This article is an excerpt from the Shortform book guide to "Profit First" by Mike Michalowicz. Shortform has the world's best summaries and analyses of books you should be reading.
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What is management accounting? What are the three principles of management accounting?
According to Mike Michalowicz, the author of Profit First, traditional management accounting has three basic principles. These principles have been used for years, and Michalowicz believes they are outdated.
Here’s an overview of traditional management accounting principles, according to Michalowicz.
Defining Traditional Management Accounting
First, let’s clarify what Michalowicz is referring to when he talks about traditional management accounting. His definition includes both commonly accepted wisdom of the business world as well as the GAAP (Generally Accepted Accounting Principles) used by the U.S. Securities and Exchanges Commission.
(Shortform note: Michalowicz refers to traditional accounting as a whole as GAAP, but the GAAP are actually smaller in scope than that. The GAAP are government standards for clear and legal business accounting, rather than a guide for traditional accounting methods.)
In particular, Michalowicz emphasizes three principles of management accounting:
Principle #1: Income Minus Expenses Equals Profit
The first main traditional accounting principle states that when doing your accounting, begin with your income and subtract all of your business’s expenses–whatever is left is your profit. (Shortform note: This is a simplified version of the calculations done on a profit and loss (income) statement.)
Principle #2: Growth Is Success
This second principle of traditional accounting says to constantly seek to grow your business and put growth as your first priority. Growth leads to an increase in your income as well as the overall value of your company in case another company wants to buy it.
- A simple example would be a restaurant’s progression from a single location to a regional chain. By opening more restaurants, the business can reach more customers, make more sales, and be worth more if bought out.
(Shortform note: Michalowicz doesn’t mention another large reason why traditional accounting wisdom emphasizes growth: Economies of scale—the theory that the more products you produce, the lower the cost to make each product will be.)
Principle #3: Consult Your Financials Frequently
The third traditional accounting principle recommends you keep a constant eye on your financial documentation. In theory, consulting this paperwork thoroughly and regularly allows you to always know how well your business is doing.
- Example: By looking consistently at your cash flow statements, you can better keep track of where most of your business’s money is coming from and where most of it is being spent, helping you make informed financial decisions.
(Shortform note: The U.S. Small Business Administration recommends you review and analyze your financials every week, even when on vacation. It claims that small businesses that review and analyze their financials annually have a 25 to 35 percent success rate, while those that review and analyze their financials weekly have a 95 percent or higher success rate.)
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- Why traditional business accounting methods don't work
- How to use the Profit First method to increase your business’s profitability and stability
- How to assess your business's current financial health
