Question

What assumptions are inherent in cost-volume-profit analysis? Since these assumptions are usually not wholly valid, why do managers still use the analysis in decision making?

Answer 1

Assumptions of CVP analysis:
1. Inventory level does not change from period to period
2. ‎Linear relationship within a relevant range
3. ‎Selling price is constant
4. ‎Costs are classified into variable or fixed

Though there are certain limitations, the CVP analysis is a very effective tool when used efficiently. These simplify the process of analyzing the effect of changes in activity level to costs and ultimately, to profit. CVP analysis provide information to aid managers in determining the break-even point and in setting short-term goals such as sales targets, profit objectives, production budgets, and pricing strategies. This is the reason why managers still use the analysis in decision making.