Break Even Analysis Assumption

Superior Essays
1.0 Introduction

CVP also known as Cost-Volume Profit analysis is a method used to calculate and determine break-even point of cost and volume of goods in a business and for management control (Kim Tan, 2011). This is better known as when total revenue equals to total costs and managers find this analysis useful when determining short-term business descisions. When a company hits break-even point, there will be no profit and no losses. Break-even is what most new start up companies want to experience as soon as possible before making any profits. According to Horngren and Foster (1991), for CVP, there are 6 underlying assumptions that must be noted:
Changes in production/sales volume are the sole cause for cost and revenue changes
Total costs
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Managers must average the contribution margins for all the products to perform cost volume profit analysis and this is not effective as getting an accurate contribution margin for one product (SimpleStudies, 2004). It is argued that selling prices and variable cost per unit do not change with volume but in real life situations, they change due to economy fluctuations and economies of scales and in the long-run, all costs are variable and CVP is a short run, marginal analysis so it doesn’t account for the full life-cycle of a product. Another limitation is that CVP assumes a linear revenue function and a linear cost function and this is a limitation because in real life business scenarios, it may not be a revenue function. The analysis also assumes that whatever is produced in the business, is sold however in businesses, not every item produced will be sold as there might be left overs that may turn to stock or even expire during it’s life. When calculating multiple-product analysis, the sales mix is assumed to be known and constant however these may change and they will definitely vary due to economies of scale and how the businesses will react to market changes Also, the selling prices and costs are assumed to be known with certainty when in reality, these can change due to …show more content…
As said by Jared Lewis (2014), “Because CVP analysis is based on statistical models, decisions can be broken down into probabilities that help with the decision-making process.”
Another advantage of the CVP model according to an article by (M. Sulaiman, 2013) is that it is detailed from the costs needed to produce the products to the amount of product that need to be produced and this will aid in the managers duty of allocating resources and materials and to alter it in the future if needed (Garrison RH, 2011). The CVP analysis also allows the manager to factor in variable costs to estimate the future performance of the company within a range of possibilities. CVP allows profit planning and from this, CVP can be used to aid in finding the best profitable mix of selling price, cost and volume, which makes calculations of expected profit at different sales levels as well as reaching break even point and the margin of safety. CVP benefits managers for budgeting purposes. For example, managers will determine the level of sales in order to meet their target profit then preparing the expected costs and revenues at production. Another advantage to the CVP analysis is desicion making. The analysis can aid managers to buying or

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