The primary purpose of doing business is to earn and maximize profit. Good decision making can make it possible. The art of accounting provides support for these business decisions. There are two main branches of accounting, financial accounting, and management accounting. Financial accounting is used to report the business’s financial activities, which are afterward used by Internal and external stakeholders for their decision-making. In contrast, management accounting is solely used by the management for business decisions.
Usually, trading and services business and particularly manufacturing business uses it for making the following decisions:
- What will be the cost of a service or product?
- How much should be the selling price?
- Which measures businesses should take to reduce their cost.
- What will be the effect on sales volume if the selling price is reduced?
- What will be the effect on sales volume if the cost is increased or decreased?
- Should we make our product or buy from the market for reselling?
- How will an asset benefit the organization if purchased?
- What will be the forecasted sales and cost of a product?
All these questions will be answered, taking into consideration the help of management accounting. Due to intense competition, the sale price of a product is decided with due care. A small extra charge can lead a business to a considerable loss. A right pricing decision wholly depends upon the costing of a product or service. There are three main components of a product’s cost, material, labor, and expenses. Reasonable costing starts with efficient handling of material. Timely ordering and the efficient issuing procedure can save material costs because management accounting’s core purpose is to optimize business resources. Labor cost and efficiency are the second main elements contributing most to the costing system after material. Management accounting guides us on how other manufacturing expenses can be controlled.
A specific amount of margin is added to the cost to arrive at the sales price. A single unit price doesn’t provide us complete analysis; the number of units sold is equally essential. Cost-volume-profit analysis is further carried out in management accounting to check the profit at different sales price levels and the number of units sold.
A term, cost behavior, is used in management accounting, which explains costs from different dimensions. According to behavior, the cost is divided into a variable cost, fixed cost, and mixed cost. Variable cost changes with the production level in the production process; therefore, it is easy to control it whenever fixed cost remains constant throughout the production process. Management accountants prepare production cost reports, which helps managers to make decisions regarding the make or buy.
As we discussed above, management accounting’s core usage is to make optimum uses of business resources. Massive investments are made in property, plant, and equipment. Through management accounting techniques, reports are generated by management accountants to assess the future return of these assets. These investments are further analyzed through capital budgeting techniques. The most straightforward method is the payback period; it tells the management how much time this investment will return. The other frequently used techniques in management accounting are NPV (Net Present Value), IRR (Internal Rate of Return), and ARR (Accounting Rate of Return). The net present value is the difference between the cost of investment and the present value of future cash flows. Suppose a business has invested $200,000 in a plant, which will return $50,000 each year for six years. The present value of this total cash inflow of $300,000 is $250,000. Hence, the project’s net present value will be $50,000, which shows that the investment is beneficial for business. The other two techniques are also used to compare the cost and benefits of these assets.
In our personal lives, we always make some plans for the achievement of long term goals. These plans are based on future forecasting. In management accounting, this future forecasting is termed as budgeting. The managers have to prepare the budgets for sales, production, materials, labor, and expenses. The sales budget is designed based on the previous year’s actual performance. All other budgets depend upon the sales budget because we couldn’t plan the upcoming production without the estimation of sales. Different types of measures are used to estimate the sales of the next accounting period. Based on these forecasted sales, managers will further plan the quantity of material, availability and cost of labor, and estimation of manufacturing expenses. So, without management accounting, budgeting is not possible.
Management is a composition of four functions, planning, organizing, leading, and controlling. In management accounting, all these four functions are implemented in an organization through periodic reports. These reports can be generated when required, unlike the financial statements prepared at the end of the accounting period. Financial accounting is used just for reporting; it doesn’t provide any help for resources management. Management accounting is used to ascertain the cost of a product and for the management of resources also. It helps management make strategic plans, break them into small goals, and evaluate these goals and accomplish these strategic plans. Managers can delay financial reporting, but the management accountant’s functions can’t be delayed because its operations are necessary for business’ smooth operations. It’s a myth that management accounting is used just for the costing of manufacturing organizations. It is widely used in the merchandising business, as well as a services business.