Question

Critically discuss the effectiveness of Cost-Volume-Profit analysis duly supported with empirical evidence.

Answer 1

Answer:

Cost-volume-profit (CVP) can be used to determine how changes in costs and volume affect a company's operating income and net income.  CVP analysis requires that all the company's costs, including manufacturing, selling, and administrative costs, be identified as either variable or fixed.

A CVP analysis consists of five basic components that include: volume or level of activity, unit selling price, variable cost per unit, total fixed cost, and sales mix.

From the cost-volume-profit analysis, one can determine the sales quantity needed to break even as well as the sales quantity required to earn a desired profit margin .

For instance, given a fixed costs of $4,000 and contribution margin of $20, it becomes possible to determine the volume of sales in order for the entity to break-even (make no profit or loss).  The break-even point = $4,000/$20 = 200.  This implies that if the entity can sell 200 units with the current level of fixed and variable costs, and selling price, it can make no profit or loss.  If more quantity is sold, then the entity can record some profit, and vice versa.  Management can use the information provided to decide if production of a product or service can be continued or discontinued if it meets or does not meet the profit goal.

But, the CVP analysis is not always accurate.  CVP analysis technique assumes that all costs in the company are completely fixed or completely variable.  Fixed costs are costs that do not change with changes in production, such as rent or insurance costs.   They are not always completely fixed as they may change periodically, then exhibiting a step fixed costs nature, though in the long run, all costs are variable.

Another issue with CVP analysis is that it is a short run, marginal analysis: it assumes that unit variable costs and unit revenues are constant, which is appropriate for small deviations from current production and sales, and assumes a neat division between fixed costs and variable costs.

Explanation:

Cost-volume-profit (CVP) analysis is a managerial accounting technique to determine how changes in costs and volume affect a company's operating income and net income.