The CVP model makes the assumptions that costs can be simply divided into fixed and variable costs. It assumes that over a range of output levels – the relevant range – fixed costs remain constant and variable costs increase directly with output. The variable costs behave in a linear fashion. The fixed costs are periodic costs so that cost items such as rent, rates, insurance, depreciation etc. are constant at all levels of output. There is also an assumption that the sales revenue behave in a linear fashion ie. the selling price  is constant per unit of output.

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Economists take a more realistic view of cost behaviour. They contend that variable costs do not behave in a linear fashion but are effected by economies of scale. Companies can benefit from discounts for bulk purchases of materials and

the economies from the division of labour. The economists’ model represented in a curvilinear graph shows the total cost line rises steeply at low output levels, levels off within a range of output and finally rises steeply again as the benefits of economies of scale decline. The total revenue line rises steeply, levels off and then declines. This curvilinear total revenue line reflects the fact that  to achieve more sales the company may have to reduce the selling price and does not increase proportionally with output.

 

As a compromise it is possible to accept the assumptions that the CVP model is based on within a certain range of output – the relevant range. Therefore, the CVP model can be used as a planning technique to:

 

 

(a)        find the break-even point

 

(b)       determine the margin of safety

 

(c)        determine a target volume

 

(d)       establish the profit volume ratio or contribution volume ratio

 

(e)        determine the operating gearing

 

 

It is possible to ascertain these by using a break-even chart or by using formulae.

 

 

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