3 Managerial Accounting Concepts Every New Entrepreneur and Small Business Owner Should Know
It is no secret the new entrepreneurs and small-business owners need to wear a lot of hats. While they don't need to be a CPA, there's some key accounting concepts that should be at the back of their mind while operating their business. By keeping these concepts in mind while operating the business, the owner and have a better view of the business and be more prepared with respect to the financial and accounting aspects of their operation. In this series we're going to look at three different areas of accounting and what small business owners and entrepreneurs can learn from each area.
We went through 3 financial accounting concepts in our last blog. Now we come to my favorite area of accounting when we bring you 3 managerial accounting concepts that every new entrepreneur and small business owner should know.
Managerial Accounting deals with the presentation, preparation, interpretation, and analysis of financial and nonfinancial information for internal reporting purposes. For many people, the concepts of managerial accounting are easier to understand and apply to a business because the concepts are not locked behind a defined set of principles that guides financial and tax accounting.
Key Managerial Accounting Concept #1 - The Cost-Benefit Principle
The first of these concepts that we're going to talk About is the cost-benefit analysis and it is the fundamental principle that many business owners run their businesses on. At face value the concept is simple: make decisions based on whether or not they will yield a positive value based on how much it costs to implement a decision versus how much benefit you gain by implementing that decision. This type of analysis should be used everywhere in the business, but where most small businesses failed to execute properly is thinking only in the short term and only looking at the numbers.
As an example, looking at only the numbers could mean choosing a different healthcare plan for the company. Why choosing the cheapest option for the company might look good on paper, it can reveal other costs in the form of employee disengagement and employee turnover. Over time the benefit from keeping employees longer and keeping them happy will surely outweigh the extra monetary cost of paying a little bit more in insurance premiums every month.
Key Managerial Accounting Concept #2 - The Break-even point
The second and most practical concept is the break-even point. The reason we say this is the most practical concept is it because it really hits home for new entrepreneurs that need to make rent or would like their business to be self-sustaining. While there are many different factors that go into calculating a break-even point, it generally boils down to: how much business do I need to do (units sold, hours worked, contracts executed) in order to cover my fixed costs? In order to determine your breakeven point, you need to know the following:
Total fixed costs for a given period (Let’s use one month as an example)
How much it costs to deliver your good or service
The selling price of your good or service
We will not go into too much detail what how to calculate this because it's so specific to every business. However, we can speak to the benefits of knowing what the breakeven represents to a small business operation. As mentioned earlier, “breaking even” could mean making rent for the month based off how many items you sold from your Etsy shop. For others, it might mean good enough web traffic to cover the website hosting cost for an informative Financial blog. Whatever your circumstances may be, knowing your break-even point is the first step to ensuring short and long-term financial sustainability for your business.
Key Managerial Accounting Concept #3 - The Payback period
If there is one question that newer entrepreneurs ask besides “what do I need to do to break even?”, it’s “how long will it take to recover my investment?” By their very nature, entrepreneurs are either taking a risk with their resources, or rationing them out very carefully to ensure nothing is wasted while the build up their operation (or both!). The payback period model frames decisions based on their initial cost and the expected future benefit over time related to that decision. For example, a company may choose to invest in a machine that will cost $4,000 up front, but will help generate additional cash flows of $800 per month for the next 10 months at least. In this case the payback period, or the time it takes for the benefits of the purchase to match or outweigh the cost is 5 months ($800 * 5 months = $4,000). This concept can be applied to equipment, software, processes, and even coffee machines, and serves as a very valuable tool for those with limited resources to plan the timing of their next investment.
If you are interested in hearing more about these concepts and how to apply them to your small business or entrepreneurial venture, please contact us! Stay tuned for the next segment where we will talk about 3 tax accounting concepts. You won’t want to miss it!