Week 3

Question 1

Cost-volume-profit (CVP) analysis

Answer 1

Evaluates how operating and marketing decisions affect short-term profit, analysing the relationships between variable costs, fixed costs, unit selling price, and the output level. It has many applications, including:

• Aids in setting prices for products and services;
• Determining the short-term cost/profit implications on decisions;
• Determining the desirability of replacing a fixed asset;
• Determining the break-even point;
• Determining the best product mix.

Question 2

The 3 steps needed to effectively use CVP

Answer 2

1. The contribution margin per unit is the difference between the selling price per unit (p) and the variable cost per unit (v). It measures the increase in operating profit for each unit increase in sales;
2. The total contribution margin is the contribution margin per unit multiplied by the number of units sold (Q);
3. The contribution margin ratio is the ratio of the contribution margin per unit to the selling price per unit. Through this ratio, the projected increase (or decrease) in operating profit caused by an increase (or decrease) in sales dollars can be determined.

Question 3

A contribution income statement

Answer 3

Separates fixed and variable costs, in contrast to conventional income statements that focus on product and non-product costs, to emphasize cost behaviour.

The total contribution margin is calculated by subtracting variable costs from sales, after which fixed costs are also subtracted to get total operating profit. Thus, changes in operating profit that result from changes in sales can be accounted for.

Question 4

Strategic Role of CVP Analysis

Answer 4

CVP analysis can help a firm execute its strategy by providing an understanding of how changes in its volume of sales affect costs and profits.

This is especially relevant for firms competing with a cost-leadership strategy, since they often increase volume (often through lower prices) to have lower total costs per unit.

CVP also has a role in strategic positioning. A firm following cost-leadership needs the analysis, especially at the manufacturing stage of the cost life cycle.

Instead, a firm with a differentiation strategy would use CVP in the early phases of the cost life cycle, since it needs to assess the profitability of new products and the desirability of new features.

Question 5

The profit-volume graph

Answer 5

Illustrates how levels of operating profit changes over different levels of
sales volume. The slope of the profit-volume line is the contribution margin per unit. Therefore, it shows how total contribution margin and operating profit change as the sales volume Q changes.

Question 6

Sensitivity Analysis

Answer 6

Includes a variety of methods that examine how an amount (e.g. operating
profit) changes if factors involved in predicting that amount (e.g. sales volume) change.

CVP is an important strategic tool since managers can use it to determine the sensitivity of profits to possible changes in costs, selling price, or sales volume. f these change significantly, the firm might have to change strategy.

Question 7

What-if-analysis

Answer 7

The calculation of an amount given different levels of a factor that influences
that amount.

Question 8

A decision tree and table

Answer 8

A form of analysis that estimates a probability for each possible event, and demonstrating the set of possible successive actions or decisions that could take place. From this, the expected value of an action can be determined, which guides decision-making by showing the result of an action based on weighted average probabilities.

Question 9

A Monte Carlo simulation

Answer 9

Method of resampling values of factors in a model according to some probability distribution to generate a probability distribution of outcomes.

Question 10

Margin of Safety (MOS)

Answer 10

The amount of planned or actual sales above the breakeven point.

Question 11

The margin of safety ratio

Answer 11

Useful measure for comparing the risk of two or more alternative
products (or decisions variables). It is expressed as a percentage of sales.

Question 12

Operating leverage

Answer 12

Refers to the extent of fixed costs in an organization’s cost structure. The
higher the relative amount of fixed costs, the higher the operating leverage and therefore the greater the sensitivity of operating income to changes in sales volume.

Firms with more operating leverage and thus a higher concentration of fixed costs are riskier, and as such highly affected by the amount of sales.

CVP analysis is useful in this case, as it may help determine the factors that
affect fixed and variable costs, and how the proportions between the two might change due to different cost drivers.

Question 13

The degree of operating leverage (DOL)

Answer 13

Measure of the sensitivity of operating income to changes in sales volume.

Question 14

Assumptions and Limitations of Conventional CVP Analysis

Answer 14

The CVP model assumes that revenues and total costs are linear over the relevant range of activity.

Therefore, it is important to remember that calculations performed within the context of a traditional CVP model should not be used outside the relevant range.

Another consideration arises from step costs, which can lead to big differences in total costs as the output changes.

Sometimes, an approximation via a relevant range is not possible. Though CVP can still be undertaken, it becomes more burdensome.