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Cost-Volume-Profit Analysis

Cost-Volume-ProfitAnalysis

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Cost-volume-profit(CVP) analysis is an approach that is used in managerial accountingas a type of cost accounting to determine how the variations in costand volume impact a business’s income (operating and net income)i.e. operating profit (Beykaei, 2012). It helps to calculate thebreak-even point of volume and cost of goods. This analysis involvesusing various equations with cost, price, volume of sales and otherparameters and variables and plotting them on an economic graph asillustrated by Beykaei (2012).

Question1

Beykaei(2012)explainthat one of the significant applications of CVP is that it is helpfulin short-term managerial and economic decision making on products andservices. In managerial accounting, it helps managers in makingwell-informed, cost-effective decisions and strategies. A manager ofa company that is evaluating whether to purchase a new machine withthe objective of reducing labor costs by 60% can apply the principlesof this costing method to make his judgment. The analysis of thecosts involved in acquiring and maintaining the proposed new machinecan be determined and then compared and contrasted with thepre-determined labor costs. Labor costs to consider include salariesand wages. In calculating the costs associated with using themachine, both the attendant fixed and variable costs have to beconsidered. Fixed costs (also ownership costs in the machine context)include depreciation, insurance, taxes, housing and maintenancefacilities expenses. Variable costs (also referred to as operatingcosts) include repairs and maintenance, machine operator`s labor,fuel and lubrication. Labor is a variable cost, meaning it increasesand decreases directly with production. The machine will attract moreof fixed costs, which will not vary with production. It is,therefore, prudent to have in mind the production level of themachine so as to realize maximum output against the fixed costs.However, if the production is below par, even with the elimination of60% of labor costs, the fixed costs associated with the machine mayreduce profitability. Once this comparison is done, a manager canthen decide for or against buying a new machine depending on the mostcost-efficient strategy.

Question2

AccordingtoBeykaei(2012), full-absorption costing involves determining the full cost ofproviding a service of manufacturing a product. Full costs, in thiscase, encompass the cost of labor and materials in addition to theoverhead costs (fixed or variable costs and direct or indirectcosts). The process of distributing this overhead costs is calledabsorption. Management can abuse this costing method to skew profitand loss statements and misstate financial results. This isattributed to the fact that not all fixed costs are subtracted fromthe accrued revenues since not all manufactured goods may have beensold. There is also the risk of producing more inventory than issold. This results in phantom profits and consequently misstatedfinancial results. An example is when a plant manager switchesproduction to orders that absorb a high amount of costs, delayingproduction of products with a low-cost absorption. Also, a managercan accept a certain order to enhance production despite the factthat another plant is more suitable to handle that order. Anotherexample of abuse of full absorption costing method is when a managerdecides to defer maintenance beyond the present accounting periodwith an aim to meet increased production.

Question3

Awardinga loan to a company that has not experienced growth in the past yearsis a big financial risk. However, I would consider various aspects ofthe situation before I deny them a loan. Failing to register growthdoes not necessarily mean a company is under-performing or failing asdemonstrated by Beykaei (2012).Itcan highlight a lack of investment in the company. A company may beperforming well but due to a lack of investment, it may fail toincrease production to meet increased market demand for its productsor services. A loan is a form of investment by the bank andtherefore, the viability of the project to recover the loan plusinterest needs to be evaluated. I would hence evaluate this companyand analyze its future potential to repay the loan. If the companyhas a viable project that can help them grow then I would not denythem the loan. If there is potential that the company will be asuccess after the investment, then it means that it will be capableof repaying that loan with its interest hence I would take thatfinancial risk and ward them a loan.

References

Beykaei,S. S. (2012). Integrationof CVP Analysis and Quality Cost in Production Systems. University of New Brunswick.