a)      Explain the relationship between cost structure and profit stability. 

Cost structure refers to the proportion of fixed and variable costs within the total operating cost structure of the business. A business with a high proportion of fixed costs to total costs would be said to have a high fixed cost structure, sometimes called high operating gearing. Travel agents, although not capital intensive, would have a high fixed cost operating structure. Outdoor catering firms would have a mainly high variable cost structure.

Operating risk is high where a business suffers from profit volatility and this occurs when profit is sensitive to small changes in key variables. Generally a business will have high operating risk or gearing when its cost structure is predominantly fixed. This is due to the fact that the pressure is on the business to achieve a required sales level to cover fixed costs. A business with a predominantly variable cost structure would have low operating risk or gearing as, should the business not achieve expected sales, the variable costs would not be charged.

b)      Compare and contrast the break-even chart and profit volume chart as providers of useful information to management.

The break-even chart and profit-volume chart are both graphic methods of presenting information supplied through the CVP model. The profit-volume chart can show the profit or loss for any

c)       Outline the arguments in favour of both the economists approach and the accountants approach to CVP analysis.

Economist approach

Economists argue that the accountants approach to CVP analysis is overly simplistic. And hence not accurate. Some of the assumptions that underlie the CVP analysis come into conflict with economic theory, especially the assumption of linearity and the constancy of selling price and variable cost per unit. Economists argue that lowering selling price acts as a catalyst to increasing demand and thus as sales volumes increase, so will variable costs. However, on account of economies of scale and quantity discounts, the variable cost per unit should fall. This is reflected in the total revenue and total cost curves that economists use, rather than the straight lines simplifications in the accountants CVP model.

1. The total revenue curve begins to slope upwards but less steeply, as price reductions become necessary and then slopes downward as the effect of price reductions outweigh the beneficial effect of volume increases, as the business approaches capacity. 
2. The total cost curve increases at a slower rate as the effects of economies of scale and quantity discounts show up. However the curve begins a steeper upward trend as the business rises towards full capacity, because the variable cost per unit will normally increase as a result of diminishing returns.  

Economists assume revenues and costs are curvilinear and this can result in two break-even points as per the break-even chart below.

Diagram 4.3:  Economist’s CVP chart

Accountants approach

Proponents of the accounting model argue that it is not intended to provide a precise representation of total revenue and cost functions throughout all levels of activity. The objective of the accountant’s CVP model is to represent an approximation of revenue and cost behaviour over the relevant range in the short term. As the relevant range of activity can be narrow and the short term time period less than 12 months, the linearity assumption is reasonable. Also, the cost of obtaining more accurate cost and revenue functions may outweigh the benefits to be gained from such information.