Limitations of Linear Cost VolumeProfit Analysis

Cost-volume-profit analysis helps explain relations among volume, prices, and costs. It is also useful for pricing, cost control, and other financial decisions. However, linear cost-volume-profit analysis has its limitations.

Linear cost-volume-profit analysis has a weakness in what it implies about sales possibilities for the firm. Linear cost-volume-profit charts are based on constant selling prices. To study profit possibilities with different prices, a whole series of charts is necessary, with one chart for each price. With sophisticated spreadsheet software, the creation of a wide variety of cost-volume-profit charts is relatively easy. Using such software, profit possibilities for different pricing strategies can be quickly determined. Alternatively, nonlinear cost-volume-profit analysis can be used to show the effects of changing prices.

Linear cost-volume-profit analysis can be hampered by the underlying assumption of constant average costs. As unit sales increase, existing plant and equipment can be worked beyond capacity, thus reducing efficiency. The need for additional workers, longer work periods, and overtime wages can also cause variable costs to rise sharply. If additional plant and equipment is required, fixed costs will also rise. Such changes influence both the level and the slope of cost functions.

Although linear cost-volume-profit analysis has proven useful for managerial decision making, care must be taken to ensure that it is not applied when underlying assumptions are violated. Like any decision tool, cost-volume-profit analysis must be used with discretion.

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