Cost–Volume–Profit Assumptions

Now that you know how CVP analysis works, think about the following assumptions we made during the analysis:

1. Changes in revenues and costs result solely from changes in the number of product (or service) units sold. That is, 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 number of units sold, that causally affects revenues.
2. Total costs can be separated into two components: a fixed component that does not vary with units sold (such as Emma’s $2,000 booth fee) and a variable component that changes based on units sold (such as the $120 cost per GMAT Success package).
3. When represented graphically, the behaviors 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).
4. Selling price, variable cost per unit, and total fixed costs (within a relevant range and time period) are known and constant.

As you can tell from these assumptions, to conduct a CVP analysis, you need to correctly distinguish fixed from variable costs. Always keep in mind, however, that whether a cost is variable or fixed depends on the time period for a decision.

The shorter the time horizon, the higher the percentage of total costs considered fixed. For example, suppose an American Airlines plane will depart from its gate in the next hour and currently has 20 seats unsold. A potential passenger arrives with a transferable ticket from a competing airline. American’s variable costs of placing one more passenger in an otherwise empty seat (such as the cost of providing the passenger with a free beverage) is negligible. With only an hour to go before the flight departs, virtually all costs (such as crew costs and baggage-handling costs) are fixed.

Alternatively, suppose American Airlines must decide whether to continue to offer this particular flight next year. If American Airlines decides to cancel this flight because very few passengers during the last year have taken it, many more of its costs, including crew costs, baggage-handling costs, and airport fees for the flight, would be considered variable: Over this longer 1-year time period, American Airlines would not have to incur these costs if the flight were no longer operating. Always consider the relevant range, the length of the time horizon, and the specific decision situation when classifying costs as variable or fixed.