Assumption of cost volume profit analysis
Assumptions of cost volume profit analysis(CVP assumptions) help an enterprise in planning and decision-making. It supplies info on how earnings and prices are affected by modifications in quantity or degree of exercise.
State the assumption of cost volume profit analysis.
Assumptions of cost-volume-profit analysis are useful only under certain conditions and only when certain hold true. These assumptions and conditions are as follows –
1.Costs can be classified accurately as either variable or fixed.
2.All units produced are sold.
3.Changes in inactivity are the only factors that affect costs.
4.Total fixed cost is a constant amount within the relevant range.
5. In multiproduct companies, the sales mix is constant.
6.Labour productivity, production technology, and market conditions will not change.
7. In manufacturing companies, inventories do not change. The number of units produced equals the number of units sold.
8.Volume of output is the only revenue and cost driver.
9.The firm analysis will be effective for a limited range of operations over which the firm was operating in the past and is expected to operate in the future. It is known as the relevant range.
10.No risk or uncertainty is involved and the analysis is deterministic.
Define CVP analysis. Discuss the limitation of CVP analysis.
Cost-volume-profit (CVP) analysis is a technique used for measuring The interrelationship between cost volume and profit in an organization by focusing on interactions among the following five elements : (1) Price of products (2) Volume or level of activity (3) Per unit variable costs (4) Total fixed costs (5) Mix or products sold.
Prof A. Matz and M.F Usry define: “Cost volume relationship is the relationship of profit to sales volume”.
CIMA London has defined CVP analysis as—: The study of the effects on future profits of changes in fixed cost, variable cost, sales price, quantity, and mix.”
Finally, we can say that cost-volume-profit analysis is the study of the effects of output volume on revenue (sales) expenses (cost) and net income (net profit).
The main limitation and assumptions in the cost volume profit analysis:
The CVP analysis is generally made under certain limitations and with certain assumed conditions, some of which may not occur in practice. Following are the main limitations and assumptions in the cost volume profit analysis:
1. It is assumed that the production facilities anticipated for the purpose of cost-volume-profit analysis do not undergo any change. Such analysis gives misleading results if expansion or reduction of capacity takes place.
2. In cases where a variety of products with varying margins of profit are manufactured, it is difficult to forecast with reasonable accuracy the volume of sales mix which would optimize the profit.
3.The analysis will be correct only if input price and selling price remain fairly constant which in reality is difficult to find. Thus, if a cost reduction program is undertaken. or the selling price is changed, the relationship between cost and profit will not be accurately depicted.
4.In cost-volume-profit analysis, it is assumed that variable costs are perfectly and completely variable at all levels of activity and fixed cost remains constant throughout the range of volume is considered. However, such situations may not arise in practical situations.
5.It is assumed that the changes in opening and closing inventories are not significant, though sometimes they may be significant.
6.Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing stock carried over to the next financial year does not contain any component of fixed cost. Inventory should be valued at full cost in reality.
Costs are categorized into variable or fixed
All prices are presumed to be categorized as both variables or fastened. In the actual enterprise surroundings, nevertheless, prices behave otherwise. Users of CVP evaluation want to have the ability to determine variable prices from fastened prices and vice versa. Also, completely different strategies are used to segregate blended prices into purely variable and purely fastened.
Variable prices per unit are fixed. Total variable value modifications instantly with the quantity of exercise. On the opposite hand, whole fastened prices stay fixed whatever the degree of exercise.
Linear relationships inside a related vary
Cost and income relationships are linear inside a related vary of exercise and over a specified time period.
Say, for instance, the fastened prices from 1 to 100,000 items is perhaps completely different from the fastened prices at 100,001 and above. Variable prices may additionally be completely different. Hence, we assume that we’re working inside one related vary for which the habits of fastened and variable prices are relevant.
Inventory degree doesn’t change from interval to interval
It is assumed that every one item produced is offered throughout the interval; therefore, there is no such thing as a change in starting and ending stock ranges.
Volume is the one issue affecting variable prices
As quantity (or degree of exercise) will increases, the whole variable value will increase instantly with the change in quantity. If the variable value per unit is, say $5 per unit, the whole variable prices can be equal to $5 multiplied by the variety of items produced. It is vital to take be aware that quantity is the one issue affecting whole variable prices. The variable value per unit is assumed to be fixed. Productivity and effectivity are ignored (assumed fixed).
Selling value is fixed
The selling value and market situations are fixed. Also, if the enterprise produces and sells a number of products, the sales combine is assumed fixed.
Despite its limitations, the CVP evaluation is a great tool in decision-making when used appropriately. The limitations simplify the method of analyzing the impact of modifications in exercise degree on prices and in the end to revenue. Assumptions in the cost-volume-profit analysis supply data to help managers in figuring out the break-even level and in setting short-term objectives akin to gross sales targets, revenue targets, manufacturing budgets, and pricing methods.