Question

CVP analysis allows the manager to plug in variable costs to establish an idea of future performance, within a range of possibilities." Why is this a weakness? Wouldn't this be a strength?

Answer 1

Cost-volume-profit (CVP) approach analyses different levels of volume of productions and the production costs associated with it. The analysis helps in understanding the impact of costs on operating profitability and their variances from budgets. CVP analysis is one of the most important tools involved in a manager’s decision-making process.

It allows the manager to plug in variable costs to establish an idea of future performance, within a range of possibilities. However, the analysis has its own strengths and weaknesses. Some of the strengths and weaknesses are discussed as under:

Weakness

- Human error

If a manager is not detail oriented or not accurate with the data that is recorded and analysed, there could be prediction errors. In such a scenario, the projections that are based on the CVP analysis would be erroneous and would not give accurate results.

- Not suitable for multi-product businesses

One of the manjor challenges with CVP analysis is that it is to be undertaken for each specific product separately. Accordingly, CVP approach can be applied to entities having simple businesses and a single product line. The analysis can be easily undertaken when an entity manufactures and sells a single product since mapping of costs and volumes of a single product is easy. However, managers of multi product businesses like restaurants that sell a variety of food items may find it difficult to apply the CVP approach for a cost benefit analysis.

- Approximations with CVP

CVP analysis is conducted by compiling very precise and accurate data. However, there is always an approximation involved when it comes to projections as it a subjective exercise. Therefore, to attain the best results, CVP analysis demands very accurate and detailed data without much approximations and estimations. If the manager is not careful and deals with the data without applying a analytical mind, the results of the CVP analysis can be faulty and skewed. Therefore, the manager is required to conduct thorough investigations on the data so collected and the analysis so conducted..

Strength

- Helps managers in decision making

As already mentioned above, CVP analysis helps managers with decision making regarding production volumes and costs associated with the production. Various projections and analysis such as cost benefit analysis, break even analysis is done by managers with the help of CVP exercise. CVP analysis is generally conducted through statistical models which facilitate the decisions making process.

- Detailed Perspectives

CVP analysis when conducted properly gives a detailed snapshot of entities operations. It helps managers in understanding the results of production by applying various simulations to the factors of production. This helps the mangers in understanding how the future would fare in various different scenarios.