Assumptions That Underlie Cost-Volume-Profit Analysis

CVP analysis is useful in assessing the effects of changes in costs and volume on a company's profit.
CVP analysis is useful in assessing the effects of changes in costs and volume on a company's profit. (Image: Images)

Cost-volume-profit (CVP) analysis is used to assess the impact of potential changes in costs and volume on a company's operating profit and net profit. CVP analysis is useful in making decisions regarding pricing of products, selection of product lines and utilization of production equipments. Additionally, CVP is at the heart of methods used for calculating the break-even point and sales levels necessary to attain targeted income levels.

Constant Selling Price

CVP analysis assumes that all products or services are sold at the same price. This assumption precludes the concept of trade and volume discounts on sales. Selling price changes may occur due to inflation and actions of competitors; for example reduction of prices by competitors forces a firm to reduce its prices too. Changes in demand and supply also affect the selling price of commodities.

Constant Sales Mix

The sales mix is the relative portion of unit sales resulting from every product or service. CVP analysis assumes the sales mix of multiple products or services is the same and firms with multiple product lines achieve expected sales mix ratios. If products have different selling prices and costs, changes in the mix will affect CVP model results.

Constant Inventory Level

The number of units produced equals the number of units sold; therefore, the number of units in beginning work-in-process and finished goods equal the number of units in these ending inventories. If inventory levels vary, some of the variable and fixed product costs may stream into or out of inventory, with a range of potential effects on profitability.

Classification of All Costs to Fixed or Variable Costs

This model assumes that all costs incurred can accurately be classified as fixed or variable costs. Fixed costs are costs that remain constant at any level of activity during a particular period; an example of a fixed cost is rent. Variable costs are those that vary with the activity level in a company; for example, the cost of raw materials increases with number of products produced.

Linear Total Costs

CVP analysis assumes that total fixed costs are constant and variable costs per unit are constant. When volume and trade discounts are obtained from suppliers, then variable costs per unit change accordingly. If worker productivity increases or reduces as activity levels change, then variable costs per unit also change.

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