Managerial Measures

Managerial Measures

Any introductory accounting course will explain that assets and expenses have a debit balance; while liabilities, income and equity have a credit balance. Subsequently, here are some of the basics of managerial accounting.

Corporations usually have a decentralized structure. Therefore, the division of a company can be a cost, profit or investment center. As their names indicate, the cost centers only incur costs, the profit centers revenues and costs, and the investment centers have control over cost, profits as well as invested funds. The distinctions come in handy in responsibility reports; obviously, it would be unfair to judge a manager based on circumstances absolutely outside his or her control. Hence, the controllable margin (CM = the amount of profit remaining after all variable but only controllable fixed costs have been deducted) is used in judging management’s performance. The judgment is based on whether there were any discrepancies from budget, and if so, were they favourable or unfavourable. A word of caution: at the corporate level all costs are controllable by top management, so CM becomes interchangeable with operating income (OI).

The emphasis on costs is clear from the economic underlying principles. Since a free market is regulated by demand and supply, in a competitive market a firm is a price taker and its only way to secure a profit is to control costs (i.e. target cost = market selling price – desired profit). Of course, these constrictions are lifted if a business is a perfect monopoly.

Managerial measures needed. Photo by Elena.

Return on investments (ROI) is calculated by dividing CM or OI by the average operating assets. For purposes of convenience the assets are averaged over the year. Another measure is residual income (RI), which is obtained by subtracting from the CM or OI, the minimum required rate of return (RRR) multiplied by the average operating assets. In a sense, it is a better measure than ROI because since any investment project with an ROI > RRR will increase the firm’ income, it would be deemed acceptable, an alternative often foregone if the overall ROI is decreased. However, the method lacks precision in that RI can be equal for two options greatly differing in amounts invested.

Asset turnover is computed by dividing sales by average operating assets, whereas to get the profit margin one divides the OI by sales.  Other popular measures are return on assets (ROA = OI /Total assets) and return on equity (ROE = OI/Shareholder’s equity).

Gross profit, also called gross margin, refers to sales minus cost of goods sold. The contribution margin equals sales minus variable costs. One of the main aspects to remember about fixed versus variable costs, is that fixed costs must be covered by the company whereas it is producing (manufacturer) or selling (merchandiser) anything or not.