Helping Managers: The Fourth Pillar of Accounting

By John A. Tracy

The accountant has to wear four different hats. And the accounting system of a business has to serve all four of the following demands on it. Accounting serves critical functions in a business:

  • Recordkeeping: A business needs a dependable recordkeeping and bookkeeping system for operating in a smooth and efficient manner. Strong internal accounting controls are needed to minimize errors and fraud.
  • Tax compliance: A business must comply with a myriad of tax laws, and it depends on its chief accountant (controller) to make sure that all its tax returns are prepared on time and correctly.
  • Financial reporting: A business prepares financial statements that should conform to established accounting and financial reporting standards, which are reported on a regular basis to its creditors and external shareowners.
  • Internal reporting and analysis: Accounting should help managers in their decision-making, controlling, and planning by providing the information they need in the most helpful format. This branch of accounting is generally called managerial or management accounting.

Branching out in the field of management accounting

Designing and monitoring the accounting recordkeeping system, complying with complex federal and state tax laws, and preparing external financial reports put heavy demands on the time and attention of the accounting department of a business. Even so, managers’ special needs for additional accounting information should not be given second-level priority or be done by default. The chief accountant (controller) has the responsibility of ensuring that the accounting information needs of managers are served with maximum usefulness. Managers should demand this from their accountants.

Following the organizational structure

In a small business, there’s often only one manager in charge of profit. As businesses get larger, two or more managers have profit responsibility. The overarching rule of managerial accounting is to follow the organizational structure: to report relevant information for which each individual manager is responsible. (This principle is logically referred to as responsibility accounting.)

If a manager is in charge of a product line, for instance, the accounting department should report the sales and expenses for that product line to the manager in charge. If a manager is in charge of building maintenance, all relevant costs should be reported to that manager.

Generally speaking, a manager is responsible for one of two types of basic organizational segments:

  • Profit centers: These are separate, identifiable sources of sales revenue and connected expenses so that a measure of profit can be determined for each. A profit center can be a particular product or a product line, a particular location or territory in which a wide range of products is sold, or a channel of distribution. Rarely is an entire business managed as one conglomerate profit center, with no differentiation of its various sources of sales and profit.
  • Cost centers: Certain departments and other organizational units do not generate sales, but they have costs that can be identified to their operations. Examples are the accounting department, the headquarters staff of a business, the legal department, and the security department. The managers responsible for these organizational units need accounting reports that keep them informed about the costs of running their departments. The managers should keep their costs under control, of course, and they need informative accounting reports to do this.

The term center is simply a convenient word that includes a variety of types of organizational segments, such as departments, divisions, branches, territories, and other monikers.

Profit centers

Large businesses commonly create relatively autonomous units within the organization that, in addition to having responsibility for their profit and cost centers, also have broad authority and control over investing in assets and raising capital for their assets. These organization units are called, quite logically, investment centers. Basically, an investment center is a mini business within the larger conglomerate, company-wide setting.

From a one-person sole proprietorship to a mammoth business organization like General Electric or IBM, one of the most important tasks of managerial accounting is to identify each source of profit within the business and to accumulate the sales revenue and the direct expenses for each of these sources of profit. Can you imagine an auto dealership, for example, not separating revenue and expenses between its new car sales and its service and parts departments? For that matter, an auto dealer may earn more profit from its financing operations (originating loans) than from selling new and used cars.

Even small businesses may have a relatively large number of different sources of profit. In contrast, even a relatively large business may have just a few mainstream sources of profit. There are no sweeping rules for classifying sales revenue and costs for the purpose of segregating sources of profit — in other words, for defining the profit centers of a business.

Every business has to sort this out on its own. The controller (chief accountant) can advise top management regarding how to organize the business into profit centers. But the main job of the controller is to identify the profit centers that have been (or should be) established by management and to make sure that the managers of these profit centers get the accounting information they need. Of course, managers should know how to use the information.