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.

UNI
TS
of
Pro
duc
t:
X-
Rac
er

Cos
t
Per
Uni
t

Tot
al
Cos
ts

1
bic
ycl
e=
$70

1
bic
ycl
e@
$70

=
$7
0

1
bic
ycl
e=
$70

2
bic
ycl
es
@
$70
=
$1
40

1
bic
ycl
e=
$70

3
bic
ycl
es
@
$70

=
$2
10

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
the
y
ma
ke
X
bic
ycl
es
per
mo
nth
....

thei
r
fixe
d
cos
ts
PER
UNI
T
will
be..
....

1,0
00
bicy
cles

$5,
000
/
1,0
00
bicy
cles
=
$5.
00
per
bicy
cle

2,0
00
bicy
cles

$5,
000
/
2,0
00
bicy
cles
=

$2.
50

per
bicy
cle

3,0
00
bicy
cles

$5,
000
/
3,0
00
bicy
cles
=

$1.
67
per
bicy
cle

4,0
00
bicy
cles

???
???
???
Qui
ck
Qui
z
try
the
se
on
you
r

ow
n

5,0
00

bicy
cles

???
???
???

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:

Fixe
d
co
mp
one
nt

$20
.00

Vari
abl
e
co
mp
one
nt

$10
.00
(10
0
extr
a
mil
es
@$
.10)

Tot
al
cos
t

$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

Sell
ing
pric
e

$
30

Vari
abl
e
cos
ts

10

Con
trib
uti
on
ma
rgin
(C
M)

$
20

2) Calculate BE units

BE
Uni
 ts

Tot
al
Fixe
d
Cos
ts

Uni
t
CM

200
0

20

100
uni
ts
to
bre
ak
eve
n

proof:
Con
trib
utio
n
mar
gin
100
unit
s@
$20

$
200
0

less
Tot
al
Fixe
d
Cos
ts

200
0

Pro
fit
(los
s)

$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?

Con
trib
utio
n
mar
gin
200
unit
s@
$20

$
400
0

less
Tot
al
Fixe
d
Cos
ts

200
0

Pro
fit
at
200
unit
s
per

mo
nth

$
200
0

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

Sell
ing
pric
e

$
20

Vari
abl
e
cos
ts

10

Con
trib
utio
n
mar
gin

$
10

2) Calculate BE units
The $400 advertising costs will increase total fixed costs; add it to the numerator (top number).

BE
Uni
ts
 =

Tot
al
Fixe
d
Cos
ts

Uni
t
CM

240
0

10

240
unit
s at
bre
ak
eve
n

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:

Con
trib
utio
n
mar
gin
200
unit
s@
$10

$
200
0

less
Tot
al
Fixe
d
Cos
ts

240
0

Pro
fit
(los
s)

($
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?
CM
Uni
t at
BE

$24
00

200

$12
CM

They must reverse the calculation, and add variable costs to CM to arrive at the new selling
price.

Con
trib
utio
n
mar
gin

$
12

Vari
abl
e
cos
ts

+
10

Sell
ing
pric
e

$
22

Proof:

Sell
ing
pric
e

$
22

Vari
abl
e
cos
ts

10

Con
trib
utio
n
mar
gin

$
12

BE
Uni
ts
 =

Tot
al
Fixe
d
Cos
ts

Uni
t
CM

240
0

12

200
unit
s at
bre
ak
eve
n

proof:

Con
trib
utio
n
mar
gin
200
unit
s@
$12

$
240
0

less
Tot
al
Fixe
d
Cos
ts

240
0

Pro
fit
(los
s)

$ 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).

Sell
ing
pric
e

$
40

Vari
abl
e
cos
ts

24

Con $
trib 16
utio
n
mar
gin

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:

BE = 240 = 150
Uni 0 unit
ts 16 s at
bre
ak
eve
 n

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) = ----------------- ==> this is the CVP formula!
CM/unit

CVP Formulas

FC + Profit FC + Profit
Vol(units) = -------------- Vol($) = --------------
$CM/unit 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) Product 1 Product 2
Sales (units) 100,000 200,000
Sales () 500,000 300,000
C/S ratio (as given above) 80% 70%

The weighted average C/S ratio is:

Total Contribution = (500,000 x 80%) + (300,000 x 70%)

Total Sales 500,000 + 300,000

= 76.25%

Sales mix (ii) Product 1 Product 2

Sales (units) 300,000 350,000
Sales () 1,500,000 525,000
C/S ratio 80% 70%

The weighted average C/S ratio is:

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

Total Sales 1,500,000 + 525,000

= 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.

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.