M3A1: Discussion—Absorption versus Variable Costing

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Once an analyst forms a cost estimate, it is important that he or she then create a financial model. The best way to do this is through cost-volume-profit analysis. The cost-volume-profit model shows the effects of any changes within an organization. Examples of changes would be sales volume, prices, and costs. The basic cost-volume-profit model is great, but it does have limitations. The largest is that it can only account for one cost driver. This model is improved upon by using activity-based costing models. When looking at any financial model, it is important to understand some basic terms. The first is the break-even point. This is when revenues equal expenses at a given sales level. Another important term is contribution margin, which is the amount of money that is left over after all variable costs are covered. Operating leverage is another important term, which is the ratio of contribution margin to operating income. A high operating leverage signals a risky company. Making financial decisions and measuring costs are very difficult for a company, no matter the size. However, these functions are necessary if the organization is to remain successful.