 State four underlying assumptions for cost-volume-profit analysis

CVP analysis is used to determine how changes in costs and volume affect a
company’s operating income and net income. Certain underlying assumptions
place definite limitations on the use of CVP analysis. Therefore, it is essential
that anyone preparing CVP information should be aware of the underlying
assumptions on which the information is to be derived. CVP analysis requires
that all the company’s costs, including manufacturing, selling, and administrative
costs, be identified as variable or fixed. If these assumptions are not recognized,
serious errors may result and incorrect conclusions may be drawn from the
analysis. A cost volume profit definition, defined also as the CVP model, is a
financial model that shows how changes in sales volume, prices, and costs will
affect profits. These components are vital to determining the success of a
company through profit margins.

Some of the key assumptions underlying the cost-volume-profit analysis are as

follows:

(1) All costs can be classified as fixed and variable

All costs are presumed to be classified as either variable or fixed. While

developing and applying cost-profit-analysis including the break-even analysis, it
is assumed that all costs can be classified into fixed and variable costs.  In the
real business environment, however, costs behave differently. In fact, it is difficult
to identify each and every cost element as fixed and variable. If anyone fails to
identify the cost as fixed and variable, the application of cost-volume-profit
analysis becomes almost impossible.

(2) Behavior or costs will be linear within the relevant range

Cost-volume-profit (CVP) analysis assumes that total fixed costs do not change
in the short-run within the relevant range. Cost and revenue relationships are
linear within a relevant range of activity and over a specified period of time. Total
variable costs are exactly proportionate to sales volume. But in reality, cost
behavior may not remain constant.

(3) The difficulty of steps fixed costs

The relevant range for many costs is very short. If prices, unit costs, sales-mix,
operating efficiency, or other relevant factors change, then the overall CVP
analysis and relationships also must be modified. In that case, it becomes very
uncomfortable to compute the required volume because it is difficult to say that
which the relevant range for our needed volume is.
(4) Selling price remains constant for any volume

The selling price and market conditions are constant. Indeed, most often quantity
discount is offered for different lots of purchase. Also, if the business produces
and sells multiple products, the sales mix is assumed constant. This causes
difficulty in determining the contribution margin per unit(CMPU) and contribution
margin ratio.

(5) There is no significant change in the size of the inventory

Application of cost-volume-profit (CVP) analysis is possible only under the

following two situations:

 Either the company should follow variable costing for the inventoriable product
cost.
 Or all the production volumes should be sold within the same period.

(6) Cost-volume-profit (CVP) analysis applies only to a short-term time

horizon

CVP analysis is a short term planning tool because nothing remains stable in the
long-run. When circumstances change, CVP analysis should also be revised to
reflect the changing situations.  In the condition of changing variables, all
equations of CVP analysis need a readjustment of figures.

Stepped fixed costs

A step fixed cost is a cost that does not change within certain high and low thresholds of
activity, but which will change when these thresholds are breached.

What is a Semi-Variable Cost?

A semi-variable cost, also known as a semi-fixed cost or a mixed cost, is a cost
composed of a mixture of both fixed and variable components. Costs are fixed for
a set level of production or consumption, and become variable after this
production level is exceeded. If no production occurs, a fixed cost is often still
incurred.

CMR:
The contribution margin ratio is the difference between a company’s sales and variable costs, expressed
as a percentage.  

In your own words explain what Break-even analysis means, and why it is
important to a business.

Break-even analysis is a business tool widely used across all industries to evaluate

business performance in terms of costs, since this is a supply-side analysis. Break-even
analysis is an important aspect of a good business plan, since it helps the business
determine the cost structures, and the number of units that need to be sold in order to
cover the cost or make a profit. Break-even analysis is usually done as part of a
business plan to see the how practical the business idea is, and whether or not it is
worth pursuing. Even after a business has been set-up, break-even analysis can be
immensely helpful in the pricing and promotion process, along with cost control.

Simply put, break-even point can be determined by calculating the point at which
revenue received equals the total costs associated with the production of the goods or
services.

Importance of Break-Even Analysis

 Manages the size of units to be sold: With the help of break-even analysis, the company
or the owner comes to know how many units need to be sold to cover the cost. The variable
cost and the selling price of an individual product and the total cost are required to evaluate
the break-even analysis.
 Budgeting and setting targets: Since the company or the owner knows at which point a
company can break-even, it is easy for them to fix a goal and set a budget for the firm
accordingly. This analysis can also be practised in establishing a realistic target for a
company.
 Manage the margin of safety: In a financial breakdown, the sales of a company tend to
decrease. The break-even analysis helps the company to decide the least number of sales
required to make profits. With the margin of safety reports, the management can execute a
high business decision.
 Monitors and controls cost: Companies’ profit margin can be affected by the fixed and
variable cost. Therefore, with break-even analysis, the management can detect if any effects
are changing the cost.
 Helps to design pricing strategy: The break-even point can be affected if there is any
change in the pricing of a product. For example, if the selling price is raised, then the
quantity of the product to be sold to break-even will be reduced. Similarly, if the selling price
is reduced, then a company needs to sell extra to break-even.

What Is an Irrelevant Cost?

Irrelevant costs are costs, either positive or negative, that would not be affected
by a management decision. Irrelevant costs, such as fixed overhead and sunk
costs, are therefore ignored when that decision is made. However, it’s critical for
a manager to be able to distinguish an irrelevant cost in order to potentially save
the business.

Relevant cost is a managerial accounting term that describes avoidable costs that are

incurred only when making specific business decisions. The concept of relevant
cost is used to eliminate unnecessary data that could complicate the decision-making
process.

 What is meant by a limiting factor (scare resource). Give two common

examples.

Before we talk about the analysis itself, let us understand what limiting factors are.
Limiting factors are required scarce resources that can restrain an organization from
making maximum profits by affecting production outputs.
They are the inputs that determine the limits in the quantity and quality of the products.
Such factors may include a shortage of materials, machine capacity, labor, financial
capital, etc.
The aim of the analysis is simple – to maximize profit in the end. As such, it entails
careful consideration of the limiting factors and their effects on each unit of production.
When you conduct the analysis, you get a clearer picture of each product’s contribution
per unit resource used. This will enable you to place greater priority on products with a
higher contribution per unit.
You can guess what the result is- more profit and the utilization of scarce resources more
effectively.
Since limiting factor analysis is conducted on a short term basis, variable costs, rather
than fixed costs, are the only relevant costs to the decision making process.
Can There Be More Than One Limiting Factor at a
Time?
Yes, your business can encounter more than one limiting factor for a given production.
For instance, there might be a shortage of labor as well as limited machine power.
Also, one limiting factor can eventually lead to another. For example, insufficient
production capital may lead to the inability to purchase enough raw materials.
This may, in turn, lead to producing a product below the standard demands in
quantity.

problem.
How Do You Find a Limiting Factor?
When there is more than one product utilizing a resource, you need a good
production plan to stay on course for profit.
 For such an effective production plan, you can follow these simple steps.
 Point out the limiting factor
 Find out the units of the resource required for each product.
 Find the per-unit contribution of each product (relative to the resource in
question). You can calculate this by subtracting the variable costs from sales.
 Rank the products in decreasing order of contribution per unit of the vital
resource.
 Use the ranking as your guide for the allocation of the said resource.
Advantages of Limiting Factor Analysis
Some advantages of limiting factor analysis are as follows;
 A proper analysis of limiting factors will give you an insight into the
implications of those factors in your business production.
 It arms you with the right details on how each product utilizes the allocated
scarce resources.
 Without this crucial knowledge, you risk channeling your energy and efforts
to less essential products.

Why is it important for an entity to determine the costs incurred and how
these costs behave?

Cost Behaviour – Importance

Following points highlight the importance of cost behavior:

 A manager needs to understand the behavior of the costs when

creating an annual budget. Knowing this allows the manager to
determine beforehand if any cost will decline or rise with the
change in the business activity. For example, if a company is
operating at the full production capacity, then to fulfill more
demand, the company will have to invest more in the production
line.
 Understanding cost behavior is essential for cost-volume-profit
analysis as well. The cost-volume-profit (CVP) analysis studies
the impact of change in costs and volume on the profit.
 It helps the management in planning and controlling costs.
  What purpose/purposes is this cost information used?
   The cost information is used for two purposes in most organizations: 1) the
cost accounting systems provide information to evaluate the performance of
an organizational unit or his manager, and 2) also provide the means for
estimating the unit cost of products or services that the organization can
manufacture or provide to others.

a) Performance measurement. This measurement can be done by comparing

current costs with those who were expected - or standard costs budgeted
cost - to the degree of knowing which of them have been controlled.
Deviations of expected with the current - variances - can be identified,
evaluated and discussed by managers.
b) Cost of goods and services. In manufacturing companies, the costs of goods
must be measured to determine the cost of items transferred from work in
process inventory to finished products. To meet the demands for information,
a cost system should measure all the costs of manufacturing process and
allocate a portion of those costs to each unit of output. The costs to obtain,
maintain and manage the manufacturing plant or building should be added to
the cost of material and productive work that requires each unit. The first are
called indirect costs and the two last are called direct costs.

c) Profit analysis. Information in costs is essential to analyse the profits obtained from

a product or product line. The information on the cost of a product enables managers
to assess the contribution margin - the difference between the price and variable
costs - and the gross margin - the difference between the price and the total cost of the
product.

d) Product mix. For the companies that offer more than one product or service the cost
information is key to handle the mix of products or services offered to
customers. With information on cost-profit, a manager can lead the effort in sales and
advertising for products that generate greater value. The products that do not create
any profit can be removed, have a price reassignation, or tied up with products that
have greater utility.

e) Price assignation. Regardless of where prices are determined by the forces of

market demand, product differentiation and advertising offer to many managers some
sort of idea to assign prices to products or services. The costs of products and trends
commonly offer signals to managers that prices should be changed. An example could
be the change in the cost of a material or critical component which can give a signal to
reassess the price of a product or service.

f) Cost of service. Many products require the seller to provide additional services to

customers. In such cases, the information about the cost of service is so important for
managers as the cost of production. The same for companies that offer services only,
unless the cost of service is measured, there is no way to know whether providing the
service is profitable or not, or whether changes in prices or advertising are needed.

Looked from another angle, the uses that the administration of a company can give to
the costs can be grouped into 4 categories, specified

 why do companies calculate predetermined overhead rates

Most companies will adopt the use of predetermined overhead rates in order to know

how their products are performing even before the accounting period ends. It is a way to
constantly evaluate the profitability of manufacturing instead of waiting until that
reporting period comes to an end.

The primary advantage of a predetermined overhead rate is to smooth out seasonal

variations in overhead costs. These variations are to a large extent caused by heating
and cooling costs, which, while high in the summer and winter months, are relatively
low in the spring and fall.