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). Another assumption is that fixed costs will not change at all levels of sales within the assumed relevant range of activity. 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.
Assumptions and Limitations Underlying CVP Analysis FAQs
The main assumptions that accountants make when using cvp analysis are that fixed costs will not change within the relevant range of activity, all costs can be classified into fixed and variable, the selling price per unit will stay constant, and fixed costs remain constant.
A semi-variable cost is a mixed cost because part of the cost is fixed and part is variable (for example, telephone expenses).
The limitations of cvp analysis are its assumptions. This means that it is assumed that the selling price per unit remains constant, variable costs vary in direct proportion to changes in activity, the projections cover only a short period, and the sales mix will remain constant if more than one product is sold.
The selling price per unit assumption means that any changes in activity will not affect selling prices within the relevant range of activity.
The assumptions when the sales mix is assumed to stay constant are that all products of a company will be treated equally, selling prices do not change with changes in product mix, and total variable costs remain constant.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, 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.
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