Assumptions and Limitations Underlying CVP Analysis
The assumptions that accountants impose when calculating CVP ratios are sources of possible limitations of the technique. Most CVP analyses are based on the static cost concept.
One assumption is that all costs can be classified into two categories: fixed costs and variable costs. This assumption is not always true because certain costs (e.g., depreciation) cannot be determined exactly. Different depreciation methods may yield different results.
There is also a third category of costs known as semi-variable costs. These costs are also called mixed costs because part of the cost is fixed and part is variable (for example, telephone expenses).
Other assumptions are that selling price per unit remains constant and that variable costs vary in direct proportion to changes in activity (i.e., as a percentage of sales revenue). In the second case, they remain constant.
Additionally, the sales mix is assumed to remain constant if more than one product is sold. Furthermore, the projections are over a short period only.
The limitations and assumptions of CVP analysis mentioned above impair but do not destroy the usefulness of the technique for managers. As such, CVP analysis still serves as a useful profit planning tool.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.