By Alison Haupt
Management accounting serves the purpose of providing complete and accurate financial information timeously to business owners to assist them with the day to day running of their business as these financial reports measures their business performance and highlights weaknesses so that, by devising planning and performance management systems to improve efficiencies and grow profits, short term decisions can be made. Unlike financial accounting which produces annual reports mainly for external stakeholders, management accounting generates monthly or bi-monthly reports for internal use by managers and business owners.
Every business owner needs to understand what management accounts are telling them. Management accounts focus on the present and provide information which the owner or their accountant can use to make projections into the future. It is very important for the business owner to know how to gain a deeper understanding of these accounts. Hence, the amount of information obtained from carrying out different levels of analysis by can reveal more information about the business.
Any analysis that tells you something new about the operation of your business is valuable and it is suggested that you use what you learn below in conjunction with any other analysis method that your accountant recommends to be valuable for your particular business.
What I intend discussing is termed the ‘four-level analysis’ method. A brief explanation of each level follows:
This is a quick examination of the information to see if any one figure stands out.
- Level 1 analysis (split into 2 types)
Type (a) Analyse one category eg. Turnover or profit.
Type (b) Compare actual results to budgets for all categories
- Level 2 analysis
Calculate the percentage difference from month to month within level 1 category
- Level 3 analysis
Perform a ratio of one category to another. Analyse the significance of this ratio
- Level 4 analysis
Analyse the results of two or more Level 3 analysis ratios, comparing them.
The following excerpts from a set of management accounts will be used throughout the discussion of the ‘four-level analysis method. I will later introduce the budgeted amounts.
This is a quick glance at the information provided above. The only slightly unusual trend is that there is a drop in cost of sales in May and June, despite an increase in turnover in the same period.
Level 1 analysis: Type (a)
Here we will use the turnover category to explain this type of analysis.
The above figures show us that turnover has increased from month to month.
Let us now analyse our turnover figures in a little more depth by establishing a base month and compare the performance of each subsequent month to that base month. For this exercise we choose January as our base month.
The percentages show the performance of each month relative to January.
Level 1 analysis: Type (b)
This analysis involves comparing the actual results to the budgeted result.
The turnover ratio is less than 100%. We would like the turnover to be as high as possible. The fact that it is below budget is a negative indication. The expense ratio is less than 100%. This is a positive indication. It should be noted that further analysis might indicate that turnover is down because expenses are down. We might not be spending what we need to, to increase turnover.
Level 2 analysis
In this level of analysis we look at a trend within a trend. Here we calculate the change in turnover from month to month. The change in turnover from month to month is:
We can see that there is an initial increase and then a decrease in turnover as the month’s progress. Thus, the percentage change from January to February is:
Example:The increase in turnover in February compared to January is: 127 960/426 533 = 30%
The percentage change from month to month is as follows:
Here we can see that although we are increasing our turnover from month, the increase is occurring at a decreasing rate. This should be regarded as an ‘early warning’ sign. Here, we have identified a potential problem.
Level 3 analysis
This level of analysis involves calculating the ratio of one category to another and analysing the significance of the results of these ratios.
We will look at the ratio of cost of sales divided by turnover. The result of this will determine what our direct expenses are as a % of the turnover. The lower the %, the better the business is performing. Ideally we would like to achieve a bigger turnover for the same costs or the same turnover for lower cost of sales (direct costs).
Example: January cost of sales R140 756 divided by turnover R 426 533 = R140 756 x 100 / R 426 533 = 33%
The results are as follows:
There is a steady decrease in the percentage cost of sales to turnover. This is a positive trend.
Let’s calculate the ratio of profit after expenses to turnover.
Example: Profit after expenses R157 177 divided by turnover R426 533 as a percentage: R157 177 x 100/R426 533 = 36.85%
The results are as follows:
The percentages are decreasing month by month, hence we are retaining a lower percentage of turnover each month as profit. This is not a good indicator for your business. It is a negative trend.
The 2 ratios above have two different results. The one a positive trend and the other a negative trend. Hence, our analysis has identified that there is an aspect of the business that can be improved and, moreover, we now know what it is. The problem is with one or more of our expenses. Viz. an extraordinary but necessary expense, eg. legal fees, staff training, preparation of annual financial statements and tax returns, etc. or one or two unnecessary expenses.
Level 4 analysis
This level of analysis is the summary area, pulling all the results together so that we can see the whole picture. We will examine the results of the earlier analysis, rather than looking at each result in isolation.
The results that we have on hand might seem conflicting:
- Turnover is increasing, but at a decreasing rate. (Okay, but levelling out)
- Cost of sales to turnover is decreasing at a steady rate. (Good)
- Profit to expenses is decreasing at a steady rate. (Bad)
We thus have both good and bad news from our analysis. We can see that there are no problems with direct costs, but there could be a problem with expenses. In management accounts we have a list of all expenses. We will need to analyse these to determine exactly where the problem lies, bearing in mind that an increase in an “investment expense” is not the same as an increase in an unnecessary expense.
The ratios that we have calculated are often called the key success ratios. These key ratios can change from time to time, business to business etc. The use of the four-level analysis will assist you in determining the key success ratios for your business.
It is important for business owners to understand that without accurate and complete monthly management reports, your accountant cannot provide you with any advice and that you and your business are effectively working in the dark leaving potential high risk problems unidentified, the consequences of which could be dire.
Alison Haupt, Accountant and Business Accounting Network franchise owner
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