Cost Volume Profit Analysis: Advantages and Disadvantages

speak to Volume Profit depth psychology Advantages and DisadvantagesCost Volume Profit Analysis is not appropriate in an environment where companies originate many assorted products.Cost mint improvement comp cease is the study of the effects of output multitude on revenue, cost and simoleons (Horngren, Sundem and Stratton). The most common delectation of cost volume gain ground analysis is to find break-even full point in terms of weigh of units sold. In its simple(a)st form cost volume cabbage analysis plows for single product companies. But most of the companies produce much than one product. Sales prance is the relative proportion of quantities of polar products that comprise innate gross revenue. When gross revenue cockle assortments, break-even point changes and so does the profit. wish any model, cost volume profit analysis is based on certain assumptions. This paper looks at the applicability of the assumptions, especi anyy for a keep company producin g more than one product. Most of the assumptions in cost volume profit model atomic number 18 based on the elongateity of cost and sales with units. Major elements impacting cost are sudden increase in frosty cost, gain in worker capacity and higher bargaining world power of the company. Similarly revenues are non-linear beca manipulation companies disc everyplace varying discounts to antithetic customers.Assumptions made in cost volume profit analysisUnit selling bell tolerates invariant. This implies that the charge of the product or service will not change as sales volume varies. In reality the slip is different as reduced selling prices are normally associated with change magnitude sales volume and this supports the supply-demand hypothesis which states that lowering of price will core in higher sales and vice-versa. It is a common practice in the business world to offer different discounts to different customers based on the volume of purchase and the strategic importance of sale. Companies offer tidy sum discounts to large customers. Managers often reduce prices as volume increases to attract more customers. excessively stiff competition representation selling product at discounts during hightail it periods or during festive eons. Bigger companies producing more than one product look at often more than one sales manager and they have their testify targets. Each sales manager would ad except his sales volume and price to maximize his products profits and this may not consequent in idealistic sales liquefy for the whole company. Hence the assumption of unending sales price is rarely applicable in todays fighting(a) world.The realistic sales-output recountingship is more uniform a curve than a straight line. And when a company is selling more than one product, the analysis of break-even point under multiple non-linear relationships becomes more difficult.The behavior of be is linear (straight line) over the relevant set up. This implies the following assumptionsCosts roll in the hay be categorise as bushel or variable. In a large fundamental law with multi-product it becomes very difficult to organize cost into fixed and variable. Not lonesome(prenominal) on that point are a large tot up of cost tangled but also in that location are a large result of cost drivers acting on those costs. Under such circumstances segregating costs into fixed and variable is a very tedious and succession down job.Unit variable costs are fixed and constant. It is possible that unit variable costs endure fixed under circumstances like where a company produces just one standard product. Most businesses esteem benefits of economics of scale as their production increases in terms of high trade discountsBetter credit and financing terms.The above benefits result in reduction of variable cost per unit with increase in number of units. The assumption of linear variable costs doesnt contrive accepted in reality and will result in a speckle where the relationship between variable cost and output is a non-linear relation (Williamson).Also when a company sells many products, unit variable costs cant be identified properly and hence not known. It is hard to classify variable cost to each product. As an example, a superstore sells thousands of products at different prices. Calculating break-even point in terms of number of units sold would be meaningless. In such scenarios, companies can use total sales and total variable costs to suppose variable costs as a percentage of total sales.Fixed costs remain fixed over a wide range of activity. Companies, based on their experience and studies, can analyse fixed cost over a range of activity. But it would be improper to assume that fixed costs would remain constant over a wide range of activity. In a multi-product company, different products will take different unit time of various production facilities. A change in sales mix may not be met by existing fixed message and involve setting up of further facilities resulting in higher fixed costs. Many times fixed cost has a musical note change and a particular fixed cost is applicable for a range of production only. Because of sudden change in fixed costs, unit costs can vary a lot just near the step change point. In case of multi product companies, because of change in sales mix, it becomes difficult to access which product has ca utilize the change in fixed costs.The susceptibility and productivity of the production process and workers remain constant. Under economics of scale, ability of production processes increases with increase in production of units. Higher production levels should result in lower variable cost due to higher productivity. This means that assumption of constant unit variable costs doesnt hold true when there is a change in productivity and efficiency. It is easier to calculate efficiency gains in a single product business. But for a company involved in mult iple products, it becomes difficult to track efficiency gains in each process.In multi-product organizations, the sales mix remains constant over the relevant range. It is hardly a scenario where all products perform as per budget expectations in terms of number of units sold. Lets graduation exercise examine the scenario where sales-output relationship is a straight line. If products have different piece percentages, change in sales mix would change overall portion. A change in sales mix is now basically a question of working out new contribution to sales balance which is a weighted average based on the number and contribution percentage of each product sold. Change in sales mix would change the contribution ratio and hence the break-even point.If now sales-output relationship is a non-linear one, it becomes much more difficult to calculate contribution percentage at different sales mix. The use of computer programming has made the lying-in of calculations much easier but mana gers can miss the learning by just focusing on overall break-even point and profits.Fearon (1960) reasoned that the problem of maintaining a constant product-mix in a multi-product company may not be that serious because of the following main pointsBreak-even analysis is not just to give exact resultant role, it is more to throw light on the problem regions for forethoughtBreak-even point should be used as approximation and as an area rather than a pointOver time, multi-product companies reach a static product mix which changes slowly. Hence constant product mix could be a good approximation for such scenarios andAlso if company uses constant margin over the cost for all products, then it is much simpler to use cost volume analysis. For companies adopting this pricing strategy, sales mix is not a complex issue.Ignores the time value of money. Cost volume profit analysis doesnt take into account the time value of money. All hard cash flows are interpreted at face value. In real world, there are differences in timing of cash inflows and outflows. Companies have to pay for buying stock, workers salary, marketing and distribution before they can realize sales. Companies pay beguile on any money borrowed to finance their working capital. Companies operating in high margin products can still manage to ignore the time value of money but companies with low-margin products have to take into account matter to charges.There is no change in inventory levels at the bloodline and end of the period. This is hardly the case as most of the companies have work in progress at the beginning and end of a period. It can be a coincidence that the inventory levels are same at the beginning and end, but very rarely a company would visualize inventory levels in such a way so that there is no net change in inventory during a period. The travail of managing inventory with multiple products is even more difficult.This is not a major(ip) issue as companies do stock taking at the end of a period for financial records. But the change in prices over the period and interest on working capital should be taken into account for proper cost volume profit calculations.Fearon (1960) suggested some techniques to hold in the product mix in a multi-product company for cost volume profit analysis. Though he suggested five different ways of adopting simple cost volume profit analysis in a multi-product company, he himself wasnt fully satisfied with any of those solutions. But he mentioned that the sales mix could be approximated to benefit from the cost volume profit analysis.With all its shortcomings and assumptions, cost volume profit analysis can be used to look at the advantageousness levels. Companies producing multiple products in todays dynamic world should carry on the analysis with a have to look at the results as an approximation and not the definite answer. charge should use the results to highlight problem areas.CONCLUSIONCost volume profit analysis is a co mmon tool used to find break-even point in terms of number of units sold. Assumptions used in cost volume profit analysis are debatable because of linearity of cost and sales price. In real world, both cost and sales price remain fixed only over a narrow range and are impacted by elements like improvement in worker efficiency, bulk discounts both in purchasing and being offered to clients and competition.When a company produces more than one product, a change in the relative proportion of quantities of different products changes the break-even point and profit. Because of the non-linearity and change in sales mix, cost volume profit analysis will not give a correct answer but could be a good approximation of what levels of production should a company target to break-even or to make certain level of profits. anxiety should use the analysis to look more at the problem areas and profitability of products rather than finding exact profit numbers.BIBLIOGRAPHYFearon, H. E. (1960). Consta nt product mix A limiting assumption in B-E analysis, National friendship of Accountants, NAA Bulletin, July 1960, Pg. 61Horngren, C.T., G.L. Sundem and W.O. Stratton. Introduction to management accounting. Prentice Hall International, 11th edition.Williamson, D. Cost Volume Profit Analysis Its assumptions and their pitfalls, (http//business.fortunecity.com/discount/29/cvpass.htm), fitting 21 January 2007