a). Name five assumptions that underline the use of break – even analysis. It is essential that anyone preparing or interpreting CVP information is aware of the underlying assumptions on which the information has been prepared. If these assumptions are not recognized, serious errors may result and incorrect conclusions may be drawn from the analysis.(Drury, 2004). Breakeven analysis (cost-volume-profit analysis) is an approach to profit planning that requires derivation of various relationships among revenue, fixed costs, and variable costs in order to determine units of production or volume of sales at which firm “breaks even” (where total revenues equal total of fixed and variable costs). The analysis is built on various assumptions. Below is a brief explanation of five assumptions underlying the use of break-even analysis or the CVP analysis. 1.
All other variables remain constant.
It is assumed that all variables other than the particular one under consideration remain constant throughout the analysis. In other words, it is assumed that volume is the only factor that will cause costs and revenues to change. However, changes in other variables such as production efficiency, sales mix, price levels and production methods can have an important influence on sales revenue and costs. If significant changes in these other variables occur the CVP analysis presentation is incorrect.(Drury, 2004). Changes in the levels of revenues and costs arise only because of changes in the number of product (or service) units sold. The number of units sold is the only revenue driver and the only cost driver. Just as a cost driver is any factor that affects costs, a revenue driver is a variable, such as volume, that casually affects revenues.(Horngren & etal, 2009). 2.
Single product or constant sales mix.
CVP analysis assumes that either a single product is sold or, if a range of products is sold, that sales will be in accordance with a predetermined sales mix. When predetermined sales mix is used, it can be depicted in the CVP analysis by measuring sales volume using standard batch sizes based on a planned sales mix. Any CVP analysis must be interpreted carefully if the initial product mix assumptions do not hold. 3.
Total costs and total revenue are linear functions of output. The analysis assumes that unit variable cost and selling price are constant. This assumption is only likely to be valid within the relevant range of production and time period. When represented graphically, the behaviours of total revenues and total costs are linear (meaning they can be represented as a straight line) in relation to units sold within a relevant range (and time period).(Horngren & etal, 2009) 4.
Profits are calculated on a variable costing basis.
The analysis assumes that the fixed costs incurred during the period are charged as an expense for that period. Therefore variable costing calculations are assumed. If absorption – costing profit calculations are used, it is necessary to assume that production is equal to sales for the analysis to predict absorption costing profits. If the situation does not occur, the inventory levels will change and the fixed overheads allocated for the period will be different from the amount actually incurred during the period. Under absorption, only when production equals sales will the amount of fixed overhead incurred be equal to the amount of fixed overhead charged as an expense.(Drury, 2004) 5.
Analysis applies to relevant range only.
It is assumed that CVP analysis is appropriate only for decisions taken within the relevant production range, and that it is incorrect to project cost and revenue figures beyond the relevant. b). (i). Determination the break – even point in units for each of the four options 1.
Reducing the selling price per unit by 20%.
Unit selling price = Sales revenue/ number of units sold
= shs 4,000,000/20,000
= shs 200...
References: Drury, C. (2004). Management and Cost accounting (6th ed.). High Holborn House, 50-51 Bedford Row,London WC1R4LR: Thomson Learning.
Horngren, C., T., & etal. (2009). Cost Accounting: A Managerial Emphasis (13th ed.). Upper Saddle River,New Jersey: Pearson Education, Inc.
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