Cost-volume-profit analysis incorporating the cost of capital.

Cost-volume-profit (CVP) analysis is a mathematical representation of the economics of producing a product. The relationships between a product's revenue and cost functions expressed within the CVP model are used to evaluate the financial implications of a wide range of strategic and operational decisions. For example, CVP analysis is employed to assess the financial implications of product mix, pricing, and product and process improvement decisions. Perhaps equally important, CVP analysis facilitates measuring the sensitivity of a product's profitability to variations in one or more of its underlying parameters. Finally, CVP analysis may be used to determine the trade-offs in profitability and risk from alternative product design and production possibilities. In effect, CVP is a quantitative model for developing much of the financial information relevant for evaluating resource allocation decisions. Despite its widespread application, CVP analysis is frequently criticized for its use of simplifying assumptions, such as deterministic and linear cost and revenue functions. Additionally, CVP is disparaged for its focus on a single product and its single-period analysis. However, as noted by Guidry et al.: "Non-linear and stochastic CVP models involving multistage, multi-product, multivariate, or multi-period frameworks are all possible, although a single model embracing all of these extensions would seem a radical departure from the whole point of CVP analysis, its basic simplicity" (1998: 75). Horngren et al. (2000) note that firms across a variety of industries have found the simple CVP model to be helpful in both strategic and long-run planning decisions. Furthermore, a survey of management accounting practices indicates that CVP analysis is one of the most widely used techniques (Garg et al., 2003). However, Horngren et al. (2000) warn that, in situations where revenue and cost are not adequately represented by the simplifying assumption of CVP analysis, managers should consider more sophisticated approaches to financial analysis. An implicit assumption, and one that is frequently overlooked in evaluating the use of CVP analysis, involves its treatment of the cost of capital. CVP analysis, like other managerial accounting techniques and models, uses accounting profitability as the primary decision criterion for evaluating resource allocation decisions. CVP analysis, like other managerial accounting techniques, ignores the cost of capital and treats it as if it were zero. However, the opportunity cost of the funds invested in the assets used to manufacture a product is a cost the same as the cost of operating resources, such as direct material, labor, and overhead. The failure of CVP analysis to incorporate the cost of capital into a product's cost function can lead to underestimating a product's cost, while overstating its profitability. For products that require a significant investment of capital, ignoring the opportunity cost of invested funds may lead to accepting products whose rate of return is less than the firm's cost of capital. In effect, traditional CVP analysis encourages managers to select products that destroy, rather than create, economic value for the firm. Finally, using an accounting measure of profitability creates a bias to employ capital relative to operating resources because the cost of capital is not reflected in a product's cost like those of operational resources. Therefore, product designers and developers may

employ investment funds beyond the point where the marginal benefit of the last dollar of capital used is equal to its marginal cost.

Cost-Volume-Profit Analysis
CVP Analysis is a way to quickly answer a number of important questions about the profitability of a company's products or services. CVP Analysis can be used with either a product or service. Our examples will usually involve businesses that produce products, since they are often more complex situations. Service businesses (health care, accounting, barbers & beauty shops, auto repair, etc.) can also use CVP Analysis. It involves three elements:
1. Cost - the cost of making the product or providing a service 2. Volume - the number of units of products produced or hours/units of service delivered 3. Profit - Selling Price of product/service - Cost to make product/provide service = Operating Profit The first two items are information available to business managers, about their own business, products and services. This type of information is not generally available to those outside the business. They constitute important operating information that can help managers asses past performance, plan for the future, and monitor current progress. As for the third item, a business can't stay in business very long without profits.

It is important to know whether the company is profitable as a whole. It is also important to know if a particular product is profitable. A business that sells 100 or more different products may lose sight of a single product. If that product becomes unprofitable (selling for less than the cost to produce & sell), the company will lose money on each and every sale of that product. The company might raise the selling price, cut production costs or discontinue the product entirely. Building a business with 100 products we know are profitable is good management. CVP & variable costing provide the tools to make this happen in a real business. A successful business can be built around a single profitable product. It can also be built around hundreds or thousands of profitable products. Many businesses start small and grow over time, adding products as they gain experience and are able to identify and/or develop new markets and products. No matter the size of the business or the number of products, the same rules apply. Each product must "carry its own weight" for the business to be profitable. Using CVP Analysis we can analyze a single product, a group of products, or evaluate the entire business as a whole. The ability to work across the entire product line in this way gives us a powerful tool to analyze financial information. It provides us with day-to-day techniques that are easy to understand and easy to use. The concepts parallel the real world, so they are easy to

visualize and use. The math is very simple - no complex formulae or techniques. Just simple formulae that can be easily modified to analyze a large variety of situations.

CVP Relationships
Cost - product cost, consisting of materials, labor, overhead, etc. Volume - number of units of product sold in a given period of time Profit - Selling Price minus Cost, per unit or in total

The greater the volume, the greater the TOTAL profit.

Approaches to product costs

Full Costing is used in financial accounting. The full cost of a product includes materials, labor and manufacturing overhead. Not included: Selling and administrative costs.

Variable Costing is used in managerial accounting. Costs are classified as either Variable or Fixed, depending on their Cost Behavior.

Cost Behavior
Costs are classified according to how they behave, in relation to units of production.

CAUTION: Cost behavior can be viewed in terms of total costs or unit costs. Both approaches will be used, but they are not interchangeable.

Fixed Costs
Total Fixed Costs - stay essentially the same month to month, regardless of the number of units produced.

Unit Fixed Costs - goes down as production goes up

Variable Costs
Total Variable Costs - go up and down in direct proportion to units produced.

Unit Variable Costs - stay the same regardless of how many units are produced. Accounting information is captured once by the accounting system. In Accounting I you learned how to analyze transactions, record journal entries, post to the ledger accounts and prepare financial statements for use by those outside the company. That is one way to organize accounting information, but it is not the only way. That same information can be organized in many different ways. In this section we are going to simplify the process greatly. Our topic is Cost-Volume-Profit, so we will focus on income statement accounts, Revenues and Expenses. For now we can ignore balance sheet accounts. Managers focus on income statement accounts because these are the ones affected by day-to-day operating activities. Companies produce/purchase and sell products or services. Companies may uses hundreds of income statement accounts to track all their different types of revenues and expenses. We are going to simplify the income statement by dividing all expenses into one of two categories: Variable and Fixed. To master this material you need to master these two concepts.

VARIABLE COSTING - in general

CVP Analysis uses Variable Costing concepts. In this context we will divide ALL costs into one of two categories: Variable or Fixed. We refer to this as "cost behavior." In CVP Analysis cost behavior will be discussed on BOTH a total cost and per unit basis. The facts will remain the same, but the behavior will appear different, depending on the context. Read carefully, especially on exams and in problems, so you understand the context of the question/problem: total cost or per unit. Since CVP Analysis can answer questions about both, we will switch back and forth frequently in our discussion. Tighten you "thinking bolts" and read carefully in this section.

In CVP Analysis we assume that the number of units produced equals the number of units sold. In other words, we factor out changes in inventory during a production period. In the "real world" managers often include inventory changes & income taxes in CVP Analysis. In this course we will ignore both inventory changes and income taxes. Here, you should gain a basic working knowledge of CVP Analysis fundamentals.

VARIABLE COSTS (VC)

Total Variable Costs increase in direct proportion to production/sales. Unit Variable Costs stay the same as production fluctuates within the relevant range.

EXAMPLE: Mike's Bikes builds the X-Racer from its inventory of parts. Each bicycle is made up of the following parts:

frame (1) seat (1) handlebars (1) wheels (2) tires (2) gears & shifting system (1) brakes & braking system (1)

Parts prices vary over time. Currently the cost to produce one bicycle is $70. UNITS of Product : X-Racer Cost Per Unit Total Costs 1 bicycle @ $70 1 bicycle = $70

= $70
2 bicycles @ $70 1 bicycle = $70

= $140
3 bicycles @ $70 1 bicycle = $70

= $210
Per Unit costs stay the same; total costs increase in direct proportion to the number of units produced or sold (sales or production volume). The Relevant Range is the number of units that can be produced or sold under normal circumstances. That might vary due to seasonal demand or factory capacity. To go beyond the relevant range would generally require the additional of more equipment, buildings, personnel, etc. and that would cause a change in all costs. We presume that

we are working within the relevant range when doing CVP Analysis. This makes the task much easier. It also helps us understand when we will need to address the need to expand our business. Variable Costs include any total cost that varies in direct proportion to volume. These commonly include:

component parts, packaging, etc. production labor sales commissions (percentage or per unit basis) other costs allocated on a per unit basis

FIXED COSTS (FC) Total Fixed Costs (FC) do not change as production/sales increases. Unit Fixed Costs decrease as production increases within the relevant range.

Ask yourself this question: Would a cost be zero if production was zero? If the answer is NO, you are looking at a fixed cost. A common example would be rent on a building. The company must pay rent on the building even if it sells no products in a given month! Some other common costs that follow this pattern are:

managers & executives salaries insurance advertising real estate & property taxes security service cleaning & maintenance costs depreciation expense on buildings, vehicles & equipment

EXAMPLE: Mike's Bikes spends $5,000 per month in fixed costs. If they make X bicycles per month.... 1,000 bicycles 2,000 bicycles 3,000 bicycles 4,000 bicycles 5,000 bicycles

their fixed costs PER UNIT will be...... $5,000 / 1,000 bicycles = $5.00 per bicycle $5,000 / 2,000 bicycles = $2.50 per bicycle $5,000 / 3,000 bicycles = $1.67 per bicycle ????????? Quick Quiz try these on your own ?????????

Answer:
$5,000 / 4,000 bicycles = $1.25 per bicycle $5,000 / 5,000 bicycles = $1.00 per bicycle

Unit Fixed Costs decrease as productions goes up. Since Fixed Cost per Unit goes down as sales/production go up, it is always a good idea to sell/produce more units. In the real world, companies try to produce approximately the same number of units they expect to sell in a given period of time. If you think about the computer industry you will see how important this can be. If a computer company manufactures too many units it may have a stock of merchandise that is hard to sell as new computer chips are introduced to the market. It may have to sell its products at a discount or even at a loss to liquidate its inventory. Chapter 8 discusses "Just In Time" (JIT) inventory management, which is used to help reduce inventory costs, by having parts delivered "just in time" to go into production. JIT inventory systems are commonly used in automobile assembly plants. Using JIT reduces a company's risk of carrying a stock of parts that may quickly become obsolete.

MIXED COSTS
Mixed costs change somewhat in relation to production, but not proportionately like Variable Costs do. Mixed costs generally have a fixed portion and a variable portion. We deal with these costs by separating them into these two parts - so we are back to only 2 types of cost behavior.

A common example of a mixed cost would be a rental car. You might rent a car for a weekend for $20, for up to a total of 200 miles. You will be charged $ .10 for each additional mile you drive. The flat rate of $20 represents the fixed component; the $ .10 per mile represents the variable component. If you drive 300 miles you will pay:

Fixed component Variable component Total cost

$20.00 $10.00 (100 extra miles @ $ .10) $30.00

We have a couple of simple ways to separate costs into their fixed and variable components. One way is called the High-Low Method. It looks at the highest & lowest costs over a period of several months to come up with a simple formula that can be used to calculate the variable & fixed costs. Separating mixed costs into their parts is an in-exact practice. At best it is an estimate, or approximation, that is only as accurate as the method we use. This is not usually a significant issue, since all costs are eventually included in our equations. However, if mixed costs constitute a percentage of total costs, it is necessary to be as accurate as possible. More sophisticated methods should be used when a higher level of accuracy is needed.

Contribution Margin
The Contribution Margin (CM) is one of the most essential parts of variable costing and managerial accounting.

CM = Selling Price - Variable Costs It can be calculated as either unit CM or total CM. CM is the profit available to cover fixed costs and provide net income to the owners. Break Even analysis One of the first uses of variable costing is calculating the break even point. This is the point at which sales exactly equals total costs. It can be expressed as either units or sales dollars. Break Even Units (BE units)- the number of units needed to cover fixed costs for a given period of time. ----------------------------------------------------

BE units example:
XYZ Co. has monthly fixed costs of $2,000. They sell a single product for $30 each. Variable costs are $10 per unit. They sell about 200 units per month. Calculate the break even point in units.

1) Calculate CM

Selling price

$ 30

Variable costs Contribution margin (CM)

10 $ 20

2) Calculate BE units

BE Units

Total Fixed Costs Unit CM

2000 20

100 units to break even =

proof: Contribution margin 100 units @ $20 less Total Fixed Costs Profit (loss) $ 2000 2000 $0

When sales are below the Break Even point a company is operating at a loss; Above the BE point they will be operating at a profit. The company is selling 200 units per month, well above the break even point, so they are operating at a profit. How much profit will they make by selling 200 units per month?
Contribution margin 200 units @ $20 less Total Fixed Costs Profit at 200 units per month $ 4000 2000 $ 2000

----------------------------------------------------

Example 2: XYZ is facing fierce competition from a new company, and management decides to lower the selling price of their product to $20 per unit. They also decide to take out advertising at a cost of $400 per month. Recalculate their Break Even point given the new information:

1) Calculate CM
Selling price Variable costs Contribution margin $ 20 10 $ 10

2) Calculate BE units The $400 advertising costs will increase total fixed costs; add it to the numerator (top number).
Total Fixed Costs Unit CM 2400 10

BE Units

240 units at break even

This will be a problem for the company. Their new break even point is higher than their normal monthly sales. They will be operating at a loss under these conditions, and must re-evaluate the decision.

proof: Contribution margin 200 units @ $10 less Total Fixed Costs Profit (loss) $ 2000 2400 ($ 600)

----------------------------------------------------

Example 3 : We can work the formula in reverse. Assume they include the advertising costs of $400 per month, and sell 200 units. What selling price will put them at the break even point? $2400 200

CM Unit at BE

$12 CM

They must reverse the calculation, and add variable costs to CM to arrive at the new selling price.
Contribution margin Variable costs Selling price $ 12 + 10 $ 22

Proof: Selling price Variable costs Contribution margin $ 22 10 $ 12

BE Units

Total Fixed Costs Unit CM

2400 12

200 units at break even

proof: Contribution margin 200 units @ $12 less Total Fixed Costs $ 2400 2400

Profit (loss)

$ 0

CM Ratio and BE sales volume

The CM can also be viewed as a percentage or ratio. To calculate the CM ratio, divide CM by the Selling Price (SP).

ABC Co. has monthly fixed costs of $2,400. They sell a single product for $40 each. Variable costs are $24 per unit. They sell about 250 units per month. Calculate their break even point in sales dollars (also called sales volume).
Selling price Variable costs Contribution margin $ 40 24 $ 16

Their CM Ratio is CM/SP = 16/40 = .40 or 40%

(In accounting we usually carry calculations out to 4 decimal places). Break Even Sales Volume Total Fixed Costs / CM Ratio = 2400/.40 = $6000 in sales per month
proof: $6000 / $40 SP per unit = 150 units to break even, or: 2400 16

BE Units

150 units at break even

When do we use CM Ratio and BE sales volume?

We can use these calculations anytime. They are especially useful when the company sells a large number of different products - in other words a large sales mix. Take for example a convenience store. They might sell 200 different items, or more. Each item carries its own selling price, and contribution margin per unit.

Calculating all those contribution margins would be a huge job. And with a sales mix, the company would have to carefully track each and every product. It is much easier to consider the merchandise as a large group, and use the CM Ratio. QuikMart operates a convenience store, and their CM Ratio is approximately 42%. Their monthly overhead (fixed costs) is $2604. What sales volume is needed to break even? BE volume = TFC / CM Ratio = $2604 / .42 = $6200 per month in sales volume It is not necessary for the owner to know exactly how many Snickers bars, Milky Way, cans of Coke etc. will be sold each month. That will depend on the what the customers want to buy. The owner will stock a variety of products. By using CM Ratio we don't need to know each item individually. Of course, in the real world not all products will earn the same CM Ratio. Some products face stiff competition, and the company will charge accordingly. For instance, they will sell milk at a price similar to grocery stores, earning a rather small CM. But the neat trinkets that adorn the front counter will be sold for twice, three, four times or more their cost, greatly improving the company's overall profit margin. A few high profit items can make up for the "loss leaders" in a company's product mix. [Loss leaders are products sold at a low price, sometimes at a loss, to attract customers, and get them to shop in your store. Free items, 2-fer sales, 1 cent sales, etc. are all examples of the loss leader strategy used by grocery stores to get your business. They hope you will buy some of the high profit items while you are shopping in their store. Sometimes they will require a minimum purchase, or limit the number of loss leader items a customer can buy.]

What is CVP Analysis?

CVP (Cost-Volume-Profit) Analysis breaks down costs into those that are fixed and those that are variable and then uses this information for rational decision making.

Contribution Margin
1. How does a contribution margin-based income statement organize costs, and why?

A contribution margin-based income statement organizes costs as variable and fixed to aid in management decision making. Knowing how costs behave, management can better budget the profitability of various decisions. This format also provides a better understanding of how volume changes influences revenues, costs, and profit.

2. What is contribution margin per unit (CMU)? What does it tell management?

The products CMU is the difference between its sales price and variable costs. This is an important concept for managers because it tells them the amount of money each additional sale will contribute to covering fixed costs and providing a profit. It equals the change in profit resulting from one additional sale.

3. What is a contribution margin ratio? What does it tell management?

CM ratio is the difference between selling price and variable costs per unit (or revenues and total variable costs), expressed as a ratio or percentage of the selling price. Thus, a 40% contribution margin ratio means 40 cents of every sales dollar is contributed to fixed costs and profits. Or, each additional dollar of revenue creates 40 in extra profit

CVP Assumptions and Limitations

accurately break down costs into fixed and variable elements fixed costs will remain fixed during the period affected by the decision being made variable costs vary in a linear fashion with sales works best when limited to a specific situation or department economic and other conditions are assumed to remain relatively stable it is only a guide to decision making

The Profit Equation ==> the CVP Equation!

We use the profit equation to derive the CVP equations

Profit = Revenues - Expenses o now rewrite revenues as Sales price * volume (i.e., number of units sold) Profit = (SP * Vol) - Expenses o now rewrite expenses as variable costs plus fixed costs Profit = (SP * Vol) - (VC + FC) o now rewrite VC as VC per unit * volume Profit = (SP * Vol) - [(VC/unit * Vol) + FC] o distribute the minus sign and collect terms Profit = Vol*(SP - VC/unit) - FC o notice that SP - VC/unit is the same thing as contribution margin per unit Profit = Vol*(CM/unit) - FC o solving the equation for volume we get

FC + Profit Vol(units) = ----------------CM/unit

==> this is the CVP formula!

CVP Formulas
FC + Profit Vol(units) = -------------$CM/unit FC + Profit Vol($) = -------------CM%

Note: When profit = 0 this is a break-even analysis We can solve for either break-even volume or break-even revenues

Graphical Representation

What-If Analysis
1. Describe what-if analysis.

What-if analysis changes a CVP equation variable and seeks its effect on volume, revenues, or profit. For example, a what-if scenario might involve determining the extra profit from spending $10,000 on advertising if it increases sales by 10%.

2. What is the margin of safety? What does it tell management?

The difference between the sales forecast and the break-even point is called the margin of safety, which is usually expressed as a percentage of the sales forecast. This is the percentage decline in sales that can occur before the company reaches its break-even point.

Assumptions Cost-Volume-Profit Analysis

Sales price per unit is constant. Variable costs per unit are constant. Total fixed costs are constant. Everything produced is sold. Costs are only affected because activity changes. If a company sells more than one product, they are sold in the same mix.

The importance of identifying and criticising the underlying assumptions of cost volume profit analysis (CVP analysis) rests on the practical application of it: anyone who has ever tried (or anyone who may wish) to apply CVP analysis in reality, whilst trying to apply the substance of CVP theory will have found severe difficulties. These notes will help you solve those problems.

In any discussion of CVP analysis, any lecturer, manual or accountant will be frequently heard to say something along the lines of "Let's assume for a moment that fixed costs remain fixed, even if output changes by a relatively large amount ..." or "Of course, the selling price in this example is constant over the whole range of output ...". There is little doubt that CVP analysis is useful in its proper context: there are many decisions made which positively shout out that CVP analysis has been employed: examples such as reduced price midday meals in restaurants compared to evening meals in the same restaurant; reduced weekend rates in hotels. All such examples are based on CVP reasoning; and there is little doubt that in the short term, at least, these special deals attract clients who would otherwise not be attracted in, and thus help to increase a business's contribution. Nevertheless, there are problems with CVP analysis when it comes to applying it. How many student accountants or young accountants have gone to work following a riveting read of a chapter on CVP analysis determined to calculate his firm's break even point only to find that reality is much more complex than the theory might have them believe?! Such problems are centred around the underlying assumptions on which CVP analysis is based. Nevertheless, it is frequently found that students are quite happy to apply CVP analysis principles in theoretical settings

but may be unaware of these assumptions and how restrictive they really are when it comes to when the examiner asks them to identify and criticise these underlying assumptions. Let's look at the assumptions one by one and analyse their limitations as we go:

1 All costs can be analysed into their fixed and variable elements.
When we talk about fixed and variable costs, we usually assume that it is possible to take a look at individual or total costs and split them into their fixed and variable elements. However, if we look at any organisation of a reasonably large size we will quickly appreciate that not only might there be several hundred costs comprising total cost but also there are many forces acting on those costs (cost drivers in activity based costing parlance). Consequently, it can not be a simple matter of a few minutes' analysis and the fixed and variable split has been fully explained. Splitting out fixed and variable costs can be a long, time consuming process; and techniques such as the inspection of accounts method really are not suitable if the analysis is to be realistic. At the very least, some kind of statistical or mathematical analysis will have to be undertaken. I have undertaken this kind of an exercise in a wide variety of companies and industries; and it takes many man hours to research the organisation, set up and work a spreadsheet, analyse the results and then present my findings. This is not to suggest that the splitting of fixed and variable costs is too difficult for the average student or practitioner. Consider diagram one below (which we can assume for the sake of the discussion is the regression line derived from an analysis of a business's total costs) and suggest the level of fixed costs and hence calculate a variable cost per unit:

2 Fixed costs remain fixed even over a wide range of activity.

Another simplifying assumption which helps to keep the arithmetic of CVP analysis simple but which does not help those of us who wish to apply the techniques. The relevant range is the range of levels of activity over which the business has direct experience. That is, it has probably produced at or over that range of outputs; or it has studied such levels of output carefully. Hence, no business will know with certainty what its fixed costs will be outside its relevant range; and there is no guarantee that fixed costs will remain fixed if the business produces at a level of output outside its relevant range: whether through expansion or contraction.

Diagram three illustrates a more realistic scenario: where a fixed cost can change as a result of a change in output level to a level outside the relevant range. The relevant range in diagram three is represented as 401 units to 800 units. The reasons why fixed costs will change in such a way include, for a reduction in output: managers and supervisors being laid off as no longer required at reduced levels of output; machinery sold; buildings sold or not rented any more. A similar analysis applies to an increase in output and fixed costs.

Fixed costs behaving in this step cost fashion is another cause for concern over glibly trying to apply CVP analysis. We may not, in fact, know how our fixed costs will behave outside our relevant range unless and until we carry out detailed cost analysis of extra relevant range scenarios.

3 Variable costs always vary directly with activity.

A nice neat assumption which might be true in some circumstances. It is possible for a cost to be truly variable and behave in a perfectly linear way: think of examples such as making one standard design of wooden tables and chairs. However, it is still useful to explore here the more likely exceptions to that behaviour.

In reality, of course, a whole host of forces can act upon a cost which is deemed to be variable. For example, once a business grows beyond a certain size it can then enjoy the benefits of greater volume: such benefits are known as economies of scale and include being awarded trade discounts, being offered cash discounts now that it can obtain credit; and quantity discounts because it can now buy in greater bulk. Consequently, even though the quantity of components in a product remains standard and fixed, their cost per unit can fall as a result of these economies of scale. These changes to the basic assumption of linearity mean that when diagram four shows a perfectly straight line, reality could be more like diagram five where we can easily be dealing with a situation where variable costs are essentially variable but which are not perfectly variable. In the case of diagram five, we see a true curve; and any analysis of an estimation of a precise relationship between variable cost and output will yield a solution but not a linear one. Again, since any reasonably large business will have many such costs, isolating the variability of all such costs can be a major task.

4 Selling prices are constant per unit.

A very similar series of arguments holds for selling prices as held for variable costs. There is no reason why any business needs to sell to all of its customers at the same price for all products. We could easily demonstrate that different prices are offered for different levels of purchasing: for example, discounts for bulk buying. The hypothesis of supply and demand also dictates that the higher the price the fewer will be sold; and the lower the price the more will be sold. Diagram six combines the basic assumed sales curve and a more realistic sales curve based on the arguments just put forward: Again, when we consider the realistic side of total sales a true curve emerges; and again, this means that any analysis of sales immediately becomes more difficult than the basic assumptions of CVP analysis would have us believe.

5 Only levels of activity affect costs and revenues

This, to some extent, is the worst of all of the assumptions from the point of view of a realistic application of CVP analysis. It is the worst because it denies there being such things as labour efficiency and changes to labour efficiency: the learning effect is ignored, or assumed away, by this assumption, of course. Along with all of the discussion so far, there are many reasons why a total cost or a cost per unit might change; and changes in the level of output is only one. Consider your own environment: why might any one of the costs with which you are associated change? In the case of a manufacturer, costs might change because someone has improved the way an operation is performed. A friend of mine, John, has a good eye for helping people to work more efficiently. One day he hoticed that an operative in a factory was working on making components for a Poly Tunnel (greenhouse type thing!) and was working on a bench but keeping his metal rods on the floor. John brought a stand around to where the operative was working and put the metal rods on there the operative then completed his jobs in half the time it used to take! The consequences of this relate to time, productivity, possibly better quality output and the cost per unit will have improved. None of the reason for this change in cost is due to the restrictive assumption of output being the only determinant of cost.

6 usually only one product can be effectively dealt with

One product business The reason for this assumption rests on the mathematics involved if more than one product is assumed to be made. Although it is not the purpose of this paper to go too deeply into such issues, we should be aware that trying to model a multi product business in terms of CVP analysis can become very frustrating indeed. Consider diagram seven, which represents a ten product business: all products have different characteristics, as we can see from the three products included in the graph.

Within this multiproduct business, there are six prices, all of which are subject to varying levels of variability. The purpose of the graph is to demonstrate that simply by analysing the total sales curve, and ignoring its constituent parts, is likely to lead to serious errors of judgement or decision making: the total sales curve is almost a straight line, but any one of the individual sales curves for any product can be significantly different to a straight line; as is the case, especially, with products three and ten. Any simplistic attempt at unravelling this business is destined to fail. The mathematical model even for this relatively simple ten product business could run to several complete lines across an A4 page. Such a model is not too unmanageable for most of us, but it is unwieldy and cannot be readily simplified just for the sake of argument; and the same arguments would apply equally well to the variable and fixed costs (although they have been excluded from diagram seven). Sales mix issues The sales mix argument is a straightforward one and it deals with the contribution to sales ratio (the C/S ratio). If a business makes two products: one with a C/S ratio of 80% and the other with a C/S ratio of 70%, the average C/S ratio will not be 75% (which would be the simple average of the two C/S ratios). The average C/S ratio has to be based on the weighted average of the two; and the value of this weighted average varies as the sales mix varies. Consider the weighted averages in each of the following cases for the business just introduced:

Sales mix (i) Sales (units) Sales () C/S ratio (as given above)

Product 1 Product 2 100,000 200,000 500,000 300,000 80% 70%

The weighted average C/S ratio is: Total Contribution Total Sales = 76.25% Sales mix (ii) Sales (units) Sales () C/S ratio Product 1 Product 2 300,000 350,000 1,500,000 525,000 80% 70%
=

(500,000 x 80%) + (300,000 x 70%) 500,000 + 300,000

The weighted average C/S ratio is: Total Contribution Total Sales = 77.41% By changing the sales mix, in a situation where the values of the C/S ratio change from product to product, the weighted average value of all C/S ratios also changes; and unless this point is appreciated, the results of any CVP analysis could easily be invalidated.
=

(1,500,000 x 80%) + (525,000 x 70%) 1,500,000 + 525,000

7 Uncertainty does not exist.

The final assumption underlying CVP analysis is that there is no such thing as uncertainty. Everything is known and knowable to 100% certainty levels. Prices are sure; variability of cost is certain; and there is nothing so certain as the level of fixed cost! It should be clear that the only certainty about certainty is that it is certain not to exist! Indeed, as has been said and widely quoted many times, the only things certain in this world are death and taxes: CVP analysis was not included on that list!

Summary
In this discussion, we have worked through a wide ranging view on the assumptions underlying cost volume profit analysis. We have done so not so that we can all now dismiss CVP theory but so that when CVP analysis is being considered, it can now be done so from a much firmer basis: by pointing out the weaknesses of the assumptions on which CVP analysis is based, the requirements for a more rigorous study can be developed. Finally, those of you studying for the later stages of your examinations now have a very good assortment of views on which to base your answer to the question: Identify and criticise the underlying assumptions of CVP analysis.