Management Accounting
There are several differences between financial reporting and managerial accounting. At the most basic, the two types of reporting are used to meet the needs of two different groups of stakeholders. Financial reporting is typically geared towards external users. In the case of my friend’s business, this is the government’s taxation arm. In a public company, shareholders, potential investors and regulators would also be included on the list of stakeholders for which financial reports are created.
Financial reporting, therefore, is based around a consistent set of standards (the generally accepted accounting principles) and is conducted solely using the accrual accounting method. This consistency helps external parties measure the firm’s outputs
Managerial accounting, by contrast, is focused on helping management to make decisions. Consistency is not demanded, because managerial accounting reports are not subject to audit. Year-over-year consistency helps managers, but there are no standards for consistency from one firm to the next. Because of this, managerial accounting is generally only conducted to the extent that management finds it valuable. However, it can reveal trends and provide information to management that would not have been uncovered in the financial statements.
(CVP) analysis is a method by which the firm can break down its production and profit figures to determine the optimal levels of production/sales for its products, with the goal of realizing the business’ potential profit. CVP analysis typically requires management to use different tools, such as a break-even analysis, a contribution margin analysis, and operating leverage analysis in order to make such determinations.
CVP analysis allows management to understand the contribution that every product makes to the firm’s bottom line. This contribution margin is a key concept in cost volume profit analysis. All other things being equal, the production and sales efforts should be focused on the product with the greatest contribution volume. This will maximize th e firm’s profits.
Another benefit of CVP analysis is that it taxes can be factored into the calculations. The major concern for my friend is that his is not as high as he would like. Thus, CVP can be used to help him understand not only which products give him the highest gross contribution margin, but the highest contribution net of taxes.
CVP analysis can also be used to work backwards as well. For example, if my friend is having doubts about the viability of his business, he can set a target net income that he wants to achieve. CVP will then allow him to understand what his sales will need to be in order to achieve that. He can adjust the targets for each product to give him a better sense of the sales mix and targets for each product that will allow him to earn the net income he seeks.
A also gives management the capability to run a sensitivity analysis. This will help mananagement to understand how sensitive the organization is to changes in the sales mix. Such information is helpful when determining future strategy and spending decisions.
The sensitivity analysis can also help is determining the ideal degree of operating leverage. In general, the greater the leverage the greater the sensitivity of the organization to change. Understanding the effect that operating leverage has on the business is one of the key benefits to CVP analysis.
One of the potential problems with CVP analysis is that it implies future performance based on either past trends or on assumptions. The market may not react as expected changes in the marketing mix, price or other variables. The sensitivity analysis can mitigate some of this effect, but the risk still exists that the market will not react in the manner that was modelled using CVP.
Another potential problem is that CVP analysis is mostly useful along product lines, and is difficult to apply across the organization. It is reasonable to use CVP for a simple case such as that of my friend, but it is more difficult to apply CVP to a more complex organization. CVP analysis is also weak in that it does not fully appreciate the complexity of cost drivers. This may lead management to make decisions without fully understanding their inputs. Some of the other assumptions also make CVP restrictive – assuming variable costs vary directly with activity; assuming stable fixed costs; not accounting for market reaction to changes in, for example, selling price; and it assumes that levels of activity are the only revenue and profit drivers.
CVP would help my friend to effectively manage his resources. He may not be making the optimal deployment of his resources, and this is resulting in not making enough money. I would advise him to implement a CVP analysis of his organization at regular intervals. He does not need to pay the accountant more for this – his business is sufficiently simple that he can handle the task himself. Because there is no need for standardization of managerial accounting, it is reasonable that he can forgo the formality of dealing with his accountant on this issue. But he should determine the contribution margins of his products and undertake an analysis of how best to , not just sales.
Works Cited
Williams, Jan R.; Haka, Susan B.; Bettner, Mark S. & Meigs, Robert F. (2002). Financial and Managerial Accounting: The Basis for Business Decisions. McGraw-Hill, New York, 2002.
Horngren, Datar & Foster. (2003). Cost Accounting. Prentice-Hall, Upper Saddle River, NJ, 2003.
Williamson, Duncan. (2000). Cost Volume Profit Analysis: Its Assumptions and their Pitfalls. Duncan Williamson. Retrieved February 19, 2009 at http://business.fortunecity.com/discount/29/cvpass.htm
