Management Accounting in a Growing Business
One of the most important factors towards the success, productivity, and growth of a business is management accounting whose significance has attracted considerable attention in the recent past because of new trends and recent developments. Actually, management accounting is considered as a business process that creates energy, which drives a company’s results and success. The significance of management accounting in today’s business environment is also attributable to the fact that business organizations are increasingly focusing on value creation instead of valuation. In light of these factors, a growing business needs to establish suitable management accounting processes based on understanding the significance of investing in management accounting systems for future organizational growth and profitability.
Management Accounting v. Financial Accounting
Management accounting and financial accounting are terms that have widely been used interchangeably despite the difference between the two concepts. While management accounting is a process that generates energy which drives an organization’s results, financial accounting is a process that basically reflects the results (Russell, 2014). Management accounting achieves this goal through providing and facilitating evaluation of cost information by the organization’s internal management in order to enhance planning, decision making, and control of the firm. Financial accounting reflects an organization’s financial results through producing financial information that is utilized by the company’s external parties like lenders and shareholders. In essence, financial accounting discloses a business’ end results to external parties whereas management accounting provides important financial information for decision making, planning, and establishment of organizational goals.
Based on this difference, management accounting is more important for a healthy business with regards to promoting the establishment of better management systems and strategies for the organization. The significance of management accounting for a healthy business is attributed to the objective of this field of accounting i.e. helping in decision making, planning, control, and establishment of business goals and objectives. As a result, this business tool is utilized by a company’s top management to handle the day-to-day operations of the organization. Managers use management accounting for decision making on daily operations based on current and anticipated market trends rather than past performance. This implies that management accounting processes rely heavily on forecasts of markets and future trends, which are crucial towards ensuring and enhancing a company’s success and profitability.
Different Classifications of Costs
The process of management accounting entails classifications of costs since the term cost is very vague and has seemingly no meaning unless it’s categorized in logical groups. The classification of costs into various categories entails grouping them based on different factors including the nature and specific purposes of the cost. Classification of costs is an important process in management accounting because it makes cost information to become more meaningful and beneficial to the business organization, especially its operations. Managers consider this process very important because it is the first step towards making decisions that are related to costs and costing in the business.
Generally, costs are classified on the basis of type, behavior, function, and relevance in order to help managers understand the behavior of costs and costing. In relation to function, there are two major classifications of costs i.e. accounting function and management function (Clarke, 2015). Accounting function relates to the amount of money to in carrying out or accomplishing certain purposes and those that help management make better decisions. They are classified into two i.e. financial accounting costs and managerial accounting costs. Financial accounting costs or accounting costs are valuations of resources utilized for certain objectives in monetary terms. An example of this classification of costs is historical costs obtained directly from the financial statements. Managerial accounting costs or financial costs are current and future costs enabling the management to make better decisions such as costs obtained from budget reports. On the contrary, management function entails production costs (operating costs) and those linked to supporting the production of product or service (non-operating costs). An example of operating costs is supply costs linked to a patient visit to the emergency department whereas an example of non-operating costs is money borrowed for equipment in the emergency room or department.
With regards to relevance, costs are classified on the basis of their relation to control and decision making by the organization’s management. There are several kinds of costs that are classified on the basis of relevance including true costs, differential costs, uncontrollable costs, controllable costs, sunk costs, relevant costs, opportunity costs, standard costs, and actual costs (Pettinger, 2012). Some major examples of costs classified on the basis of relevance include utility costs and costs of labor.
On the basis of type, costs are classified depending on their specific nature in the process of management accounting. In this case, costs classified depending on material, expenses, and labor. Moreover, they are also classified based on traceability, which includes direct costs, indirect costs, full costs, and average costs. Direct costs are those that can be traced to an organization’s department, product or service such as costs of supplies and labor costs whereas indirect costs are overhead costs that cannot be linked to a particular department, product or service such as costs of heating and cooling. While full costs incorporate direct and indirect costs, average costs is obtained through dividing full costs and the number of products and/or services.
In relation to behavior, costs are categorized based on their link to the volume of products and/or services in the business. They include variable costs, fixed costs, semi-variable costs, and marginal costs. Variable costs are those that differ proportionately to the business volume such as supply cost, which is directly proportionate to volume whereas fixed costs are those that remain constant based on changes in volume. An example of fixed costs is the cost of heating and cooling an emergency room, which remains the same regardless of the number of patients. Semi-variable costs are those that differ incrementally relative to volume changes such as costs of hiring new staff, which depends on increment in operational needs to certain extent or level. On the contrary, marginal costs are those associated with the production of one more unit of a product and/or service in the business.
Importance of Fixed and Variable Cost in Determining Breakeven Point
As previously mentioned, fixed costs are those that remain the same regardless of changes in production and/or sales volume whereas variable costs are those that change depending on the proportion of business volume in relation to manufacturing and sales. Differentiating between fixed and variable costs is important towards determining breakeven point of a business and for planning various levels of business activities. Breakeven point occurs when a company’s output or sales level through which revenue is derived is exactly equal to the costs of producing or selling that specific output (Rural Women’s Network, n.d.). In this case, the business has neither made a profit or loss.
For many businesses, the process of determining breakeven point is crucial since it provides insights on the organization’s realistic capability to cover costs and generate profits. Actually, breakeven point analysis is important for business in generating profits since any sales above the breakeven point starts providing net profits to the business. Fixed costs and variable costs play an important role in this analysis since business operations usually incorporate these costs because of their link to activities like production planning, budgeting, and profit forecasting. Therefore, the combination of fixed and variable costs is crucial towards determining the breakeven point.
The significance of differentiating fixed and variable cost in determining the breakeven point in a business is the need to understand the behavior of the various kinds of costs of expenses relative to production and sales volume. Generally, business managers are faced with the need to effectively examine the behavior of different costs or expenses relative to production and sales volume in order to obtain a realistic picture of the organization’s operations and activities. Through differentiating these costs, the company’s management understands their response to changes in manufacturing and sales, which is vital towards achieving breakeven point. The differentiation also helps in this process through determining the level of profitable price for products and/or services. In addition to helping determine the profitable price level for products and/or services, differentiating fixed and variable cost helps in achieving breakeven point by providing insights regarding the various aspects of the overall business strategy (Inc., n.d.). In this case, the differentiation helps in decision making regarding pricing or products and/or services, which eventually enables the achievement of breakeven point.
Apart from the achievement of breakeven point of a business, differentiating fixed and variable cost is also important towards planning different levels of business activities. This is mainly because the differentiation provides insights regarding the organization’s profitable and non-profitable activities. In this case, the organization’s management gains insights on activities and strategies that generate more profit and promote achievement of organizational goals as well as those that are not profitable. The insights obtained regarding profitable and non-profitable activities and strategies are then utilized for planning different levels of business activities towards realization of optimal productivity and profitability. By achieving breakeven point, the differentiation of fixed and variable cost help in planning business activities since the information regarding production and sales volume is used towards establishing realistic operational strategies and activities. Actually, differentiating these costs is vital since business planning activities and processes necessitate segregation of expenses or costs into these two classifications for improved operations. Moreover, the process helps in planning business activities through providing information that is utilized to track and manage operations.
Importance of Operational Budgets for Business’ Success
Planning and strictly managing a company’s financial performance is essential once a business becomes operational. The creation of a budget, particularly operational budget, is the most effective means towards ensuring the business and its finances are on track. An operational budget can be described as a comprehensive projection of all projected income and expenses depending on the anticipated sales revenue within a specific period of time. An operational budget usually incorporates several sub-budgets such as sales budget, which is important and is usually prepared first. However, operational budgets do not incorporate capital outlays since they are long-term costs and this type of budget is a short-term budget. The main objective of an operating budget is to describe income-generating activities of the business like production, sales, and finished products inventory (Peavler, n.d.).
Some of the major components of operational budgets include sales budget, production budget, direct materials purchases budget, direct labor budget, overhead budget, ending finished goods inventory budget, cost of goods sold budget, selling and administrative expenses budget, and budgeted income statement. However, these components are included in an organization’s operating budget depending on the nature and type of business. These components help in enhancing the capability of operating budgets in achieving their objectives for the business.
Operational budgets are important for the success of the business since they are related to various aspects of the operations and strategies of the organization. First, operational budgets contribute to the success of the business by enabling business owners and managers track progress, change processes and procedures when necessary, and plan for growth (Banks, n.d.). A business’ success depends on the management’s ability to effectively plan for growth, make necessary changes, and track progress. Operational budgets contribute to the success of the business through addressing these important aspects for the management. Operational budgets are used as tools for establishing sales targets and making adjustments based on changes in market conditions. These targets and adjustments guide the business’ operations and strategies, which help in achieving success, productivity, and profitability.
Secondly, operational budgets contribute to the success of the business by providing insights on the amount of money required to cover bills or operational expenses on a monthly basis. This is primarily because operational budgets relates to daily expenses for organizational activities and operations such as rent, utility, wages, and purchases of required resources. As a result, a company or business organization can effectively plan for its operations based on costs of the various activities. The information is used to plan for growth by ensuring that the company has income left over after the purchase of assets and operations. This is a crucial element towards ensuring success since the business ensures its costs of operations do not exceed its income or profits.
Third, having operational budgets promote business success by enabling managers to identify specific financial goals and objectives for a specified period of time (Suiter, n.d.). Once the financial goals for the time period are established, the management ensures the adoption of policies and practices that contribute towards their realization, which results in success through increased productivity. The establishment of financial goals for a specific period of time is carried out through estimating revenues and expenses when preparing operational budgets. The estimations are based on what is anticipated in the immediate future based on market conditions. The company prepares for future business cycles and activities through estimates of revenue and expenses in operational budgets. In addition, operational budgets contribute to effective management of activities within the organization based on the estimations of revenue and expenses. Therefore, operational budgets promote the success of the business through better management of activities and estimations of revenue and expenses.
Management accounting is an important process towards promoting and ensuring the health and success of a business since it facilitates the establishment of effective management systems and strategies. Apart from being different from financial accounting, management accounting incorporates several major components and processes including classification of costs and costing, breakeven point analysis, and development of operational budgets. As evident in this analysis, development of effective management accounting systems is crucial for an organization’s profitability, growth, and success.
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