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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...
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 maximize after-tax profit, 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
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