According to Jon Scheumann “a successful organizations need a culture that is attuned to cost management and pay attention to cost structure” From that statement manager must pay attention and carefully thinking when do decision making to the cost. For example when manager want to target the profit. They must take every cost that related in production such as variable cost and fix costs. Cost Volume profit analysis is used in decisions making in a company.
The reasons why used cost volume profit analysis as a method to make decisions making because it helps manager to estimate future cost, revenue, expenses and profit that helps them to monitor the level of activity in production and monitor the plan. Besides that when used CVP analysis we can identify monitor the activity level and make analysis to avoid loss, find a target profit and maximize the production of unit. Moreover CVP analysis can help manager to identify the risk and effect for their decision making and a technique to analyse the profit change bases on sales volumes, costs, and process.
When do CVP analysis the manager can get the information like the product that want to analyse the volume is required to achieve a certain level of profit total of revenue is needed before the company will incurred loss(break event point) Those fix cost can effects the organization to an unacceptable level of risk. a) A break – even analysis must be interpreted in the light of the limitations of its underlying assumption … (From Cost Accounting: A managerial Emphasis, by C. T. Horngren).
Introduction to Assumption
What is assumption? Assumption is something like a rule is must be made or a certain item be ignore when do assumption in CVP analysis. Why need to do assumption in CVP analysis? There is a limitation of CVP analysis. The effectiveness of CVP analysis must be done with assumption in order to make CVP analysis is useful when the manager do decision making for the future plan. How to make the assumption?
It to simplify the cost that hard to calculate and that cost behaviour is always changes. So when do the assumption we can solve it faster at any of period of times and situations. In order to make assumption we must to understand that every assumption is made that no has too much cost, long period, break a law and company policies. Normally when did the new assumption people hard to accept and need time to convince them.
After we done with assumption for CVP analysis, we should listing all assumption to make other analysis. If assumption is made is violating, the CVP analysis is can easily modified and make it realistic. What use of assumption? To simplify a complex analysis more easily and to set up some condition and control it when do an analysis. Sometime when we do assume there a risk we must to be taken and face it like hidden cost, increasing in petrol cost and tax.
To used assumption in CVP analysis the manager must recognize the cost first. For example when do CVP analysis, we must identify sales volume, cost, and profit. So when identify the cost there are condition must be made to make the assumption 1. All cost included variable and fixed cost Why we assume that variable cost and fixed cost included all cost? Because in the firm, we are cannot identify each type element of cost. Besides that firm cannot identify which element of cost should be fixed or variable cost.
If the firm cannot identify Fixed and variable cost, it impossible to used cost volume profit analysis. For example if the firm cannot identify fix and variable cost there will be a problem when do CVP analysis. There are a way how to identify which costs are fixed and variable cost. Every cost that related in production and always changes base on the volume of the unit produce is variable cost. Example cost of material and labour to produce item in production. For fix cost is the cost that not affected when level of activity in production is changing.
Example is rent and manager salary. So when the firm done correctly to identify fixed and variable cost, it can do CVP analysis correctly and manager can used the correct CVP analysis to make decision making. 2. In graph Cost are in straight line Assume that fixed cost no change in any of range. Variable Cost is proportional and parallel to the line revenue. So in the reality cost of behaviour not remain constant. It mean when we do CVP analysis we must assume a straight line (constants) so when do a calculation it easy to calculate the cost and make analysis.
For example if we see in graph the cost is curve line it hard to calculate the cost if the cost is out of range from the graph. So that why we must assume in straight line so it easy to calculate and identify the cost even it out of range in graph. 3. Price is fixed for every volume was purchase/selling ( selling price/direct material) When buy a lot of item, item we buy was offering/make a discount. These make a problem to determine contribution margin ratio. Example normally when we buy/sell a lot of item we can receive/give discount. Event we know that it hard to calculate when price always changes base on the quantity item of we buy/sell.
So in order to make easy calculation we must make assumption fixed price every volume was purchase and selling and ignore the cost that give effect the change in price and volume. 4. Variable cost is fix per unit not calculated based on volume produce So when it calculated per unit it hard to identify what actual cost and hidden cost of total volume produce. Even cannot identify actual and hidden cost help when do CVP analysis. If we calculate variable cost base on volume produce we can get difference cost because of hidden cost. That why we must use variable cost fix as per unit so we can used to calculate in CVP analysis.
For example if we cannot used this assumption it hard to identify unit control margin ( ucm ) so if cannot identify unit control margin it hard to find Break Even Point (BEP). 5. Sales Mix constant In level of activity, if product y have different level of activity compare to product z. So in graph it can show two product y and product z. From the graph we can see which products give higher profitability or not. If company produce a excess from the target in will incurred loss. For example company manufacture umbrella and rain coat for raining seasons. So it produced more products during that season.
Limitation of CVP analysis
Cost volume profit analysis is limit to acquire a lot of information. Event cost volume profit can help decision making in future for the short run but in Long run it cannot be used because of the information that get is not up to date and always change from time to time. So manager need to do again analysis in order to get up to date information. Besides that, Cost volume profit is only suitable for a single product when manager used CVP analysis to make decision making.
For multi products such as Mc Donald or KFC that run more than one product. It is cannot be used because every type of product did not have same level of activity. So that why when there have two or more product it assumes has same activity. Beside that hard to make variable ratio cost for every product. Moreover, It is hard to identify what element or type of cost that relate. If the manager cannot identify what type of product it make impossible to used Cost Volume Profit Analysis.
For example part time worker should assume as variable cost or fix cost. Beside that Cost Volume Profit cannot identify the performance of worker. So that why performance worker were assume as fixed when we know in reality the performance of worker always change. In addition, cost volume profit cannot identify the hidden cost when produce more product in future or the changes of currency money and company or government policy. For example hidden cost like increasing petrol cost, tax, or maintenance machine.
Cost Volume Profit (CVP) Analysis is an important part of short term decision making in a business. Although CVP analysis is cannot get all information need but it help manager to make fast decision making. Event we know that there are many limitation and assumption must be make when do the decision making. The contribution margin is central to CVP Analysis. It is also the basis for determination of the break even point in a business.