Break Even Analysis:

Assumptions and Terminology
Following are the assumptions on which the theory of CVP is based:
1. The changes in the level of various revenue and costs arise only because of the changes in the number of product (or service) units produced and sold, e.g., the number of television sets produced and sold by Sigma Corporation. The number of output (units) to be sold is the only revenue and cost driver. Just as a cost driver is any factor that affects costs, a revenue driver is any factor that affects revenue.
2. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output. Variable costs include the following:
o Direct materials
o Direct labor
o Direct chargeable expenses
Variable overheads include the following:
o Variable part of factory overheads
o Administration overheads
o Selling and distribution overheads
3. There is linear relationship between revenue and cost.
4. When put in a graph, the behavior of total revenue and cost is linear (straight line), i.e. Y = mx + C holds good which is the equation of a straight line.
5. The unit selling price, unit variable costs and fixed costs are constant.
6. The theory of CVP is based upon the production of a single product. However, of late, management accountants are functioning to give a theoretical and a practical approach to multi-product CVP analysis.
7. The analysis either covers a single product or assumes that the sales mix sold in case of multiple products will remain constant as the level of total units sold changes.
8. All revenue and cost can be added and compared without taking into account the time value of money.
9. The theory of CVP is based on the technology that remains constant.
10. The theory of price elasticity is not taken into consideration.
Many companies, and divisions and sub-divisions of companies in industries such as airlines, automobiles, chemicals, plastics and semiconductors have found the simple CVP relationships to be helpful in the following areas:
· Strategic and long-range planning decisions
· Decisions about product features and pricing
In real world, simple assumptions described above may not hold good. The theory of CVP can be tailored for individual industries depending upon the nature and peculiarities of the same.
For example, predicting total revenue and total cost may require multiple revenue drivers and multiple cost drivers. Some of the multiple revenue drivers are as follows:
· Number of output units
· Number of customer visits made for sales
· Number of advertisements placed
Some of the multiple cost drivers are as follows:
· Number of units produced
· Number of batches in which units are produced
Managers and management accountants, however, should always assess whether the simplified CVP relationships generate sufficiently accurate information for predictions of how total revenue and total cost would behave. However, one may come across different complex situations to which the theory of CVP would rightly be applicable in order to help managers to take appropriate decisions under different situations.
Limitations of Cost-Volume Profit Analysis Assumptions and Terminology
Following are the assumptions on which the theory of CVP is based:
1. The changes in the level of various revenue and costs arise only because of the changes in the number of product (or service) units produced and sold, e.g., the number of television sets produced and sold by Sigma Corporation. The number of output (units) to be sold is the only revenue and cost driver. Just as a cost driver is any factor that affects costs, a revenue driver is any factor that affects revenue.
2. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output. Variable costs include the following:
o Direct materials
o Direct labor
o Direct chargeable expenses
Variable overheads include the following:
o Variable part of factory overheads
o Administration overheads
o Selling and distribution overheads
3. There is linear relationship between revenue and cost.
4. When put in a graph, the behavior of total revenue and cost is linear (straight line), i.e. Y = mx + C holds good which is the equation of a straight line.
5. The unit selling price, unit variable costs and fixed costs are constant.
6. The theory of CVP is based upon the production of a single product. However, of late, management accountants are functioning to give a theoretical and a practical approach to multi-product CVP analysis.
7. The analysis either covers a single product or assumes that the sales mix sold in case of multiple products will remain constant as the level of total units sold changes.
8. All revenue and cost can be added and compared without taking into account the time value of money.
9. The theory of CVP is based on the technology that remains constant.
10. The theory of price elasticity is not taken into consideration.
Many companies, and divisions and sub-divisions of companies in industries such as airlines, automobiles, chemicals, plastics and semiconductors have found the simple CVP relationships to be helpful in the following areas:
· Strategic and long-range planning decisions
· Decisions about product features and pricing
In real world, simple assumptions described above may not hold good. The theory of CVP can be tailored for individual industries depending upon the nature and peculiarities of the same.
For example, predicting total revenue and total cost may require multiple revenue drivers and multiple cost drivers. Some of the multiple revenue drivers are as follows:
· Number of output units
· Number of customer visits made for sales
· Number of advertisements placed
Some of the multiple cost drivers are as follows:
· Number of units produced
· Number of batches in which units are produced
Managers and management accountants, however, should always assess whether the simplified CVP relationships generate sufficiently accurate information for predictions of how total revenue and total cost would behave. However, one may come across different complex situations to which the theory of CVP would rightly be applicable in order to help managers to take appropriate decisions under different situations.
Limitations of Cost-Volume Profit Analysis
The CVP analysis is generally made under certain limitations and with certain assumed conditions, some of which may not occur in practice. Following are the main limitations and assumptions in the cost-volume-profit analysis:
1. It is assumed that the production facilities anticipated for the purpose of cost-volume-profit analysis do not undergo any change. Such analysis gives misleading results if expansion or reduction of capacity takes place.
2. In case where a variety of products with varying margins of profit are manufactured, it is difficult to forecast with reasonable accuracy the volume of sales mix which would optimize the profit.
3. The analysis will be correct only if input price and selling price remain fairly constant which in reality is difficulty to find. Thus, if a cost reduction program is undertaken or selling price is changed, the relationship between cost and profit will not be accurately depicted.
4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and completely variable at all levels of activity and fixed cost remains constant throughout the range of volume being considered. However, such situations may not arise in practical situations.
5. It is assumed that the changes in opening and closing inventories are not significant, though sometimes they may be significant.
6. Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing stock carried over to the next financial year does not contain any component of fixed cost. Inventory should be valued at full cost in reality.
Sensitivity Analysis or What If Analysis and Uncertainty
Sensitivity analysis is relatively a new term in management accounting. It is a “what if” technique that managers use to examine how a result will change if the original predicted data are not achieved or if an underlying assumption changes.
In the context of CVP analysis, sensitivity analysis answers the following questions:
a. What will be the operating income if units sold decrease by 15% from original prediction?
b. What will be the operating income if variable cost per unit increases by 20%?
The sensitivity of operating income to various possible outcomes broadens the perspective of management regarding what might actually occur before making cost commitments.
A spreadsheet can be used to conduct CVP-based sensitivity analysis in a systematic and efficient way. With the help of a spreadsheet, this analysis can be easily conducted to examine the effect and interaction of changes in selling prices, variable cost per unit, fixed costs and target operating incomes.
The CVP analysis is generally made under certain limitations and with certain assumed conditions, some of which may not occur in practice. Following are the main limitations and assumptions in the cost-volume-profit analysis:
1. It is assumed that the production facilities anticipated for the purpose of cost-volume-profit analysis do not undergo any change. Such analysis gives misleading results if expansion or reduction of capacity takes place.
2. In case where a variety of products with varying margins of profit are manufactured, it is difficult to forecast with reasonable accuracy the volume of sales mix which would optimize the profit.
3. The analysis will be correct only if input price and selling price remain fairly constant which in reality is difficulty to find. Thus, if a cost reduction program is undertaken or selling price is changed, the relationship between cost and profit will not be accurately depicted.
4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and completely variable at all levels of activity and fixed cost remains constant throughout the range of volume being considered. However, such situations may not arise in practical situations.
5. It is assumed that the changes in opening and closing inventories are not significant, though sometimes they may be significant.
6. Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing stock carried over to the next financial year does not contain any component of fixed cost. Inventory should be valued at full cost in reality.
Sensitivity Analysis or What If Analysis and Uncertainty
Sensitivity analysis is relatively a new term in management accounting. It is a “what if” technique that managers use to examine how a result will change if the original predicted data are not achieved or if an underlying assumption changes.
In the context of CVP analysis, sensitivity analysis answers the following questions:
a. What will be the operating income if units sold decrease by 15% from original prediction?
b. What will be the operating income if variable cost per unit increases by 20%?
The sensitivity of operating income to various possible outcomes broadens the perspective of management regarding what might actually occur before making cost commitments.
A spreadsheet can be used to conduct CVP-based sensitivity analysis in a systematic and efficient way. With the help of a spreadsheet, this analysis can be easily conducted to examine the effect and interaction of changes in selling prices, variable cost per unit, fixed costs and target operating incomes.