Limitations of CVP Analysis for Planning and Decision Making 6 / 6

Limitations of CVP Analysis for Planning and Decision Making

These are:

  1. Cost-volume-profit analysis is invaluable in demonstrating the effect on an organisation that changes in volume (in particular), costs and selling prices, have on profit. 

    However, its use is limited because it is based on the following assumptions: either a single product is being sold or, if there are multiple products, these are sold in a constant mix. 

    We have considered this above and seen that if the constant mix assumption changes, so does the break-even point.

  2. All other variables, apart from volume, remain constant, i.e. volume is the only factor that causes revenues and costs to change.

     In reality, this assumption may not hold true as, for example, economies of scale may be achieved as volumes increase. 

    Similarly, if there is a change in sales mix, revenues will change. Furthermore, it is often found that if sales volumes are to increase, sales price must fall.

  3. The total cost and total revenue functions are linear. This is only likely to hold true within a short-run, restricted level of activity.

  4. Costs can be divided into a component that is fixed and a component that is variable. 

    In reality, some costs may be semi-fixed, such as telephone charges, whereby there may be a fixed monthly rental charge and a variable charge for calls made.

  5. Fixed costs remain constant over the ‘relevant range’ – levels of activity in which the business has experience and can therefore perform a degree of accurate analysis. 

    It will either have operated at those activity levels before or studied them carefully so that it can, for example, make accurate predictions of fixed costs in that range.

  6. Profits are calculated on a variable cost basis or, if absorption costing is used, it is assumed that production volumes are equal to sales volumes.

Illustration

Hughes plc has recently developed a personal music player and is now considering what price to charge for the new product. 

A market research company has produced the following forecasts of demand at three potential selling prices:

selling price$250$350$450
sales units per annum1000080006000
fixed costs per annum$800000$500000$200000

Variable costs are forecast at $220 per unit at any activity level.

Required:

a) Calculate, for each potential selling price, the budgeted profit, the break-even point in units and the margin of safety ratio (i.e. the margin of safety expressed as a percentage).

b) Using the graph paper provided, draw and label a break-even chart for a selling price of $350 for activity levels between 0 and 8,000 units.

(CAT Paper T7 June 2005 Qs 2 amended)

(a)
$$$
selling price250350450
variable cost220220220
---------------
contribution per unit30130230
total units1000080006000
total contribution30000010400001380000
fixed cost800000500000200000
---------------------------
profit(50000)5400001180000

Breakeven point in units = Fixed costs/contribution per unit

selling price ($)250350450
contribution per unit (1)30130230
fixed cost ($)(2)800000500000200000
breakeven point (units) (2 / 1)266673846870
budgeted units1000080006000
margin of safetynil41545130
margin of safety rationil52%86%

MOS = Budgeted Sales – Break-Even Sales

Or

Budgeted Sales – Break-Even Sales
---------------------------------
Budgeted Sales

b) Breakeven Chart

Diagram

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