‘Accounting’ forms an important part of any business organization regardless of its nature, size or structure. It is the process by which a business is able to record, classify, summarize and analyse the business transactions and communicate financial information to the decision makers and users of such information both inside and outside the business organization.
Organizations, today, are operating in complex business environment that is marked by intense competition, complicated organization structures, multiple stakeholders, regulations and procedures. This has meant increased uncertainty for the business enterprises and, therefore, made quality decision making more important than ever.
Thus, the management of a business enterprise needs to undertake several key decisions for smooth running of the day to day operations. These include decisions in respect of resource allocation, sources of capital, budget allocation, cost control, policy formulation etc.
But, all these decisions primarily depend on the quality of information provided to the management. More reasonable the financial information provided to the management, the better the decisions undertaken by the management.
This is where management accounting plays its role. Management accounting is a branch of accounting that assists the management in formulating policies, planning and controlling the operations of a business enterprise. Thus, in contrast to financial and cost accounting, management accounting is termed as internal accounting. This is because it collects information from financial and cost accounting systems, processes the data so as to make it useful for the management in decision making process.
In this article you will learn the concept of management accounting, its functions and techniques used in management accounting.
What is Management Accounting?
As per American Accounting Association, management accounting is the use of appropriate techniques and concepts in processing historical data and projecting economic data of a business entity:
- to assist the management in formulating plans for reasonable economic objectives and
- in making rational decisions with a view towards these objectives.
Similarly, according to the Chartered Institute of Management Accountants (CIMA), London, management accounting is an essential part of management concerned with identifying, presenting and interpreting information used for:
- formulating strategies
- planning and controlling activities
- decision making
- providing information to shareholders and other stakeholders of the business entity
- providing information to employees
- optimizing the use of resources and
- protecting assets of the business entity
Thus, management accounting makes use of certain tools and techniques to produce accounting information that is useful for the management. Further, in addition to past economic data, it makes use of projected economic data as well as non – accounting information to undertake effective decision making.
Functions of Management Accounting
All the transactions or activities that are undertaken to run day – to – day operations are the result of decisions taken by the management.These transactions or activities impact the functioning and overall performance of the business entity.
Since these activities affect the health of the business, it is necessary to record, measure, evaluate and report them to the management. This is to enable the management to analyse how its decisions are affecting the overall position of the enterprise and take requisite actions accordingly.
With the help of management accounting, the management is able to apply the tools and techniques that help in evaluating its decisions and see if such decisions lead to meeting the enterprise objectives.
Further, management accounting helps the management in formulating plans and policies, analyse the accounting information, make decisions, control overall performance etc.
Thus, management accounting performs a number of functions to meet its objectives. These are as follows:
Planning and Forecasting
Planning is an indispensable part of any business enterprise. Management accounting assists the management to undertake planning so as to achieve the underlying objectives of the business entity.
Thus, once the management decides upon the company objectives, it needs to define a set of activities necessary to be implemented in order to achieve those objectives.
For instance, with financial planning technique of management accounting, the management decides upon (i) the financial goals that need to be achieved, (ii) formulates financial policies in respect of sources of capital, resource allocation etc and (iii) laying out financial processes.
Likewise, forecasting too is a function of management accounting that assesses the possible future events. It makes use of the historical information to understand trends and make informed judgments.
Management accounting involves forecasting in respect of sales, expenses, costs and the financial needs of the business. Various quantitative and qualitative forecasting techniques are implemented to understand the relationship between various factors that can impact the business.
Management needs to examine and take investment decisions with regards to the acquisition of fixed assets. That is, which fixed assets it must acquire and which it must not.
These are crucial decisions as reversing such decisions would mean higher costs for companies. Further, these decisions give benefits to the business entity over a long period of time.
Thus, capital budgeting is a process that involves evaluating the capital expenditures and their underlying returns so that investment in most profitable projects can be made.
By using various capital budgeting techniques including NPV analysis, IRR, payback period etc, management is able to evaluate capital investments and take buying decisions accordingly.
Financial Statement Analysis
Another important function of management accounting includes Financial Statement Analysis. This is the process of evaluating the financial data provided by the financial statements including income statement, balance sheet and cash flow statement.
Such an analysis helps the management in understanding the financial position and operating performance of the business. It also helps in forecasting the future condition and performance of the company.
There are various techniques used by the management to undertake financial statement analysis. These primarily include trend analysis, common size statement analysis, comparative statement analysis, ratio analysis etc. This provides useful economic data to the management that further helps in decision making process.
Variance analysis is another important function of management accounting. It is the study of the differences between the standard, budgeted or planned figures and the actual figures.
Under variance analysis, management compares the standard or planned costs to the actual costs and measures the variation. This is done to understand the overall performance of the business entity and take requisite control measures to fix the problems.
Thus variance analysis involves:
- Calculating the variances
- Determining the underlying reasons for each of the variances.
This helps the management to know the individual variances, factors responsible for such variances and corrective measures that are necessary to be taken to reduce the variances and improve the overall performance.
Break Even Analysis
Break even analysis is undertaken to understand the number of goods or services that a business needs to sell at a given price or the amount of revenue it needs to earn in order to cover its fixed costs.
The key figure monitored by the management under break even analysis is the break even point. It is nothing but a point where the volume of sales are such that they cover the fixed cost of the business entity.
Break even point is calculated by dividing fixed costs with the difference between per unit sales price and per unit variable cost.
Fixed costs are the costs that do not change with the changing output. Sale price is the selling price per unit of output and variable costs that are needed to produce a unit of output. Therefore, variable costs vary with the changing output.
Marginal costing is nothing but the incremental cost of producing additional goods or services. This management accounting function gives management information in respect of nature of costs and impact of such costs on the profits of the business entity.
Thus, under marginal costing, costs are divided into fixed and variable costs. Further, marginal cost is calculated to see the impact of changes in the number of units of output or type of output on the profits the business entity.