Question

Explain the similarities and differences between financial and managerial accounting, and prepare, use and interpret a contribution margin income statement using cost, volume, profit and break-even techniques.

Answer 1

Similarities between financial and managerial planning

1. Both are the parts of total accounting information system.

2. Economic events are dealt in the both system of accounts.

3. The economic events are qualified only in terms of rupees.

4. Both are concerned with financial statements, revenues, expenses, assets, liabilities and cash flows.

5. Both the system of accounts are accumulating and classifying the accounting information for the preparation of financial statements.

6. Some database is used for preparing financial statements and reports under both system of accounts.

7. Both are determining and measurement of costs for different accounting periods and even for different departments and sections.

8. The same accounting principles and concepts are used in both system of accounts for the purpose of cost accumulation and cost allocation

Difference between financial and managerial planning

• Aggregation. Financial accounting reports on the results of an entire business. Managerial accounting almost always reports at a more detailed level, such as profits by product, product line, customer, and geographic region.

• Efficiency. Financial accounting reports on the profitability (and therefore the efficiency) of a business, whereas managerial accounting reports on specifically what is causing problems and how to fix them.

• Proven information. Financial accounting requires that records be kept with considerable precision, which is needed to prove that the financial statements are correct. Managerial accounting frequently deals with estimates, rather than proven and verifiable facts.

• Reporting focus. Financial accounting is oriented toward the creation of financial statements, which are distributed both within and outside of a company. Managerial accounting is more concerned with operational reports, which are only distributed within a company.

• Standards. Financial accounting must comply with various accounting standards, whereas managerial accounting does not have to comply with any standards when information is compiled for internal consumption.

• Systems. Financial accounting pays no attention to the overall system that a company has for generating a profit, only its outcome. Conversely, managerial accounting is interested in the location of bottleneck operations, and the various ways to enhance profits by resolving bottleneck issues.

• Time period. Financial accounting is concerned with the financial results that a business has already achieved, so it has a historical orientation. Managerial accounting may address budgets and forecasts, and so can have a future orientation.

• Timing. Financial accounting requires that financial statements be issued following the end of an accounting period. Managerial accounting may issue reports much more frequently, since the information it provides is of most relevance if managers can see it right away.

• Valuation. Financial accounting addresses the proper valuation of assets and liabilities, and so is involved with impairments, revaluations, and so forth. Managerial accounting is not concerned with the value of these items, only their productivity.

Contribution Margin

A contribution margin income statement shows all variable expenses deducted from sales and arrives at a contribution margin. Fixed expenses are then subtracted to arrive at the net profit or loss for the period, or the amount remaining that will contribute to covering fixed costs and to operating profit.

CM = Unit Price – Unit Variable Cost

or

CM Ratio = (Unit Price – Unit Variable Cost) / Unit Price

uses of margin cost

Fixed Costs

A business will incur costs that it cannot trace to the production or sale of a product. These costs are known as fixed costs and occur even when the company does not produce any product(s). Common examples of fixed costs include rent and insurance. The contribution margin must also cover these types of costs in order for a business to achieve and maintain profitability. If the contribution margin does not exceed a company's fixed expenses, it does not make a profit. A company that has a contribution margin that is less than its fixed expenses incurs a loss.

Selling Price and Volume

The contribution margin often helps a company decide whether it should manipulate its selling price and sales volume. Some of the ways a company can increase a contribution margin is by reducing fixed costs, increasing the sales price or increasing the number of units sold. A higher contribution margin usually means that a business is able to spend more on advertising to increase its sales volume. Lower contribution margins might mean that a company will have to rely on less-expensive forms of promotion, such as publicity and customer referrals.

Optimal Production Levels

A contribution margin analysis shows how much a company should sell. Let's assume that the company that makes printers with a $10 unit contribution margin and has $10,000 in fixed expenses. The company would need to sell 1,000 printers to break even. If the company wants to make a profit of $50,000, it would need to sell 6,000 printers. In short, a contribution margin analysis helps a company figure out how to reach its profitability goals.

CVP

Cost Volume Profit (CVP analysis), also commonly referred to as Break Even Analysis, is a way for companies to determine how changes in costs (both variable and fixed) and sales volume affect a company’s profit. With this information, companies can better understand overall performance by looking at how many units must be sold to break even or to reach a certain profit threshold or the margin of safety.

The main components of CVP analysis are:

1. CM ratio and variable expense ratio
2. Break-even point (in units or dollars)
3. Margin of safety
4. Changes in net income
5. Degree of operating leverage

CVP Analysis setup

The regular income statement follows the order of revenues minus cost of goods sold gives gross margin, while revenues minus expenses lead to net income. A contribution margin income statement follows a similar concept but uses a different format by separating fixed and variable costs.

The contribution margin is the product’s selling price less the variable costs associated with producing that product. This value can be given in total or per unit.

Break-Even Point

The break-even point (BEP), in units, is the number of products the company must sell to cover all production costs. Similarly, the break-even point in dollars is the amount of sales the company must generate to cover all production costs. The formula is shown below:

The formula for break-even point (BEP) is:

BEP = total fixed costs / CM per unit