Question

As a cost and management accountant you always advocate about the use of cost volume profit (CVP) analysis and activity based costing in different cost management scenario. That’s why management of the PQR Limited wants you to explain the following issues for their next cost management move for the organisation.

Required:

1. What is a cost driver? What is the cost driver in conventional cost volume profit (CVP) analysis? How is the cost driver measured in conventional CVP analysis?      

2. In activity–based costing, costs are classified into unit level, batch level, product level and facility level. How are these categories typically handled in CVP analysis, where there are only two categories available: fixed or variable?                                                                   

3. In an environment where activity–based costing is necessary and appropriate, is the relevance of conventional CVP analysis enhanced or diminished? Explain.      

4. Explain the additional limiting assumption of using CVP analysis under activity–based costing.

                                               

Answer 1

1) Cost drivers are used to describe the events or forces that are the significant determinants of the cost activities, e.g.: production scheduling cost is generated by the number of production runs that each product generates. Then the number of set ups would represent the cost driver for production scheduling. These drivers may be classified in two categories like resource cost driver which measures the quantity of resources consumed by an activity, and activity cost driver which measures the frequency of demand, place of activity on cost objects.

However, the number of unit sold is treated as sole cost and revenue driver in conventional cost volume profit (CVP) analysis. Here cost is assigned on the basis of one or more volume-based cost drivers and number of units produce is the sole driver of revenue and cost in conventional cost volume profit analysis.

2) In conventional cost volume profit (CVP) analysis, total cost are broadly divided in into fixed and variable component only where the variable cost is based on volume of output or number of units produced or sold. However, fixed costs are always fixed upto a particular range. This range is the limit of cost-driver activity level which is based on the relationship between cost and cost driver e.g.: building rent is generally fixed and will increase if additional space (building) is required for further production.

3) Conventional cost volume profit (CVP) analysis is based on single cost driver (volume based) the driver which is not adequate to for the management for controlling and allocating the cost appropriately to final output. Therefore, traditional cost volume profit (CVP) analysis should not be adopted where activity-based costing is necessary and appropriate. Therefore, the relevance of conventional CVP analysis would be diminished and activity-based costing should be implemented because the single volume-based cost driver is not sufficient for all the needs of the management.

4) Following are the additional limiting assumptions of using conventional cost volume profit (CVP) analysis:

• Fixed and variable cost patterns can be established with reasonable accuracy and that fixed costs remain static and marginal costs are completely variable at all levels of output.
• Selling prices are constant at all sales volumes.
• Factor prices (e.g.: material prices, wages rates) are constant at all sales volumes.
• Efficiency and productivity remain unchanged.
• In a multi product situation, there is constant sales mix at all levels of sales.
• Turnover level (volume) is the only relevant factor affecting costs and revenue.
• The volume of production equals the volume of sales.