Make better decisions with the right numbers: a practical guide to management accounting

You have an important decision to make at work. How will that decision affect your company’s bottom line? Analysing decisions through numbers is the realm of managerial accounting, as Gaizka Ormazabal and Eduardo Soler of the Instituto de Estudios Superiores de la Empresa at the University of Navarra in Spain explain in their new technical note Accounting for Decision Making.

Using examples, the authors walk through formulas for quantifying the impact of decisions, starting simply and then adding layers of complexity. Ormazabal and Soler explain how to quantify the impact of decision alternatives using two approaches: one based on cash flow and the other on income statements. They also discuss a decision’s time horizon, questions of capacity and forecasting uncertainty – all issues relevant to managers today.

To illustrate managerial accounting concepts, the technical note puts an example front and centre.

A European company produces diesel engines for garden tractors. In 2013 the company sold 100,000 engines for €500 each ($710). In 2014 an important retailer asks the company to supply it with 1000 engines in only a week. It offers to pay only €400an engine. Should the company accept this €400,000 order?

An executive at the company might first consider the €400,000 question by looking into the relevant costs. The real question, however, is which costs to consider.

The company’s per-unit production costs of €330 are obviously relevant here, but what about its total production costs of €450a unit? Are labour costs relevant? Is manufacturing overhead? Not all expenses are affected by the retailer’s single order, so they may not need to be included in the analysis, even if they are required on the income statement.

To analyse which costs are relevant, the authors turn to cost classifications – namely fixed and variable costs, direct and indirect costs and sunk costs and opportunity costs. Those categories are not mutually exclusive, but are mostly useful for managers seeking to identify relevance to the decision at hand.

The simplest way to measure the economic value of the decision is to find the difference between the potential revenues and the relevant costs. If the value is positive, the order probably should be accepted. If it is negative, the order probably should be rejected.

The note starts with those simple computations to illustrate the basic reasoning of managerial accounting. Later more layers of complexity are added to the mix. For example, is the company running at or under capacity? Is there a scarcity of resources to consider? Is this a short-term operational decision or are there issues of the company’s sustainability in the long run?

The rule of thumb when deciding on an order’s short-term impact is to consider the difference between revenues and variable costs. What about the long term, though? Can the company continue as a viable proposition if all its customers follow the retailer’s lead and demand discounted engines?

Fixed costs may not affect a short-term decision when the company is operating under capacity, but they do matter in the long run. A company’s investments in its production facilities or the hiring of workers become more relevant when the longer time frame is being considered. Long-term planning also should take into account the value of money over time and should reflect a company’s liquidity needs and its cost of capital.

From an operational point of view, a decision’s impact on cash flow is relevant to management. That said, the impact on the company’s income statement matters too. Investors’ perceptions, potential financial contracts, taxes and even employee incentives may be at stake.

Working with the income statement, decision-making calculations should follow generally accepted accounting principles, which requires taking into account the depreciation of fixed assets. Inventory valuation policies also may affect the analysis, based on whether or not fixed costs are included in the decision-making calculations.

In sum, the differences between GAAP earnings and cash-flow analyses can be significant. Both approaches are important for optimal decision making, but you should take care to perform the computations separately and not mix them. Managers who understand and use accounting to make decisions know how much is at stake in getting the numbers right.

• Original Article: http://www.brw.com.au/p/business/make_better_decisions_with_accounting_M239PQUYUmE33m8R5UfPPP