Managerial accounting is an accounting system that aims to provide information to managers and internal users for decision-making. Information obtained from managerial accounting can help management fulfill its planning, organizing, and monitoring functions.
While not typically considered a bookkeeping task, small businesses can benefit greatly from a bookkeeper who can perform some basic managerial accounting. This is because it helps small business owners and managers make rational and informed decisions for major and minor business undertakings.
KEY TAKEAWAYS
- Managerial accounting produces accounting information for internal users. Thus, this information is not intended for external users.
- There is no specific set of standards governing managerial accounting. Generally Accepted Accounting Principles (GAAP) rules may be applied but are not required.
- Small businesses can benefit greatly from the services of a managerial accountant, especially if the business wants to improve its processes and products.
Purposes of Managerial Accounting for Small Businesses
1. Making Informed Decisions
It’s important that managers and owners make decisions based on actionable information. Managerial accounting can help gather and process accounting information that can be used to make decisions.
For example, small businesses can conduct financial statement analysis to assess the business’ liquidity, solvency, and performance before applying for a small business loan. In this way, small business owners can evaluate if there is indeed a need for external financing and if the business can repay the loan.
2. Planning for the Future
Managerial accounting aims to provide information concerning the future. Through forecasts and budgets, small businesses can plan business operations, anticipate changes, allocate resources, and prepare room for growth.
3. Improving & Gauging Performance
To make a profit has always been the primary short-term goal of every small business while growth is always the long-term goal. Through managerial accounting reports, small business owners can assess if the company is meeting its short- and long-term goals.
By comparing budgets with actual results, managers and small business owners can assess if the employees are performing accordingly. It also lets them see if business goals are being met with resource efficiency in mind.
Managerial accounting focuses mainly on internal users—unlike financial accounting, which caters to external users. Reports from managerial accounting don’t comply with GAAP but are merely intended to help small business owners make rational decisions.
Pillars of Managerial Accounting
The concept of managerial accounting is intertwined with the concept of management. Managerial accounting takes three out of the five functions of management.
1. Planning
Planning is the process of setting goals and objectives and determining how these can be achieved. In managerial accounting, planning involves creating forecasts and budgets that translate the business’ goals and objectives into quantitative information. The main tool used in planning is the master budget or the business’ main financial planning document, which contains lower-level budgets.
2. Organizing
Organizing is the process of using and allocating business resources to put plans into action. In management theory, organizing pertains to the delegation of tasks, assignment of responsibilities, execution of plans, and creation of the organizational chart. Managerial accounting helps in organizing the business by aiding management with reports that help managers act upon business problems and operational bottlenecks.
3. Monitoring
Monitoring is the process of evaluating the business’ performance in achieving its plans. It involves comparing actual results with planned results and assessing whether the business was able to meet, exceed, or fall short in its goals. Managerial accounting helps in providing variance analysis reports, segment reports, and budget-to-actual comparisons to provide quantitative insights.
Types of Managerial Accounting
Managerial accounting covers a diverse set of accounting concepts that mainly helps managers and small business owners make a decision. Knowing what’s included in managerial accounting can help you determine which tools you need to conduct analysis when needed. Here are the eight types of managerial accounting:
Budgeting & Profit Planning
Budgeting is the process of formalizing business goals and objectives into quantitative form. The end result of budgeting is a budget, a document that shows the business’ commitment to execute plans, acquire resources, and use resources. The central document for the financial aspect of business planning is the master budget. It is an aggregation of all lower-level budgets, schedules, and proforma financial statements.
In other words, the master budget is the perceived results of the business’ efforts in achieving business goals. It serves as a guide for all members of the organization to align their personal goals with the growth of the business. It is important to include employees in the budgeting process since their participation enhances morale and encourages them to be proactive rather than reactive.
You can check out our article on sales forecasting and our guide to creating a budget, which includes a downloadable budget template.
Cost Accounting
Cost accounting is one of the crucial subsets of managerial accounting. This subset also serves as the bridge between financial accounting and managerial accounting. Since the objective of every for-profit business is to generate profit, proper accounting for costs is necessary to manage a profitable business.
Cost is the monetary measure of resources used to produce a good or perform a service. We can simply refer to cost as the money we pay to suppliers for purchasing goods and services or the money we pay to other parties, such as employees or utility companies, to obtain certain benefits for the business.
We can define cost further based on its classifications.
Overhead are costs that can’t be directly traced to the business products and services. Since tracing them is difficult, it’s best to allocate them. The most common overhead allocation method is using a predetermined overhead rate. Cost accounting calls this practice “peanut-butter costing” because overhead costs are allocated evenly across all products and services using broad averages.
While this is easy and convenient, allocating overhead evenly can result in overcosting or undercosting of products and services. Hence, some businesses implement activity-based management and activity-based costing (ABC). The ABC method of overhead allocation eliminates the use of broad averages. Instead, ABC computes overhead rates based on cost pools divided by cost drivers.
For small businesses, overhead allocation is important to determine which activities are truly profitable. If overhead is applied incorrectly, it can appear that you are losing money on what are profitable activities.
Direct materials, direct labor, and overhead are the three major components of the cost of products or services. However, it’s not always straightforward for businesses needing to determine the overall cost of a product. Managerial accounting uses three cost accumulation methods, namely: job-order costing, process costing, and hybrid costing to determine the total cost of a product or service:
- Job order costing: Cost components are accumulated per job and each job may have different costs. This accumulation method is suitable for businesses that sell products and services that are unique to every customer. For example, a roofing company might use job order costing to accumulate the costs of removing and disposing of the old roof and purchasing and installing a new roof for a customer.
- Process costing: Cost components are accumulated per process. This accumulated method is suitable for manufacturing companies that produce and sell similar goods to customers. For instance, a company manufacturing cooking oil may use process costing to accumulate costs incurred in pre-processing, extracting, grinding, purifying, refining, and packaging processes.
- Hybrid costing: A costing accumulation method that includes features of both job order and process costing.
Cost-volume-profit (CVP) Analysis
Another important concept in managerial accounting is the relationship between cost, volume, and profit. Understanding these relationships can help managers and small business owners predict the future (planning function) and evaluating actual results (monitoring function). The main tool used in CVP analysis is the breakeven point or the point at which total cost is equal to total revenue.
Under CVP analysis, you can also evaluate pricing decisions and determine if your current price is enough to recover costs. Moreover, you can also analyze operating leverage by looking at how profit responds to changes in sales with respect to current levels of fixed cost. Overall, small businesses can benefit from CVP analysis because it provides insights about the business’ cost structure and ability to generate revenue.
Performance Evaluation
Another important subset of managerial accounting is performance evaluation. This subset responds directly to the monitoring pillar of managerial accounting.
The most basic performance evaluation tool is financial analysis. By using ratios to interpret figures in the financial statements, small businesses can assess the liquidity, solvency, performance, and profitability. Our guide on financial ratio analysis discusses in greater detail all the financial ratios you’ll need to evaluate overall business performance and health.
Standard costing and variance analysis is another tool for evaluating performance. Implementing standard costs aids in organizing company spending and helping managers to use business resources efficiently. When standard costs don’t meet with actual cost, variances occur and managers need to review variances as a way of monitoring performance and correcting inefficiencies.
Comparing differences in actual and budgeted amounts is another form of variance analysis. Variances may be favorable or unfavorable, but not all variances are worth investigating. You should investigate variances that are too significant to ignore, whether it is favorable or unfavorable. Having a favorable variance doesn’t immediately mean it’s positive for the business. It is best to explore other qualitative factors involved.
Evaluating performance also involves determining the areas where performance can be evaluated properly. By using responsibility accounting as a tool for performance evaluation, small business owners can evaluate managers in areas that they control. It is demoralizing for managers to make them accountable for shortcomings that are outside of their department or team.
Tools like segment margins and return on investment (ROI) can help you evaluate the performance of specific departments. A segmented income statement presents income and expenses pertaining to the particular segment or department, and this income statement can measure the department manager’s efficiency and effectiveness.
The ROI can be used to measure if the manager has been able to generate high returns. You can compare the manager’s ROI with the company’s standard ROI as a point of comparison.
The balanced scorecard is a concept developed to measure performance by combining financial and nonfinancial metrics. The approach can be useful for small businesses to provide a holistic evaluation of performance for employees and managers.
This concept covers four perspectives:
- Financial perspective: This looks at the financial aspect of performance, such as return on investment, cash flow results, profit margin, and other performance metrics.
- Customer relationship perspective: This looks at how the customers perceive the business. We look at metrics, such as number of orders, number of repeat orders, number of complaints, and customer satisfaction surveys.
- Internal processes perspective: This looks at the business’ internal processes and how aligned is management and employees with the business’ mission, vision, goals, and values. Metrics, such as manufacturing efficiency, cost of rework, and productivity factors, are used in evaluation.
- Learning and growth perspective: This looks at the improvement of value through employee satisfaction. We use job satisfaction surveys, employment retention rates and turnover, and continuing professional development are metrics used to measure this perspective.
Differential Analysis & Relevant Costing
Differential analysis is a managerial accounting tool used for short-term decision-making. It focuses on weighing the quantitative and qualitative factors involved in making a decision. When conducting differential analysis, the decision makers only include relevant costs. Costs are relevant when they are future costs that are different across alternatives.
Hence, costs that are present in all alternatives are excluded in differential analysis because they are irrelevant to the decision. Popular examples of differential analysis include:
- Outsourcing decision (make or buy)
- Special order decision (accept or reject)
- Continue or shutdown business segment
- Repair or buy new equipment
Small businesses should be familiar with this managerial accounting tool because it can help managers and small business owners make calculated risks and decisions. However, differential analysis considers both quantitative and qualitative factors before arriving at a decision.
Capital Budgeting
Expanding your small business or introducing new products are crucial business decisions. It requires significant capital investment and long-term planning. Capital budgeting is the managerial accounting tool that will be useful for long-term decision-making.
In capital budgeting, you have to consider how long-term projects or plans are evaluated, funded, and measured to ensure maximization of wealth. Small businesses don’t have large coffers so being wise about significant investments is an important thing to consider in managing small business funds.
Capital budgeting decisions include
- Evaluating and screening projects and long-term investments
- Obtaining funding for long-term projects
- Assessing return on investment using discounted and undiscounted models
Strategic Cost Management (SCM)
Another important subset of managerial accounting is SCM. Under SCM, the goal of the small business is to reduce costs while improving the strategic position of the business. SCM focuses on cost leadership, differentiation, and focus. The ultimate goal of SCM is to increase customer value and satisfaction without increasing too much on costs.
- Total quality management (TQM): The overall goal of TQM is to exceed customer expectations by integrating all organizational functions. The main metric in TQM is the cost of quality wherein the business takes a look at costs involved in ensuring product quality (preventive and appraisal costs) and costs involved in dealing with poor quality (internal failure and external failure costs).
- Continuous improvement: The philosophy of continuous improvement is a constant effort to reduce costs, eliminate waste, simplify processes, and improve customer service. Businesses can execute this through small and gradual improvements or big and radical changes (business process reengineering).
- Just-in-time (JIT) system: This inventory management concept strives to reduce inventory handling costs by ordering goods needed only for current production needs.
- Value engineering: This strategic technique looks at the value chain with the end goal of reducing costs along the process. It also involves targeting costs to obtain a desired profit level for products.
Frequently Asked Questions (FAQs)
Managerial accounting’s main focus is to provide useful accounting information to internal users. Ultimately, managers and small business owners can use this information to maximize business resources and profit.
Regardless of business size, the help of a managerial accountant in influencing business decisions can yield positive results. Very small businesses might benefit from a bookkeeper who can also perform some basic managerial analyses, like budgeting.
Bottom Line
Managerial accounting is a branch of accounting that aims to serve internal users with information needed for decision-making. This information is useful for planning, organizing, and monitoring business operations to ensure proper use of resources and maximization of profit.
