When an aspiring entrepreneur starts a business, the office is full of excitement, enthusiasm and great expectations. Employees are hired to answer the phones, and salespeople are selling. The owner is buying raw materials, and the workforce is manufacturing the products.
But – how is the company doing? Is it making a profit? Everyone is working really hard, so they must be doing something right. So how do you keep the score of the game? This is where accounting in business steps in.
The Role of Accounting
The purpose of accounting is to provide financial information to the stakeholders of the business: management, investors and creditors. Accounting measures and summarizes the activities of the company and communicates the results to management and other interested parties.
Managers need accurate and timely financial data to make intelligent decisions, and accountants are the ones who produce this information. While the accounting process collects the data and presents it in various types of reports, the accountants help interpret the meanings of the reports and suggest ways to use these details to solve business problems.
Accounting can be classified in two forms: management and financial. Management accounting helps to run the business, while financial accounting reports on how well it’s running.
Internal Management Accounting
Managerial accounting produces internal reports that are designed for management and are used for decision-making. These reports are modified and adapted to the specific purposes and needs of individual managers and are not usually released to parties outside the company.
A few examples of management accounting reports are aging of accounts receivable, inventory levels, monthly sales and status of accounts payable. Internal accounting reports are also used for the preparation of budgets and forecasts.
Accounting Data for Decision-Making
Running a business requires accurate data about the company’s assets, liabilities, profits and cash position. Accounting provides this crucial information. Accounting plays a significant role in evaluating the viability of investments. Proper consideration of an investment demands a careful analysis of costs and projections of expectations for future cash flows. Certain criteria, such as determining hurdles to return on investment, must be met.
Consider the decision managers often face of whether to invest in a new plant or expand the existing facilities. A choice might be to invest $1 million in a new production facility or spend $300,000 to expand a production line. Each alternative will have different cash outflows in the beginning and varying future cash inflows. Each approach will have a different return on investment. So, which one should management choose? The company’s accountants will analyze the figures for each investment, calculate the rate of return for each project and present their findings to management.
This is a situation where accounting procedures produce the relevant financial data that management needs to make intelligent decisions. They also have to explore the various ways to finance these investments. Decisions must always be backed up with valid facts and figures.
Accounting for Government Regulations
Businesses must comply with government regulations and pay taxes on corporate income, Social Security taxes and sales. Accountants make sure the filings are accurate and on time. Any mistakes made when reporting income can result in fines and penalties.
Accounting for Planning
Successful organizations create plans to achieve their objectives. These plans include cash flow projections, sales planning, purchases of fixed assets and projecting inventory levels. An accounting analysis of historical data will provide the basis for making forecasts and developing plans to meet those targets.
Using Accounting Data for Budgeting
Budgets are essential to running a successful business. Accounting uses historical data to form the basis for future budgets and cost controls. With this information, managers can prepare overhead expense budgets and sales plans, and create cash flow projections. Then they monitor the regular accounting reports to make sure costs stay within the budgets.
Cost Accounting for Products
Manufacturing companies use cost accounting to calculate the cost of making products, determine break-even sales volumes and set optimum inventory levels. Managers need to know how much it costs to make their products to develop pricing strategies that allow the company to make a reasonable profit
An important responsibility of management is to control costs. However, to do this, managers must have predetermined standard costs of operations to use as yardsticks for measurement.
Take, for example, a company that manufactures yellow widgets. The company’s accountants have determined that manufacturing costs for this product include $2.57 in materials, $8.38 in labor and applied production overhead of $3.16 per unit. The total cost of production for a yellow widget is $14.11. The selling price is $23.51, giving the company a gross profit margin of 40 percent.
With these figures in hand, management can monitor production costs on a weekly or monthly basis to make sure the costs of production do not exceed these standards. If accounting reports show a discrepancy above the intended cost of manufacturing, then management knows to step in, find the cause of the problem and take corrective action.
Accurate accounting of manufacturing costs for each product is essential to the development of a sales plan and a projected product mix. More than likely, each product will have a different gross profit contribution, and management must establish sales goals for each item to reach the overall gross profit level needed to cover overhead and produce the target net profit.
Ratio Analysis Based on Financial Data
Financial ratios are vital metrics used to gauge the performance of all aspects of a company’s condition and operations; accounting provides the data required to construct these ratios. A company’s liquidity is measured by the current and quick ratios. Profit margins and expenses are reported as percentages of sales and compared to budgeted benchmarks. Financial leverage is a ratio of total debt to capital investment.
Managers often meet with department heads to discuss possible changes in strategies and operations. They explore various “what-if” ideas. For example, what would happen if the company decided to improve profits by cutting administrative salaries? Would that be a good idea? Probably not. Employees don’t like cuts in their wages.
But what if the managers chose to stimulate sales by lowering the selling prices of the products? Profits per unit would go down, but the decrease would hopefully be more than made up by the increased sales volume. An accounting analysis and projection would help clarify the results of this decision and determine if that strategy would be a wise move.
Financial Accounting for External Users
Financial accounting produces reports for external users, such as owners, investors, employees, creditors, unions and government agencies. These reports for external use are the profit and loss statement, balance sheet and cash flow statements. Unlike internal management accounting reports, financial statements prepared for outside users are compiled using Generally Accepted Accounting Principles.
Financial accounting reports whether the company made an adequate profit and how likely it is to pay dividends to shareholders. Curious investors will examine the financial statements to gauge the safety of their investments and potential for future growth and increase in value. Employees will look at the statements and get an idea of whether they can expect raises or increased contributions to pension funds.
Accounting reports, both managerial and financial, are essential to productively manage any company or organization. There is no substitute. Not having accurate and timely information about how effectively a business is running is a recipe for disaster.
Source: Small Business