Assumptions of Cost-Volume-Profit Analysis - Essay Example

Running header: cvp Student’s name: Instructor’s name Subject code: Date of submission: Assumptions of CVP Analysis The assumptions underlying cost-volume-profit analysis make it a difficult method to apply in real world settings Introduction CVP analysis is a method of cost accounting used in managerial economics that is based on determination of breakeven point of cost and volume of goods. The method is useful to managers in making short-term economic decisions. For it to be relevant, cvp makes some assumptions. For instance, CVP assumes that the sale price, variable cost and fixed cost per unit are constant. However, these assumptions are very simplistic and they fail to hold water in real life (Parvathy, 2014). As such, owing to these assumptions that underlie cost-volume-profit analysis, it becomes difficult to apply CVP in the real world. However, this does not mean it has zero application in real life. Some managers still find the method applicable in making managerial decisions. This paper discusses the applicability of cost-volume-profit analysis in the real world settings with regard to the assumptions it makes. Assumptions of CVP analysis Some of the assumptions underlying CVP analysis place limitations on the application and use of CVP analysis. As such, knowledge of the assumptions of CVP is important in a bid for one to make informed decisions on utilizing cvp in making managerial decisions. The key assumptions of CVP analysis include; a) It is possible to classify all costs as fixed and variable-CVP analysis assumes that all costs can be classified into being either fixed or variable costs. However in real life it is difficult to identify each and every cost element as being fixed or variable. In addition, the flexible policies of firms make it more difficult to identify costs as being fixed or variable. In case one is unable to identify their cost fixture as such, then the applicability of cost – volume- profit analysis is rendered almost impossible (Hemed, 2010). b) That costs will be linear within the relevant range-CVP analysis assumes that total fixed costs remain constant in the short run within the relevant range. In this regard, it is assumed that total variable costs will be exactly proportionate within the relevant range. c) That selling price and variable costs per unit will not change with volume d) That sales volume approximates production volume and that there are no significant inventories balance fluctuations e) That a company produces either a single product or a product mix that is constant f) That productivity is constant in the short run (Lewis, 2013). It is assumed that by applying CVP, firms derive a number of benefits. CVP is useful to managers in terms of providing them with information that is useful in making decision making. Using CVP, managers are able to answer pragmatic questions that are needed in business analysis. Such questions include what the company’s break-even point is and hence assist managers to project how the firms future spending and production will lead to the firm’s success. For instance, it is assumed that when managers know their break even points, they will be able to tweak spending and increase production efforts and hence increase their profitability. Given that CVP is based on statistical models, it is possible to break down decisions into probabilities which help the managers in their decision making processes. CVP also provides detailed snapshot of the company’s activities (Jared, 2011). This range from the costs necessary for production of a product to how much product is produced. This is helpful in helping the managers in deciding what the future holds with specificity if the variables are varied. As such, CVP is a useful tool to the management in decision making. However, as stated above, some of the assumptions underlying CVP bring into doubt the applicability of CVP in modern day business. Thus, the applicability of CVP in real life is examined below in detail. Whether CVP is applicable in real life; CVP analysis is a very useful tool for decision making. However, as stated above, it is based on some assumptions that are rarely realizable in real life situations. The fragility of its assumptions therefore places limits on how much reliance can be placed on it as a decision making tool in real life. For instance, it assumes that fixed costs are constant while both revenue and variable cost curves are linear over relevant output volume (Kee, 2007). As such, the analysis assumes that it is only volume that affect costs and that the price of cost factors and of the products produced are unaffected by volume of output. This assumption is challenged in real life since fixed costs may or may not remain constant over the entire output range that the analysis considers especially when the volume range in consideration is fairly extensive. The assumption that the variable cost curve is linear implying that the change in direct cost is directly proportional to the change in the volume is also doubtful. When demand for input factors increases, their price will also increase (Johnson, 2014). This is likely to affect the variable cost curve with the variable cost increasing proportionately faster as the output volume is expanded. For this assumption to hold true therefore, it would be necessary that the volume range being examined is limited so as to make the behavior of both variable and fixed costs more accurately determined. This will make the cvp analysis retain its usefulness and hence its applicability in real life (Basu, 2004). As such, the assumption that the cost volume relationship is a linear one is hence only applicable over a narrow output range commonly referred to as relevant range. In the long run, the applicability of cvp is thus constrained. The assumption on the revenue curve may also not hold in real life. This is because to increase sales, the firm may find it necessary to reduce its prices and hence a straight line may not be an accurate portrayal of how sales behave in real life. Computations are therefore often needed at various price levels which would give rise to several total revenue curves instead of just one curve. In addition, the break even chart used in the analysis uses a rather simplified picture of the cost revenue relationships. Each of the factors considered in the CVP analysis is bound to be affected by external forces that the firm has no control of as well as the influences of each factor on the other (Graves, 2013). It is based on the above criticisms of the assumptions of the CVP analysis is limited in real life. It would be wise if organizations would use the CVP analysis as a guide to decision making but not as a tool for substituting judgment and common sense. Does the above criticism mean that CVP is not applicable in real life? The above criticism does not imply that CVP cannot be applied in real life. What this implies is that the assumptions underlying cvp analysis as discussed above make it a difficult method to apply in real world settings. Managers do employ it but in combination with other decision making tools (John, 2012). The main criticism of cvp which limits its applicability in real life is the fact that it is constrained in the amount of information that it is able to provide in a multi-product operation scenario especially given that most firms in the contemporary world is multiproduct operations. Most of the analysis that is utilized by business managers using cvp is only based on single products. As such, multi-product businesses including those of hospitality industry like restaurants would usually find big difficulties in their attempts to apply cvp. For instance, menu items for restaurants may have many variable cost ratios thus making the challenge of applying cvp even more difficult as it has to be done for each item that the organization offers and this has to be done in the short run (Kinney, 2012). Despite the above limitations, cvp analysis’s real usefulness is in the fact that it enriches the management’s understanding of the relationship between their costs volumes and prices structures as the factors that affect the profitability of their firms. Thus cost- volume –profit analysis is a useful tool that serves to assist the management in their decision making process in the short run. However, in the long run, cvp it would be unwise for management to rely on cvp to make production and hence operations and profitability decisions. Conclusion This paper has examined the claim that the assumptions underlying cost-volume-profit analysis make it a difficult method to apply in real world settings. In this regard, cvp analysis has been portrayed as a useful tool for decision making by firms. The assumptions that underlie cvp have been examined in detail. Some of them include constant sales price, constant total fixed cost, constant variable cost per unit, constant sales mix as well as the assumption that the units sold will equal those that are produced. The limitations of these assumptions have been examined in detail. Of particular interest is the fact that the assumptions are only applicable in the relevant range and for a single product. Cvp applicability in the long run has been found constrained by changes in the above factors. As such, the claim that the assumptions underlying cost-volume – profit analysis make it difficult method to apply in real world setting has been found to be true. However, it has been concluded that despite the weaknesses in the assumptions, cvp has been found to be a useful decision making tool in the real world. It has been suggested therefore that cvp be applied together with other decision making tools in a bid to reach at more informed production and hence profitability decisions by firms. References: Parvathy, A2014, Limitations of cost volume profit analysis, Retrieved on 10th September 2014; from http://www.bms.co.in/limitations-of-cost-volume-profit-analysis/ Hemed, B2010, Principles of accounting, London, Rutledge. Lewis, J2013, Advantages and disadvantages of cost-volume-profit analysis, Journal of business finance & accounting, vol.11, no.2, pp.19-25. Jared, K2011, Cost accounting, London, Prentice Hall. Kee, R2007, Cost-volume-profit analysis, Journal of Managerial Issues, vol. 19, no.4, pp.9-16. Basu, O2004, Assumptions of conventional linear CVP analysis, Journal of Management Accounting Research, vol.5, no.3, pp. 1-32. Graves, M2013, Cost Accounting: Theory and Practice, Oxford, Oxford University Press. Kinney, M2012, Cost accounting: Foundations and evolutions, London, Rutledge. Johnson, G2014, Multiproduct C-V-P analysis under uncertainty, Journal of Accounting Research, vol. 25, no. 2, pp. 278-286. John, M2012, Cost accounting simplified, New York, Taylor & Francis. Read More