9.1. Helping Managers Do Their Jobs
As previous chapters explain, accounting serves critical functions in a business. A business needs a dependable recordkeeping and bookkeeping system for operating in a smooth and efficient manner. Strong internal accounting controls are needed to minimize errors and fraud. A business must comply with a myriad of tax laws, and it depends on its chief accountant (controller) to make sure that all its tax returns are prepared on time and correctly. A business prepares financial statements that must conform with established accounting standards, which are reported on a regular basis to its creditors and external shareowners. In addition, accounting should help managers in their decision-making, control, and planning. This sub-field of accounting is generally called managerial or management accounting.
This is the first of three chapters devoted to this branch of accounting. In this chapter, I pay particular attention to the internal accounting report to managers that provides essential feedback information needed for controlling current profit performance, and which also serves as the platform for planning future profit performance. I also explain how managers use accounting information for analyzing how they make profit and why profit changes from one period to the next. Chapter 10 concentrates on financial planning and budgeting, and Chapter 11 examines the methods and problems of determining product costs (generally called cost accounting).
NOTE
Designing and monitoring the accounting system, complying with tax laws, and preparing external financial reports all put heavy demands on the time and attention of the accounting department of a business. Even so, managers' needs for accounting information should not be given second-level priority. The chief accountant (controller) has the responsibility of ensuring that the financial information needs of managers are served with maximum usefulness. Ideally, a manager tells the accountant exactly what information he needs and how to report the information. In the real world, however, this is not exactly how it works. The accountant has to more or less read the mind of the manager. Oftentimes the accountant has to take the initiative regarding the information to report to managers and how to report it.
9.1.1. Following the organizational structure
The first rule of managerial accounting is to follow the organizational structure: to report relevant information for which each manager is responsible. (This principle is sometimes referred to as responsibility accounting.) If a manager is in charge of sales in a territory, for instance, the controller reports the sales activity for that territory during the period to the sales manager. Two types of organizational units in a business are of primary interest to managerial accountants:
Profit centers: These are separate, identifiable sources of sales revenue that expenses can be matched with, so that a measure of profit can be determined for each. A profit center can be a particular product or a product line, a particular location or territory in which a wide range of products are sold, or a channel of distribution. Rarely is the entire business managed as one conglomerate profit center, with no differentiation of its different sources of sales and profit.
Cost centers: Some departments and other organizational units do not generate sales, but they have costs that can be identified to their operations. Examples are the accounting department, the headquarters staff of a business, the legal department, and the security department. The managers responsible for these organizational units need accounting reports that keep them informed about the costs of running their departments. The managers should keep their costs under control, of course, and they need informative accounting reports to do this.
NOTE
In this chapter, I concentrate on accounting reports for managers of profit centers. I don't mean to shun cost centers, but, frankly, the type of accounting information needed by the managers of cost centers is relatively straightforward. They need a lot of detailed information, including comparisons with last period and with the budgeted targets for the current period. I don't mean to suggest that the design of cost center reports is a trivial matter. Sorting out significant cost variances and highlighting these cost problems for management attention is very important. But the spotlight of this chapter is on profit analysis methods and the primary accounting report for managers of profit centers.
Note: I should mention that large businesses commonly create relatively autonomous units within the organization that, in addition to having responsibility for their profit and cost centers, also have broad authority and control over investing in assets and raising capital for their assets. These organization units are called, quite logically, investment centers. Basically, an investment center is a mini business within the larger conglomerate. Discussing investment centers is beyond the scope of this chapter.
9.1.2. Centering on profit centers
From a one-person sole proprietorship to a mammoth business organization like General Electric or IBM, one of the most important tasks of managerial accounting is to identify each source of profit within the business and to accumulate the sales revenue and the expenses for each of these sources of profit. Can you imagine an auto dealership, for example, not separating revenue and expenses between its new car sales and its service department? For that matter an auto dealer may earn more profit from its financing operations (originating loans) than from selling new and used cars.
Even many small businesses have a relatively large number of different sources of profit. In contrast, even a relatively large business may have just a few mainstream sources of profit. There are no sweeping rules for classifying sales revenue and costs for the purpose of segregating sources of profit — in other words, for defining the profit centers of a business. Every business has to sort this out on its own. The controller (chief accountant) can advise top management regarding how to organize the business into profit centers. But the main job of the controller is to identify the profit centers that are established by management and to make sure that the managers of these profit centers get the accounting information they need.