An Introduction to Management Accounting

For many years it was thought that accounting is just simple book-keeping and maintaning books of accounts which could provide a business no more benefit than the determination of the profitability of the company.

All of this has changed now, as today accounting is being used as a decision-making tool which assists the management of a company in getting the right and timely information for any decision which may have long term implications. Not only that, but today more and more finance professionals are moving up the ladder within organizations and reaching executive positions. Accounting is no more bound by the elementary record-keeping which is so unfairly associated with the subject.

The subject of Management Accounting is the invention of the decision-making necessity within all organizations. It is a form of accounting which focuses on just what I mentioned above that is extracting the relevant information for any particular decision on hand.

This is the field in accountancy which has made the subject a lot more interesting and vibrant. Something which the future accountant must keep in mind while he chooses the specialist field within the broad umbrella of Accounting.

Double-Entry System

Having looked into the basics of accounting for different class of items, now we have a basic understanding of how accounting works. The relative treatment of different transactions is always based on the double-entry method which means that every transaction will have two effects (Debit and Credit) which will always make both sides of the entry equal (Total of Debit and Credit for any transaction will always become equal).

For example, we purchased a car for business use.

The asset i.e. car will be debited because the rule for asset increase is debit. Whereas, we purchased the car on cash say 1000 $. Cash is also an asset for a business (it is a short term asset which is the current ability of the company to pay off its debts.) , so the payment of cash marks a decrease in an asset which you will remember means a credit of that asset.

The entry becomes:

Car a/c 1000 $ (Dr.)

Cash a/c 1000 $ (Cr.)


Now, as you can see the entry had two effects a debit and a credit and both were equal in worth. That is the double-entry method and this is the widely accepted and the basis for all acounting being done all over the place.

Some, transactions for your personal review are here:

1. The company purchased furniture worth 200 $ on credit.
2. Paid salaries to employees amounting to 1000 $.
3. Made sales worth 50,000 $ on cash.

The rules for the above mentioned entries will be based on the basic rules which I mentioned in my previous posts. The effects will be two and will be equal always!

FOH Applied Rate and Cost Drivers

One of the tools used for controlling FOH costs is the use of an FOH applied rate. Now how do we calculate this applied rate and what is its purpose? I'll start with the purpose. This is a budgeted rate based on the expected working conditions of the company, which is used to budget for the coming period.

The formula of FOH rate is = Total Budgeted Indirect Expenses/Expected capacity

The expected capacity could be expected hours of labour for the company's budgeted target of production, hours of machine running for the production of units expected, etc. Whatever it may be it is up to the management but it is better that the denominator chosen be the cost driver of that product.

Cost Driver is any activity in the production process that is primarily and largely responsible for the costs incurred. The higher the quality of the cost driver chosen the better the calculated applied rate.

Factory Overhead (FOH)

While ascertaining the overall cost of the finished goods manufactured by a company, we first identify the three basic elements which constitute the product. These, as you may remember, are Materials, Labours, and Factory Overhead (FOH).

Right now, I am going to venture into some details relating to FOH; which are the indirect expenses incurred by the company during the production process, and which become part of the product. Indirect here means that the costs of these expenses cannot be easily identified with a single unit of product produced. For example, when a supervisor looks over the work being done on several units of products the salary of the supervisor which should have otherwise been classified as Labour cost, would be treated as an indirect cost and all indirect costs would fall under the head FOH.

The business continues to spend money on all sorts of expenses like electricity, water charges, watchman's pay, rent, etc., but all of these expenses will only be included in the cost of product if these relate to the factory. For control purposes, the management of a company doesn't just spend money haphazardly without any control tool. Luckily some tools are available to the management which include preparing budgets, using an FOH applied rate, calculating FOH variances, etc. These will be discussed later.

Rules for Journalizing Transactions

The basic operation of financial accounting within an organization starts from the journalizing of day-to-day transactions. Any business transaction no matter how inconsequential it may seem has to be properly recorded in the Journal.

As, I mentioned in the previous posts regarding classfication of elements, after having identified the respective class of the item, we only have to follow some basic rules. These rules are mentioned hereunder:

For Assets the rule is that if the asset is flowing towards the company (whose accounts we are maintaining), then the Asset account will be debited. And if the asset is disposed off in any way then the Asset account will be credited. These rules are the absolute rules of thumb for accounting. So, remember them always!

As I referred to previously Liability is treated oppositely to Assets. An increase in a Liability i.e. the company's payable increases, then the Liability account will be credited. And in case the liability is reduced by payment then the Liability account will be debited.

Likewise, the incurring of any expense will be debited and the earning of any revenue or income will be credited.

Capital is not absolutely but technically treated as a Liability which the company owes to the Owner of the business. So, the treatment is same as that for liabilities. When capital is introduced into the business then this increase is credited to the Owner's capital because this transaction results in the company owing more to the Owner. And debited when the Owner withdraws something out of the company for personal use.

DEBIT AND CREDIT

Having looked into the basic classifications of items related to an enterprise i.e., ASSETS, LIABILITIES, INCOME, EXPENSES, and CAPITAL, I will now briefly mention the basic rules of accounting for all of these items. These basic rules are based on two things; DEBIT and CREDIT!

These are rather alien terms which have been in vogue in the subject of accounting and form the basis of all accounting. Before explaining these two terms let me say that the names don't matter here but the function does. Let's start from a simple example, Income and expenses are the exact opposites of each other, agreed? Good! So, while accounting for any new income earned by a company the treatment should be fundamentally opposite to the incurring of an expense.

Similarly, as I said before Assets and Liabilities are mirror images of each other. So, the acquisition of an asset should be accounted for, as the direct opposite treatment of liabilities. And this brings us to THE ACCOUNTING EQUATION! It goes like this:

ASSETS = CAPITAL + LIABILITIES

This equation signifies the fact that whenever, one element of the equation is affected it will affect some other element as well, and the equation will hold good.

For example, lets say I purchased an asset on credit worth 100 $. So, now the equation will be:

+ 100$ = 0$ + 100$

+ 100$ = + 100$

See, just like this the equation will always hold true. When we purchased the asset our asset increased by 100$ in value, but as we didn't pay the supplier so our liability also increased by 100$, and will remain there until we pay off the supplier in full. This is plainly the foundation of all accounting treatments.

And DEBIT and CREDIT is actually the phenomenon of these accounts being the opposites of each other. So, the increase of one is the dimunition of the other. The increase of ASSET is a DEBIT but contrary to that the increase in the LIABILITY is a CREDIT; THE EXACT OPPOSITE. I hope you got the idea. If not we can further discuss the issue.

Post your Problems

Dear accounting students,

This blog has been created for you! I want you to take advantage of this opportunity and ask any questions which you have regarding Accounting. If you have any issues or any mind-boggling problems then please feel free to post them here.

Remember, the best way to get to the bottom of such issues is by discussing and talking them over. So, if you have any problems START POSTING!

The Fundamental Concept

Whenever, we would wish to account for any item in the subject of accounting the first step is to identify the nature of the element. Is the item an asset, liability, income, expense, or capital. The treatment of the item depends on this identification.

However, for beginners I think we better distinguish between the above mentioned items.

• ASSETS are expenditures which are incurred by an entity which benefit the organization for more than one accounting period. Such items are called Capital expenditures because the benefit exceeds the normal accounting period being followed by the company. Such expenditures are non-recurring in nature i.e. these are relatively rare. For example, if a company purchases a truck for usage in business, then this transaction will be a capital expenditure and the item should be classified as an asset. Why? The benefits from the truck are expected to flow to the entity over a long period of time, which would definitely exceed the normal accounting period. Such items are BALANCE SHEET ITEMS.

• The mirror image of an asset is a LIABILITY. Liability is an obligation of the company which might have accrued against any expenditure. For example, when a certain transaction takes place like the purchasing of the truck mentioned above, it should be against the payment of its sales price. But businesses don't run on cash payments all the time. Suppliers allow their customers to purchase items on credit i.e. the payment is made at a later time. Any item which results in a future obligation like this is classified as a liability which is also a BALANCE SHEET ITEM.

• EXPENSES, on the other hand are expenditures just like asset are, but these are mostly recurring in nature and the benefits of these are not expected to flow to the entity beyond the normal accounting period. Such items are INCOME STATEMENT ITEMS.

• INCOME as the name suggests is revenue generated by the entity's normal trading operations. There might not necessarily be an inflow of cash, because remember we also allow credit to certain customers of ours. The revenue generated is the primary source of survival of the company. This is also an INCOME STATEMENT ITEM.

• Finally, CAPITAL refers to the investment made or drawings by the owner of the business. This is the intial source of funds which the owner used to get the business up and running. Later on the person may invest more depending on the requirements of the business. In addition to it, he may withdraw part of his investment.

Cost Elements

For a manufacturing concern the basic undertaking is the production of goods which are commonly referred to as finished goods.

Now in order to arrive at the cost of these goods produced it is important to classify the costs which are incurred in the process. Furthermore, if the cost calculated is accurate then it also assists management in determining the appropriate pricing policy.

There are three basic cost elements which are part of an organization's manufacturing process: Materials, Labour, and Factory Overheads.

Materials, as the terminology suggests refers to the cost of materials which are consumed in the production process. Similarly, Labour refers to the wages paid to workers during the production process. Finally, Factory Overheads (FOH) are the indirect expenses which were incurred during the production process.

Under these three heads the costs incurred on the product are classified and this ultimately becomes the part of the finished goods produced.