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The modern day management decision making is surrounded by numerous factors the managers ought to put into consideration before coming up with a feasible solution to a problem. The dynamics of business have radically changed over the recent past and as such, making the area of business management a very critical part in the running of the organization. The financial and non-financial factors that affect the running of the business are important indicators of the way in which decisions ought to be made.
It is as a result of this that the issue of managerial accounting arises. While financial accounting deals with external reporting of the affairs of the organization to the external stakeholders such as the shareholders, the government and soon, the managerial accounting, also referred to as cost accounting provides communication to the internal management of the organization (Ahmed 165).
One important area of concern in managerial accounting is the cost-volume profit analysis. This paper provides an analysis of the business application of cost-volume profit analysis.
Cost Volume profit analysis
This is defined as the analysis of the revenues generated by a specific business activity at a specific activity level. It can be seen to be the study of the effects of increased activity of sales on expenses and profit.
In order to properly understand the concept of cost volume profit analysis, it is important to define a few related terms that are useful in the analysis. These terms are the cost behavior, the contribution margin and the break-even analysis.
The cost behavior is defined as the manner in which costs change due to change in related parameters such as the activity level of production etc. The management ought to clearly understand the nature of the organizational costs so as to enable them to properly manage the costs and the activities of the organization (Barry 136).
The contribution margin is defined as the different between the revenue generated for the sales and the variable costs of the business activity. The importance of the contribution margin comes when analyzing the nature of costs.
For example, a business that is labor intensive will have high contribution margins while the business that is capital intensive will have low contribution margin. The break even analysis is the analysis that indicates the level of activity that the business shifts from making losses to making profit. These three terms are very important in studying the cost volume profit analysis.
The Application of Cost Volume Profit analysis
Profit forms part of the most important driver in any business organization. This is because most businesses exist for the sole purpose of making profits. This makes the area of costs analysis an important part of the business management. There are several uses of cost volume profit analysis in a business.
The CVP analysis is used to determine the total sales required in order to reach the predetermined net profit. These usually comes with the analysis of the various cost behaviors of the organization and as such, make important decisions on what activity to increase or decrease in order to reach that particular activity profit (Antony and Robert 263).
This may be achieved through a simple equation: Target sales- variable expenses- fixed expenses = target net income. From the above mentioned equation, the management is able to identify the various cost behaviors such the fixed and the variable costs after which an activity level that achieves the predetermined profit target is established.
A company that has successfully implemented this is the AT&T where the target profits have been achieved though proper and effective tracking of the sales volumes.
Another way of achieving this is setting the sales target volume in units which is equal to the sum of fixed costs and the target net income divided by contribution margin per unit. This equation therefore provides the formula that ought to be followed in order to achieve the target volume in sales and hence the target profits. There are several companies that up to date use the CVP analysis in their cost management.
These companies include service companies such as the airline companies, for instance, the British airways. These companies spend a huge amount of money in advertising since it has high levels of contribution margin. The importance of this is that the advertising helps increase the sales and, as a result, increase the profitability of the organization.
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The Cost-volume profit analysis is also used to determine the break-even point. This is referred to as the area in the break-even analysis chart that indicates the level of activity that the firm ought to attain in order to meet the costs incurred in generating the revenues.
It is an important aspect in the break even analysis more so during hard economic times when the company only targets to avoid loss. The break-even point therefore indicates a point at which, at a given fixed costs and a predetermined variable cost. The business will recover all these cost and move into making profits.
It is also useful in determining the margin of safety. This is a term that is used to identify how far the sales would fall below the targeted volume for an organization to start making losses. It can also be used to determine the level of sales that is required in order for the firm to shift from loss to profit making.
This can be a useful indicator of performance in the various functional areas of the organization. The analysis of margin of safety thus helps the organization to take corrective measures whenever there is a slump in the target activity level of the organization. Margin of safety is given by the following equation: Planned unit sales – break even sales = the margin of safety.
Since the cost volume profit analysis is considers costs, it can also be used by the business to establish the behavior trends of costs and sales. There are several cost behavior trends that are associated with this. Costs can be classified in to two broad categories; fixed costs and variable costs. Fixed costs are the costs that do not change with a change in the level of activities of an organization. This means that they remain constant with any level of sales.
The importance of such cost management is that a cost manager ought to properly understand that fixed costs require high level of sales in order to generate profit since at zero sales the costs are already incurred. The variable costs are affected by a change in the level of activity such as sales and as such the management ought to ensure a maximization of the variable costs in order to reach or even surpass the set profit target.
The cost volume profit analysis also helps determine the sales mix that will achieve the set revenues and hence the set profits. Sales mix is defined as the combination of quantities that comprise the total sales. The importance of sales mix analysis comes where the firm has different contributions for different products.
An understanding of the sales mix means that the organization will plan their activities in such a way that the fixed costs will be shared among the various activity levels of the organization. The business will be able to reach the set profit if it arranges its sales mix in such a way that the fixed costs are properly shared in order to compliment the variable costs of the various products.
The cost volume profit analysis is also useful in cost planning for nonprofit organizations. this is particularly so when a nonprofit organization has a budget for a certain activity and needs to plan its output in such a was the available resources will be utilized optimally to achieve the set target.
For instance a school could have a certain activity such as an educational tour for the students but with limited budget. The analysis of the fixed costs and the variable costs of the tour will determine say the number of student that are required in order to fully utilize the funds available for the educational tour.
The Cost volume profit analysis is a useful management tool when it comes to attaining the profit levels of the organization. As such, the management of any company ought to clearly articulate the requirement of the Cost volume profit analysis so as to show the levels of activities in which the company ought to reach in order to attain the set profit target.
Ahmed, Riahi-Belkaoui. The new Foundations of Management Accounting. New York: Quorum Books, 1992. Print.
Antony, A. Atkinson and S. Kaplan Robert. Management Accouting: Information for Decision-Making and Strategy Execution. New York: Quorum Books, 2011. Print.
Barry, Eugene Leonard. Management Accounting Demystified. New York: McGraw Hill, 2003. Print.