Key Assumptions in Cost-Volume-Profit Analysis and Their Impact on Results
Cost-volume-profit analysis (CVP) helps one understand the relationship between cost, volume, and profit. Key assumptions that CVP analysis relies on include fixed selling price, fixed costs, and static market conditions. A constant selling price implies that it remains the same regardless of changes in market conditions (Miller-Nobles & Mattison, 2020). If the sale price changes, it will affect the contribution margin per unit, affecting the break-even point. T
he same applies to production costs, changes that lead to a change in the cost of a unit of production and, as a result, affect the contribution margin and break-even points. In addition, CVP assumes that the business is operating in a stable market environment (Miller-Nobles & Mattison, 2020). However, any changes in the market, such as increased demand or competition, lead to changes in how companies operate, making results less accurate.
Understanding Variable, Mixed, and Fixed Costs with Examples
Variable costs are company costs that change with changes in production or the level of activity (Miller-Nobles & Mattison, 2020). These types of expenses include the cost of materials or labor, which grow in direct proportion to the increase in the volume of work. Fixed costs remain the same regardless of the company’s activities, such as the cost of rent or salaries of managers (Miller-Nobles & Mattison, 2020). Mixed costs consist of both fixed and variable elements, which include costs such as paying electricity bills, employee benefits, telecommunications expenses, and different charges.
Using Sensitivity Analysis to Predict Profits and Guide Managerial Decisions
A manager can use sensitivity analysis to predict profits and make essential business decisions during the launch of a new company product. Sensitivity analysis will help determine the cost-effectiveness of changes and profitability for the business. In addition, through this approach, the manager can identify potential risks and opportunities (Miller-Nobles & Mattison, 2020).
To do this, the manager needs to determine the key variables, including the selling price, the cost of production, and the expected sales volume. In addition, based on this data, it is possible to determine the optimal cost of a new product and cost optimization opportunities and set a break-even point (Miller-Nobles & Mattison, 2020). Thus, sensitivity analysis is necessary in case of significant changes in business activities.
Reference
Miller-Nobles, T., & Mattison, B. (2020). Horngren’s Financial & Managerial Accounting: The Managerial Chapters (7th ed.). Pearson.