Business owners, CEOs and management need accurate and relevant financial and operating information to make informed decisions that are based on facts and economic reality. Decisions abound concerning the allocation of capital and other scarce resources, for optimum return and to create value. Information is required for most management decisions to evaluate opportunities and quantify risk.Critical decisions may relate to issues such as:
• Pricing
• Capital allocation
• Capital investment ranking
• Make or buy decisions
• Adding or dropping products/lines
• Purchasing decisions
• Performance measurement
• Strategic planning
• Expansion or divestiture
Management Accounting is distinct from financial accounting in that financial accounting is primarily done for external users such as stockholders, banks and the IRS. Financial accounting follows a set of rules called GAAP and is often prepared on a monthly, quarterly or annual basis. It tends to be more backward looking in nature, ensuring that transactions are accurately and that financial statements are complete and presented fairly.
Management accounting is used to provide internal management with information that can be leveraged for decision making and to better manage the business. Information is derived from financial system and operating systems and then analyzed, (often reformatted) and presented. Management accounting gives more weight to economics, statistics and behavioral aspects of the business – being part art and part science. It benefits from knowledge and insight about the specific business, and can also utilize quantitative and analytical techniques. Management reports may be prepared on a regular basis or as needed for decision support.
It is important to identify and utilize the most relevant information in any decision-making activity. Financial information from the accounting system is often used as a starting point. Although such information may be useful information, it is not always suitable in its original form. Only relevant revenue and cost information should be included and these often differ between alternate decision scenarios. If the same under all scenarios, they should be excluded for decision making. Sometimes these relevant costs are referred to as incremental revenues and costs, meaning that they vary based on the decision paths under consideration.
Allocated amounts found in financial records must always be scrutinized carefully. Overheads and other expenses are often allocated on an arbitrary basis using revenue, machine hours, or labor hours as the basis for allocation. A better method of allocating expenses utilizes an activity-based approach, in an attempt to more accurately allocate expenses based upon the activities that actually drive them.
Other items that are often found in financial information that may not be relevant for decision making include retroactive accounting adjustments, one time or non-recurring expenses, expenses to support growth, sunk costs, depreciation expense, and allocated fixed costs. These must be removed or adjusted for, before the analysis takes place, as they distort the view of economic reality that is essential for sound decision making.
Once the relevant information is obtained there are many techniques and approaches available. Breakeven analysis, activity-based costing, capital investment appraisal techniques, discounted cash flow, flexible budgeting, contribution margin analysis – to name a few. It is important that the right technique be used in the appropriate circumstances. Sometimes more than one technique is applied.
Models are often used to simulate and aid in the quest to accurately model reality. A sound decision model reflects the economics of the organization and maps the relationships between key variables and drivers of the business. Inputs include market forces, prices, customers, revenue, operating expenses and capital expenditures, risk and strategy. For any given construct of inputs, the output generated should be reliable enough for an informed decision to follow.
Perfect accuracy is not the goal here. More important is to validate the relationships between the variables and not to inadvertently omit a key component. The purpose of modeling and other analytical techniques is to make a sound and informed decision. This is a situation where being approximately right is always preferable to being precisely wrong.
Ultimately, the goal is to identify and isolate the most accurate and relevant information for the decision under consideration. Information must be put into context as critical decisions have a long-term impact to the business. Uninformed decisions and those based on inaccurate or incomplete information, will ultimately lead to lost opportunity, increased risk and lower cash flow and profits. A CFO or other professional, properly versed in decision support analysis techniques can be of immense help. Poor decisions can make the difference between success and failure, of projects, ventures, and sometimes even entire organizations.
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