Cost Volume Profit Part2

ACCA F2 - Management Accounting

Here, we start with the basic assumptions underpinning CVP analysis. I will just mark the points. For detailed explained article visit "Cost Volume Profit (CVP) analysis". The assumptions are:

Ø  All variables remain constant except volume

Ø  Only one product is being produced or there is a constant sales mix

Ø  Total cost and total revenue are linear functions

Ø  Profits are calculated using variable costing (i.e. marginal costing)

Ø  Costs can be accurately divided into their fixed and variable elements

Ø  The analysis applies only to the relevant range

Ø  The analysis applies only to a short term horizon

Not all assumptions hold accurately in practice. An easily understandable example is presented in CIMA article.

Check paragraph 4 "…….The cost of the gas used for cooking is more problematical. Although the number of baguettes sold will affect gas usage, it's highly unlikely that the gas will be turned on and off each time a baguette is produced, since that would be an inefficient way to operate. So, while the gas is not fixed cost, it should be treated as such for this analysis because it's more fixed than variable in nature…….."

For changing environment underpinning assumption I recommend you to visit CPA Ireland article page 1.

Target profit: Firms like to know the profit position for the period before they proceed with any project/activities. This is known as target profit. Under CPV analysis substituting (target profit + fixed cost) to fixed cost in break-even formula will give target sales unit/total revenue.

Margin of safety: Uncertainty exists in projected target. Therefore, once target are set for project/activities, firms need to calculate margin of safety. It is the amount fall in sales/sales unit from the target or budget to keep the firm in break even and is often expressed in percentage. Simply, it means (Target or budgeted -Breakeven)/Target.

CIMA Article: Management Accounting Fundamental - CVP analysis

CPA Ireland Article: Cost Volume Profit (CVP) analysis