Examining the appropriateness of the accountants method of analyzing costs

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This report serves two main purposes. The first is to explain why the accountant's way of analyzing costs is suitable to be used for the purpose of determining the budgeted sales for 2010 for Sri Melati Sdn. Bhd. The second purpose is to calculate the expected profit for the company under different scenarios. It is hoped that the report will be useful for decision making purposes.

2. Analysis of Costs

The main issue faced by the management of the company is deciding which method is better for analyzing costs - the economist's way or the accountant's way? Before answering this question, let us first examine some of the key features of each method.

2.1. The Economist's Way

First of all, the economist's way of analyzing costs has its merits. It involves calculating costs, volume and profit over a wide activity range. As such, when shown graphically, revenues move in curvilinear fashion. This is because the company can only sell more by reducing the selling price per unit so total revenue does not increase proportionately with output (Drury, 2006, p. 242). On the other hand, variable costs increase sharply at lower sales and production levels because of the high operating costs. However, once the business operates efficiently, costs rise less steeply and increase in linear fashion. Yet, once the company has produced beyond capacity, costs rise steeply once again because of problems of scheduling and plant breakdowns. As a result, the business is likely to have two breakeven points.

2.2. The Accountant's Way

On the other hand, the accountant's way of analyzing revenue and costs is that they have a linear relationship. While this may initially seem to be quite different from the economist's way, essentially they are the same. The major difference between the two methods is that the accountant's way is aimed at predicting cost-volume-profit (CVP) relationship within the relevant range where a business is likely to be operating on constant returns to scale, whereas the economist's way takes a wider scope, that is from the lowest to the highest extremes. This is why both methods reveal similar costs and revenue figures within the relevant range (Drury, 2006, p. 259).

While Mr. Goodare may have misgivings about the accountant's way of analyzing costs, his fears are unjustified. The accountant's way is valid and also accurate at calculating costs and revenue within the relevant range.

2.2.1. Key Assumptions of CVP Analysis

Before explaining the merits of the accountant's way, we first need to understand the various assumptions underlying it. First is the assumption that all costs can be resolved into fixed and variable elements. It is assumed further that fixed costs are costs that remain constant regardless of production and they are for capacity purposes, for example factory rental. On the other hand, variable costs vary proportionately with output so when the firm produces more, the more it spends on variable costs. Raw material and labour costs are common examples of variable costs.

For the sake of simplicity, it is assumed that the only factor affecting costs and revenue is volume. Technology, production methods and efficiency are assumed to remain unchanged, even though in reality such factors have been proven to increase efficiency. The calculations for CVP are for an individual product or a constant mix of products, as in this report. Finally, it is assumed that there will be no uncertainty. Hence, discount and risk factors are not included, unlike in more complex investment appraisal methods.

2.2.2. Limitations of CVP Analysis

Many people criticize CVP because of its limitations. For example, CVP cannot be used to predict with accuracy outcomes outside of the relevant range. While it is conventional to draw charts with lines starting from zero, relationships at the extremes of activity cannot be relied upon. Also, fixed costs are likely to change at different levels of activity. Therefore, a stepped fixed cost line is probably the most accurate representation. Furthermore, variable costs and sales are unlikely to be linear. Extra discounts, overtime payments, the effect of the learning curve, special price contracts and other similar matters make it likely that the variable costs and revenue lines are some form of curve rather than a straight line. In this respect, the economist's way of calculating costs is superior. In addition, it is difficult to classify all costs as either fixed or variable because some costs are semi-variable in nature.

Another criticism is that CVP is only useful in the short term. Different methods need to be used to predict cost behavior over a longer time horizon. CVP also assumes that changes in the level of output are the sole determinant of cost and revenue changes. This is likely to be a gross over-simplification in practice although volume changes do have a significant effect on costs and revenue. In addition, CVP assumes that there is a constant mix of products although in reality, multi-product firms do not manufacture goods in a fixed proportion. Normally, production of products depends on demand and it is difficult to apply CVP in such instances. Similarly, CVP assumes that there is a constant rate of mark-up on marginal cost though this is not the case in practice. The final criticism of CVP is that it takes no account of risk and uncertainty and this may distort actual cost figures.

2.2.3. Uses of CVP Analysis

I suppose Mr. Goodare is aware of these criticisms, hence his skepticism about the advantages of CVP. However, this is unfair and ignores the purposes of CVP. It should be remembered that CVP is meant for the short term and for a narrow range, as reflected in the assumptions made. In no way is CVP appropriate for calculations at the low and high extremes of output nor is it suitable to predict cost behavior in the long-term. Instead, it serves short term decision making and if applied correctly, it can be immensely useful.

CVP is useful in breakeven analysis. Central to this is the calculation of the breakeven point, which is the sales volume at which the company obtains neither profit nor loss. The breakeven point is crucial to identify how much a firm needs to sell to achieve profitability. CVP is used in the construction of breakeven charts which range from traditional breakeven charts to profit graphs, an example of which is shown in a later section.

All breakeven charts share a number of characteristics. A breakeven chart is linear and profits or losses can be identified on the chart. The relationship between costs, volume and profit is revealed through the chart. The costs and sales at different levels of activity can be read from the chart and the breakeven point is highlighted by the intersection between the revenue line and the total cost line. The margin of safety is the difference between the normal or actual sales and the breakeven point. It can be read from the breakeven chart and the margin of safety shows by how much the sales volume must fall before a loss is made.

However, breakeven analysis is much more than that. It can be used in budget planning and control, as done by Sri Melati Sdn. Bhd. Also, CVP is immensely useful for decision making in terms of pricing, sales mix and product mix decisions (Das, 2007, p.233) and it is a useful tool for sensitivity analysis. As demonstrated in this report, CVP is very effective in calculating sales and profits under different scenarios. Hence, managers can use it to determine the effect on sales and profits when items such as unit costs and selling prices are changed. This can help management accountants decide on the best course of action depending on the situation.

Furthermore, breakeven analysis can be used for profit planning. It can be used to identify profitable product lines and overall profitability of the business. Hence, CVP can also be used for product analysis.

Therefore, the accountant's way of analyzing costs for the 2010 budget is suitable and appropriate. CVP can be used to prepare short term budgets. Owing to its simplicity, CVP is also easy to use. It is much easier to calculate the breakeven point and target profit using CVP compared with the economist's way and this is why it is very popular. Similarly, it is much easier to plot a CVP breakeven chart that an economist's breakeven chart because one only needs to plot a few coordinates for the former, whereas the latter requires extensive calculations.

In short, the accountant's way can be used to determine costs for the next period. It is an effective and simple way and since it is within the relevant range, computations should be accurate.

Based on the initial budget, the company will record a budgeted profit of RM2, 835, 000 in 2010. The above income statement is prepared in accordance with marginal costing and costs are separated as variable and fixed. It shows the contribution for each type of product as well as the total contribution.

In this new budget, sales forecasts have been revised downwards, reflecting the current gloomy economic situation. The sales mix has also been altered. As such, total revenue will drop to RM16, 021, 800 resulting in an overall net profit of RM1, 760, 400. Below are the combined workings for the two budgets.

The breakeven point in the old forecast is RM4, 095, 360 while it is RM3, 760, 00 for the new forecast. This means that under the new forecast, the company requires to sell less to break even, which is better considering the current economic slump. Although fixed costs remain the same under both forecasts, the difference is sales mix causes the reduction in breakeven point. Therefore, the new sales mix is more efficient than the initial estimates.

The above profit estimates are based on the two proposals put forth by Mr. Goodare. Both are calculated based on the revised sales mix provided by Mr. Goodare. Under Proposal 1, sales of RM17, 690, 563 are required to generate RM2, 000, 000 in profits. Under Proposal 2, sales of RM30, 861, 502 are required to generate RM2, 500, 000 in profits.

Even though businesses aim to earn as much profit as possible, it seems that Proposal 2 is less efficient at generating profits. The difference in profit is only RM500, 000, yet approximately RM13, 000, 000 more in sales is required to achieve the desired profit under Proposal 2. Going further, the C/S ratio also drops significantly under Proposal 2. Therefore, it is not wise to slash prices in a bid to increase sales. Proposal 2 also seems curiously odd because Mr. Goodare appears to be very prudent in his sales estimates by revising them down, yet Proposal 2 would require the firm to generate even more sales than the initial sales forecast. In a depressed economy, Proposal 2 seems to be unrealistic.

Hence, Proposal 1 is the better option. Even though the target profit is lower, its target sales are much more reasonable and stand a greater chance of being achieved.

5. Profit/Volume Graph

The Profit/Volume chart depicts the profits obtained for the old and new forecasts. The point where both lines intersect the x-axis is the breakeven point and the point they intersect with the y-axis is the fixed cost. Using a graph is a popular way of reading the breakeven points and target profits, even though they are approximations. A better way of estimating the breakeven point and target profit is through calculations.

6. Conclusion

It is hoped that this report will demonstrate the appropriateness in using the accountant's method of analyzing costs and revenue. While the economist's way has its strengths, the assumptions used in the accountant's methods are justifiable and CVP is useful for the purposes of budgeting and short term decision making. The second part of the report provides estimates for sales and profits under different scenarios. These figures are calculated using CVP, thus illustrating how useful and effective CVP can be when applied correctly.