Cost Volume Profit Analysis and Its Assumptions
Cost-Volume-Profit Analysis (CVP) is a simplified model, useful for elementary instruction and for short-run decisions. A vital element of CVP analysis is the point where total revenues equal total costs (both fixed and variable costs). At this breakeven point (BEP), a company will experience no income or loss.
Under cost volume profit analysis profit is computed as TR- TC (TR = total revenue and TC = total cost). In this
Total revenue = Sales price * Number of units and
Total costs = Fixed costs + Variable costs*number of units
It is based on some assumption here are some of them
1. This analysis presumes that costs can be reliably divided into fixed and variable category which is difficult in practice.
2. It presumes an ability to predict cost at different activity volumes which requires lot of experience and expertise.
3. It assumes that variable cost fluctuates with volume proportionately, while in real life it is seldom the case.
4. It assumes that efficiency and productivity remains unchanged which in this dynamic world is almost impossible.
5. This analysis assumes that volume is the only relevant factor affecting cost. In real life situations, other factors also affect cost and sales strongly.
6. This analysis assumes that production and sales will be synchronized at all points of time implying that changes in beginning and ending inventory levels will remain immaterial in amount also the prices of input factors will remain constant.
7. This analysis assumes that selling price will be constant at all level of sales which we all know is not possible because for achieving higher sales company will have to offer discounts to its customers and hence selling price will not be constant.
From the above it can be seen that there are certain assumptions which should be taken into account while using cost volume profit analysis so as to get better results from this method.
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