Objectives of Management Accounting
Cost-volume-profit (CVP) analysis is a simplified method to determine how changes in costs and volume affect a company's overall operating income and net income. The major simplification applying this method is based on classification of all costs as either variable or fixed in relation to a measure of the volume of output activity (Horngren, Sundem, & Stratton, 2002). There are several assumptions that should be made to perform this analysis (Wikipedia, 2008):
1. Sales price per unit can be considered constant.
2. Variable cost per unit can be considered constant.
3. Total fixed costs are constant.
4. If a company sells more than a one product, constant sales mix is preserved.
5. All the produced units are sold.
6. Unit costs are exclusively affected by activity changes.
CVP, as a starting point, is able to assist managers making important business decisions in their efforts to improve effectiveness of organization without jeopardizing its future by taking unjustified risky steps. There are just several examples of the decision-making situations where CVP proves to be helpful:
§ Development of the proper sales mix – combination of different product lines. Analysis outcomes might lead to the strategic and tactical changes to additional support for the most profitable products.
§ Pricing policy development. With increased production volumes, the share of the fixed costs will be gradually decreasing, giving the ability to offer multiple purchase discounts to the bulk buyers.
§ Fixed costs analysis. CVP will help to analyze effects of the possible changes in the fixed costs to affect the bottom line. It might include, for example, additional budgeting for marketing and advertising, or evaluation for the more effective utilization for the manufacturing space and equipment.
§ Working with vendors and suppliers. CVP will assist in evaluation of the possible impact of raw materials and outsourced elements costs on the product sales revenues, and keeping that under control by having alternative sources, if possible.
Modern businesses are subject for possible rapid changes in a business environment, so every organization should understand how sensitive its sales, costs, and income are to the potential changes. To apply the sensitivity analysis, analyst changes the data input in a systematic order to determine the effect of every change to the organizational outputs. Sensitivity analysis is a way to predict the outcomes of management decision if a situation turns out to be different from the key expectations (Investopedia, 2008).
As sensitivity analysis has a quite wide application scope, we will apply the approach to the basic CVP analysis for the management decision making. This “what if” approach helps crafting safe and solid decisions for the organization development. There are just several examples of the situation where sensitivity analysis proved to be helpful:
§ Fixed costs sensitivity analysis show the company output changes in relation to the fixed cost deviation. For example, if R&D expenses for the certain product development would be higher than it was specified in the planned budget, how it will impact the product profitability. Or, if lease price for the manufacturing building will be suddenly increased, will the company’s financial outcomes suffer.
§ Variable costs sensitivity analysis show the company output changes in relation the possible variable cost deviation. For example, if cost of the raw materials on the market increases, how the production will be affected. Or, how the higher equipment utilization might require the additional variable preventive maintenance and repair associated costs.
§ Pricing sensitivity analyses evaluate the pricing component possible deviation. If the low-priced competitive product appears on the market, company is often required to adjust its pricing policy by discounting its products and introducing low-price sales campaigns. How it might impact the company financial results and profitability?
Breakeven analysis is closely linked to the CVP analysis, where the central point of the management evaluation is a breakeven point, determined by the financial situation, when business produces neither profit nor loss. As core of the breakeven analysis is a meaningful breakeven point, it assists manager to make business related decision that will influence business effectiveness and profitability. On a short period of time, more profits generated by business activities mean successful business operations. However, considering a long-range success, company has to invest in the future as well by constantly spending on Research and Development, equipment maintenance, Human Resources training and development, purchasing new assets, and many other areas. Without close look on the breakeven analysis, company might get to the point when unnecessary and unjustified spending will cause financial losses.
Breakeven analysis can provide a valid sales objective that can be expressed in either dollars, or units of production, or sales, or whatever else is relevant for the business. If the breakeven point is known, it can be a definite target to be reached and exceeded by carefully reasoned steps. Once decision makers know the level of sales to be reached before business will be profitable, they can evaluate how reasonable is it, based on the market conditions, production capabilities, consumer trends, etc. If the breakeven point is close to the manufacturing capacity or overall market size, this should generate a warning signal, as without a reasonable safety margin, the outcome predictions could be easily overestimated (Osgood, 2008).
At this point, business analysts are required to evaluate all the components of the breakeven analysis to locate any possibilities of lowering breakeven point. The solution might be in reducing fixed cost and variable costs, for example, by increasing effectiveness and equipment utilization, looking for cheaper raw materials and purchased components, outsourcing certain business functions to the third party, else. The solution might lay in raising the products or services sale pricing as well by increasing quality and usability of the offerings. Working with different schemes and running them through various hypothetic scenarios will help reaching the optimal solution for the better company outcomes.
Another application for the breakeven analysis approach is related to the possible sales prices deviation due to the particular market conditions in the highly competitive environment. What if the competitor announces a significant prices drop for their products? Will company be able to sustain profits, as it will be forced to fully or partially match the product pricing decrease? Breakeven analysis is simple, but quite powerful tool, giving managers ability of the effective business situation evaluation and planning for the new product penetration on the market.
Regression analysis represents one of the methods of assessment of cost function historical data, giving a significant advantage for researcher by applying the cost analysis not as a static valuation, but showing a trend through a certain time period. It is very important in the rapidly changing business environment of the modern world to make valid assumptions based on the multiple sets of variables.
Regressive analysis is the most accurate, but also the most complicated, method of cost function valuation and prediction. It is based on separation of a mixed cost into its fixed and variable elements by fitting a regression line that minimizes the sum of the squared errors. In contrary to the high-low method, it utilizes not just two sets of the data, but all the numbers available to the analyst. Comparing with visual-fit method, it can be characterized by a higher level of objectivity, as the results are mathematically calculated through the statistical approach. It does not rely on the researcher subjective judgments and coarse estimates. Also, least-squares regression analysis supplies additional statistical information on the level of confidence for the outcomes, and the validity of the future estimates.
As costs estimates in the cost behavior is completed, and the analysts obtain a clear picture of direct relationship between cost and its cost drivers, the following research to be performed on the possible positive influence on the cost structure by smart and effective manipulation with the available cost drivers. Technically, it can be performed by specialized statistical software or by commonly-used standard spreadsheets programs from the Microsoft or Open Office standard packs. As graphical representation of the data sets is completed, cost structure trend becomes clearly visible, and different assumptions and proposed changes are introduced in no time.
Almost all managerial decisions are based on forecasts. As every decision becomes operational at some point in the future, it should be based on the future conditions (Arsham, 2008). The first step of understanding the future is to understand the current cost structure of the products or the services, supplied by the organization. All the reviewed analysis methods are giving to the manager valuable tools, assisting to decrease subjectivity of the business decision-making and to improve the modeling of the business operations optimization for higher profits and better competitiveness on the modern market.
Arsham, H. (2008). Time-critical decision making for business administration. Retrieved March 3, 2008, from http://home.ubalt.edu/ntsbarsh/stat-data/Forecast.htm
Horngren, C. T., Sundem, G. L., & Stratton, W. O. (2002). Introduction to Management Accounting. Upper Saddle River, NJ: Prentice Hall, pp. 2-110.
Investopedia (2008). Sensitivity analysis. Retrieved March 2, 2008, from http://www.investopedia.com/terms/s/sensitivityanalysis.asp
Osgood, W.R. (2008). Breakeven analysis. Retrieved March 3, 2008, from http://www.buzgate.org/nh/bft_beven.html
Wikipedia (2008). Cost-volume-profit analysis. Retrieved March 2, 2008, from http://en.wikipedia.org/wiki/Cost-Volume-Profit_Analysis
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