Cost Volume Profit Analysis

Question 1

Operating gearing is…

Answer 1

The relationship between contribution and fixed cost - when a business has a high fixed cost compare to variable cost, operating gearing is high
- high gearing makes a firms profit sensitive to the sales volume - if sales fall and the business has a high operating gearing then the business will need to take drastic action to cut costs

Question 2

Disadvantages of break even analysis…

Answer 2

• non linear relationships
• stepped fixed costs as the number of different types of fixed costs will have different stepping points E.g. rent, supervisor salaries
• fixed costs may relate to more than one product and so can sales revenue

Question 3

Marginal analysis is used in 4 different areas….

Answer 3

• pricing/assessing opportunities to enter contracts
• determining the most efficient use of scarce resources
• make or buy decisions
• closing or continuation decisions

Question 4

Advantages of CVP analysis…

Answer 4

• provides management with useful information for managerial budgeting and decision making
• it’s a systematic method of examining the relationships between selling prices, total sales revenue, volume of production, expenses and profit
• it provides information that could help management to improve the relationship between these variables to increase profit

Question 5

Limitations of CVP analysis…

Answer 5

• CVP is only an estimate therefore it lacks accuracy
• it’s hard to categorise fixed and variable costs therefore it may not be accurate
• if any of the factors change such as price, operating efficiency or unit costs, then relationships between them must also be modified
• assumptions need to need to be recognised to make sure correct conclusions are drawn from the analysis e.g. the right amount of sales information is produced
• the use of scarce resources could cause problems as the price of resources may start of cheap due to economies of scale but as they are becoming scarce they can cause the price to go up so the cost of materials is not linear and can cause problems and wrong conclusions will be drawn

Question 6

CVP as BEP analysis is…

Answer 6

• cost behaviour in relation to output and it involves fixed and variable costs

Question 7

Contribution margin is…

Answer 7

The excess of total sales revenue over the total variable costs

• it can be thought of as the contribution towards paying of the fixed costs
• once all fixed costs have been covered, any further contribution is all net profit
• contribution is important as it increases as volume increases

Question 8

The effect of operating gearing..

Answer 8

• the company decision will be affected by many factors such as:
  
  • business’s attitude to risk
  • future prospects (expected sales volume)

Higher operating gearing = higher risk but bigger reward

• companies like McDonald’s and Pizza Hut have high variable costs and low fixed costs so they can continue to make a profit even if they experience a wide fluctuation in sales
• easyJes and Volkswagen have high operating gearing so they have higher variable costs and Low fixed costs but sales tend to be above the break even point to produce high profits, these businesses are more vulnerable to sharp economic and business cycle swings

Question 9

Optimal use of scarce resources..

Answer 9

• most businesses make more than one product or deliver more than one type of service
• they operate with certain restraints (demand, shortage of labour, materials, equipment capacity)
• restraints can be solved in long run but in short term firms often face problem of deciding how to Best utilisation a constrained resources
• since fixed costs are not affected within short period of time, management can focus on maximising total contribution margin