As managers get more decision making responsibilities because of decentralized management, organizations must find ways to evaluate those managers in an effective way. The first step in the process is assigning responsibility centers to each manager.
A responsibility center is a segment of the company for which a manager is responsible. This allows the company to gather quantitative information regarding the segment in order to assess the performance of the manager. There are four types of responsibility centers:
- Cost Center – The majority of managers are responsible for cost centers. A cost center is a segment where the manager is only responsible for managing costs. Examples of cost centers include human resource departments and production departments. These departments are not concerned with revenue generation. Therefore, managers are evaluated on their ability to manage costs. When attempting to determine if a segment is a cost center, determine if revenue is a factor. If revenue is not a responsibility of the manager of the department, the department is a cost center.
- Revenue Center – While revenue is a major factor for most businesses, revenue centers are actually the smallest portion of responsibility centers. Typically, revenue centers are sales territories and sales departments. These managers are evaluated based off their ability to generate revenue. This segment is rare because most managers that are generating revenue are also responsible for managing the costs of generating that revenue.
- Profit Center – These responsibility centers are also quite common. A profit center manager is responsible for generating revenue but also managing costs to increase profitability. These managers include retail managers, like Target or Wal-Mart store managers. These managers must maximize profitability in their stores, but major decisions about asset management (like renovations and improvements) are outside their scope of responsibility.
- Investment Center – While we spend a lot of time discussing profit, asset management is just as important. If assets are not managed efficiently to maximize the profit that can be made with those assets, the company runs the risk of hurting cash flow and future profitability. Managers in an investment center are responsible for asset management and profit maximization. These managers have the ability to approve the construction of new factories, stores, and the purchase of major equipment. Investment center managers include CEO’s of major companies and small business owner-managers. If asset management is involved, the segment is an investment center.
The sell or process further decision type is mainly applicable to farms and producers of natural resources. These businesses must decide to sell farm products or natural resources as is or turn that inventory into another product. For example, if a farm has an apple orchard, the farm can sell the apples or process the apples into apple sauce, apple pie, apple juice, or apple butter.
When making the decision to sell as is or process further, any costs associated with producing the raw product should be disregarded from the decision making process. Similar to the other short-term decisions we have discussed, these costs are not relevant. Why? Remember that the definition of a relevant cost is a cost that differs among the alternatives. in the case of our apple farm, we have the cost of producing the apples, whether we sell the apples or turn them into another product. Costs incurred to produce the apples should not be considered.
What should businesses consider when making these decisions?
1. How much revenue will the company generate by selling the product unprocessed?
Calculate the total amount of revenue generated by multiplying the number of units by the price per unit.
2. How much revenue will the company generate by processing the product further?
This calculation might be a bit more difficult because the units might change. For example, if a decides to turn apples into apple sauce, it takes more than one apple to make a jar of apple sauce. It might take three apples to make a jar of sauce. Therefore, you must determine how many jars can be produced with the apples you have. Once you know that, you can then multiply by the price to calculate total revenue.
3. How much additional cost will be generated to process the produce further?
Clearly, there are additional costs associated with turning apples into apple sauce. Additional ingredients, packaging, labor, and equipment are required. All of these items mean additional costs. Total the costs associated with processing the product further.
Subtract the costs associated with processing from the revenue that could be generated from selling the processed product. Compare your net profit from the processed product to the revenue that could be generated from the raw product. Choose the option that will generate the most profit.
Let’s look at an example.
Seeds Farm, Inc. produces apples which it sells to local grocery stores. The Farm is considering turning the apples into apple butter. The local grocery stores have stated that they would be willing to pay $2.35 per jar of apple butter. The Farm produces 750,000 apples per year and sells them to the grocery stores for 15 cents each. The apples cost $90,000 to produce. Each jar of apple butter would require 5 apples. Additional costs related to the production is estimated to be $1.25 per jar. Should Seeds Farm sell the apples as is or convert the apples to apple butter?
We need to consider each of the alternatives: selling apples or making apple butter. Is any of the information in the problem irrelevant? Yes, the cost of producing the apples. Whether Seeds Farm sells the apples or sell apple butter, they will need to pay to produce the apples. Since the $90,000 is common to both alternatives, it is irrelevant.
Let’s look at how much revenue the Farm will generate if the apples are sold as is.
750,000 apples X .15 per apple = $150,000
Since the apples are being sold as is, there are no additional costs associated with this revenue.
Now let’s compute how much could be made if Seeds Farm produces apple butter. First, we will look at the revenue. Since it takes 5 apples to make each jar, figure out how many jars can be produced first.
750,000 apples / 5 apples per jar = 150,000 jars
Calculate the total revenue based on 150,000 jars.
150,000 jars X $2.35 per jar = $352,500
That is a lot more revenue, but remember there are also costs associated with generating that revenue.
150,000 jars X $1.25 per jar = $187,500
$352,500 – $187,500 = $165,000 net profit
Finally, compare your results:
The farm will make more money if it makes apple butter than if it sells apples.
Managerial accounting is the art of planning, decision making and controlling in business. In order to do that, we must identify what we want to track. Are we looking at a product, a store, a department within the company, or even a customer? Since managerial accounting gives us so much flexibility, we need to make sure we understand to what we want to assign costs.
A cost object is anything for which a company wants to assign costs. Cost objects can take many different forms including:
- Individual units of a product
- An order for a specific customer
- A product line
- A department within the company, like the marketing or human resources department
- A geographic segment of the business
- A store
- A service provided by the company
- A customer
There is almost no limit to what you can identify as a cost object as long as you can find a way to assign costs to it. The most important aspect of determining a cost object is the ability to assign costs in order to get a complete picture to plan, make decisions and perform controlling activities. If you cannot fully assign costs to the object, you may want to consider if the object chosen is the correct one. In most cases, we can find ways to assign costs, however.
Direct and Indirect Costs
All costs related to a cost object are either direct costs or indirect costs.
A direct cost is a cost that is easy to trace to a cost object. For an accounting or law firm, it is easy to trace the number of hours and cost of working on a client because all staff is required to assign their time to clients throughout the work week. Engines used in a Boeing 747 are easy to trace to each plane and therefore the cost is easy to calculate. The salaries for marketing employees are easy to trace to the marketing department of a company. Direct costs are assigned to a cost object easily.
An indirect cost is a cost that must be allocated to a cost object because it cannot be directly traced to the cost object. The cost of a receptionist in an accounting firm is hard to allocate to individual clients because his or her time is not being tracked by client. Supervisors at the Boeing plant are supervising employees working on several different projects and it is impractical to track his or her time to each individual plane. Some materials are so insignificant that the cost of tracking how much glue goes into a product outweighs the benefit of knowing the cost of glue per unit.
Sometimes it is possible for a cost to be a direct cost for one cost object and an indirect cost for another object. For example if my cost object is the marketing department, costs associated with marketing salaries are a direct cost which are easy to assign to the marketing department. However, if the cost object is one of 20 products a company manufactures, the marketing salaries are an indirect cost for that product since the cost is not easy to trace back to our cost object.
Types of Businesses, Product Costs and Period Costs
After taking financial accounting, many students dread the idea of another semester of journal entries, debits, and credit.
Fortunately, managerial accounting is very different from financial accounting. I have had a number of students in the past who hated financial accounting but really liked managerial accounting. Typically, most non-accounting majors feel that managerial accounting is more relevant to their field. I hope that you will give managerial accounting some time before you make judgement on the subject.
There are a number of ways in which managerial accounting differs from financial accounting. Let’s look at some of them here.
Who are the users of managerial accounting information?
Unlike financial accounting which is designed for external users, managerial accounting is focused on internal managers. Managerial accounting is designed to help managers plan for the future, make decisions for the company ,and see if their plans and decisions were accurate (also called controlling).
Who makes the rules in managerial accounting?
In financial accounting, the rules are set by the Financial Accounting Standards Board (FASB) or by the International Accounting Standards Board (IASB). The standards set by FASB are collectively called GAAP (Generally Accepted Accounting Principles) and the standards set by the IASB are collectively called IFRS (International Financial Reporting Standards). These rules must be followed when companies are filing reports for external users.
Because the reports generated are for internal management, there are no reporting rules in managerial accounting. In this course, we discuss best practices for obtaining the information that managers need to plan and make decisions. There is no external body that states what our managerial reports must look like.
This also means that managerial accounting is not as simple as learning the income statement, statement of stockholder’s equity, balance sheet and statement of cash flows (maybe easy was the wrong word here). In managerial accounting if you can come up with something you want to measure, we can usually create a report for it. That means that the possibilities are almost endless. Want an analysis of future marketing costs and projected return on investment? We can do that. Want to know if we should continue to make our product by hand or automate the process? Yup, we can do that, too. That’s one of the things I love about managerial accounting. It takes a lot more thought and creativity than financial accounting.
Looking at segments to monitor performance
Financial accounting requires us to look at each company as a whole. Many companies are made up of a number of different brands but all of those brands are reported together in one set of financial statements. Think of a company like GAP. GAP not only owns all the GAP branded stores, but also Banana Republic, Old Navy, Piperlime, Athleta, and Intermix. All of these brands are lumped together into a single set of financial statements.
It would be very difficult for managers to do planning and decision making based on the single set of financial statements for a company like GAP. Instead, managers will break a company into segments based on what makes sense for the company. Some examples of ways that managers can break a company into segments include:
- Geographic location – breaking the company into regions
- Product lines – casual, dress, business wear
- Specific products – a particular cut of jeans
- Customer demographics – men vs women, urban vs. suburban, age groups
If a manager can define a segment and believes that the information will be useful to planning, decision making,or controlling, reports can be generated for that segment.
Focus on the future
Financial accounting is all about historical information. In the financial statements, we are reporting things that have already happened.
Since managerial accounting deals mainly with planning and decision making, we are looking into the future and trying to predict what will happen based on historical trends. We are always looking for the most up-to-date information to use in these tasks. Managerial accountants are more focused on relevant information, where financial accountants are required to ensure that information is reliable and objective. In order to make decisions in a timely manner, managers must be able to gather information quickly.
Creating reports as often as needed
Financial accounting dictates that reports are created quarterly and annually. Because managerial accounting reports are created for planning, decision making, and controlling, reports are created whenever this functions need to take place. Many financial reports are created on a daily basis as part of the controlling function. Other reports are only created once in order to aid in the decision making process. Budgeting reports can be created monthly, quarterly, or annually based on need. There are no frequency requirements in managerial accounting. Reports are created as needed to fulfill management needs.
Managerial accounting is quite different from financial accounting but study habits are very similar
As you can see, managerial accounting is very different from financial accounting. As you progress through your managerial accounting course, the differences will become more clear. However, I believe that the way you study for managerial accounting is similar to the successful study habits for financial accounting.
Yes, there are a lot of numbers and equations in managerial accounting but you can actually make it through the course without knowing a single formula. Focus on the concepts in the course. Link those concepts to the way a business actually operates. When you think of these concepts in terms of the processes that are going on in the business, the numbers are easy to calculate. As I write the material for this course, I will always discuss the processes to help you get around learning the formulas but I will list the formulas as well. It is my hope that as your understanding of the concepts increases, your reliance on the formulas will decrease.
Managerial accounting uses basic math just like financial accounting. If you can add, subtract, multiply, and divide, you have all the math skills needed for this course. Don’t get overwhelmed by all the numbers. Focus on the concepts and the numbers are not difficult.
One last piece of advice
This may be the most important piece of advice I can give you. Label all of your numbers. If something is expressed in dollars, label it as dollars. If something is expressed in machine hours, label it. If you $100,000 and divide it by 25,000 machine hours, your answer will be $4/machine hour. This will be very useful as you try to apply this number to other parts of a problem. Get in the habit of labeling all of your numbers early. This will save you a lot of time and confusion as you progress through the course.
Introduction to Managerial Accounting: Overview
If you are currently enrolled in an accounting course (which I sure hope you are because most people don’t browse my site for fun) you’ve probably heard some pretty terrible things about accounting. I remember when I took my first accounting course. I was scared to death before I walked in the door.
The textbooks certainly don’t help. My first accounting book was over 1,000 pages. The book was filled with lots of small text and complicated charts. Today’s accounting textbooks are certainly prettier but I’m not sure the text has gotten any more interesting or understandable. My goal is to help guide you through your accounting classes in an easy straightforward manner. In order to do that, we need to discuss what accounting is and what it is not.
What is accounting?
I would argue that accounting is the most important business class you will take. It doesn’t matter how great your product or service is if you can’t make the numbers work. Accounting is the language of business. It lets businesses communicate with investors, creditors and other stakeholders so they can make decisions about the business. Knowing this language makes you a powerful player in the business community.
There are two major branches of accounting: financial and managerial.
Financial accounting is what most people think of when they think of accounting. Financial accounting is based on communicating information to external users (users who are outside the company). This includes investors, creditors, customers, suppliers and various government agencies. Financial accounting is all about following the rules. It deals mostly with historical information.
Managerial accounting, also called cost accounting, deals with compiling information to allow managers to make decisions and plan for future business needs. In managerial accounting, we frequently deal with “what if” scenarios. There are very few rules in managerial accounting, but there are lots of best practices. It deals mostly with the present and future.
Accounting is NOT a math class
I can’t stress this enough. Accounting is not a math class. It may look like a math class because there are numbers, but the numbers are just part of the language.
Many students get instantly discouraged because they see numbers and think “Oh but I’m terrible at math.” At that instant, the brain switches off. I have had plenty of students who were “terrible at math” do extremely well in my classes. They lived by the mantra “accounting is not a math class.” The most complicated math you will encounter in financial or managerial accounting is division. I usually require my students to purchase a basic four function calculator like the one shown here because that is about as complicated as it gets.
It’s true. Accounting really is a language and you should try to learn it in the same way you would approach a language class. The biggest mistake students make is ignoring the terminology in the course. They focus on formulas but without the conceptual understanding of the terminology, they don’t know when to use the formulas. It’s like trying to write a sentence in Spanish without knowing any of the vocabulary. You may know that the adjective goes after the noun, but without knowing any nouns you can’t write a sentence.
On the flip side, I have students who had such a good conceptual understanding of the terminology, they didn’t need to know the formulas because the calculations came naturally once the concepts were known. That is actually how I learned accounting. With a thorough knowledge of the concepts, I did not memorize a single formula.
How to study for your financial accounting course
There are three areas you should focus on when learning new material in a financial accounting course:
- The terminology and concepts – This includes the account names and types. This is critical to your ability to do well in the course.
- Structure – similar to learning sentence structure when learning a language, there is a lot of structure in financial accounting. Journal entries have a particular structure, as do trial balances and financial statements. Learning the structure and what goes where is extremely important.
- Calculations – Notice that I put this last. This really is the least important of the three. If you can add, subtract, multiply, and divide you have all the math skills you need. When you understand the terminology, concepts, and structure you will barely notice the calculations.
For the account names and types, I recommend flashcards. I know it it seems old school but it really works. For each account, create a card. This is what I put on my cards:
On the front, I have the name of an account. On the back, I put the type of account it is and if the normal balance is a debit or credit. On some cards, I put a description for the account. Some students confuse accounts receivable and accounts payable, so it might be a good idea to put a description to make the difference between the two accounts more clear. Each time you encounter a new account, create a card for it.
After you have completed each chapter in the course, take a single sheet of printer paper and make yourself a page of notes. You should be able to boil down each chapter into a single page of notes. the accounts are already covered with your flash cards. The notes page should contain key terms and examples of journal entries. This quick reference guide will save you time when completing assignments or just to refresh your knowledge when needed,
Having the flash cards and the single page of notes will make studying for each exam so much easier. Whatever you do, do NOT reread the chapters. Studies show you only retain about 20% of what you read. Your best bet is to do more problems and study your flash cards and quick notes.
Introduction to Financial Accounting: Objectives and Overview