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

Part 1

Assumptions made in CVP analysis

1. Sales price per unit is constant for any volume
2. Variable cost per unit is constant
3. Total Fixed cost is constant and do not change in short run
4. All costs can be classified in Fixed and Variable
5. CVP is a short term analysis tool beacuse in long term no cost remains fixed.
6. No change in size of inventory, begining inventory equals closing inventory
7. Sales mix remains constant incase of multi-product

Part 2

In the given case, the following assumption is considered :-

1. All costs can be classified in Fixed and Variable
2. Fixed cost is constant
3. CVP is a short term analysis tool
4. Except fuel cost, all other variable cost remains same
5. Price per ticket is constant

Limitations of Assumptions

CVP is short term analysis tool, so its not useful for long term analysis.
CVP requires neat classifications of Fixed cost and Variable Cost but some time it can't be done accurately.
Fixed cost unlikely stay constant after certain level of activity of period.
Inflation, efficiency, technology effect the Variable cost per unit But CVP requires fixed Variable Cost per Unit.

Part 3

Because of many assumptions, from CVP analysis we can get an approximate answer. It lacks accuracy and precision.
It gives different result in different circumstances so it need to be updated in accordance with each circumstances.
Based on its analysis, Not long term decision can be taken.

On contrary,

It is good for understanding present condition of business and useful in taking short term decision making.
It may lacks accuracy but its analysis can give near to accurate result.