Executive management’s job is to provide sets of directives that show the way they want their business to expand. These are often goals about financial success but can include bold statements on innovation, employee recognition, company brand or a number of other things that seemingly have nothing to do with the bottom line. In order for management to set goals that are achievable, it’s important that they have the information they need to make good decisions.
Not all decisions can be made based on money, but in the end, the business’s financial performance will determine its future. It’s up to managers and executives to learn how to strategically use financial information to make intentional decisions that will line up with the company’s overall objectives and goals but will also allow the company to continue to be profitable.
Being able to evaluate performance over time also helps managers estimate how quickly business and policy changes move through the company. This then helps them better time announcements, upgrades and expansions. Most businesses have dreams, and it’s up to the company to be successful enough that profits can be reinvested in the business for it to expand and grow.
Management accounting, also known as managerial accounting or cost accounting, is the collection of methods used to analyze a business’s financial performance internally to better make managerial decisions to direct the company.
In contrast, financial accounting is the practice of compiling financial reports containing relevant information for external parties, such as auditors, in compliance with laws and regulations. The objectives of management accounting are to focus entirely on internal decision making, and it is used for strategic planning as well as to make decisions on pricing, operations and capital planning.
The characteristics of managerial accounting allow the departments within the business a better understanding of how their work affects the company’s bottom line, shows them what’s available in the capital budget to plan for future improvements and highlights areas of higher profitability to help guide business control decisions. The information is usually presented in a managerial report compiled by the accounting and finance departments, including analysis of costs and profits in a somewhat standard format.
Accountants use a variety of techniques to take the vast amount of financial data available and calculate a set of values and trends that will give management meaningful information. These include product costing, inventory valuation, margin analysis, constraint analysis and forecasting.
Product costing summarizes the accounting transactions required to produce the goods or services being offered and then compares them to the standard/expected cost to see whether the assumptions made within the previous accounting period’s budget were correct. This allows management to review the costs that went into production of their final product, mark any inputs that varied outside of their expected range and evaluate product pricing as needed.
This is extra important in markets that fluctuate or for products whose raw material prices can vary from month to month. Product costing should be robust enough to absorb these kinds of potential upsets.
Inventory valuation is usually done in hand with product costing in order to get details on the production process as a whole. The entire inventory of the company’s goods and products is valued, and the cost of keeping that inventory is summed.
This can help build a picture of overhead cost, which is an important piece of understanding the real product cost. It also gives management an image of the product mix in storage and whether that product mix matches what’s moving on the market.
Margin analysis examines the incremental benefits of increased production, which determines the break-even point for production rates. It’s used to predict the most profitable product mix but can also shine some light on the more physical limitations of production and identify areas for capital project improvement that could shift the sales mix into a more profitable area. The focus is mainly on developing a product mix that matches demand in the most efficient way for production.
Constraint analysis looks at the production process as a whole to further identify bottlenecks and roadblocks in the production process. It looks at the costs of certain steps as well as the production levels achieved in different process pieces and can help build a picture of areas that need improvement. This usually focuses on a rate-limiting step in production or in the process that could result in higher production numbers if expanded.
Account forecasting occurs when accountants look at trends in past data and use their knowledge of the business's financials to predict future information. This can help management estimate budget costs for the next accounting period as well as identify periods of unusual deviation to be examined. Forecasting should be paired carefully with knowledge of the market in order to keep expectations within the realm of possibility.
The accounting department also often evaluates its own records to ensure that the flow of cash and assets into and out of the company is functioning efficiently. These can also help management better understand the financial functions of the company, which makes for better financial decisions. These types of reports include:
- Budget Reporting: This report compares actual expenses to the predicted or planned expenses in the last accounting period’s budget. These budget projections usually come from historical budgeting data, with changes made as planned to match the company’s forward plan. These reports can show areas where budget predictions were either too high or too low, helping managers understand where to cut costs and where to focus attention. Budget reports are usually pulled by department so that the managers can review the costs for which they are responsible and suggest budget changes.
- Accounts Receivable Aging: This specific report looks at outstanding customer balances not yet paid within a set amount of time (usually 30, 60 and 90 days). If too much money is owed, the company’s cash flow can be affected, and short-term operations may fluctuate. This helps narrow down customers for accounts receivable to contact but can also suggest a change in the company’s credit terms if invoices are not paid on time. Efficient use of company credit is important to keep budgets on track.
An area not yet mentioned within the purview of managerial accounting is the capital budget_._ The importance of the capital budget usually depends on the industry in question. A company focusing on services like insurance will have a capital budget that is completely different than a manufacturing company, for example.
The amount to be included in the capital budget is usually set by executive management and does not always include enough to cover every capital project request. The capital budget is not treated like an overhead budget. Capital is for investments into the business’s processes and resources, while overhead is the cost of the business as it is in the moment.
Managerial accounting will look at proposed capital projects and use a set of tools and estimates to determine whether a project should move forward.
- Internal Rate of Return: This compares the cost of the project itself with the expected cash flow return of the project once completed. The concept is simple: Projects that return more than what they cost increase the business’s value. Projects with a higher IRR are expected to bring in more money than those with a lower IRR, which usually puts them at top priority over other work. Projects with a lower IRR may, however, be prioritized if they bring something else of value to the table, such as a new product.
- Payback Period: This refers to the length of time needed to reach the break-even point — when the project has paid for itself. Depending on the scope of the project, this can be anywhere from weeks to years. Projects with a long payback period (10+ years) are less likely to be chosen than those with shorter payback periods, although longer-term projects always need to be considered when they impact the useful life of the production facility.
- Avoidance Analysis: This is a way to evaluate whether maintenance or repair can significantly extend the lifetime or function of existing assets rather than purchasing new ones. It’s important to consider the costs of repair, downtime and potentially limited operation against new features, improved reliability and upgraded equipment. This analysis will help determine whether it’s better to repair or replace.
For capital budget projects that have already been approved, it’s important to track the project’s spending and how much of that spending has actually been invoiced and paid.
Capital budget accounting is constrained by accounting rules, and it’s important to be sure invoices are pulled from the capital fund. Otherwise, if dates are missed and accounts are closed, those costs could end up coming out of an operating budget instead. Reports on ongoing projects track projected spending versus actual spending and project progress against the initial plan, and they detail any unexpected expenses or time delays that may have occurred.
The managerial accounting reports usually focus on short-term periods, analyzing recent business for a period of maybe three months, or a quarter. This allows management to focus on the business market as it is right now over a short period and make predictions likely for the next quarter as well. It also helps to narrow down the time of evaluation to more directly see the impact a change in business may have made on company figures. Looking at financials over the previous year won’t give any information about a small change made in March, for example.
That’s not to say that long-term accounting reports have no place. In fact, it’s important to look at these financial variables over both short-term and long-term periods. Looking back at monthly values over a year can give a trend of the company’s performance and provide an understanding of whether things moved in the expected directions or not.
Capital budget spending is usually analyzed at the end of a year before new projects open up for the following year. Monthly spending on procurement, overhead and inventory can be analyzed. This will help highlight months where upsets or unexpected market fluctuations have influenced the business’s bottom line.
In today’s business atmosphere, most of these calculations and summaries can be done by enterprise software systems, which have the usual accounting functions built in to help finances run smoothly.
These systems usually automate basic accounting functions like purchase orders, approvals, receiving and requisitioning so that the department has all of this information linked together at its fingertips. There are significant benefits to having systems like this, namely because it allows accountants to drill down into upsets and discrepancies to really determine the problem at hand.
It’s worth working through the wide amount of data available to distill it down to a set of numbers that anyone in the organization can understand. Managerial accounting reports provide this distillation of information to be used by all department managers when decisions must be made.