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Assumptions in Cost-Volume-Profit (CVP) Analysis

Certain underlying assumptions place definite limitations on the use of CVP analysis. Therefore, it is essential that anyone preparing CVP information should be aware of the underlying assumptions on which the information is to be derived. If these assumptions are not recognized, serious errors may result and incorrect conclusions may be drawn from the analysis.
Some of the key assumptions underlying cost-volume-profit analysis are as follows:

1. All costs can be classified as fixed and variable
while developing and applying cost-profit-analysis including the break-even analysis, it is assumed that all costs can be classified into fixed and variable costs. In fact, it is difficult to identify each and every cost element as fixed and variable. In the traditional type of recording costs, it is very difficult to segregate costs into fixed and variable. Moreover, the flexible policy of the company also makes it more difficult to identify the cost as fixed and variable.
If anyone fails to identify the cost as fixed and variable, the application of cost-volume-profit analysis becomes almost impossible.

2. Behavior or costs will be linear within the relevant range
Cost-volume-profit (CVP) analysis assumes that total fixed costs do not change in the short-run within the relevant range. Total variable costs are exactly proportionate to sales volume. But in reality, cost behavior may not remain constant.

3. Difficulty of steps fixed costs
Relevant range for many costs is very short. In that case it becomes very uncomfortable to compute the required volume because it is difficult to say that which the relevant range for our needed volume is.

4. Selling price remains constant for any volume
Indeed, most often quantity discount is offered for different lots of purchase. This causes difficulty in determining the contribution margin per unit(CMPU) and contribution margin ratio.

5. There is no significant change in the size of inventory
Application of cost-volume-profit (CVP) analysis is possible only under following two situations:
* Either the company should follow variable costing for the inventoriable product cost.
* Or all the production volume should be sold within the same period.

6. Cost-volume-profit (CVP) analysis applies only to a short-term time horizon
CVP analysis is a short term planning tool, because nothing remains stable in the long-run. In the condition of changing variables, all equations of CVP analysis need readjustment of figures.

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