Owners wanting to maximise the profitability of their business, and reduce the chances of it getting into financial difficulty, must embrace a business technical term that by itself does not mean a lot. That term is management accounting.
Financial Accounting Versus Management Accounting
From a technical point of view, there are two types of accounting. The first is financial accounting, which relates to the production of financial statements mainly on an annual basis. These statements include the balance sheet on the profit and loss statement that shows what the historical performance of a business has been.
Management accounting is more of an ongoing process because it involves measuring a business’s performance on a regular basis. Instead of just producing historical results, management accounting statements include other financial data to assess the performance of a business.
The best analogy for management accounting is the process that coaches for a sporting team go through when monitoring and improving the performance of their team. The coaches will break down the performance of their team into components and measure each of these separately. For example, in soccer the coaches not only measure how many goals are scored, but also how many shots, assists, tackles and passes a player makes.
These results are then compared with what the coach’s expectations are for each player, how the performance compares with previous games and how the performance compares to the opposition or competitors.
This measuring of performance by the coach is not limited to the grand final, but is carried out for every match played during the season.
Management accounting for your business should be no different – the measuring should be carried out throughout the financial year on at least a monthly basis.
When it comes to measuring the performance of your business, one of the most important things to consider is what the business is expected to achieve. This requires the preparation of a cash-flow budget that shows how your business is expected to perform over the next 12 months.
You need to look at each item in the profit and loss statement and estimate how your business will perform on at least a monthly basis over the next financial year.
The monthly cash-flow budget results for each income and expense item is then entered into the budget field of a profit and loss statement. This means that when looking at how your business has performed at the end of each month, you can compare the results against the expected results, and how the business performed in the previous year.
Benchmarking Your Results
For a small business, the next important step in management accounting is to benchmark these results against that of similar businesses.
Finding out the results of your competitors may seem impossible, but in actual fact it’s not that hard. One of the first places to get this information is from a professional or industry body that you belong to.
If the benchmarking results cannot be obtained from this source, your accountant could be subscribing to a benchmarking service and will be able to supply you with the required information.
If all else fails, the Australian Taxation Office (ATO) can be a great source of benchmarking information. The ATO produces benchmarking results for virtually all industries that lodge tax returns.
The ATO benchmarking results can be used to compare the performance of your business. This means that if your profitability is below what is expected by the ATO, it can provide insight into the areas of your business that need improving.
There is another benefit of using ATO benchmarks. If you receive a ‘please explain’ letter from them, asking why your business is underperforming against industry benchmarks, it can help you explain why this is happening and remove any suspicion that some form of tax avoidance is occurring.