Question

Cost-volume-profit [CVP] analysis is a widely used, basic business model. Discuss the underlying assumptions made in the application of the model and whether this limits the usefulness of the model. Would you rely on the model? Why or why not?

Answer 1

Cost volume analysis is a method used in managerial accounting that looks on the impact of varying cost and volume on profit. This method is also known as break even analysis

CVP= Fixed cost ÷ Contribution margin

CVP analysis is subject to following limiting assumptions

1. Costs are classified as fixed or variable

2.There is a linear relationship between cost and revenue with in relevant range for a particular time period

3. Sale volume is the only factor affecting the variable cost.

4. Selling price and market conditions are constant

5 Fixed cost is constant irrespective of level of activity.

I will relay on the model beaciuse use, C VP Analysis is a short term analytical tool used identify and Analyses the factors affecting profit and the relationship between cost volume and profit. CVP analysis is used to predict and evaluate the implications of its short run decisions about fixed costs, marginal costs, sales volume and selling price for its profit plans on a continuous basis.

CVP analysis is having following limitations too.

1.CVP analysis uses approximation and estimates to assembly necessary data. This will affect the accuracy and precision of analysis.

2. CVP analysis is performed within a relevant range of operating activity and it is assumed that productivity and efficiency of operations will remain constant. This assumption may not be valid.

3. CVP analysis is only reliable if costs are fixed within a specified production level