The Need for Management Accounting Information - Essay Example

The Need for Management Accounting Information Executive Summary A concrete management decision is based on reliable information which is explicit and generated from mechanisms that are rational. Management accounting information is one such information. By virtue of being in-depth and forward looking, this information is used by managers to make strategic decisions as opposed to relying on financial accounting information which is historical. An organization that utilizes management accounting information is better placed to conduct cost benefit analyses and CVP analyses for short term decision making. It can also make better capital budgeting decisions, strategic plans, cost allocation and financial forecasts. This paper, in a bid to show the need for management accounting, discusses how management accounting information is used by organizations to make informed decisions that give them a competitive edge against its peers that do not use such information. Introduction Management accounting is a branch of accounting that provides accounting information for use by the management internally (Drury 7). Sharma duly notes that the accounting information provided by management accountants is utilized in decision making by a firm (Sharma 100). The information forms a basis for informed decisions to be made. It is imperative to have the relevant information before making decisions especially those that have immense impacts on the fortunes of an organization. Concrete management decisions, if based on reliably generated management information, can ensure profitability (Riahi-Belkaoui 28). Management information simplifies complex accounting phenomena drawn from different disciplines, classify them and present them in a way that managers can understand and, consequently, make informed decisions. Okoli asserts that the value of making the right decisions cannot be overstated; it is extremely valuable than indecision and, certainly, more desirable than wrong decisions (Okoli 53). For a profit making organization, the indecision of a manager is as bad as making the wrong decision. This paper delves into the impact that management accounting information has on a management decision making hoping to show the need for managers to be furnished with this kind of information. In an effort to achieve that objective this paper starts by highlighting the characteristics of management accounting information and differentiating it from financial accounting information. It then goes further to show the need for management accounting information by interrogating how management accounting information is used in an organization. The objectives this information meets and the roles it plays in an organization represent the reasons why it is needed in an organization. Characteristics of management accounting information as compared to financial accounting information Most people are incapable of differentiating between management accounting information and financial accounting information (Okoli 52). However, their differences are many and glaring. Despite these differences as shall be addressed in the herein after, both management and financial accounting information have a similar objective; that of providing information to the information user (Schaffer and Heidmann 197). This information seeker, among other reasons, desires to get hold of this information so as to make informed decisions. To that end, both of these information sources desire to equip decision makers, both internal and external, to make viable decisions. The first characteristic of management accounting information is that it is forward-looking (Pierce and O’dea 258). It is primarily concerned with assessing prevailing economic conditions and forecasting based on those conditions and trends. This is in stark contrast to financial accounting information that is historical and aimed at documenting past performance (Williams et al 24). Management accounting information goes beyond detailing performance and instead show how that performance could be varied by the trends in the industry. This information is crucial to managers especially during budgeting. For most organizations using a static budget, the budgetary requirements are generated from the lower levels managers going up. The final budget for the organization is, thus, an aggregate of the various smaller budgets from the different cost centers (Riahi-Belkaoui 36). These budgets are prepared by managers using management accounting information employing variance analysis and prediction techniques. Management accounting information is, therefore, forward looking while financial accounting information is historical. The other characteristic of management accounting information is that it is meant to be used internally by the management unlike financial accounting information (Schafer and Steiners 6). Financial accounting information, as has been explained, records the company’s past performance. This information is used by external users. The users in utilizing financial management information include shareholders, creditors, investors, the government and its agencies and even the employees (Clarke 85). The shareholders, for example, will consult the statement of financial performance to know the financial health of the company and assert the dividends that they ought to be paid in the concluded financial period. The government, through its various agencies, may want to know whether the organization is participating in the activities it listed in its business permit or articles of organization and also whether they filed the right amount of tax returns. The creditors use financial accounting information to determine the financial health of the organization to determine the risks associated with lending that organization. Management accounting information is used internally by the managers. This information contains items like the efficiency of the machines used in production and the employees. The information is used to gauge the organization’s performance determining whether it is operating at the optimal level among other functions as shall be discussed in the next phase of this study. Since management accounting information is to be used internally, it is usually kept confidential (Pierce and O’dea 260). The public does not get to scrutinize this information. Furthermore, the organizations are not obligated by law to provide such information even to the shareholders. This information is, in fact, used by the top level managers for their strategic decision making (Needles, Belverd and Crosson 722). Information depicting the breakeven point for the business’ products, for example, cannot be understood by a lay person and may even be confusing. Financial accounting information is tailored for external users and is sufficiently understandable. Closely related to the aforementioned characteristic is that management accounting information is more detailed that financial accounting information (Pierce and O’dea 265). Financial accounting information is outward-looking and intended for use by people and entities external to the generating organization. As such, it is toned down to a level that is understandable to person with basic financial knowledge. Management accounting information is certainly meant for professionals (Schafer and Heidmann 200). A lot of jargon and abstraction is used since the targeted audience understands it. A lay person, for instance, may be able to understand what net profit, dividends and depreciation are but may find it hard to conceptualize what are overhead costs, breakeven points, net present value and other technicalities used by management accountants. And since this information is usually not based on a case but rather predictive, a lot of abstraction is included in an effort to construct a model upon which subsequent forecasts are based upon (Okoli 57). Lastly, management accounting information is drawn from different disciplines unlike financial accounting information (Sharma 103). The rules affecting its compilation and dissemination are also different from those of financial accounting. Whereas management information is compiled based on the needs of the manager, the financial accounting information is compiled based on the provisions of the generally acceptable accounting principles. Management accounting information can also be generated by management information systems and regulated by internal controls instituted by the organization unlike financial accounting information (Sharma 104). These controls provide a basis for good decision making. The roles and needs for management accounting information According to Schaffer and Heidmann, management accounting information is used in a wide array of activities where the information is used for financial and non-financial decision making, policy formulation, planning and control by managers (Schaffer and Heidmann 210). Some of the activities and areas where management accounting information is needed for the aforementioned functions include price modeling, sales management, cost benefit analysis, cost volume profit analysis, capital budgeting, annual budgeting, cost allocation and buy and lease analysis among others. a) Cost benefit analysis A cost benefit analysis is conducted in order to calculate the benefits and costs of an option or a decision (Sharma 100). It involves calculating and comparing the pros and cons of an option or a project an organization wishes to undertake. Managerial accounting information is needed in cost benefit analysis to show the feasibility of the option under consideration and also to justify the inclusion of the different costs in the valuation of the option (Williams et al 40). Ordinarily, an option or a project will be considered feasible if the benefits outweigh the costs. A sound option is one where the quantified benefits are more than the costs. Apart from evaluating the feasibility of a project, management accounting information also provides an avenue for comparing different projects (Boundless.com). Management accounting information can be used to generate figures and models that can be used to compare the projects. This can help a manager ascertain which of the various projects or options is the most profitable. Management accounting information is important in cost benefit analysis primarily because it expresses the costs and benefits in monetary terms (Riahi-Belkaoui 30). It also employs the concept of time value of money to predict the value a certain investment will have in a few years time. The cost of the foregone is quantified in monetary terms to further ascertain that the choice made is the right one. If the organization decides not to make a decision, management accounting information can also value the costs and benefits of the status quo (Williams et al 45). An organization may not be able to make the best decisions if the decision makers are not furnished with this information. If the management decides to use financial accounting information it relies on historical data which cannot be used to determine the feasibility of a future project with immense certainty. b) Cost Volume Profit analysis Cost Volume Profit (CVP) analysis is used by managers to make short run decisions (Needles, Belverd and Crosson 727). Most of the organizations that do not use CVP analysis merely speculate when making short run decisions. Figure 1 below sows the breakeven point that many managers target to make decisions that have immediate impact. Figure 1: The breakeven point where total cost equal sales revenue (Source: Boundless.com) Management accounting not only shows the sales revenue and the total cost but delves further to show the level of activity or products to be sold in order to break even. This information is crucial in setting up the unit selling price (Clarke 78). If an organization is to rely on financial accounting information it cannot set a unit selling price, at least not based on substantiated model. A CVP analysis expands the functions of the breakeven analysis. Apart from providing a means of ascertaining the breakeven point and the unit selling price, a CVP analysis can help managers ascertain total fixed costs and variable costs per unit. This information can be used to determine whether the business venture is maximizing its profitability and may also be used to tell whether the business has reached its shutdown point (Williams et al 45). Through determining the fixed costs and selling price, management accounting information provides managers with sufficient information to make the make-or-buy decisions and lease-or-buy decisions among others. This is because management accounting information not only focuses at the end but also the means. The information provided determines what a product’s contribution is and how many products need to be manufactured, bought or leased in order to meet the organization’s objectives. c) Capital budgeting Management accounting information is needed by managers for capital budgeting decisions. Capital budgeting is the process where an organization plans for its corporate projects and is one of the major areas that use management accounting information (Drury 10). These projects are usually long term in nature. Due to their long term nature, these projects often require substantive amount of capital which certainly have a significant impact on the capital structure of the organization (Clarke 90). Some of an organization’s capital budgeting decisions may revolve around purchase of new machinery, disposing off of machinery, and research projects among others. Such capital decisions affect the amount of debt, retained earnings and even equity from the shareholders as the cash to finance them will be derived from those capital entities. Management accounting information helps determine the value these projects will have to the firm at the moment and in the future. The information is also used to search for investment opportunities and evaluate the benefits receivable from the projects or investments by examining its cash flows. Management accounting information can also be used to evaluate competing projects and decide on the one with superior income (Pierce and O’dea 280). Capital budgeting decisions are major business decisions and require utmost caution before making them. This is because they involve significant capital outlay. The cash flows from the invested capital will not start from the start, and even if they do, they will be received over a long period of time. The projects and decisions are futuristic and can easily be affected by changes in economic climate and discounting rates. These decisions are also not reversible; once the investment has been made there is no recalling it back. Due to these characteristics, informed decision making is absolutely crucial. Management accounting information comes in handy in that it can be used to prioritize the projects and make known the influencing variables and parameters which may affect the project (Needles, Belverd and Crosson 728). Prioritization is imperative since the firm has limited resources necessitating the most viable option to be chosen. Management accounting information can be used to show the time lag between the commitment of the capital and the time the benefits start trickling in (Drury 67). Management accounting information will provide a basis to determine the project evaluation methods that can be used and choose the best one. The commonly used project evaluation techniques include payback period, accounting rate of return, net present value, profitability index and internal rate of return (Sharma 129). The choice of the evaluation technique will influence the capital budgeting decision. For example, it will influence the perceived economic life of a project, the initial capital outlay, the long term survival of the firm, the accuracy of the future cash flow benefits and the mode of phasing out the capital expenditure. In all these decisions, management accounting information is needed and prominently used by managers. d) Budgeting Management accounting information is also needed for budgeting decisions. Budgeting decisions should not be set arbitrarily or purely based upon historical data (Okoli 62). The sales volume, material usage and efficiency of the production processes are indispensable elements when budgeting. Through such management accounting information the plans for the cost centers are expressed in quantitative form. Management accounting information is needed by managers to control the resources at their disposal making sure that the amount budgeted for is actually accessible (Clarke 90). The information will be used to create a model that can then be used by managers to forecast revenues and expenditures. Most importantly, the information will enable a manager spot a project’s constraints and address it adequately. e) Financial forecast Management accounting information is crucial for financial forecasting. Financial forecasting is the process of projecting financial outcomes (Williams et al 56). Although historical data is used to provide a basis, the time value of money used by management accountants can be used to forecast income. Management accounting information such as that provided through future value of the lump sum, future value of an annuity, present value of the lump sum and many other techniques of ascertaining the future value of money and an investment can be used for financial forecasting. f) Strategic planning Management accounting information is needed by managers to make strategic decisions. Strategic decisions are made by the top management and are used to provide the general direction of the organization through policy formulation (Pierce and O’dea 280). Information such as the working capacity of the machines and employees helps managers ascertain the position of the organization. The position of the organization affects resources allocation and determination of possible revenues. Therefore, management accounting information can be used for scenario planning for an organization. g) Cost allocation Cost allocation is the practice of managers assigning costs to the cost centers (Drury 79). Cost allocation provides a basis for decision making in that it tracks the organization’s cost through its departments. If the costs are correctly allocated the organization can keep track of all the activities in the organization; cost recovery is, therefore, enabled through management accounting. Devoid of this information, an organization may find it difficult to assign costs to cost centers. Furthermore, through cost allocation financial discipline across the cost centers can be enforced. Management accounting information, therefore, enables the empowerment of the various departments enabling them to make better decisions (Schaffer and Heidmann 197). Conclusion and Recommendations As is evident from the discussion, management accounting information is immensely applied in an organization decision making. Its need cannot be overstated. This information is, however, not self complementary, it has to be used in conjunction with financial accounting information in order to make the best decisions (Boundless.com). An organization basing its decisions solely on financial accounting information, at best, is speculating in its decisions. Management accounting information provides that insight, model and rationality that is lacking in financial accounting. Furthermore, it is forward looking as opposed to historical and very detailed placing managers at an advantaged position to make informed decisions. I, therefore, opine that an organization ought to have long term corporate objectives to enable the creation of a model that uses the relevant management accounting information to make decisions (Clarke 97). If the model developed is consistent with the organization’s objective then the decisions developed by the model will always be pertinent and correct besides being consistent. Also, it is imperative that the organization ensure effective communication between its departments. This should enable efficient information flow which empowers managers to make the best decisions given a circumstance (Pierce and O’dea 285). Lastly, the interpretation and implementation of the management accounting information generated by the system depends on the structures and controls instituted by the organization. The top management should ensure these structures are in place. Management accounting information is, thus, greatly needed and if well utilized it can go a long way towards eradicating conflicts, uncertainties, and, most importantly, indecision (Sharma 104). Work Cited Boundless.com. Usage of accounting information. Boundless, 7th March 2014, Web. 7th March 2014. Clarke, Peter. Accounting information for managers. Chicago: Cengage Learning EMEA, 2002. Print. Drury, Colin. Management accounting for business. Chicago: Cengage Learning EMEA, 2005. Print. 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Williams, Jan., Haka, Susan., Bettner, Mark., and Meigs, Robert. Financial and managerial accounting. The basis for business decisions. New York: McGraw Hill, 2002. Print. Read More