Topic 1: Assumptions of CVP Analysis

The assumptions underlying Cost-Volume-Profit Analysis make it a difficult method to

apply in real world settings.

Cost-Volume-Profit Analysis is an analytical tool in the process of management, which is

being utilized by business managers for the purpose of making business decisions better.
Cost-Volume-Profit Analysis is an approach to examine the effect of changes in selling
price, sales volume, cost & product-mix on the overall financial results & profitability of the
business.
Cost-Volume-Profit Analysis involves the study of interrelationships between profits,
revenue, cost & levels of output including product mix; if dealing in multiproduct.
Understanding of interrelationship among key elements, provide support & guidelines for future
planning & for development of significant control & assessment decisions, being involved in
cost-volume-profit analysis.
For determining the importance of Cost-Volume-Profit Analysis, assumptions being
underlined on which theory of CVP Analysis is based upon must be distinguished. Underlining
assumptions of CVP Analysis place certain limitations on its usage in either way.
The conditions which are supposed to be implemented as underlining assumptions for the
usage of CVP Analysis are listed below.
1. Selling price is constant. The price of a product or service will not change as volume
changes.

2. Costs are linear & can be accurately divided into variable & fixed elements. The variable
element is constant per unit, & the fixed element is constant in total over the entire relevant
range.
3. Sales volume in terms of units remains constant, for companies having individual product. In
multiproduct companies, the sales mix is constant.
4. In manufacturing companies, inventories do not change. The number of units produced
equals the number of units sold.
The assumptions underlying Cost-Volume-Profit Analysis make it a difficult method to
apply in real world settings. Numerous difficulties have been faced by many businesses while
applying Cost-Volume-Profit Analysis due to its underlined unrealistic assumptions. Application
of CVP analysis model along with underlined unrealistic assumptions will definitely lead
towards misleading results.
The usefulness of CVP analysis is being restricted by its unrealistic assumptions, as
discussed below with examples.
Following data is being analyzed to show effect on the profitability due to proposed or
uncertain changes in various factors; supposed to be constant in underlying assumptions of CVP
analysis.

Budgeted Sales Revenue (100,000 units)

Less: Budgeted Variable Cost
Contribution Margin
Less: Budgeted Fixed Cost
Budgeted Net Profit
Profit/Volume Ratio

Total
2,000,000
1,000,000
1,000,000
400,000
600,000
50%

Per Unit
20
10
10

a) It is assumed that sales prices will be constant at all levels of activity. This may not be true,
especially at higher volumes of output, where the price may have to be reduces to win the
extra sales. The selling price may change because of economic factor or management itself
may initiate changes due to good market conditions or competition or for some other reason.
Effect on overall profitability due to change in selling price (either increase or decrease) is
shown below:

Decrease 20%

Budgeted

Per
Total

Increase 20%
Per

Total
Unit

Per
Total

Unit

Unit

Budgeted Sales Revenue

(100,000 units)
Less: Budgeted Variable Cost
Contribution Margin
Less: Budgeted Fixed Cost
Budgeted Net Profit
Percentage change in Profit
Profit/Volume Ratio

1,600,000

16

2,000,000

20

2,400,000

24

1,000,000
600,000
400,000
200,000
-66.67%
37.5%

10
6

1,000,000
1,000,000
400,000
600,000

10
10

1,000,000
1,400,000
400,000
1,000,000
+66.67%
58.3%

10
14

50%

Due to increase in selling price; contribution margin & contribution margin ratio
increases, break-even point either in units or amount decreases, sales volume (either in units
or amount) to achieve the desired profit decreases & margin of safety (either in units or
amount or ratio) increases as a result of it. Whereas, due to decrease in selling price all
affects changes in opposite way.

b) It is assumed that fixed costs are the same in total & variable costs are the same per unit at all
levels of output. This assumption is a great simplification.
i.
Fixed costs will change if output falls or increases substantially (most fixed costs are
step costs). Change in fixed costs might be caused by increase in management salaries
or increase in property tax or due to any other reason. Effect on overall profitability
due to change in fixed costs (either increase or decrease) is shown below:

Decrease 25%

Budgeted

Per
Total

Increase 25%
Per

Total
Unit

Per
Total

Unit

Unit

Budgeted Sales Revenue

(100,000 units)
Less: Budgeted Variable Cost
Contribution Margin
Less: Budgeted Fixed Cost
Budgeted Net Profit
Percentage change in Profit
Profit/Volume Ratio

2,000,000

20

2,000,000

20

2,000,000

20

1,000,000
1,000,000
300,000
700,000
+16.67%
50%

10
10

1,000,000
1,000,000
400,000
600,000

10
10

1,000,000
1,000,000
500,000
500,000
-16.67%
50%

10
10

50%

Due to increase in fixed cost; no effect has been observed in contribution margin &
contribution margin ratio, break-even point either in units or amount increases, sales volume
(either in units or amount) to achieve the desired profit increases & margin of safety (either
in units or amount or ratio) decreases as a result of it. Whereas, due to decrease in fixed cost
likewise; no effect has been observed in contribution margin & contribution margin ratio &
all other affects changes in opposite way.

ii.

The variable cost per unit will decrease where economies of scale are made at higher
output volumes, but the variable cost per unit will also eventually rise when
diseconomies of scale begin to appear at even higher volumes of output (for example
the extra cost of labor in overtime working). Change in variable costs might be
caused by increase in the price of material, labor or other variable factors. Effect on
overall profitability due to change in variable costs (either increase or decrease) is
shown below.

Decrease 20%

Budgeted

Per
Total

Increase 20%
Per

Total
Unit

Per
Total

Unit

Unit

Budgeted Sales Revenue

(100,000 units)
Less: Budgeted Variable Cost
Contribution Margin
Less: Budgeted Fixed Cost
Budgeted Net Profit
Percentage change in Profit
Profit/Volume Ratio

2,000,000

20

2,000,000

20

2,000,000

20

800,000
1,200,000
400,000
800,000
+33.3%
60%

8
12

1,000,000
1,000,000
400,000
600,000

10
10

1,200,000
800,000
400,000
400,000
-33.3%
40%

12
8

50%

Due to increase in variable cost; contribution margin & contribution margin ratio
decreases, break-even point either in units or amount increases, sales volume (either in units
or amount) to achieve the desired profit increases & margin of safety (either in units or
amount or ratio) decreases as a result of it. Whereas, due to decrease in variable cost all
affects changes in opposite way.

iii.

Uncertainty in the estimates of fixed costs & unit variable costs is often ignored.

c) It is assumed that sales volume in terms of units will remains constant at all levels of activity,
for companies having individual product. It is not certain to remain sales volume constant as
due to changing level of demands or due to availability/unavailability of raw materials,
labors, variable factors or due to any troubleshooting in production process or due to good
market conditions or due to any other reason. Effect on overall profitability due to change in
sales volume (either increase or decrease) is shown below.

Decrease 20%

Budgeted

Per
Total

Increase 20%
Per

Total
Unit

Per
Total

Unit
100,000

Unit

Budgeted Sales Volume

80,000

120,000

Budgeted Sales Revenue

1,600,000

20

2,000,000

20

2,400,000

20

Less: Budgeted Variable Cost

Contribution Margin
Less: Budgeted Fixed Cost
Budgeted Net Profit
Percentage change in Profit
Profit/Volume Ratio

800,000
800,000
400,000
400,000
-33.3%
50%

10
10

1,000,000
1,000,000
400,000
600,000

10
10

1,200,000
1,200,000
400,000
800,000
+33.3%
50%

10
10

50%

Due to increase in sales volume; no effect has been observed in any of the factor
including contribution margin & contribution margin ratio, break-even point either in units or
amount, sales volume (either in units or amount) to achieve the desired profit but margin of
safety (either in units or amount or ratio) increases as a result of it. Whereas, due to decrease
in sales volume effect on margin of safety (either in units or amount or ratio) changes in
opposite way & keeping all other factors mentioned above unchanged.

d) Production & sales are assumed to be the same, so that the consequences of any increase in
inventory levels or of de-stocking are ignored. It is not possible to maintain the relationship
of equilibrium between the number of units produced & number of units sold as number of
units can be produced on the basis of sales forecast but it is not certain that exactly the same
number of units will be demanded in actual, thats why at least reasonable amount units must
be produced to meet the upcoming demand for such products. Similarly in the multiproduct
companies, companies often adjust their sales mix of products to attain maximum profit & to
enhance their market share, so its not possible to make the sales mix constant.

Implication of CVP analysis based upon its underlining assumptions is only applicable
for relevant range & it is being used for short-term time duration. Perhaps the greatest danger lies
in relying on simple CVP analysis when a manager is contemplating a large change in volume
that lies outside the relevant range. For example, a manager might contemplate increasing the
level of sales far beyond what the company has ever experienced before.
However, CVP analysis model still can be useful for various purposes if molded as per
the situation & circumstances prevailing in the organization, despite having unrealistic
assumptions.
As it is being helpful in setting the selling price, determining the product mix,
maximizing the use of production facilities & evaluating the impact of changes in cost.
It is being concluded that all variables must be considered while making decisions as
several changes can take place in any situation while contradicting the underlying assumptions of
CVP analysis. In above discussion of underlying assumptions, every assumption is being

elaborated with example separately; including single variable in it. Whereas, in real life it is often
observed that changes has taken place among numerous variables which contradicts the
underlying assumptions of CVP analysis, so all variables must be evaluated & analyzed before
making decision in any respect.

References:

Dickinson, J.P. (1974). CostVolumeProfit Analysis under Uncertainty, Journal of

Accounting Research, 12(1), pp. 1827.

Jaedicke, R.K. and Robichek, A.A. (1964). CostVolumeProfit Analysis under

Conditions of Uncertainty, the Accounting Review, pp. 91726.

Johnson, G.L. and Simik, S.S. (1971). Multiproduct CVP Analysis under

Uncertainty, Journal of Accounting Research, 9(2) pp. 27886.

Paul A. Phillips, (1994) "Welsh Hotel: CostVolumeProfit Analysis and
Uncertainty", International Journal of Contemporary Hospitality Management, 6(3),

pp.31 - 36
Koppula.Chandra Sekher (2014). C.V.P Analysis (under conditions of uncertaintysensitivity). QIS COLLEGE OF ENGINEERING & TECHNOLOGY.