounting reports (which are issued quarterly or annually), so that they convey information in real time.
How does management accounting differ from cost accounting, the third major type of accounting?
Cost accounting determines the costs of specific activities within a production process.
Management accounting includes this element of cost accounting and uses it in decision-making and strategy planning. Therefore, cost accounting can be said to be a part of management accounting with a much smaller scope.
Management Accounting Concepts
The main concepts of management accounting are related to estimating and tracking costs. In tune with this, management accounting concepts include cost analysis, cost behaviour, and cost variances.
For a manufacturing business, the applications of these concepts include dealing with the costs of acquiring raw materials, developing new products, and recruiting new workers, for example.
For a service business, the application of costs may include technical support and customer service training.
Cost-benefit analysis (CBA), also known as benefit-cost analysis, is a systematic approach to estimating the benefits or advantages of implementing a business project or taking a course of action and comparing them with the costs involved.
It is a tool that helps business managers choose the best option from a set of alternatives in terms of benefits in labour, time, and cost savings.
The CBA is a procedure for ascertaining whether benefits outweigh costs or vice versa, and allows managers to determine whether an investment or another decision is justified.
In using CBA, monetary values are assigned to assumed costs of a project and benefits from it. The time taken for the benefits to repay the costs is also calculated.
Let us take a simple example.
Suppose a furniture shop is doing very well and is overburdened by contracts. At this time, the shop owner secures a new contract worth Rs. 100,000 that has to be completed in three months. He knows that he can hire an additional carpenter to take up the new project for monthly wages of Rs. 30,000 or total wages of Rs. 90,000.
Should he take up the contract?
This is where a CBA of the business situation helps: a CBA would tell him that he would gain Rs. 10,000 when the contract is fulfilled at the end of three months, that the benefit outweighs the cost by 10 percent, and that he should probably accept the contract.
A CBA for a project in a company will certainly be more sophisticated than the simple example above.
Two factors — the assumption of benefit and the time taken for the benefits to start justifying the cost, called the payback time — are what will make it a complex exercise.
The net present value of the benefit will have to be calculated by taking into account the inflation and the “lost return of investment” (the income that could have been earned if the funds spent on the project were invested somewhere else, in a fixed deposit in a bank, for example).
In the story of the furniture shop above, the gain calculated at this present moment is Rs. 10,000, but it may actually be less at the end of three months because of inflation and lost return of investment.
Yet another factor, the payback time, has to be decided as part of a CBA. In the example above, if the new carpenter takes an additional 10 days to complete the project and overshoots the deadline, the benefit will be completely wiped out
Another matter to consider is that there may be benefits that cannot be assessed in terms of money—in the example above, the benefit earned by getting a new customer. When implementing some projects, it may be difficult to ascertain the actual benefits in monetary terms and the CBA may prove to be subjective.
Moreover, it is difficult to use CBA when the benefits accrue over a period of time, and the value of money changes because of inflation, etc. In such cases, net present value and internal rate of return calculations can be used to find out the project benefits.
A Balanced Scorecard, developed by Robert S. Kaplan and David P. Norton, is a strategy tool that helps clarify the vision or mission statement of a corporation and prepare a development plan that involves all the different wings of the business entity.
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In the industrial age, manufacturing companies focused mainly on financial performance, ignoring aspects such as customer satisfaction. For example, a company in those days would not worry too much about cutting down customer service costs to improve profits.
In this current information age, few companies can afford to take such a limited view.
A Balanced Scorecard helps them to view organisational functions from four perspectives and improve each.
The four perspectives are the learning and growth perspective, business process perspective, customer perspective, and finance perspective.
The idea is that by improving the learning and development (human resources) perspective, the business process would improve, leading to better customer satisfaction, which would then bring increased profits. Objectives, measures, targets, and initiatives are identified for action under each perspective.
Since the collection and communication of data for a Balanced Scorecard can be laborious, companies now use custom-made or commercially available software packages.
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