Cost refers to money expenditure of a firm on wages and salaries, machinery and equipment, materials, rent, and insurance. As such, money costs relate to money outlays by a firm. Every producer is concerned with money costs because they are essential in making decisions on various matters in a company. It is worth realizing that the success and efficiency of a firm depend on its suitable size. As such, the firm's size should be optimum as to ensure maximum profitability. Essentially, the firm's optimum size is that particular point which results in the lowest production cost and maximum efficiency. Various cost concepts can be used by managers to make production decisions (Lanen, 2016). The cost-volume-profit analysis is a valuable tool that can be used by managers to efficiently determine how changes in costs and volume affect the company's operating income and net income. Analysis of cost is important in a company because it provides a basis for managers to determine whether to produce or not and how to produce when a decision to produce is taken.
The cost-volume-profit (CVP) analysis is an important managerial accounting technique that is concerned with the effect of sales volume and product costs on operating income of a company. The cost-volume-profit study deals with the manner in which operating profit is affected by changes in variable costs, fixed costs, as well as selling price per unit ( Zimmerman & Yahya-Zadeh, 2011 ). There are various assumptions held in CVP analysis. The first assumption states that all costs can be categorized as either variable or fixed. The second assumption states that the selling price per unit, variable cost per unit and total fixed cost are constant. The final hypothesis posits that all units produced are eventually sold. CVP is one of the most widely used tools in managerial accounting to help managers to make better business decisions.
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CVP analysis involves the use of two critical costs concepts: contribution margin and gross margin. The contribution margin is the difference between sales and variable costs. Thus, in calculating the contribution margin, the variable costs are normally deducted from the sales. On the other hand, the gross margin refers to the difference between sales and the sum of both variable and fixed costs. As such, the gross margin is simply the difference between sales and cost of goods sold. Calculating both the contribution margin and gross margin can give the manager valuable, albeit different information.
The dominant function in analyzing CVP is calculating the break-even point in units for the company. The break-even point can be calculated by multiplying the sales price for the company's products by the break-even point in units. The break-even point in units refers to the number of units a company has to produce to make zero profit. Simply put, break-even point in units is the number of units where the total revenue equals the total expenses. When the point where operating income is zero has been reached, then the break-even point in units has been attained. As such, if the operating income is positive, a company has registered a profit, whereas if the operating income is negative, the company has made a loss. Essentially, the break-even analysis is the primary focus of the CVP analysis. The primary objective of typical CVP analysis is to determine a company's break-even point. Ideally, CVP analysis helps company managers to determine what it will take in sales for their company to break-even. Therefore, the CVP analysis shows how expenses, revenues, and profits change as sales volume changes. More specifically, CVP analysis enables managers to answer certain pragmatic questions that are essential for business analysis (Garison et al., 2010). For instance, break-even analysis helps managers to project how future spending and production will contribute to the success of failure of the company. Since CVP is based on statistical models, managerial decisions can be broken down into probabilities that can significantly help with the decision making process.
The contribution margin often changes with changes in output levels due to moving variable and fixed costs. The contribution margin is the difference between sales and variable costs. As output levels increase, the amount of variable costs may increase. As variable costs rise, the contribution margin may reduce. This is because the contribution margin is calculated by subtracting total variable costs from sales. As such, as output levels increase, the sales increase as well as the variable costs. This translates to changes in the value of contribution margin.
Although the contribution margin closely relates to gross margin, some significant differences exist between the two. Both contribution margin and gross margin involve sales and variable costs. However, the contribution margin considers variable costs alone. On the other hand, gross margin is the difference between sales and the sum of both variable costs and fixed costs. Contribution margin is used to determine the volume that can result in maximum profitability. The gross margin is used to determine whether a company makes a profit or loss from the goods produced. Profitability is determined by subtracting total fixed costs from the contribution margin. As such, gross margin is the difference between contribution margin and total fixed costs. Both contribution margin and gross margin are essential for purposes of making managerial decisions. Contribution margin helps managers to determine the profitability of individual products while gross margin shows how much money is left over for operations, debt repayment, expansion, distribution to owners, along with other miscellaneous expenses.
References
Garrison, R. H., Noreen, E. W., Brewer, P. C., & McGowan, A. (2010). Managerial accounting. Issues in Accounting Education , 25 (4), 792-793.
Lanen, W. (2016). Fundamentals of cost accounting . McGraw-Hill Higher Education.
Zimmerman, J. L., & Yahya-Zadeh, M. (2011). Accounting for decision making and control. Issues in Accounting Education , 26 (1), 258-259.
