Cost-volume-profit analysis

Full Answer Section Why do managers put such a great amount of emphasis on controlling fixed costs? Fixed costs are the costs that a company incurs regardless of the level of production. These costs include rent, salaries, and insurance premiums. Because fixed costs do not change with volume, they can have a significant impact on profitability. For example, if a company's fixed costs are $100,000 and its variable costs are $50 per unit, then the company needs to sell 2,000 units to break even. However, if the company can reduce its fixed costs by $50,000, then it only needs to sell 1,000 units to break even. As a result, managers put a great amount of emphasis on controlling fixed costs. They can do this by negotiating lower rents, renegotiating salaries, and finding ways to reduce insurance premiums. What is meant by the statement, my company has good operating leverage? A company has good operating leverage if a small change in sales results in a large change in profits. This is because the company has a high proportion of fixed costs. For example, if a company has a 10% increase in sales and a 10% increase in variable costs, then its profits will increase by more than 10%. This is because the company's fixed costs will not increase with sales. How does good operating leverage magnify earnings results with modest revenue increase? Good operating leverage magnifies earnings results with modest revenue increase because a small change in sales can lead to a large change in profits. This is because the company has a high proportion of fixed costs. For example, if a company has a 10% increase in sales and a 10% increase in variable costs, then its profits will increase by more than 10%. This is because the company's fixed costs will not increase with sales. What are the limitations of using operating leverage to predict profitability? The limitations of using operating leverage to predict profitability include:

• The assumptions of CVP analysis may not be valid.
• The company's cost structure may change over time.
• The company's sales may not be constant.

As a result, managers should use operating leverage as a tool to help them make decisions, but they should not rely on it exclusively.

Sample Answer Assumptions of cost-volume-profit analysis Cost-volume-profit (CVP) analysis is a managerial accounting tool that helps businesses analyze the relationship between costs, volume, and profits. It is based on a number of assumptions, including:

• Linearity: The relationships between costs, volume, and profits are assumed to be linear. This means that costs and profits change in direct proportion to changes in volume.
• Price stability: The price of the product or service is assumed to remain constant.
• Fixed costs: Fixed costs are assumed to be constant over the relevant range of production.
• Variable costs: Variable costs are assumed to vary in direct proportion to changes in volume.

Are these assumptions always valid? The assumptions of CVP analysis are not always valid in the real world. For example, prices may not always remain constant, and fixed costs may not always be constant. However, the assumptions of CVP analysis can be a useful approximation of reality in many cases.