Benefits and potential problems associated with cost-volume-profit (CVP) analysis
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Dear Admin,
A friend has asked you for some advice: ‘My small business now makes a profit; I am only too aware of this, as I now face a big tax bill each year, when my tax accountant has prepared my annual accounts. However, I don’t feel much better off personally, so this is not quite what I had expected when I took the risk of resigning my job and setting up my own firm. The accountant is now trying to persuade me to pay her even higher fees, by letting her prepare monthly “management accounts” for me. She says that I would also benefit from something called CVP analysis on my various product lines. I know that you are now doing an MSc. What does she mean here, and is this likely to be worth my paying her for?’
In formulating your Key Concept Exercise, consider the following questions:
•What is the difference between financial reporting and management accounting?
•What are the benefits and potential problems associated with cost-volume-profit (CVP) analysis?
•What advice would you give your friend?
Outline the difference between financial reporting and management accounting information and explain the benefits and potential problems associated with cost-volume-profit (CVP) analysis. How might the technique that you have discussed assist your friend in the effective management of his business resources? What advice would you give him? Base your answer on research, your readings and your own experiences. Please cite all references.
Also,
1) The answer must raise appropriate critical questions.
2) Do include all your references, as per the Harvard Referencing System,
3) Please don’t use Wikipedia web site.
4) I need examples from peer reviewed articles or researches.
5) Turnitin.com copy percentage must be 10% or less.
Note: To prepare for this essay please read the required articles that is attached
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SAMPLE ANSWER
Cost-volume-profit (CVP) analysis
MFR.COLL.W4
As a business grows and continually becomes complex, the need to adopt more sophisticated accounting practices is inevitable in order to effectively manage profitability. Management financing has gained increased popularity among contemporary businesses because of its usefulness in decision making, budget and profit prediction. Managing costs is also a core activity for any organization with an aim of promoting profitability; hence the need to consider Cost Volume Profit (CVP) Analysis. Having acquired a significant level of knowledge on accounting, I would advise you to consider your accountant’s suggestion to include management accounting and CVP analysis besides the normal financial accounting. While this may seem expensive it is of great benefit in the long-run because you will have greater control of your business and thus identify better profit making strategies. How then do the above concepts work? What does one need to know before embarking on them? These are discussed as follows.
Management versus Financial Accounting
The obvious question that would arise from an individual with limited accounting knowledge would be “why do we need management accounts while we are already preparing financial statements? Is financial accounting not adequate to provide the management with information for decision making purposes? The only way to address such sentiments would be to do a comparison between management accounting and financial accounting in order to show the importance of management accounting.
Fotache et al (2011, p. 48) notes that one of the most significant difference between financial and management accounting is that while financial accounting is more about reporting a company’s performance for a particular accounting period, management accounting focuses on development reports for specific areas of the business, to track performance, identify any underlying problems and provide solutions necessary to address them in order to promote profitability. Financial accounting is generally undertaken for the external audience in a bid to report the organization’s profitability and financial position while management accounting is meant for internal stakeholders (Stoicea, Dinu and Stoian, 2011, p. 260 – 262). Essentially, financial accounting is mostly done for compliance purposes while management accounting is for internal use and the purpose of reports may therefore vary. This means that it can be more detailed and more specific to areas of the business that need to be addressed including pricing, cost and profitability of single items.
Financial accounting data is historical and often a representation of the organization’s past performance. Management accounting on the other hand may consist of both past and projected financial information. Examples of future data include cost budgets and profit approximations. Due to its level of detail, management accounting is an effective tool for promoting decision making within the organization and is often associated with timeliness, accuracy and integration (Odar, 2005, p. 85).
Cost-Volume-Profit (CVP) analysis
By definition, this refers to the process of determining how a shift in costs and volume of a company’s products can have on its operating income (Kee, 2007, p. 478). The results of CVP analysis are then used in developing budgets and other purposes such as determining the selling price and cost estimations necessary to ensure profitability. CVP analysis is therefore important for future projections and decision making. What should be expected by businesses which consider the use of CVP analysis? The best approach would be to compare its benefits versus its limitations as below.
Given its ability to project information on product costs, volume and profitability, CVP analysis is a vital tool for decision making. Underwood, Bush and Heath (2009, p. 14) notes that CVP analysis is highly detailed and is likely to answer most of the questions that may be raised concerning future profitability of products. CVP analysis is of great significance in terms of decision making at the management level. Using the detailed information derived from the CVP analysis, the management can easily make decisions on costs and effectively determine the best prices for their products; with an assurance that most important factors affecting these variables have been addressed during the CVP analysis (Răvaş, 2013, p. 103). Effective budgeting and profit planning is often associated with CVP analysis and as noted by Răvaş (2013, p. 104), CVP analysis results inform the best combinations between cost, volume and selling price which will lead to the best possible profit levels and is thus an important tool for business.
CVP analysis however has its own limitations. Among the limitations is the fact that CVP analysis is based on estimations. This means that despite relying heavily on factual data, the results of a CVP analysis is not usually the true representation of the situation but rather a tentative result (Kee, 2007, 481). It is however notable that determining actual figures when projecting just like in budgeting can be difficult and CVP is merely a tool necessary to give an idea of what to expect when costs and volume change. According to Chan and Yuan, 1990, p. 83), CVP has traditionally been known for not being able to deal with risk and uncertainty. CVP analysis also limits usage for companies with multiple products due to the cumbersome exercise which must be performed on each product individually. Kee (2007, p. 482-483) notes that in the presence of a different variable cost for each product such as in the case of a restaurant business, this may pose difficulties for companies with multi products.
The discussion above generally covers information necessary in making a decision on whether to adopt management accounting and CVP analysis or not. It is however apparent that upgrading your accounting practices would be of great benefit to your company through more informed and proactive decision making, more accurate projections and less miscalculations. I would therefore advise you to consider your accountant’s suggestions in order to benefit from these accounting concepts.
Reference list
Fotache, G, Fotache, M, Bucşă, R, & Ocneanu, L 2011, ‘The Changing Role of Managerial Accounting in Decision Making Process Research on Managing Costs’, Economy Transdisciplinarity Cognition, 14, 2, pp. 45-55, Business Source Complete, EBSCOhost, viewed 19 June 2015. Retrieved from http://eds.a.ebscohost.com/ehost/pdfviewer/pdfviewer?sid=e05bd091-96aa-4974-9850-996cee79f7cd%40sessionmgr4002&vid=0&hid=4113
Kee, R 2007, ‘Cost-Volume-Profit Analysis Incorporating the Cost of Capital’, Journal Of Managerial Issues, 19, 4, pp. 478-493, Business Source Complete, EBSCOhost, viewed 20 June 2015. Retrieved from http://eds.a.ebscohost.com/ehost/pdfviewer/pdfviewer?sid=40a26d48-4e3f-4dd9-8bfd-10de071c6b91%40sessionmgr4001&vid=0&hid=4113
Odar, M, Kavcic, S, & Jerman, M 2015, ‘The Role of a Management Accounting System in the Decision-Making Process: Evidence from a Post-Transition Economy’, Engineering Economics, 26, 1, pp. 84-92, Business Source Complete, EBSCOhost, viewed 20 June 2015. Retrieved from http://eds.a.ebscohost.com/ehost/pdfviewer/pdfviewer?sid=db3f7ae5-d41a-4c85-97e1-3321b0dfe707%40sessionmgr4004&vid=0&hid=4113
Răvaş, B 2013, ‘The Classic Cost-Volume-Profit, A Possible Useful Tool In Providing Performance For The Tourism Units’, Young Economists Journal / Revista Tinerilor Economisti, 10, 20, pp. 102-107, Business Source Complete, EBSCOhost, viewed 20 June 2015. Retrieved from http://eds.a.ebscohost.com/ehost/pdfviewer/pdfviewer?sid=33db2295-c7ae-46d8-8943-b6b166682c80%40sessionmgr4001&vid=0&hid=4113
Stoicea, P, Dinu, T, & Stoian, E 2011, ‘Management Accounting Opossite Financial Accounting In Agricultural Companies’, Agricultural Management / Lucrari Stiintifice Seria I, Management Agricol, 13, 3, pp. 259-266, Business Source Complete, EBSCOhost, viewed 20 June 2015. Retrieved from http://eds.a.ebscohost.com/ehost/pdfviewer/pdfviewer?sid=d2e5a42c-217c-453c-9d4d-ac9b7eb8c5a7%40sessionmgr4004&vid=0&hid=4113
Underwood III, J, Bush, R, & Heath, W 2009, ‘Picture The Numbers: A Conceptual Illustration Of Linking Marginal Reasoning, Marketing Actions, And Pro Forma Cvp Analysis With A Spreadsheet Picture’, Journal For Advancement Of Marketing Education, 14, Pp. 13-22, Business Source Complete, Ebscohost, Viewed 20 June 2015. Retrieved From Http://Eds.A.Ebscohost.Com/Ehost/Pdfviewer/Pdfviewer?Sid=06186262-E7a8-4cfe-Bba5-5382b2626519%40sessionmgr4003&vid=0&hid=4113
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