When we enter the world of accounting, our first task is to learn about financial statements. As we progress in our journey, we discover ratio analysis, capital budgeting, and also a term known as cost or managerial accounting. A fundamental branch of accounting, it addresses such issues as: What makes businesses competitive? How do businesses formulate future strategies? Is it viable to set up a new business in existing market conditions? As a result, managerial accounting is an ideal career path for analytically minded professionals with a penchant for turning numbers into insights.
What is Managerial Accounting?
Managerial accounting is one of the four fundamental types of accounting. As the name suggests, it deals with the “management” of business affairs. Additionally, it is known as “cost” accounting because the effective management of a business often comes down to handling its costs. The Chartered Institute of Management Accountants (CIMA) is a global body dedicated to managerial accounting. It provides accreditation and sets the standard for best practices in the field.
Managerial accountants are involved in obtaining and processing information on the entirety of the business cycle. These insights allow managers charged with decision-making to respond to pressures and opportunities in a timely manner. Additionally, accountants specializing in the field identify ad hoc accounting information like opportunity costs to make managers aware of potential pitfalls.
Why is Managerial Accounting Important?
Managerial Accounting targets timely identification, measurement, analysis, interpretation, and communication of key financial indicators. This information is usually tailored around the strategic priorities of a specific organization. In other words, the role of managerial accounting might be to supply insights into such key business areas as costs, pricing, competition, marginality, budgeting, and a host of others.
Managerial Accounting in Action
Managerial accounting employs various tools to empower business managers to make strategic decisions. Let’s look at an example to illustrate some of them.
Drunch is a boutique café located in Mayfair, London. The menu features mostly Mediterranean cuisine, and a selection of house-brand chocolates. It is owned by two sisters who are also CIMA certified accountants. They are planning an expansion of their café for next year. As a result, they are planning on acquiring two new outlets in Chelsea and Notting Hill by the end of 2023. Moreover, they are investing heavily in marketing and looking into options to update their menu, to sustain the expansion of the business.
Budgeting and variance analysis
The first step in their plan would be to draft up a budget. They will incorporate all their expected costs for the upcoming year such as rent, salaries, cost of ingredients. And also, project expected income from sales (revenue). Later, when the actual figures are available, they can compare those with the budgeted ones. For example, the sisters budgeted marketing expense to be $5000 for the upcoming year, however, the actual expense came up to $6000. This is known as an adverse variance of $1000. We must investigate the cause and come up with a solution to prevent them from going over budget next time.
Expanding the business will include a substation investment in rental space. While looking for places to rent, they need to be sure that they will generate adequate returns on their investment. So, they must consider the expected net present value of their future investment. For example, this will entail determining whether enough customers walk in, inspired by the location and interior? Is it worth renting a corner premises or a more isolated one? Comparing the projected revenue in either case can give them an idea about which would be a better choice.
Similarly, when it comes to reviewing their selling prices the sisters need to make a decision. How expensive or affordable should their new menu be? To do this they can use a managerial accounting method called absorption costing.
Let’s say the annual fixed overheads for their Mayfair premises is $80,000. Their best-selling dish is the Pink Panther Praline. So, they will use absorption costing to adjust its price. This will allow the cost of fixed overheads to be “absorbed” in the final price of the dish. The sisters will do that by determining an overhead absorption rate (OAR) which utilizes the major activity hours as a base (labor or machine hours). The total annual labor hours needed for the preparation of this bestselling dish are 10,000.
OAR = Fixed Overheads / Labor Hours
Hence, OAR = $80,000 / 10,000 hours or $8 per labor hour
Now, each dish uses $10 worth of ingredients and 1 labor hour.
So, the final price would be = $10 + 1 labor hour ($8 OAR) = $18
Process Costing and Capacity Management
While making sure they set the right places is important, so is having a clear sense of what their inventory is worth. Since they manufacture their chocolates in-house, they will employ process costing to determine its value. They will do that by factoring the value of any work-in-progress in the final cost of the inventory.
Opening Work-in-progress= $15,000
Work-in-progress during the month = $35,000
Closing work-in-progress = $30,000
The value of work-in-progress will be = opening work in progress + work in progress during the month – closing work in progress
That is, $15,000+ $35,000 – $30,000
Hence, the final value of the work in progress will be = $20,000
Make or Buy Decisions
As they go along valuing their inventory, they get an idea. What if it’s more profitable to start buying their chocolates instead of making them in-house? This managerial accounting process is known as make or buy decision-making.
For example, the cost of goods sold (COGS) sustained while making the chocolate comes at $35,000 per annum. But a local chocolatier is willing to supply the same amount for $32,000 per annum. Therefore, in order to cut costs, the sisters might consider starting to purchase the chocolate instead of making it.
Cost-volume profit analysis
The sisters also have a dish on the menu called Egg Royale. This is a very expensive dish to make since it includes Caviar and Salmon. They want to evaluate whether it’s profitable for them to continue having this on their menu. Hence, they can undertake cost-volume profit analysis. This will help figure out how many dishes they need to sell to break even. They will then compare that number with their existing sales of the dish, and
CVP (Break-Even) in units of dishes = Fixed Costs / Contribution per unit
Where contribution per unit is = Selling Price per Unit – Variable Cost per Unit
So, let’s say their expected fixed costs for the new location total $50,000 per annum.
Their Selling Price per Egg Royale is $15
Their Variable Cost per Egg Royale is $10
Therefore, their break-even number of Egg Royale Units will be = $50, 000 / ($15 – $10) = $10,000 Egg Royale Units.
This means, Drunch needs to sell at least 10,000 Egg Royale dishes per year in order to make it a profitable consideration. If they can rake up 10,000 Egg Royale sales, those would be a viable menu choice. If not, the sisters will have to discontinue them.
These are just some of the many crucial functions of managerial accounting. We could add a host of others, such as constraint analysis, cash flow analysis, etc. Furthermore, the field of accounting is growing more and more strategic in a changing world. Financial information is now increasingly more forward-looking. Simultaneously, timely identification and rectification of issues allow companies to be at the top of their game. Dig deeper into these topics and start gaining the skills you need to become a successful managerial accountant with our Complete Finance Manager course.
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