CVP Analysis: A New Look

Article excerpt

Cost Volume Profit analysis (CVP) is one of the most hallowed, and yet one of the simplest, analytical tools in management accounting. In a general sense, it provides a sweeping financial overview of the planning process (Horngren et al., 1994). That overview allows managers to examine the possible impacts of a wide range of strategic decisions. Those decisions can include such crucial areas as pricing policies, product mixes, market expansions or contractions, outsourcing contracts, idle plant usage, discretionary expense planning, and a variety of other important considerations in the planning process. Given the broad range of contexts in which CVP can be used, the basic simplicity of CVP is quite remarkable. Armed with just three inputs of data - sales price, variable cost per unit, and fixed costs - a managerial analyst can evaluate the effects of decisions that potentially alter the basic nature of a firm.

However, the simplicity of an analytical tool such as CVP can cut both ways. It can be both its greatest virtue and its major shortcoming. The real world is complicated, no less so in the world of managerial affairs; and a typical analytical model will remove many of those complications in order to preserve a sharp focus. That sharpening is usually achieved in two basic ways: simplifying assumptions are made about the basic nature of the model and restrictions are imposed on the scope of the model. Those simplifications and restrictions impinge on the reality and relevance of analytical models, so attempts to improve them will involve releasing some of their underlying assumptions or broadening their scope. In this article, we propose a variation of the CVP analytical model by broadening its scope to include cost of capital and the related impact of asset structure and risk level on strategic decisions, while at the same time preserving most of its admirable simplicity.

Our variation of the conventional CVP model provides more useful information to management because it focuses on more than operating expenses and sales revenues. Financial managers have long recognized the importance of including cost of capital and business risk variables in capital budgeting decisions (Brigham, 1995). Our model not only incorporates these admittedly important variables but recognizes the fixed and variable nature of capital costs.

Criticisms of CVP Analysis

Most criticisms of CVP relate to its basic underlying assumptions. Economists (Machlup, 1952; Vickers, 1960) have been particularly critical of those assumptions. Their criticisms take many forms, but they all arise from CVP's departures from the standard supply and demand models in price theory economics. Perhaps the most basic difference between CVP analysis and price theory models is that CVP ignores the curvilinear nature of total revenue and total cost schedules. In effect, it assumes that changes in volume have no effect on elasticity of demand or on the efficiency of production factors. Managerial accountants recognize these economic critiques, but they believe nonetheless that CVP analysis is a very useful initial analysis of strategic decisions (Horngren et al., 1994).

Additional criticisms of the underlying nature of CVP analysis arise from its similarities to standard economic models, rather than its differences. Similar to standard economic price theory models, basic CVP analysis usually assumes, among other things, the following: single-stage, single-product manufacturing processes; simple production functions with one causal variable; cost categories limited to only variable or fixed; and data and production functions susceptible to certainty predictions. Further, CVP analysis is typically restricted to one time period in each case. The shortcomings of CVP seem daunting, but CVP is pliable enough to overcome them all, if necessary and desirable. Nonlinear and stochastic CVP models involving multistage, multi-product, multivariate, or multi-period frameworks are all possible, although a single model embracing all of those extensions would seem a radical departure from the whole point of CVP analysis, its basic simplicity. …