Cost-Volume-Profit Analysis: Assumptions and Real-World Limitations

This report delves into the intricacies of Cost-Volume-Profit (CVP) analysis, focusing on its underlying assumptions, strengths, and weaknesses. The analysis begins by acknowledging the core assumptions that underpin CVP analysis, such as the linearity of costs and revenues, and the classification of costs into fixed and variable categories. The report then explores the limitations that arise when these assumptions are not perfectly met in real-world business environments, particularly when dealing with fluctuating variable costs, multiple products, and dynamic market conditions. The report further assesses the strengths of CVP analysis, particularly its usefulness when costs can be easily traced and measured, and when a company sells its products at a stable price. Conversely, it highlights the weaknesses of CVP analysis in complex business scenarios such as when labor costs change due to demand. The report concludes by emphasizing the need for a nuanced understanding of CVP analysis, recognizing its utility while acknowledging its limitations in practical application.

Cost Volume profit and implication of its assumptions
Cost volume profit (CVP) analysis explains the change in profits in relation to the change
in cost and volume of products or products. But CVP analysis is subject to certain underlying
assumptions which limit the use of CVP analysis. So it can be said that CVP analysis can be
valid only when certain assumptions are valid and they are properly applicable within the
analysis. In response to the author’s comment that CVP analysis is useful in certain
circumstances when underlying assumptions are applicable is correct and I totally agree with
them. In order to make use of CVP analysis there is requirement to classify the costs into
variable or fixed cost but in real business environment cost behave differently as it is not always
compulsory that variable cost change in exact proportion with change in volume and also fixed
cost remain same despite of change in volume. So it can be said that when variable cost does
align with the change in volume i.e. variable cost changes within the range then it is not possible
to apply the CVP analysis or it can be applied with certain modification. The assumption that
there exists the linear relationship within the relevant range of activity or specific period of time
makes CVP analysis unhelpful as in certain cases it is not possible to predict the range. Similarly
other assumptions of CVP analysis cannot be applicable in certain circumstances of real life
cases that make CVP analysis inappropriate to use (Krantz, 2016).
The assumptions on which CVP analysis is based must be fulfilled in order to have
proper use of results gained through this analysis. It can be better understood through application
one of its assumption in practical example. The most important assumption that is taken while
making the CVP analysis is that volume is only factor that impacts the variable cost and not
other factors are taken into consideration. As per assumption if volume (or level of activity)
increases, the total variable cost increases directly in relation to change in volume. It means if
variable cost is $10 per unit than total variable cost will come to number of units (Volume)
multiplied by variable cost. It means there is no impact of learning curve (efficiency) and
productivity level on the total variable cost but in real it is not true as increase in number of unit
decreases the labour cost (learning curve constraint) and variable cost increase due to increase in
productivity level or vice versa. So, in real life it is not possible make sure that all the
assumptions of the CVP analysis can be applicable and result gained through CVP analysis are
100% accurate.

As per the response on author’s statement, there can be strength and/or weakness
associated with each of them. Here are strength and weakness on the basis of peer mentioned
above:
Strengths:
 CVP analysis is useful when variable cost and fixed cost can be easily traceable and it is
measurable.
 When company sells its product only at one price without changing it as per market
condition it helps to make proper calculation of CVP and also provide required
information needed by the cost manager.
Weakness:
 In companies where there are lot of products and price changes as per market condition,
then use of CVP leads to wrong results
 CVP analysis cannot be used where labour cost changes due to change in demand
(Davies & Crawford, 2011).

References
Davies, T. & Crawford, I., (2011). Business accounting and finance. Canada: Pearson.
Krantz, M. (2016). Fundamental Analysis for Dummies. USA: John Wiley & Sons.