What can you learn from relaxing CVP assumptions?

Sensitivity analysis is a what-if technique that examines how a result changes if the assumptions underlying the initial analysis change. These analyses help managers understand what might happen if everything does not go according to plan, or help them understand what they observe. For instance, building on what you have learned in this chapter, think of the consequences of the following events or decisions in terms of both operating income and operating risks:

  • the actual product mix has a greater proportion of product with a high contribution margin;
  • the company automated a production process, making it more efficient (lower unit variable cost) but increasing fixed costs;
  • an advertising campaign associated with a slight decrease in price boosted the sales volumes.

Some decisions made by managers affect the relative distribution of costs between fixed and variable. Sensitivity analyses thus highlight the risks associated with different options in terms of cost structure. In the next video, I discuss some of these events in terms of impact on break-even and operating leverage and in Chapter 7, we will dive deeper into the impact of such changes on the operating income.

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