Title image to article management accounting theory

Why Should You Read Management Accounting Theory?

Reading management accounting theory, in the simplest way put, is outright boring!

What’s worse is when the task is to read up on management accounting theory. Now that could scare away the bravest of souls.

But then, what begs attention is the fact that reading up on management accounting theory has scores of benefits.

Unlike traditional accounting, (more commonly referred to as financial accounting in the present day), where the focus lies on merely recording and representation of financial data – book keeping; management accounting is to do with the interpretation of that data and using it to make sound financial decisions.

So why should you read management accounting theory? Well here are 5 reasons

List of five points why theory should be read in management acocunting

Reason #1: Constraints

No matter how well funded a business may be, the bitter truth remains that it always operates under an environment of constraint. These constraints could be labor hours, machine hours, availability of finance, optimum utilization of resources etc. A non-efficient utilization of any resource spells doom for a business since it has a direct bearing on its profitability. The task of the manager is therefore to not only identify the constraint but weave his organization around it. More often than not identifying a constraint is easier said than done. There are way too many variables that seek our attention, which in turn draws attention away from the key issue.

Management accounting theory lists a theory called a ‘Theory of Constraints. This theory helps an individual identify a resource that is not as freely available (which becomes a bottleneck), and then optimizing the use of that resource by subordinating all other freely available resources to the constrained resource, to see how profitability can be maximized.

Reason #2: Starting from scratch

Sometimes, when we need to do a better job than our previous attempt, the first thing to do is to wipe the slate clean and start from scratch. Humans sadly have a tendency to save face when they take a poor decision; by committing greater resources to the decision, in the hope that they are proven right in the future.

Thus, when we review decisions that are connected with the allocation of money, we can depend on a theory called ‘Zero-Based Budgeting’. This gem of a management accounting theory, demands that managers justify every expense that is being made, even if the expense has been occurring for years.

So while traditional accounting asks managers to increase the budget for an expense made in the past, zero-based budgeting asks us to justify the cost every single instance, resulting in a bias free decision making.

 Reason #3: Delegation

The biggest challenge one faces with delegation is wondering whether an activity will be as well done by someone else instead of us. Focusing on the financial aspect of a task, we wonder whether the cost of carrying out a task will be kept under check or not.

Management accounting theory lists a concept known as ‘Responsibility Accounting’. This concept helps individuals plan and control a company’s responsibility centers, such as an individual division better by preparing budgets for each division. The entire company’s transactions are listed under at least one responsibility center and the costs associated with each transaction thereof. Correspondingly, budgets for each center are prepared to map the operational cost of each center. Reports that are prepared at the end of each month/quarter, help compare the allocated budget to each center for completing their tasks and the actual budget used. This automatically highlights how efficient or inefficient a center is. This, in turn, guides managers to what and where improvements need to be brought about to increase profitability.

Reason #4: Pricing a Product / Service

Every product or a service has asset number of inputs that it requires to be completed. These may be in the form of raw material or time. If the inputs required, are repetitive and can be mapped, so can their costs. Management accounting theory lays a method to assign costs to products on the basis of these listed inputs which is called ABC or ‘Activity based Costing’. This method of costing is really useful when a company wants to be able to map its expenses accurately. So while traditional accounting might label an activity under indirect or overhead expense, cost accounting has a theory for it.

Managers using this method of management accounting, assign 100% of an employees’ time to different activities that he carries out by which they are able to compute the total cost for the company for each activity. This tool has been reported to be extremely efficient to price products (and also services with time).

activity based costing picture

Reason #5: Again Pricing a Product / Service

Prudence is a rare gift. It allows us to foresee challenges and correct them well in time. Management accounting theory has a concept under it called ‘Target Costing’ that allows managers to proactively manage costs and even reduce them in the early stages of design and development cycle of a product instead of the very expensive corrections during or even post its launch.

This concept entails 3 parts. The 1st is the market driven costing that studies markets to define the cost a company can afford to incur to meet long-term profit goals. The second is cost reduction strategies that are implemented to bring to the cost of a product to its target level. The third is the component level target costing that shifts costing goals to component suppliers. This tool has been one of the most effective costing tools when it comes to new product launches and helps long term profitability in a company.

To sum up, it should be kept in mind that management accounting does not replace traditional financial accounting in any way. If nothing, theories of management cost accounting definitely help a manager leverage the data that financial accounting provides to make sound judgments. These theories are as useful for the advanced user as they are for novices.

And the best part – they aren’t as boring as we think.

Adrian

I'm Adrian, a chartered management accountant with many years of practical experience. I studied strategy, financial controlling and entrepreneurship in Switzerland and England.

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