Question

1. Why would a company use CVP analysis?

2. The e-text lists five assumptions in CVP analysis. Pick one of these assumptions and discuss the impact of changes in the assumption on the CVP analysis.

3. How does operating leverage impact the operating risk and profit levels of a company?

Answer 1

1. Cost volume profit analysis is useful to management as it helps in understanding interrelationships between cost, volume and profit. It helps in understanding the nature of costs and how they move with volume in achieving profitability of the organisation. CVP analysis is of the important managerial tools need in today competitive world to gain strategic advantage. It is regularly used managerial technique in day to day operations of the firm.

a) It helps in understanding cost structure of products, divisions, etc. Cost is classified into variable cost and fixed cost. Variable cost varies at different level of activity and fixed cost remains same.

b) It helps in profitability evaluation. The difference sales and variable cost that is Contribution helps in recovering fixed cost and checking profitability at different levels of activity

c) It helps in Break-even analysis. Break-even point is the point at which there is no profit or loss. In other words Contribution is equal to fixed cost

d) It helps in taking various decisions like – product pricing, division analysis, make vs buy, shutdown vs continue, etc

e) It helps the firm in Cost management through cost control and cost reduction. It helps in target costing by deciding the cost of products

2. One assumption is Costs can be classified into variable cost and fixed cost. This is one of the important assumptions because variable costs change at unit level and fixed cost remain same at absolute level for a relevant range of production. With this assumption the firm can calculate profitability statement at different levels of output. If this assumption does not hold true it is not possible to draw the profitability statement at different levels of output at same variable cost per unit. This would give varying answers and hence drawing conclusions or making decisions will be difficult and not reliable ones

3. Operating leverage is the impact of fixed cost on the earnings of the company. The higher the fixed cost and lower variable cost structure the operating leverage will be higher. Higher operating leverage during growth times will yield higher profit compared to firms having lower operating leverage. Net increase in profit is calculated by multiplying Operating leverage by growth percentage.

Similarly during the sales decline higher operating Leverage Company will yield higher losses since the fixed cost will be constant and Contribution will not be enough to recover the fixed cost charges.

	High Operating Leverage	Low Operating Leverage
Risk	High	Low
Fixed cost	High	Low
Profits	High profits during growth times	Low profit during growth times