Question

Briefly describe the cost-volume-profit analysis model and discuss how it can be used. Also, briefly explain the limitation of basic cost-volume-profit analysis as it relates to an organization’s sales mix

Answer 1

Cost-volume-profit analysis model is an accounting analysis tool that is used to determine how the operating income and net income of a company is affected due to changes in its costs and volumes. In other words the technique of cost-volume-profit analysis helps in determining the effect on operating profit of a business due to two main factors - its sales volume and due to its product costs.

Cost-volume-profit analysis model can be used under different scenarios to determine the impact of changes in variable costs, fixed costs, selling price and sales mix on the operating profit. The formula for cost-volume-profit analysis is: px = vx+FC+Profit

In the above formula p = price per unit, v = variable cost per unit, x = the quantity and FC = fixed cost.

Besides the above analysis cost-volume-profit analysis model is also used to calculate contribution margin, unit contribution margin and contribution margin ratio.

The basic cost-volume-profit analysis model has some limitations when it comes to sales mix of an organization. The sales mix in real life does not remain constant as the demand levels are highly dynamic. However the basic cost-volume-profit analysis model assumes sales mix to remain constant. This is an unrealistic assumption and will not hold in the real world for multiple product analysis.