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In any business it is very obvious for questions like, what effect on profit can it expect if it produces more products? What quantity of products and services must a business sell in order to break even for the year? What happens to the breakeven point of the business if it decides to add or increase the quantity of a product or services they currently offer? to arise. The analytical technique that helps the managerial accountants to address these questions is called Cost Volume profit analysis. (Tata McGraw-Hill, 2008 p.298). It provides with vital information about the effect of revenue raised and the cost incurred within a certain business. CVP analysis can also be used to analyse the effect on profit due to changes in prices, costs, tax, interests and the mix of product sold by the organisation. (Tata McGraw-Hill, 2008 p.298).
CVP analysis is used by the managers in day to day basis in order to run the business smoothly. Correct use of this can lead to a detailed understanding of what actions should and can be taken in order to save the business from facing any loss, and make profit or at least break even. CVP analysis is a helpful tool for the management but it also suffers with some limitations. It provides the management with the insight of the current position of the business and also reflects any potential problems the company could face in a short run. CVP graph directs management’s attention to this situation but is not able to provide a solution to any potential problem within the business. (Tata McGraw-Hill, 2008 p.303).
Many assumptions should be made in order to produce a CVP analysis such as, keeping the total revenue linear which means the price or product or service will not change as sales changes, keeping total expense linear which means the total fixed and the unit variable expense remains unchanged as activity varies, the efficiency and productivity remains constant and the sales mix in a multi products company remains constant. (Tata McGraw-Hill, 2008 p.314). All these assumptions are very much necessary in order to produce a CVP analysis but they are not necessarily constants in a day to day business. If by any reasons the sales mix changes in the business than a new CVP analysis should be made for this new sales mix. CVP analysis provides the management of any organisation with vital information that it requires for day to day operation but also has some limitations.
Tata McGraw-Hill (2008) Managerial Accounting: Creating Value in a Dynamic Business Environment. New Delhi, Tata McGraw-Hill Publishing Company Limited.