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Unformatted text preview: INTRODUCTION Conceptually, conventional linear cost-volume-profit (CVP) analysis is a simplified, short term planning technique that evolved as a practical version of the theoretical model of the firm described in economics textbooks. 1 From an accounting perspective it is compatible with the direct, or variable costing method of inventory valuation. To use the CVP model, a company must separate total costs into fixed and variable categories using one of the methods described in Chapter 3. Recall from our earlier discussions of these terms that variable costs are those costs that vary with changes in the level of activity. The only activities that are allowed to affect variable costs in traditional cost-volume-profit analysis are production output and sales. Remember that fixed costs are those costs that do not vary with changes in the activity level. Conceptually, fixed costs are not constant. By definition, fixed simply means that these costs are not driven by short run changes in production or sales volume. Although explicit recognition of non production volume related cost drivers is a key concept in activity based costing, the idea is ignored in the conventional linear CVP model. 2 Finally, it is important to recognize that the concept of fixed and variable costs is a short run concept. All costs tend to vary in the long run as the company adds to its' capacity to produce and distribute products and services. Therefore, the short run emphasis of CVP analysis tends to conflict with the long run emphasis of activity based costing and the lean enterprise concepts of JIT and TOC. This creates another thought provoking controversial issue. The purpose of this chapter is to describe the assumptions and techniques of the conventional linear cost-volume-profit approach as well as the controversy concerning the compatibility of CVP analysis with ABC and the continuous improvement concepts. The chapter is divided into five main sections. The first section addresses the underlying assumptions of the conventional linear model and the implications of relaxing these assumptions. This section is mainly conceptual and is illustrated with a series of graphs. The second section illustrates the basic planning techniques for a single product company that provide the foundation for more realistic problems. The third section extends the basic analysis to multiproduct companies. Both sections two and three are more mechanical than conceptual and are mainly illustrated with a series of related equations. The fourth section is fairly short, but illustrates how to convert the analysis to a cash flow basis. The last section introduces the controversy associated with the CVP approach as it relates to the newer concepts of ABC, JIT and TOC. Since the CVP methodology is closely related to direct or variable costing, this chapter helps provide a better foundation for the more detailed comparison of direct and absorption costing presented in Chapter 12....
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