Lecture 3 - CVP + Revenue Pricing

Question 1

How does CVP analysis work?

What is the primary use of CVP?

Answer 1

Uses:

• Help management identify how changes in costs, volumes and prices affect profits.
  
  • E.g. breakeven or a certain level of profit.
• Or conduct a sensitivity analysis – ‘what-if’ questions (i.e. change key variables, selling price, variable costs, fixed costs)

Question 2

What are the 3 assumptions CVP makes?

Answer 2

1. Total costs can be split into fixed and variable components
2. Constant Variables: The unit selling price, unit variable cost and total fixed costs are known and constant.
   
   1. E.g. total costs and total revenues are linear with respect to output.
   2. Costs and revenue have a single common driver à output.
3. Constant Sales Mix: The proportion of different products sold (i.e. sales mix) will remain constant.

Question 3

What is the contribution margin?

Answer 3

Contribution margin is the portion of revenue that contributes towards covering fixed costs (and then profits).

Question 4

How much of a given unit needs to be produced to yield a given target profit?

Question 5

What is a sales mix?

Answer 5

Sales mix – the relative proportion in units of each type of product or service sold.

When a company has more than one type of production.

e. g. sales mix Product A: Product B (3:1), or (0.75,0.25)
- think how you would split 1 unit.

Question 6

What is WACM?

How do you calculate it?

What is it used for?

Answer 6

WACM = The average of the products’ contribution margin per unit, weighted by relative sales units of each product (sales mix)

Used for: To determine each individual product’s contribution to be allocated to fixed costs or profits, based on the predicted sales mix.

Question 7

What is operating leverage?

How does it impact costing and risk?

Answer 7

Operating Leverage:

• Outlines how sensitive operating profits is to changes in sales volume.
• Operating leverage depends on the proportion of cost that is fixed vs variable
  
  • The higher proportion that is fixed à the higher the operating leverage
    
    • Thus, higher sensitivity of profit to changes in sales volume.
• Exposed to greater downside and upside potential.
• Measure:
  
  • Total contribution margin/operating profit.

Higher operating leverage à more FC to cover (therefore must produce more units).

Question 8

What are the 4 limitations of CVP analysis?

Answer 8

Limitations of CVP analysis:

1. Accuracy of fixed and variable costs
2. CVP analysis only works in a given relevant range
3. Assumes sales mix remains constant
   
   1. Neglects customer’s market behaviour (may have a limit)
   2. Lacks complexity of changes in the sales mix as we increase production.
4. It also assumes that the number of units produced is an accurate cost allocation base.
   
   1. E.g. assumes that each unit of different production will require the same resources.
   2. This may not be the case, e.g. if the Saguaro Pale Ale requires a longer time brewing in the fridge than it’s counterparts, it will likely consume more fixed cost of refrigeration space and thus makes our CVP analysis inaccurate.