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 these limits the usefulness of the model. Would you rely on the model?

Write about 150 words.

Answer 1

The profit-volume and cost-volume-profit graphs rely on some important assumptions which includes total costs can be divided into a fixed component and a component that is variable with respect to the level of output; the behaviour of total revenues and total costs is linear (straight-line) in relation to output units within the relevant range; the unit selling price, unit variable costs and unit or total fixed costs can be accurately identified and are constant; the analysis either covers a single product or assumes that the proportion of different products (sales mix) when multiple products are sold is known and will remain constant as the level of total units soldchanges; all revenues and costs can be added and compared without taking into account the time value of money (this assumption is relaxed when considering capital investment decision ;changes in the level of revenues and costs arise only because of changes in the number of products(or service) units produced and sold. The number of output units is the only revenue and cost driver; the price per unit and the variable cost per unit (and therefore the contribution marginper unit) remain the same over all levels of production; fixed costs remain the same over all contemplation levels of production and sales equal production.

Yes, these limits are useful and we can easily rely on it.