Cost-volume-profit analysis (CVP analysis) helps a business in planning and decision-making.
It provides information regarding changes in profits and costs brought about by changes in volume or level of activity.
The CVP analysis is subject to the following limiting assumptions.
Costs are classified into variable or fixed
All costs are presumed to be classified as either variable or fixed. In the real business environment however, costs behave differently. Users of CVP analysis need to be able to identify variable costs from fixed costs, and vice versa. Also, different methods are used to segregate mixed costs into purely variable and purely fixed.
Variable costs per unit are constant. Total variable cost changes directly with the volume of activity. On the other hand, total fixed costs remain constant regardless of the level of activity.
Linear relationship within a relevant range
Cost and revenue relationships are linear within a relevant range of activity and over a specified period of time.
Say for example, the fixed costs from 1 to 100,000 units might be different from the fixed costs at 100,001 and above. Variable costs may also be different. Hence, we assume that we are working within one relevant range for which the behavior of fixed and variable costs are applicable.
Inventory level does not change from period to period
It is assumed that all units produced are sold during the period; hence, there is no change in beginning and ending inventory levels.
Volume is the only factor affecting variable costs
As volume (or level of activity) increases, the total variable cost increases directly with the change in volume. If the variable cost per unit is, say $5 per unit, the total variable costs would be equal to $5 multiplied by the number of units produced. It is important to take note that volume is the only factor affecting total variable costs. The variable cost per unit is assumed to be constant. Productivity and efficiency concerns are likewise ignored (assumed constant).
Selling price is constant
The selling price and market conditions are constant. Also, if the business produces and sells multiple products, the sales mix is assumed constant.
Despite its limitations, the CVP analysis is a useful tool in decision-making when used correctly. The limitations simplify the process of analyzing the effect of changes in activity level to costs and ultimately, to profit. CVP analysis provide information to aid managers in determining the break-even point and in setting short-term goals such as sales targets, profit objectives, production budgets, and pricing strategies.