A friend has asked you for some advice: �My small business now makes a profit; I am only too aware of
this, as I now face a big tax bill each year, when my tax accountant has prepared my annual accounts.
However, I don’t feel much better off personally, so this is not quite what I had expected when I took the
risk of resigning my job and setting up my own firm. The accountant is now trying to persuade me to pay
her even higher fees, by letting her prepare monthly �management accounts� for me. She says that I
would also benefit from something called CVP analysis on my various product lines. I know that you are
now doing an MSc. What does she mean here, and is this likely to be worth my paying her for?�
In formulating your Key Concept Exercise, consider the following questions:
�What is the difference between financial reporting and management accounting?
�What are the benefits and potential problems associated with cost-volume-profit (CVP) analysis?
�What advice would you give your friend?
Outline the difference between financial reporting and management accounting information and explain
the benefits and potential problems associated with cost-volume-profit (CVP) analysis. How might the
technique that you have discussed assist your friend in the effective management of his business
resources? What advice would you give him? Base your answer on research, your readings and your
own experiences. Please cite all references.
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MFR.COLL.W4
As a business grows and continually becomes complex, the need to adopt more sophisticated
accounting practices is inevitable in order to effectively manage profitability. Management
financing has gained increased popularity among contemporary businesses because of its
usefulness in decision making, budget and profit prediction. Managing costs is also a core
activity for any organization with an aim of promoting profitability; hence the need to consider
Cost Volume Profit (CVP) Analysis. Having acquired a significant level of knowledge on
accounting, I would advise you to consider your accountant’s suggestion to include management
accounting and CVP analysis besides the normal financial accounting. While this may seem
expensive it is of great benefit in the long-run because you will have greater control of your
business and thus identify better profit making strategies. How then do the above concepts work?
What does one need to know before embarking on them? These are discussed as follows.
Management versus Financial Accounting
The obvious question that would arise from an individual with limited accounting knowledge
would be “why do we need management accounts while we are already preparing financial
statements? Is financial accounting not adequate to provide the management with information for
decision making purposes? The only way to address such sentiments would be to do a
comparison between management accounting and financial accounting in order to show the
importance of management accounting.
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Fotache et al (2011, p. 48) notes that one of the most significant difference between financial and
management accounting is that while financial accounting is more about reporting a company’s
performance for a particular accounting period, management accounting focuses on development
reports for specific areas of the business, to track performance, identify any underlying problems
and provide solutions necessary to address them in order to promote profitability. Financial
accounting is generally undertaken for the external audience in a bid to report the organization’s
profitability and financial position while management accounting is meant for internal
stakeholders (Stoicea, Dinu and Stoian, 2011, p. 260 – 262). Essentially, financial accounting is
mostly done for compliance purposes while management accounting is for internal use and the
purpose of reports may therefore vary. This means that it can be more detailed and more specific
to areas of the business that need to be addressed including pricing, cost and profitability of
single items.
Financial accounting data is historical and often a representation of the organization’s past
performance. Management accounting on the other hand may consist of both past and projected
financial information. Examples of future data include cost budgets and profit approximations.
Due to its level of detail, management accounting is an effective tool for promoting decision
making within the organization and is often associated with timeliness, accuracy and integration
(Odar, 2005, p. 85).
Cost-Volume-Profit (CVP) analysis
By definition, this refers to the process of determining how a shift in costs and volume of a
company’s products can have on its operating income (Kee, 2007, p. 478). The results of CVP
analysis are then used in developing budgets and other purposes such as determining the selling
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price and cost estimations necessary to ensure profitability. CVP analysis is therefore important
for future projections and decision making. What should be expected by businesses which
consider the use of CVP analysis? The best approach would be to compare its benefits versus its
limitations as below.
Given its ability to project information on product costs, volume and profitability, CVP analysis
is a vital tool for decision making. Underwood, Bush and Heath (2009, p. 14) notes that CVP
analysis is highly detailed and is likely to answer most of the questions that may be raised
concerning future profitability of products. CVP analysis is of great significance in terms of
decision making at the management level. Using the detailed information derived from the CVP
analysis, the management can easily make decisions on costs and effectively determine the best
prices for their products; with an assurance that most important factors affecting these variables
have been addressed during the CVP analysis (Răvaş, 2013, p. 103). Effective budgeting and
profit planning is often associated with CVP analysis and as noted by Răvaş (2013, p. 104), CVP
analysis results inform the best combinations between cost, volume and selling price which will
lead to the best possible profit levels and is thus an important tool for business.
CVP analysis however has its own limitations. Among the limitations is the fact that CVP
analysis is based on estimations. This means that despite relying heavily on factual data, the
results of a CVP analysis is not usually the true representation of the situation but rather a
tentative result (Kee, 2007, 481). It is however notable that determining actual figures when
projecting just like in budgeting can be difficult and CVP is merely a tool necessary to give an
idea of what to expect when costs and volume change. According to Chan and Yuan, 1990, p.
83), CVP has traditionally been known for not being able to deal with risk and uncertainty. CVP
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analysis also limits usage for companies with multiple products due to the cumbersome exercise
which must be performed on each product individually. Kee (2007, p. 482-483) notes that in the
presence of a different variable cost for each product such as in the case of a restaurant business,
this may pose difficulties for companies with multi products.
The discussion above generally covers information necessary in making a decision on whether to
adopt management accounting and CVP analysis or not. It is however apparent that upgrading
your accounting practices would be of great benefit to your company through more informed and
proactive decision making, more accurate projections and less miscalculations. I would therefore
advise you to consider your accountant’s suggestions in order to benefit from these accounting
concepts.
Reference list
Fotache, G, Fotache, M, Bucşă, R, & Ocneanu, L 2011, ‘The Changing Role of Managerial
Accounting in Decision Making Process Research on Managing Costs’, Economy
Transdisciplinarity Cognition, 14, 2, pp. 45-55, Business Source Complete, EBSCOhost, viewed
19 June 2015.
