Question

Explain how CVP can be used to benefit management decisions. Use your own words to describe a situation where CVP could be used to benefit a specific decision. What factors can be controlled in the calculation? What happens to CVP when you leave the relevant range of operations? Explain the difference between a traditional Income Statement and a contribution margin Income Statement. What information does each provide and when should each be used?

Managerial Accounting.

Answer 1

Cost-volume-profit (CVP) analysis is one of the important managerial tools used by management in decision making. It helps a firm in gaining strategic advantages in today’s competitive world.

Below is the usefulness of cvp analysis for various management decisions in a firm

· It helps in understanding the breakeven point and margin of safety. Breakeven point is the point at which there is no profit or loss. Margin of safety is the sales which give profits to the firm. Any sales below margin of safety will lead to losses to the firm

· CVP analysis helps in new product launches and pricing. For example : cost plus pricing, variable cost pricing, full cost pricing, etc

· It helps in preparation of profitablity statement at different levels of activity. For example : Variable cost varies based on activity level and fixed cost is constant at all levels

· It assists management in various decisions making like Make vs. buy, acceptance of special order, continue or discontinue of divisions or segments, shutdown or continue.

· It helps in utilisation of constraints in a better way. For example: labor hours, machine hours. It allocates scarce resources based on contribution margin and helps in efficient allocation and utilisation of resources

· It helps in determining the sales level needed for achieving operating profits

· It helps in preparation of income statement at various levels like product level, segment level, customer level, etc

CVP can be used to benefit a specific decision like acceptance of a special order. A special order can be accepted based on relevant cost analysis like variable cost. The factors that can be controlled are variable costs and avoidable fixed costs.

CVP works with the assumption of all costs can be classified into variable cost and fixed cost. The classification of costs is valid for a relevant range. Beyond this range the behaviour of cost will change. For example: fixed costs will increase in a step way and increase for next range of activity

Traditional Income statement and Contribution margin income statement

Traditional income statement is based on Absorption costing and contribution margin income statement is based on variable costing. Traditional income statement is based on product cost which includes variable manufacturing cost (Direct material, direct labor and variable manufacturing overhead) and fixed manufacturing overheads. Contribution margin income statement considers only variable manufacturing cost as product cost. The fixed manufacturing overheads are treated as product cost and charged to the income statement.

Information given by Traditional income statement and usefulness

· It gives Cost of goods sold based on product cost which includes fixed manufacturing overhead

· It gives Gross profit earned during the period

· It should be used for external financial reporting as per GAAP guidelines

· It should be used in situations like valuation of business, insurance claim for inventories

Information given by Contribution margin income statement and usefulness

· It gives Contribution margin based on Sales and variable cost

· It gives total period cost that is fixed cost incurred in a period

· It should be used for various internal decisions making for operational and strategic purpose.