Managerial Accounting Cost-Volume-Profit Analysis Is a Tool

Managerial Accounting

Cost-volume-profit analysis is a tool used in managerial accounting that helps companies to determine the level of production (and sales) required by the company to break even. In CVP analysis, costs are separated into fixed and variable costs. The assumption is that the fixed costs do not change, while the variable costs do change with the level of production. Once sales are taken into account, so are variable costs, with the leftover being the contribution to fixed costs. The point where the contribution equals the fixed costs is the breakeven point. The basic CVP formula, therefore, is as follows:

Profit = total revenue -- variable costs -- fixed costs

There are a couple of main reasons why CVP analysis is valuable. The first is that this form of analysis can help guide production/sales decisions. CVP analysis can, for example, help a company know when a product should be cut from its roster. The CVP analysis helps determine the sales volume that a product needs to breakeven, so when expected sales are lower than this point, the product should be discontinued. The CVP analysis is also valuable in providing sensitivity analysis on these same production/sales decisions. The company can determine, for example, what combination of sales and price is optimal. This can best done in conjunction with an analysis of the product's elasticity of demand, so that changes in price can be measured according to expected changes in demand. Doing this can help a firm find the point at which the price/demand relationship delivers the highest contribution to fixed costs.

CVP analysis can also be used in other ways. By understanding the relationship between price, output/demand, and the different elements of the variable costs, the company can implement performance standards. This in turn provides the basis of variance analysis. The company can use this information to improve its production processes, worker productivity and fixed cost management. CVP analysis is fairly simple, but it can provide the basis for any number of other forms of analysis that contribute to improving a firm's profitability.

2. Product costing is contrasted with period costing. In the former, costs are tracked by product rather than by time period. For example in conventional financial accounting a company produces an income statement showing all costs incurred during the period. With product costing, the costs associated with producing each product are tracked. This allows the firm to better understand which products contribute more to fixed cost coverage. This can help the firm in making product decisions -- firms know which products are the most profitable so they can emphasize those products in their marketing and production. In addition, product costing helps firms to make pricing decisions, because it reveals how much the cost of production on each of their products actually is.

There are different components to product costs. There are direct costs, such as the material and labor that are directly associated with the production of a good. There can also be indirect costs. For example, the overhead associated with production. If a product is 40% of a firm's production, then the company may choose to allocate 40% of its overhead costs to the product. This is not necessary, however. Product costs can simply be the variable costs, with the contribution being the final number, at the discretion of the company.

3. Variance analysis is where the financial manager analyzes the variance between the budget and the actual results. The budget is produced before the relevant time period, and the actual results are tabulated afterwards. The variance analysis compares the two, in order to find out how and why the actual performance differed from the budgeted performance. The variance can be either positive or negative. The total analysis looks at the bottom line variance and then analyzes the various line items in order to determine a root cause or causes of the bottom line variance. The percentage variance is important because this indicates areas where variance was above or below the norm. Raw number variance can help identify the greatest contributors to overall variance. Variance analysis is a means by which a manager can better understand how costs behave, and can be used to either make adjustments or to help make better adjustments in the future.

Variance analysis is used to help determine the rationale for deviations in performance. If a company underperforms in an area, the only way that it can fix the problem is if it understands what the problem is. This is the role played by variance analysis. The areas of variance that contributed the most to performance are identified. Subsequent analysis within these areas can be either quantitative or qualitative, but the initial quantitative analysis is a variance analysis. The company at that point has the opportunity to amend its practices, or otherwise make changes to its business in order to ensure that the deviations do not occur again in the future.