Uses and Limitations of Cost Volume Analysis - Essay Example

MINI QUESTION MAIN USES AND LIMITATION OF COST VOLUME ANALYSIS It involves studying the behavior of costs in relationship to the given level ofactivity. Managers attempt to understand the relationship between cost, revenue and net income. Uses It's useful to managers because it shows them how changes in activity levels will influence the profitability levels. Managers can also identify critical output from which the organization will break even. The analysis aids the managers in decision making such as choice of services to offer. It also assists in pricing of products, production levels and selecting appropriate strategies to achieve targeted profit levels. It may be used to determine the break even point of a business activity. Its also used to calculate target costs, target profits and to provide sensitivity analysis on the impact of changes on the factors affecting the profit. Limitations The analysis is done in the short term because this is the period the managers can predict revenue, cost and net income with reasonable certainity. There are many assumptions in this analysis which limit the reliability of cost volume analysis. Some of the assumptions are that the selling prices and variable cost per unit are constant. It assumes that there is only one product mix and doest take into account if there would be a spill over effect there were many product mixes. 2. NET PRESENT VALUE AND INTERNAL RATE OF RETURN Advantages of net present value It recognizes the time value of money It considers the benefits arising out of the proposed investment alternative over its entire life time. A changing discount rate can be build into the net present value calculation by ordering denominator, this feature becomes important as the rate normally changes because the longer the life span, the lower is the value of the money and higher the is the discount rate. The method is exclusive for selection of mutually exclusive investment project. This method of selection is instrumental in achieving the objective of the financial management which is mostly to maximize the shareholders wealth. Limitation of net present value This method may not give satisfactory results in the case of two projects with different effective life span. Its an absolute measure of two projects, this project favors the project with which has a higher present value though its likely to have a higher initial capital outlay, its not dependable when projects have different capital outlays. It's difficult to calculate as well as to understand and use in comparison with the pay back method or even the returns on the capital employed. Advantages of internal rate of return It considers the time value of money. It takes into account the total cash flows and outflows. It's easy to understand It's consistent with the overall objective of maximizing the shareholders wealth. Limitation of the internal rate of return It involves tedious calculation. It produces multiple rates which can be confusing. 3. ACTIVITY BASED COSTING This is a controlling and a planning tool which allocates costs to products in value chain analysis. It enables the overhead costs to be allocated to the respective product which incurred it rather than using the traditional methods where by the overhead costs were allocated as a percentage of the total overhead costs. It enables the managers to identify the products which incur higher costs therefore to charge them at a higher price or look for means to control these costs. 4. PEST ANALYSIS Political environment: These affect the operations of the business in UK; these laws encourage the existence of free markets where the market forces set the equilibrium hence there is fair competition. This encourages the supermarket to compete at a fair ground with its competitors. Economic environment: this affects the consumer consumption depending with the disposable income; this affects the way in which the supermarket will stock its products. Corporate taxes will also determine the manner in which it will price its products. If the taxes are very high then this will be reflected in the prices. Technology: the level of technology used in production affects the prices of the products of the supermarket, if the competitors are well off with better technology then are likely to have higher returns if the market prices are equal. Social: if the products being sold are organic in nature, this will enable it to have a bigger market share than its competitors. 5. THE ADVANTAGES AND DISADVANTAGES TO BUSINESSES OF RELATING MANAGER PAY TO PERFORMANCE AGAINST BUDGET Performance related pay is known to improve manager's production due to the fact that they have a budget against which controls them in using the firm resources. The budget is a tool of control where the actual events and activities are compared and any deviation is investigated hence making them get paid with reference to the budget. It gives means of communication the organization goals and plans to various responsibility managers and intern they use the budget to communicate to other employees therefore acting as basis for assessment and therefore ensuring that the managers align their goals to those of the firm. The budgets also act like as means to motivate the manager since they strive to achieve organizational goals outlined. It's disadvantageous to relate the manager pay to performance against the budget because the budget is a tool for controlling the actual performance against the planned. This can lead the managers to manipulate the figures to enable the get the required targets. The factors beyond the manager control can lead to deviation between the actual results and the expected results. Since budgets are prepared for a certain period of time, they can be used to measure the performance of the managers in the short run since there are limited uncertainties as compared to the long run where there unexpected occurrences can affect deviate the actual performance from the planned performance. ESSAY QUESTIONS 1. HOW MANAGEMENT ACCOUNTING USES PLANNING AND CONTROL IN THE PROCESS OF MANAGING A BUSINESS Planning is the determination of the intended course of action for the managers. It involves developing expectation about the future of the business and it begins with setting the objectives which combines financial, physical and technical aspects and developing the best alternative way for achieving the business stated objectives. It involves allocating the business resources to achieve the objective of maximizing the profit. Controlling is function of the management for ensuring the events take place as planned. Control is exercised when action is taken to return to go as planned and it is an important tool in the financial management. There are three stages of control, first there are the planned standards for performance, then there is comparison between the set the performance and standards set and then corrective action is taken if there are differences. Control concentrates on what can be done now to improve the performance rather than dwelling on what went wrong. Budgetary control is widely used in management accounting involving use of cash flow budgets for financial control. The need for controlled decisions arises out of the unforeseen changes in the business or in the external environment. This includes changes in the prices for both inputs and outputs, changes in corporate objectives, changes in the governmental policies like on taxes and may be catastrophes affecting the business. Budgets can be used to determine the behavior of managers because targets can be based on budgeted information which gives incentives to managers to work towards required targets. It can also restrict the amount spent on various activities to fit with the company's strategy Budgets can result inappropriate behavior e.g. if profit targets are easily being met, managers may try to hide profits away in provisions to be released the following year and can also result in decision being made which do not maximize shareholder wealth (e.g.. if targets are profit based, managers may decisions to maximize profits rather than shareholder wealth) Budgets should be used to control the behavior of manager because they ensure the managers choose activities which are align to the budget, it also provide them with a form of forward vision checks the performance of the manager against the budget and lack of a budget leads to inconsistency in decision over time, under utilization of the resources and lack of direction in the management. 2. THE MAIN TYPES OF DECISIONS FOR WHICH BUSINESSES MIGHT USE FULL COSTING INFORMATION AND COMMENT ON WHY SOME PEOPLE PREFER TO USE MARGINAL COSTING TECHNIQUES Decision making is an activity which cuts across all the four functions of the management that is planning, organizing, directing and controlling. Managers are usually the judges and it measures their ability to make good decisions, which is getting the right thing done to solve the problems appropriately. Decision making is therefore the activity of selecting from among the possible alternatives a future course of action. Decision making involves identifying problems, defining the most likely solutions, assessing the likely qualitative and quantitive effects of each solution, decide on the best solution, taking action and finally reviewing the results of the action. Full cost accounting is also called true cost accounting and it is involved in collecting information concerning costs and advantages for all the proposed alternatives for solving a certain problem. This involves evaluating the economic, social and environmental impact of these decisions. Unlike other standard method of accounting, full cost accounting involves accounting for costs rather than outlays, hidden costs, externalities, direct costs, indirect costs, accounting for past and future outlays and according to the life cycle of a product. Full cost accounting is used in making decision which is likely to take long to be changed in the short run; it may be used in waste management decision. Managers prefer the marginal cost technique because fixed costs often don't change in the short term and so are not relevant to be included in such decisions, it is therefore often more useful for making decisions such as taking on one-off projects, outsourcing etc and it excludes any allocated costs of changes in production which can make profit fluctuate TRADITIONAL COSTING TECHNIQUES AND DESCRIBE HOW ABC COSTING METHOD ATTEMPTS TO OVERCOME THESE DISADVANTAGES Traditional costing can result in an arbitrary allocation of general overheads to product, this can lead to incorrect decisions being made if the costing information isn't particularly accurate and was developed in a manufacturing age which was labor intensive and therefore often driven by labor hours. This is less relevant today. To over come these disadvantages, activity based cost allocates costs based on activities that help to generate the costs and is therefore less arbitrary costs are broken down into activities which are usually higher in number than allocation methods in traditional costing which should / may result in a more accurate costing and more relevant to service industries where in the absence off direct materials, the proportion of overheads is significant. Activity based costing should be adopted at the expense of these traditional accounting techniques. REFERENCES: Stephen C. Harper (2003), Business and Marketing, McGraw-Hill Publishers, New York Robin Wood (2001) Managing Complexity, Prentice hall publishers, UK Wikipedia the free encyclopedia (2007) costing and accounting, retrieved on 10th May, available at www.en.wikipedia.org Read More