To be effective in planning and decision-making, management must have studies that enable reasonably accurate projections of how each of these aspects will affect earnings. Additionally, management must grasp how revenues, costs, and volume interact to generate profits. Cost-volume-profit analysis provides all of these analyses and information.
Cost-Volume-Profit (CVP) analysis is a method for systematically assessing the links between selling prices, total sales revenue, and the volume of production, expenses, and profit. CVP analysis can be critical in providing management with information about financial results when a specified level of activity or volume fluctuates, information about the relative profitability of the company’s various products, and information about the likely effects of changes in selling price and other variables.
This data can assist management in optimising the link between these variables. Similarly, CVP analysis can be used to determine selling prices, product mix selection, alternative marketing methods, and analysing the influence of cost increases or decreases on the profitability of a company firm.
Assumptions and Limitations of CVP Analysis
As with all methods of analysis, CVP analysis relies on certain assumptions and these assumptions might limit the applicability of the results for decision making. It is important to understand, however, that the limitations are due to the assumptions that the cost analyst makes; that is, they are not inherent limitations to the method of CVP analysis itself.
For example, many people point to the assumptions of constant unit variable cost and constant unit prices for all levels of volume as important limitations of CVP analysis. However, these assumptions are simplifying assumptions that are made by the analyst. If we know that unit prices are lower for higher volumes, we can incorporate that relation into the CVP analysis. The result will be a more complicated relation among costs, volumes, and profits than we have worked with here and the breakeven and target volume formulas will not be as simple as those we have derived. But with
analysis tools such as Microsoft Excel we can model the more complicated relations and find the break-even point (or points) if they exist.
The lesson from this is that CVP analysis is a tool that the manager can use to help with decisions. The more important the decision, the more the manager will want to ensure that the assumptions made are applicable. In addition, if the decisions are sensitive to the assumptions made (for example, those prices do not depend on volume), the manager should be cautious about depending on CVP analysis without considering alternative assumptions.
- Due to the numerous assumptions, CVP is at best an approximation. CVP analysis requires estimations and approximations for data collection, and so lacks accuracy and precision.
- In CVP analysis, total revenues and total costs are believed to be linear and can be represented by straight lines. In some instances, this assumption may be discovered to be false. For example, if a business firm sells more units, the variable costs per unit may fall as a result of increased factory efficiency.
- CVP analysis is conducted within a meaningful range of operational activity, with the assumption that operational productivity and efficiency stay constant. This assumption may be incorrect.
- CVP analysis presupposes that expenses may be reliably classified as fixed or variable. In reality, such categorisation can be challenging.
- The CVP analysis is based on the assumption of no change in inventory levels over the period. That is, the quantity of opening inventory equals the quantity of closing inventory. This also implies that the number of units generated during the period is equal to the number of units sold. When inventory levels fluctuate, CVP analysis gets more complicated.
- If pricing, unit costs, sales mix, operational efficiency, or other important variables change, the overall CVP analysis and linkages must be adjusted as well. Cost data are of limited value as a result of these assumptions.
- Additionally, a number of issues develop when performing a multi-product analysis in conjunction with a CVP analysis. The first issue is determining the facilities that unrelated products share. The analysis will be satisfactory if fixed expenses and facility usages can be directly associated with individual items. A second issue arises when the units of measurement have a non-linear relationship. Typically, different items have varying contribution margins and are produced in varying volumes at varying costs.