The Downside of Using the Profit-Volume-Cost Model with QuickBooks - dummies

The Downside of Using the Profit-Volume-Cost Model with QuickBooks

By Stephen L. Nelson

Like any abstract explanation of reality, the profit-volume-cost model isn’t perfect and there is a downside to using this model with QuickBooks. If you want to get nitpicky — and you should for a moment — several practical problems creep into the calculations of the profit-volume-cost formula and its application to your real-life business affairs.

Having such problems doesn’t mean that you shouldn’t use the model. They only change the way that you work with the model.

  • Any assumptions that you make about variable costs and fixed costs typically apply only over a range of sales revenues. In the boat-building business, for example, the numbers used in the preceding sections don’t apply if the boat builder scales up and builds 500 boats a year. That’s obvious, right?

    It may be that the range of sales revenues valid for a 60 percent gross margin percentage — and, therefore, $160,000 of fixed costs — is really somewhere between 0 boats per year and 8 boats per year. Move to a sales revenue level above eight boats a year, and very likely, either the gross margin percentage or the fixed cost amount changes.

  • In the super-long run, as a practical matter, there’s no such thing as a fixed cost. Essentially, every cost is variable. In the boat-building business, for example, you could — in the long run — lay off two craftsmen and move to a smaller shop. Perhaps you could even build boats in your backyard.

    Fixed costs, in other words, are fixed only for a particular period of time. If you move beyond that period of time, the fixed costs are no longer fixed. This seems like an obvious point, but it’s important to recognize.

  • In the super-short term, there’s no such thing as a variable cost. (Or at least there aren’t very many variable costs.) For example, in the boat-building business, even if you pay your laborers an hourly wage for building the boats, you probably can’t send the laborers home early just because work for the day is done.

    You can’t tell your laborers at the end of Tuesday not to come in Wednesday, Thursday, or Friday just because you have no work for them. Other variable costs may work the same way — not always, but sometimes. In any case, recognize that some costs may vary over a month or year but not over a day or a week. In other words, in the super-short term, variable costs often aren’t very variable.

The three preceding conundrums indicate that profit-volume-cost analysis suffers some limits. You can’t use a gross margin percentage and a fixed cost amount for just any sales revenue estimates; you use those two items of data for a carefully considered range of sales revenue volumes.

Furthermore, you can’t use profit-volume-cost analysis for super-short time frames. Variable costs in that case aren’t really variable. And you can’t use profit-volume-cost analysis for super-long time frames because in the long run, no fixed cost stays fixed.

To generalize, the profit-volume-cost analysis tool provides rough measurements. These rough measurements can be very useful to you, but they’re really just rough measurements. Always apply common sense when using profit-volume-cost analysis.

Think about sort-of fixed costs and sort-of variable costs. By admitting up front that the fixed costs aren’t always solidly fixed and that the variable costs aren’t always solidly variable, you might find myself getting more comfortable with the profit-volume-cost analysis formula.