Look at the following diagram showing the Operating Income of two different companies at various levels of activity:
Clearly, the operating income of company B shows a greater variation than the operating income of company A. The profit slope (i.e. the increase in profit for every additional unit sold) of company B is steeper, which means that its profit increases, or decreases, faster. This makes the operating income of company B highly volatile, and therefore risky. But why is it more volatile?
In practice, several reasons can explain this pattern. You already have seen one in Chapter 2 about costing: company A may be smoothing its earnings through accounting choices or by maintaining a constant volume of production. Inventories can indeed be used as buffers absorbing shocks in either direction: fixed costs incurred in periods of low activity can be kept in the inventory (increasing operating income on these periods) and expended only in periods of high activity (decreasing operating income on these periods). On the contrary, company B may be working in “Just-In-Time” (JIT), i.e. minimizing inventory levels and thus reducing its ability to distribute fixed costs more evenly over time.
CVP analysis provides an alternative explanation for this pattern. It follows a sequence of steps to show how differences in cost structure, i.e. in underlying cost behaviors, may determine the volatility of operating income.
Cost structure refers to the relative proportion of variable and fixed costs.
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