Question

Cost Behavior and Cost-Volume-Profit (CVP) Analysis are very important and useful concepts and tools used by management and other decision-makers. CVP analysis and one's understanding of cost behavior is helpful for business planning and controlling purposes.

Due to the temporary downturn in the economy, sales revenues have decreased by 50% to 60% for many restaurants and eateries, retails stores and service-oriented businesses (e.g., hair salons ) thus affecting profitability and the ability to continue business operations.  In order to survive the slowdown, businesses must make some adjustments or risk going out of business.

1. As a consultant, which of the Cost-Volume-Profit techniques and tools would you use to help these businesses make decisions? Assume the business is a restaurant. Briefly explain your choice(s).
2. In term of actions involving cost reduction or increasing revenues, briefly provide some recommendations for these businesses to help them stay profitable or at least minimize losses during this period? (Be specific).. Hint: Think about what some business have been doing to control their costs and generate other streams of revenues.

Answer 1

Cost-volume-profit (CVP) analysis is one of the important managerial technique and tool used by management in decision making. It helps a firm in gaining strategic competitive advantages in today’s competitive world. Managing cost is of utmost importance for survival when there is downturn in the economy. CVP analysis is the relationship between cost, volume and profits of the firm. It assumes all costs are either variable cost or fixed cost and then analyses the cost based on activity level to predict future costs. It helps in analysing profitablity at different levels of activities and selection of the best alternative. Break even analysis and margin of safety analysis helps business in making decisions which are reliable

Some of the actions for cost reduction or increasing revenue are given below

· The variable cost structure should be thoroughly reviewed to save all the possible unit variable cost. This will increase the contribution margin per unit. For example : material cost should be renegotiated with the vendors , sourcing should be localised as far as possible to save the freight costs, etc

· All Fixed costs should be thoroughly reviewed to save all the avoidable fixed costs in the business. The higher fixed cost leads to higher breakeven point. Hence lowering the fixed cost helps in improving profitablity to the business at the earliest. For example: review rental agreements, insurance cost, etc

· Ensure economies of scale are obtained in operations for example: Merge the branches and other operating units as far as possible and bring them under one roof so that the fixed cost incurred can be leveraged. This reduces the cost of operations

· The firm should create profitablity statements at different levels of activities to see what selling price can have an impact on improving profitablity based on various investment alternatives. For example: increase in promotion expense can increase sales. CVP analysis helps in understanding the impact at various sales levels and takes appropriate decisions.

· All products, divisions or segments should be reviewed for continue or discontinue decision. The thumb rule is if the contribution margin is higher than the avoidable fixed cost continue the product or division. If contribution margin is lower than the avoidable fixed cost the product or division should be eliminated immediately.

· Revenue can be accepted through special orders which are priced above the variable cost since it helps in giving contribution margin that can helps in recovering the fixed cost.