Financial accounting reports the past to outsiders; managerial accounting supplies numbers to managers so they can plan, decide and control. This article revisits both: the accounting basics you need to read statements, and the cost and control tools managers use every week.
1. Accounting basics and statements
The accounting equation is Assets = Liabilities + Owners’ equity. Every transaction is recorded twice (double entry, debit and credit), following the rule of debiting what comes in and the receiver, and crediting what goes out and the giver. Core conventions: going concern, accrual (record when earned or incurred, not when cash moves), matching, consistency, conservatism and materiality.
| Statement | Question it answers |
|---|---|
| Income statement | Did we make a profit over the period? (Revenue − expenses) |
| Balance sheet | What do we own and owe at a date? |
| Cash flow statement | Where did cash come from and go (operating, investing, financing)? |
Ratio analysis turns statements into signals:
| Group | Ratios | Reading |
|---|---|---|
| Liquidity | Current ratio (current assets ÷ current liabilities), quick ratio | Can we pay short-term bills? |
| Profitability | Gross margin, net margin, ROE, ROCE | How well do we earn? |
| Efficiency | Inventory turnover, debtor days | How fast do assets convert? |
| Leverage | Debt-to-equity, interest cover | How risky is the funding? |
In the real world: a company can show an accrual profit and still run out of cash if customers pay late, which is why the cash flow statement and working capital matter. Many failed start-ups were “profitable” on paper and short of cash.
2. Cost concepts
| Classification | Types |
|---|---|
| By behaviour | Fixed (rent), variable (materials), semi-variable (electricity with a base charge) |
| By traceability | Direct (traceable to a product) and indirect/overhead |
| By function | Production, administration, selling |
| For decisions | Relevant (future and different between options), sunk, opportunity, avoidable, controllable |
Costing methods assign overhead to products:
- Absorption (full) costing: all production costs, fixed overhead included, go into the product.
- Marginal (variable) costing: only variable costs go into the product; fixed costs are written off as period costs. It supports short-term decisions.
- Activity-based costing (ABC): overhead is traced to activities (set-ups, orders, inspections) and then to products by cost drivers, giving fairer product costs where overhead is large.
In the real world: a business with many small-batch products may look profitable on a labour-hour basis but lose money on complex products once set-ups and orders are costed by activity. Cloud and FinOps teams do something similar when they allocate shared infrastructure to teams by tags and usage drivers.
3. Marginal costing and break-even (CVP)
Contribution = Sales − Variable cost. Contribution first covers fixed cost; the remainder is profit.
- P/V ratio = Contribution ÷ Sales
- Break-even point (units) = Fixed cost ÷ Contribution per unit
- Break-even sales (₹) = Fixed cost ÷ P/V ratio
- Margin of safety = Actual sales − Break-even sales
- Target profit units = (Fixed cost + Target profit) ÷ Contribution per unit
Worked example. Price ₹100, variable cost ₹60, fixed cost ₹2,00,000. Contribution per unit = ₹40, so break-even = 5,000 units (₹5,00,000). To earn ₹1,00,000, sell (2,00,000 + 1,00,000) ÷ 40 = 7,500 units.
Decision uses of marginal analysis:
| Decision | Rule |
|---|---|
| Make or buy | Compare the relevant variable cost of making with the buying price |
| Accept a special order | Accept if it earns positive contribution and uses spare capacity |
| Drop a product | Drop only if its contribution is below the avoidable fixed cost |
| Limiting factor | Rank products by contribution per unit of the scarce resource |
| Sales mix | Favour the mix with higher weighted contribution |
In the real world: an airline treats a seat as a near-zero marginal-cost item once the flight is scheduled, so it sells last-minute seats cheaply: any contribution beats an empty seat. Break-even thinking drives how many subscribers a streaming service needs to cover content spend.
4. Budgeting
A budget is a quantified plan for a period. The master budget brings sales, production, purchases, labour, overhead, cash and capital budgets together into a budgeted income statement and balance sheet.
| Type | Idea |
|---|---|
| Fixed | Set for one activity level |
| Flexible | Adjusts to the actual activity level, giving a fairer comparison |
| Zero-based (ZBB) | Every item must be justified from zero each period |
| Rolling/continuous | Always looks 12 months ahead, extended as each month ends |
| Performance/programme | Linked to outputs and outcomes |
| Capital budget | Long-term investments, appraised by NPV, IRR and payback |
Budgets work best when managers participate (bottom-up), targets are demanding but achievable, and they are used to learn, not just to blame. A known danger is budgetary slack, where managers pad their budgets.
In the real world: 3G Capital popularised zero-based budgeting at companies such as Kraft Heinz, where it cut costs sharply, though critics argue the squeeze later hurt brand investment. Government departments use performance budgeting to link spending to results.
5. Standard costing and variance analysis
A standard cost is the planned cost per unit. Comparing it with the actual cost gives variances, which tell managers where to look (management by exception).
| Variance | Formula | Points to |
|---|---|---|
| Material price | (Std price − Actual price) × Actual quantity | Purchasing |
| Material usage | (Std qty − Actual qty) × Std price | Waste, quality |
| Labour rate | (Std rate − Actual rate) × Actual hours | Wage rates, mix of grades |
| Labour efficiency | (Std hours − Actual hours) × Std rate | Productivity |
| Sales price and volume | Selling price and quantity versus plan | Market conditions |
Favourable (F) and adverse (A) variances need interpretation, not blame: buying cheap material (favourable price variance) can cause wastage (adverse usage variance). Target costing works backwards: selling price minus target profit gives the allowable cost, and design must meet it.
In the real world: Toyota is known for target costing and Kaizen costing, which push cost reduction into design and continuous improvement. Retailers track shrinkage (usage variance) on inventory in the same way.
6. Responsibility and performance control
Responsibility accounting assigns costs and revenues to the manager who can control them, through responsibility centres:
| Centre | Manager controls | Measure |
|---|---|---|
| Cost centre | Costs | Budget vs actual |
| Revenue centre | Sales | Revenue vs target |
| Profit centre | Costs and revenue | Profit |
| Investment centre | Profit and assets | ROI (profit ÷ capital employed), EVA |
Economic Value Added (EVA) = Net operating profit after tax − (capital × cost of capital); it shows whether the business earns more than its capital costs. Transfer pricing sets internal prices between divisions, using market, cost-plus or negotiated prices, and aims to make divisions act in the company’s interest. The balanced scorecard (Kaplan and Norton) adds customer, internal process and learning perspectives to financial ones, so that short-term profit is not the only target. Management control systems combine planning, measurement, feedback and incentives; a poorly chosen metric (for example, rewarding only sales volume) can cause dysfunctional behaviour.
In the real world: Indian conglomerates run divisions as profit or investment centres and compare them on ROCE. When a measure is made a target, people optimise the measure, not the goal (Goodhart’s law), which is why scorecards balance several measures.
One-minute recap
| Topic | Key idea | Where you meet it |
|---|---|---|
| Statements and ratios | Income statement, balance sheet, cash flow; liquidity, profit, leverage | Reading annual reports, credit decisions |
| Cost concepts | Fixed, variable, relevant, sunk; absorption, marginal, ABC | Product costing, cloud cost allocation |
| CVP and break-even | Contribution, P/V ratio, margin of safety | Pricing, subscriber targets |
| Budgeting | Flexible, zero-based, rolling | Annual planning, cost cuts |
| Variances | Price, usage, efficiency; target costing | Monthly reviews, procurement |
| Control | Responsibility centres, ROI, EVA, scorecard | Divisional performance |
Next in MBA Revisited: Business Communication.
Written by Claude, Anthropic’s AI assistant, as part of MBA Revisited, a quick refresher of the PGDM subjects one at a time.