Question

Competency #1 Define cost-volume-profit analysis and identify its major assumptions and limitations.

minimum of 300 words.

Please do not copy online

Answer 1

CVP Analysis:

CVP analysis involves analysing the interrelationships among revenues, costs, levels of activity, and profits. CVP analysis is useful for numerous decisions related to production, pricing, marketing, cost structure, and many more. Although CVP analysis is most useful for planning, it can also be used to assist with controlling decisions and evaluating decisions.

Consider a decision about choosing additional features of an existing product i.e. product modification. Different choices can affect selling prices, variable cost per unit, fixed costs, units sold, and operating income. CVP analysis helps managers make product decisions by estimating the expected profitability of these choices

Activity Based CVP Analysis

Conventional CVP analysis assumes volume based measures. An alternative approach isactivity based costing. In an activity-based costing system, costs are segregated into unit and non-unit-based categories. Activity-based costing acknowledges that some costs vary with units produced and some costs do not. However, while activity-based costing admits that non-unit- based costs are fixed with respect to production volume changes, i also argues that many non-unit-based costs vary with respect to other cost drivers. In contrast, the volume based approach combines the cost of these activities and treat them as fixed costs since they do not vary with output volume. Activity based costing provides a more accurate determination of costs because it separately identifies and traces non-unit based costs to products rather than combining them in a pool of fixed costs as volume based approach does

The Break-even can then be expressed as follows: Break-even units = [Fixed costs + (Setup cost x Number of Setups) - (Engineering Cost x Number of Engineering Hours) (Price - Unit Variable Cost)

A comparison of the ABC break-even point with the conventional break-even point reveals two important differences First, the fixed costs differ. Some costs previously identified as being fixed may actually

vary with non-unit cost drivers, in this case setup and engineering hours.

Second, the numerator of the ABC break-even equation has two non-unit-variable cost terms: one for batch-related activities and one for product- sustaining activities

The use of activity-based costing does not mean that CVP analysis is less valuable. In fact, it becomes more valuable, since it delivers more precise understanding concerning cost behaviour. These understandings produce better decisions. CVP analysis within an activity-based framework, however, must be improved

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CVP Analysis - Conditions of Uncertainty

Cost-Volume-Profit analysis suffers from a limitation that it does not consider adjustments for risk and uncertainty. A possible approach by which uncertainty can be incorporated into the analysis is to apply normal distribution theory. If the manager is comparing this product with other products then this approach will enable him or her to assess the risk involved for each product, as well as to compare the relative break-even points and expected profits. The analysis can be changed to include fixed cost, variable cost and selling price as uncertain variables. The effect of treating these variables as uncertain will lead to an increase in the standard deviation because the variability of the variable cost, fixed cost and selling price will add to the variability of profits. Probability distributions play important role in providing decision-making information. It provides information that helps the decision maker better understand the risks and uncertainties associated with the problem. Ultimately, this information may assist the decision maker in reaching a good decision

CVP Analysis in Just in Time Environment

In a firm has implemented Just In Time, the variable cost per unit sold is reduced, and fixed costs are increased. Direct labor is considered as fixed instead of variable. On the other hand, direct material, vary with production volume (unit- based variable cost) due to emphasis on total quality and long-term purchasing. Waste, scrap, and quantity discounts are removed. Other unit based variable costs, such as power and sales commissions, also exist. Further, the batch - level variable is absent as in Just in Time, the batch is equal to one unit. Therefore, the cost equation for Just in Time can be expresses as follows:

Total Cost Fixed Cost + (Unit variable Cost x Number of Units) + (Engineering Cost Number of Engineering hours)

"Managers often use CVP analysis to guide other decisions, many of them are of strategic nature due to tremendous potential of increase in the profitability and organisational effectiveness"

CVP Analysis in Service and Non-Profit Organisations

CVP analysis can also be applied to decisions by service and non-profit organisations. To apply CVP analysis in service and non-profit organisations, we need to focus on measuring their output, which is different from tangible units sold by manufacturing and merchandising companies.

Assumptions and Limitations:

The CVP analysis is subject to the following limiting assumptions.

1.Costs are classified into variable or fixed: All costs are presumed to be classified as either variable or fixed. In the real business environment however, costs behave differently. Users of CVP analysis need to be able to identify variable costs from fixed costs, and vice versa. Also, different methods are used to segregate mixed costs into purely variable and purely fixed.

Variable costs per unit are constant. Total variable cost changes directly with the volume of activity. On the other hand, total fixed costs remain constant regardless of the level of activity.

2. Linear relationship within a relevant range:Cost and revenue relationships are linear within a relevant range of activity and over a specified period of time.

Say for example, the fixed costs from 1 to 100,000 units might be different from the fixed costs at 100,001 and above. Variable costs may also be different. Hence, we assume that we are working within one relevant range for which the behavior of fixed and variable costs are applicable.

3. Inventory level does not change from period to period : It is assumed that all units produced are sold during the period; hence, there is no change in beginning and ending inventory levels.

4. Volume is the only factor affecting variable costs: As volume (or level of activity) increases, the total variable cost increases directly with the change in volume. If the variable cost per unit is, say $5 per unit, the total variable costs would be equal to $5 multiplied by the number of units produced. It is important to take note that volume is the only factor affecting total variable costs. The variable cost per unit is assumed to be constant. Productivity and efficiency concerns are likewise ignored (assumed constant).

5. Selling price is constant: The selling price and market conditions are constant. Also, if the business produces and sells multiple products, the sales mix is assumed constant.

In spite of CVP being a useful technique, it suffers from some of the following limitations:

1. Because of the many assumptions, CVP is only an approximation at best. CVP analysis needs estimates and approximation in assembling necessary data and thus lacks accuracy and precision.

2. In CVP analysis, it is assumed that total sales and total costs are linear and can be represented by straight lines. In some cases, this assumption may not be found true. For instance, if a business firm sells more units, the variable costs per unit may decrease due to more operating efficiencies in the factory.

3. 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.

4. CVP analysis assumes that costs can be accurately divided into fixed and variable categories. Such categorization is sometimes difficult in practice.

5. CVP analysis assumes no change in the inventory quantities, during the period. That is, opening inventory units equal the closing inventory units. This also means that units produced dur­ing the period are equal to units sold. When changes take place in inventory level, CVP analysis becomes more complex.

6. If prices, unit costs, sales-mix, operating efficiency, or other relevant factors change, then the overall CVP analysis and relationships also must be modified. Because of these assumptions, cost data are of limited significance