Question

Critics of CVP analysis claim that the assumptions underlying the analysis are almost certain to be violated in practice, thus severely limiting the practical value of the various techniques covered in this chapter. Moreover, say the critics, in the highly competitive environment in which many companies operate, the assumptions necessary for CVP analysis are even more likely to be violated. Arguably, companies that face stiff competition and thus could benefit most from CVP analysis may be the least likely to be able to use the techniques because of the restrictive assumptions.

Required:

Do you agree with the claims made by the critics of CVP analysis regarding its limited value in practice? Why or why not?

(Please write another answer than the one that is already used on another post. Thank you)

Answer 1

CVP analysis is the analysis of cost, volume and profit of the firm. It helps in evaluating profitability of the firm by understanding relationship between the cost incurred, volume and the profit. This analysis works with assumption like cost can be classified into variable and fixed, linear relationship of costs, variability of cost with volumes, fixed selling price, No inventory , etc

However there is strong criticism of the CVP analysis in today’s world regarding the assumptions used in analysis. For example: The basic assumption of cvp is that costs can be classified into variable and fixed. In today’s world’s all costs cannot be classified into variable or fixed. For instance, labor cost which is treated as variable cost in cvp is a fixed cost during the COVID 19 pandemic. Another assumption is that costs are linked to the volume whereas the real driving factor of the cost can be different than volume. In the current crisis period where volume is very low or negligible a lot of variable costs have become fixed cost since it is not driven by volume but cost is getting incurred. Hence the criticism against CVP is agreeable given the situation.

Another example:

CVP analysis assumes the selling price of the product is fixed however during uncertain times the companies take decision to liquidate the stock given that it is part of working capital and has financing cost. Hence companies tend to ignore the assumptions of cvp analysis and take decision based on business need of the hour.

However, CVP as a managerial technique cannot be totally disregarded in the practice. It is one of the techniques that should be used by managers in evaluation of alternatives since it helps in developing analytics around the cost and profitablity