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Cost-Volume Profit Analysis and Activity-Based Costing

The 21st business environment has changed the way business is conducted and the fundamentals underlying the performance measurements, thanks to the advancement of technology and globalization. Most organizations have shifted from the traditional financial accounting practices to the more advanced and reliable managerial accounting. Moreover, focus has shifted from traditional costing methods that were more volume based in nature to the performance driven value costing method. Thus, today’s competition is more aligned to the value addition through specialized technology and outsourcing. While Cost Volume Profit (CVP) analysis and Activity Based Costing (ABC) remain viable tools for external financial reporting, their contribution to forecasting and performance review can not be ignored.

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Value costing in 21st century organizations is becoming important in management decision making. With competition becoming more global and stiffer, companies are turning to value addition activities in order to acquire a competitive edge over competitors. Managerial accounting has become more aligned to efficiency and creating value for all stakeholders in the company through integration of both financial and non-financial information. According to Gunasekaran (2005), agency theory and employment contracting form the basis towards which costing models are directed in virtual enterprise environment. Moreover, value creating activities should be enhanced and directed towards meeting the strategic operational goal of the organization.

The traditional costing methods focused on provision of information that is major financial in nature and competitive advantage enhance through cost reduction and pricing. However, the value addition aspect has not been addressed. The 21st century enterprises are more virtually integrated, and are faced with more sophisticated global competition with e-commerce taking charge of the market. In addition, most enterprises are now leaning towards outsourcing, flexible management control system, customer relations management and flat organizational structure. Therefore, the performance and cost measurement system adopted should address these changes in business environment. Performance Based Costing (PBC) system is essential as it ensures the improvement of areas that add value to the organization and its stakeholders (Gunasekaran, 2005). Establishment of sound Critical Success Factors contributes to the overall performance of the organization and in turn creates value to customers.

Although value costing is crucial in order to compete effectively, some of the 20th century costing methods are still important in some decision making areas of an organization. Various costing methods have been used at different times. These include, average costing which concentrated entirely on total cost and total output, marginal costing which applied the concept of contribution to make costing decisions, opportunity costing which enhanced decision making based on missed opportunities and transfer pricing which advocated for cost absorption across sections. In addition, Activity based costing (ABC) based on allocating costs to activities, target costing which is market driven, and throughput costing which is inventory based, have had their importance in management decision making.

Activity Based Costing has been one of the mostly approved methods in the recent past. It involves allocation of costs to cost objects based on their usage in activities. Resource consumption for every activity will determine the cost to be assigned and thereby providing accurate costing information for decision making (Gunasekaran 2005). However, it fails to address the issue of indirect costs which cannot be easily apportioned to the activities. Target costing tend to lean on the consumer needs. Therefore costs are predetermined and the products made based on this cost. This is important in the sense that the competition in the market has become global and the market forces have taken over the task of price determination.

Cost Volume Profit Analysis (CVP) is one of the traditional methods of costing that has had a lot of impact in management accounting. It is one of the best tools a manager can use to identify untapped profit potential in an organization. CVP adopts the contribution margin concept in analyzing relationship between unit variable cost, unit price scale of operation and mix of products. Business enterprises have to be profitable in order to be competitive in the industry. CVP uses the break-even-point concept to make production and pricing decisions as well as making decisions about investment proposals, make or buy product development and operating leverage. The analysis presents relevant financial information to the management accountant to be used in forecasting and budgeting.

However, in the current business environment, CVP has little relevance and its contribution is insignificant. Although it helps make decisions on overall organizational operations, decrease in scope of operations being analyzed may lead to inaccuracy of the analysis. It assumes that production capacity, unit variable costs and sunk costs remain constant within a certain range which is not quite practical in the current situation. It also relies on sales volume as the main cost driver and assumes that, over a range of operation, costs and revenues are linearly related. Moreover, the model does not take into account the presence of opening and closing inventories.

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References

  1. Gunasekaran, A. et al. (2005) Performance Measurement and Costing System in New Enterprise.
  2. Gupta, K. M. and A. Gunasekaran. (2005). Costing in new enterprise environment: A challenge for managerial accounting. Management Auditing Journal. Vol. 20, pp. 337-353, Bradford.
  3. Shim, J. K. (2000). Accounting and Finance for the Non-Financial Executive: An Integrated Resource Management Guide for the 21st Century. New York: CRC Press Publishers.

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