Question

Unit 5 - Chapter 5 - Cost-Volume-Profit Relationships

Many of you are familiar with Amazon. In its second year of operations, sales increased eightfold. Two years later, sales were $1.6 billion. Although its sales growth was impressive, Amazon's ability to lose money was equally amazing. One analyst nicknamed it Amazon.bomb, while another, predicting its demise, called it Amazon.toast. Why was it losing money? The company used every available dollar to reinvest in itself. It built massive warehouses and bought increasingly sophisticated (and expensive) computers and equipment to improve its distribution system. This desire to grow as fast as possible was captured in a T-shirt. This buying binge was increasing the company's fixed costs at a rate that exceeded its sales growth. At one point, the company predicted its sales would increase by at least 28% in a given quarter, but that its operating profit would decrease by at least 2% and perhaps by as much as 34%. How might this scenario be used in a CVP analysis situation, and how might Amazon have modified its spending to increase profits in conjunction with increasing sales?

Answer 1

Answer :

1.

Cost - volume - profit relationship provides analysis to make various decisions by estimating profitability at various different levels of output.

Cost - volume - profit uses variable costing approach that is

Sales XXX

- Variable Cost ( XXX )

Contribution margin XXX

- Fixed Cost ( XXX )

Opreating Margin XXX.

Using the data given in the question regarding amzon :

Estimated increase in sales in given quarter by amzon will be 28% ( given ).

Estimated increase in variable costs in given quarter will be 6% ( assumption is made to facilitate the calculation )

Estimated increase in fixed costs in given quarter will be 32% ( assumption is made on the basis of information given in question regarding increase in fixed costs higer than increase in sales )

Using cost - volume - profit model

Sales : 28% ( increase )

- Variable Costs : 6% ( increase )

Contribution margin 22% ( increase )

- Fixed Costs : 32% ( increase )

Opreating profit : 10% ( decrease )

Cost - Volume - Profit analysis will enable the amzon to estimate operating profit at different levels of sales and it also provides information about percentage change in variable at different levels of sales as well as impact on fixed costs on overall profitability of the business.

Thus , cost volume profit analysis enables the amzon to estimate highest sales level to ensure the higher operating profitability level and re-consider the spending in order to ensure higher operating profitability level.

2.

Modification in spending :

As calculated above using cost - volume - profit analysis one can understand that even with 6 % increase in estimated variable costs in the short run it is considerable amount of high growth.Estimated Contribution margin has been increased by 22%  

But due to high fixed costs in either building warehouses or buying high end computers and other equipment estimated operating profit has been decreased by 10% inspite of increase in estimated sales by 28%.

In order to increae operating profitability amzon has to modify its fixed expenditures. Infrastructure development in business is very much necessary to ensure smooth functioning of the business. But excessive spending on fixed costs that is even above growth rate of sales. This is not an advisable business practices. By taking into account Cost - volume profit analysis amzon should try to reduce the fixed Expenses to ensure increase in profit in conjunction with the increase in the sales.