Cost Volume Profit Analysis

COST-VOLUME-PROFIT ANALYSIS
COST-VOLUME-PROFIT ANALYSIS (CVP analysis) examines the behavior of total revenues,

total costs, and operating income as changes occur in the output level, selling price, variable cost
per unit, or fixed costs of a product.
CVP analysis considers the interrelationships among the following components:
✓ Volume or level of activity

✓ Unit selling prices
✓ Variable cost per unit
✓ Total fixed costs
✓ Sales mix
Illustration: A company’s projected profit for the coming year is as follows:
Sales (@ ₱20) ₱200,000
Less: Variable costs (@ ₱12) (120,000)
Contribution margin ₱ 80,000
Less: Fixed costs (64,000)
Operating income ₱ 16,000
1. How many units were sold?

2. Calculate the contribution margin per unit.
3. Calculate the break-even point in number of units.
4. Calculate the contribution margin ratio.
5. Calculate the break-even point in pesos.
6. How many units must the company sell to earn operating income equal to ₱30,000 before
tax?
7. How many units must the company sell to earn operating income equal to ₱30,000 after
tax? The corporate-wide tax rate is 40 percent?
8. What is the degree of operating leverage? If the sales revenue is expected to increase by
10%, what is the percentage increase in profit?
ASSUMPTIONS OF COST-VOLUME-PROFIT ANALYSIS

• The behavior of both costs and revenues is linear throughout the relevant range of the
activity index.
• Costs can be classified accurately as either variable or fixed.
• Changes in activity are the only factors that affect costs.
• All units produced are sold.
• When more than one type of product is sold, the sales mix will remain constant (the
percentage that each product represents of total sales will stay the same).
LIMITATIONS OF COST-VOLUME-PROFIT ANALYSIS
• Because of the many assumptions, CVP is only an approximation at best. CVP analysis
needs estimates and approximation in assembling necessary data and thus lacks accuracy
and precision.
• In CVP analysis, it is assumed that total sales and total costs are linear and can be
represented by straight lines. In some cases, this assumption may not be found true. For
instance, if a business firm sells more units, the variable costs per unit may decrease due
to more operating efficiencies in the factory.
• CVP analysis is performed within a relevant range of operating activity and it is assumed
that productivity and efficiency of operations will remain constant. This assumption may
not be valid.
• CVP analysis assumes that costs can be accurately divided into fixed and variable
categories. Such categorization is sometimes difficult in practice.
• CVP analysis assumes no change in the inventory quantities, during the period. That is,
opening inventory units equal the closing inventory units. This also means that units
produced during the period are equal to units sold. When changes take place in inventory
level, CVP analysis becomes more complex.
• If prices, unit costs, sales-mix, operating efficiency, or other relevant factors change, then
the overall CVP analysis and relationships also must be modified. Because of these
assumptions, cost data are of limited significance.
Contribution margin is the amount of revenue remaining after deducting variable costs. It can be
expressed as a per unit amount or as a ratio.
• Contribution Margin per Unit = Unit Selling Price – Unit Variable Costs.
• Contribution Margin Ratio = Contribution Margin per Unit ÷ Unit Selling Price.
Break-even Analysis
• At the break-even point, the company will realize no income but will suffer no loss.
Methods of Computing Break-even Point

1. Equation Method or algebraic approach
Required Sales = Variable Costs + Fixed Costs + Target Net Income.
2. Contribution margin method or formula approach (see Illustration, page 1)
3. Graphic approach
MARGIN OF SAFETY – It is the difference between actual or planned sales volume and break-
even sales.
• Margin of Safety = Sales – Break-even Sales
• Margin of Safety Ratio = Margin of Safety ÷ Sales
Exercise: ABC company makes a single product that it sells for P16 per unit. Fixed costs are
P76,800 per month and the product has a contribution margin ratio of 40%. If the company's actual
sales are P224,000, its margin of safety and margin of safety ratio are:
OPERATING LEVERAGE – a measure of the extent to which fixed costs are being used in an
organization. The greater the fixed costs in relation to variable cost, the greater is the operating
leverage available and the greater is the sensitivity of income to changes in sales.
DEGREE OF OPERATING LEVERAGE (DOL) - a measure of the sensitivity of profit changes
to changes in sales volume. DOL measures the percentage of change in profit that results from a
percentage of change in sales.
= Contribution Margin / Operating income
• The higher the degree of operating leverage, the greater the change in profit when sales
change.
PERCENTAGE CHANGE IN PROFIT = DOL × Percentage change in sales
SENSITIVITY ANALYSIS - a “what if” technique that examines the impact of changes on an
answer.
Increase in Sales Decrease in BEP
Decrease in Sales Increase in BEP
Increase in Variable Cost Increase in BEP

Decrease in Variable Cost Decrease in BEP
Increase in Fixed Cost Increase in BEP

Decrease in Fixed Cost Decrease in BEP
Exercise: If the fixed cost attendant to a product increases, while variable cost and sales price
remain constant, what will happen to (1) contribution margin and (2) break-even point?
Contribution Margin Break-even Point
a. Increase Decrease
b. Decrease Increase
c. Unchanged Increase
d. Unchanged Unchanged
Exercise: The income statement for ABC Inc., is as follows:

Sales ₱650,000
Less: Variable expenses (240,000)
Contribution margin ₱410,000
Less: Fixed expenses (295,200)
Operating income ₱114,800
Fellows produces and sells a single product. The income statement is based on sale of 100,000
units.
1. Compute the break-even point in units and in revenues. 72,000 units; 467,977
2. Suppose that the selling price increases by 10 percent. Will the break-even point increase or
decrease? Recompute it.
3. Ignoring the price increase in Requirement 2, suppose that the variable cost per unit increases
by ₱0.35. Will the break-even point increase or decrease? Recompute it.
INDIFFERENCE POINT is the level of volume at which total costs, and hence profits, are the
same under both cost structures
FORMULA:
FC1 – FC2
CM1 – CM2
Exercise: ABC company has decided to introduce a new product. The new product can be
manufactured by either an automated method or a manual method. The manufacturing method will
not affect the quality of the product. The estimated manufacturing costs by the two methods are as
follows:
Automated Manual
Variable manufacturing costs ₱ 72 ₱ 112
Variable selling and administrative costs 8 8
Fixed manufacturing costs ₱ 480,000 ₱ 220,000
Fixed selling and administrative costs 80,000 80,000
The company’s market research department has recommended an introductory unit sales price of
₱ 240.
1. Determine the annual unit sales volume at which the company would be indifferent
between the two manufacturing methods.
SALES MIX is the relative proportion in which each product is sold when a company sells more
than one product. It is important to managers because different products often have substantially
different contribution margins and break-even points.
Exercise: ABC Inc. sells wallets and money clips. Historically, the firm’s sales have averaged three
wallets for every money clip. Each wallet has an ₱8 contribution margin, and each money clip has
a ₱6 contribution margin. The company incurs fixed cost in the amount of ₱180,000. The selling
prices of wallets and money clips, respectively, are ₱32 and ₱15.
1. How many units is needed to break even?
2. How many wallets and money clips does this represent?
Additional Exercises:
1. ABC, Inc., sells Product M for P5 per unit. The fixed cost is P210,000 and the variable cost
is 60% of the selling price. What would be the amount of sales if ABC is to realize a profit
of 10% of sales?
2. DEF Company is planning to sell 100,000 units of Product Y for P12 a unit. The fixed cost
is P280,000. In order to realize a profit of P200,000, what would the variable cost be?
3. XYZ Company has projected cost of goods sold of P4,000,000, including fixed cost of
P800,000. Variable cost is expected to be 75% of net sales. What will be the projected net
sales?
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COST-VOLUME-PROFIT ANALYSIS

COST-VOLUME-PROFIT ANALYSIS (CVP analysis) examines the behavior of total revenues,

✓ Volume or level of activity

1. How many units were sold?

ASSUMPTIONS OF COST-VOLUME-PROFIT ANALYSIS

Methods of Computing Break-even Point

2. Contribution margin method or formula approach (see Illustration, page 1)

Increase in Variable Cost Increase in BEP

Increase in Fixed Cost Increase in BEP

Exercise: The income statement for ABC Inc., is as follows:

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