Question

In a recent news report, the following statement was made: "A report put out by brokerage house CLSA about Jet Airways said that the fall in ATF (fuel) prices has brought down the load factors (flight occupancy) required for the airlines to break even from 78 percent to 63 percent." The load factor is the percentage of available seats on a flight that are occupied.

Questions

What are some important assumptions commonly made in CVP analysis?

What significant assumptions and limitations should be considered when using this piece of information?

Do these assumptions impose serious limitations on the analysis? Why or why not?

Answer 1

The important assumptions commonly made in CVP analysis are as follows:

- Sale price shall remain constant.

- All costs can be classified into fixed and variable.

- Behavior of costs and revenue is linear.

- Fixed costs remain constant within a relevant range.

The significant assumptions and limitations which should be considered when using this piece of information are as follows:

- Selling price shall remain constant i.e. per seat pricing will be the same. This is a highly unrealistic assumption as customers expect the price to go down with the fuel prices.

- The second assumption is that competitors shall also maintain the same prices. Even this assumption is highly limiting as the competitors will reduce their prices to capture the market and Jet airways will also have to adopt competitive pricing to maintain its position in the market.

These assumptions do pose serious limitations on the analysis as break even point is determined by the contributuion margin. If revenue which is based on the selling price shall not remain constant, the whole idea of reduction in the break even point becomes redundant.