D0009

COST-VOLUME-PROFIT ANALYSIS
Cost-volume-profit (CVP) analysis is a study of the effects of changes in costs and volume on a company’s
profit. Managers use these relationships to plan, budget, and make decisions. It is also a critical factor used in
settling selling prices, determining product mix, and maximizing use of production facilities.
Although the word profit appears in the term, CVP is applicable in all economic sectors; it is not confined to
profit-seeking enterprises only. Managers in not-for-profit organizations also routinely use CVP analysis to
examine the effects of activity and other short-run changes on revenues.
The CVP model can be expressed through a formula or a graphical presentation. CVP is a component of
business intelligence, which is gathered within the context of knowledge management. The first step to CVP is
classifying the cost behavior (as discussed in previous topics of this chapter). Though before studying deeper
on CVP analysis, a review of its basic concepts is recommended.

Basic Components
The CVP analysis considers the interrelationships among the following components: volume or level of activity,
unit selling prices, variable cost per unit, total fixed cost, and sales mix.
The following assumptions underlying each CVP analysis must be considered to constitute limitations:
1. The behavior of both costs and revenues is linear throughout the relevant range of the activity index.
This implies that the price of the product or service will not change as sales volume varies within the
relevant range.
2. Costs can be classified accurately as either variable or fixed (or mixed). Total fixed expenses remain
constant as activity changes, and the unit variable expense remains unchanged as activity varies.
3. Changes in activity are the only factors that affect costs, which further imply that the efficiency and
productivity of the production process and workers will remain constant.
4. All units produced were sold.
5. In multiple product organizations, the sales mix will remain constant over the relevant range. That is,
the percentage that each product represents of total sales will stay the same. Sales mix complicates
CVP analysis because different product will have different cost relationships.

CVP Income Statement

Management often prefers to be presented by a CVP income statement that reflects classified variable and
fixed costs and a computation for the contribution margin. Contribution Margin is the amount of revenue
remaining after deducting variable costs (discussed on week 6). Before CVP income statement was developed,
accountants used to prepare a traditional income statement which does not disclose the breakdown of each
expense into its variable and fixed components. Thus, many operating managers find the format difficult to
comprehend and use.
• The traditional income statement is very simple; its cost of goods sold (COGS) includes both variable
and fixed manufacturing costs as measured by the firm’s product-costing system. The gross margin is
computed by subtracting the COGS from sales. Selling and administrative expenses (each expense
includes both variable and fixed costs) are then subtracted to get the net income.
• The contribution income statement meanwhile, highlights the distinction between variable and fixed
expenses. Slide 4 shows that all variable expenses are subtracted from sales to determine the
contribution margin. The resulting total will then be applied to cover fixed costs to arrive at a contribution
result representing profit.
As said earlier, contribution income statement is preferred by operation managers because it is readily apparent
how income will be affected by a given percentage.

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Examine the sample problem below:

TIMEX COMPANY
Income Statement
For the Year Ended December 2007

Sales………………………………………………………………….P750,000
Less: Variable expenses:
Variable manufacturing ……………………….P 420,000
Variable selling ………………………………… 22,500
Variable administrative ……………………….. 7,500 450,000
Contribution margin …………………………………. P300,000
Less: Fixed expenses:
Fixed manufacturing…………………………. P 150,000
Fixed selling …………………………………. 30,000
Fixed administrative………………………… 45,000 225,000
Net income…………………………………………………………. P 75,000

Assumption: TIMEX Company manufactured and sold 2,000 units with P 375 product selling price.
Suppose management projects a sales volume for the current year (2008) will be 25% greater than in 2007. No
changes are anticipated in the sales price, variable cost per unit, of fixed cost. Examination of the contribution
income statement shows that if sales volume increases by 25 percent, the following changes will occur:

Income Statement Item Year 2007 Change Year 2008

Amount Amount

Sales P750,000 P187,500 P937,500

(P750,000 x 25%)
Total Variable Expenses P450,000 P112,500 P562,500
(P450,000 x 25%)
Contribution Margin P300,000 P75,000 P375,000
(P300,000 x 25%)
Total Fixed Expenses P225,000 P 0* P225,000
Net Income P75,000 P75,000** P150,000
*No change in fixed expenses when volume changes.
**Income changes by the amount of the contribution-margin change.
Notice that the net income increases by the same amount as the increase in contribution margin. Therefore, the
contribution margin changes in direct proportion to the change in sales volume. Given these facts, we can now
try to compute for the increase in net income using this shortcut. Recall that the contribution margin ratio is the
percentage of contribution margin to sales.
Increase in sales revenue x contribution-margin ratio = increase in net income

P187,500 x .40 = P75,000

Where: Contribution-margin ratio = Contribution margin

Sales revenue
= P300,000
P750,000
= 0.40 or 40%
The analysis presented makes use of cost-volume-profit relationships that are disclosed in the contribution
margin statement. Such analysis cannot be made with the information presented in the traditional income
statement.
Break-even Analysis

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CVP has wide-range applicability. It can be used to determine a company’s break even point (BEP), which
refers to the level of activity, at which total revenues equal costs (there is no profit nor loss). At breakeven, the
company’s revenues simply covers its costs. BEP is computed to establish a reference point for the managers
to set sales goals and project the sales volume necessary to achieve a desired target profit.
The break even point can be:
• Computed from a mathematical equation
• Computed by using contribution margin
• Derived from a cost-volume-profit (CVP) graph
The break-even point can be expressed either in sales units or sales dollars/peso.
The presentation through a mathematical equation is commonly shown as:
Sales = Variable Costs + Fixed Costs + Net Income
Let us try to evaluate the Income Statement prepared by TIMEX Company (assuming that the company has a
single product). Since at break even point the net income is zero, we can conclude that breakeven occurs where
total sales equal variable costs plus fixed costs.

A sample computation below was prepared to further illustrate:

(Total variable expenses ÷ Quantity) x Quantity

Sales = Variable Costs + Fixed Costs + Net Income

Product selling price x Quantity

P375Q = (P450,000 ÷ 2,000) + P225,000 + P 0

= P225Q + P225,000 + P0

P150Q = P225,000

Q = 1,500 units

Where:
Q = sales volume in units
P375 = selling price
P225 = variable cost per unit
P225,000 = total fixed costs
Thus, TIMEX Company must sell 1,500 units to break even. To find the BEP peso sales required, we will multiply
units sold at break-even point times the selling price unit:
BEP peso sales = 1,500 units x P375
= P562,500
BEP can also be computed using the contribution margin approach. We can recall that contribution margin
equals total revenues less variable costs. Now we will apply that knowledge; contribution margin must be equal
to total fixed cost to breakeven. BEP with this method can be computed using either the contribution margin per
unit or the contribution margin ratio.

The BEP computation for both technique is shown below:

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Fixed Costs
BEP in units =
Contribution Margin per Unit
Thus, deriving values from the income statement of TIMEX Company:

P225,000
BEP in units =
P150*

= 1,500 units

*Contribution margin unit amount was derived from unit selling price minus unit variable cost: P 375 - P 225* =
P 150.

*(P 450,000/ 2,000 units)

TIMEX Company generates P150 of contribution margin with each unit that it sells. This amount is used to pay
off fixed costs. Therefore, the company must sell 1,500 units to cover its total fixed costs.
The use of contribution margin ratio on the other hand can be shown in this formula:

Fixed Costs
BEP in peso =
Contribution Margin Ratio

P225,000
=
40% *

= P562,500

*Contribution margin ratio is equal to total contribution over total sales:

P300,000 / P750,000 = 0.40

Lastly, graphical representation is also known as one of the most effective way to find BEP. This graph is
referred to as CVP graph as it also reflects costs, volume, and profits.
Sales volume is presented along the horizontal axis. This axis should extend to the maximum level of expected
sales. Both sales revenue (sales) and total costs (fixed plus variable) are recorded on the vertical axis.
Let’s try to construct evaluate the CVP graph constructed for TIMEX Company:
Step 1: Draw the axes of the graph. Label the vertical axis in peso and the horizontal axis in units of Sales.
Step 2: Draw the fixed-expense line. It is parallel to the horizontal axis, since fixed expenses do not change
with activity.
Step 3: Compute total expense at any convenient volume. For example, select a volume of 1,000 units:

Variable expenses (1,000 x P375 per unit) ….………… P 225,000

Fixed expenses …………………………………………… 225,000

Total expenses (at 1,000 units)...………………..…...…. P 450,000

Plot this point (P450,000 at 1,000 unit) on the graph (see point A).
Step 4: Draw the variable-expanse line. This line passes through the point plotted in step 3 (point A) and the
intercept of the fixed-expense line on the vertical axes (P225,000)

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Step 5: Compute total sales revenue at any convenient volume. We will also use 1,000 units again. Total
revenue is P375,000 (1,000 units x P375 per unit). Plot this point (P375,000 at 1,000 units) on the graph (see
point B)
Step 6: Draw the total revenue line. The line passes through the point plotted in step 5 (point B) and the origin.
Step 7: Label the graph for better interpretation.

The BEP is determined by the intersection of the total revenue line and the total expense line. The CVP graph
tells information more than the BEP calculation. It also reflects the effects on profit of changes in volume. The
vertical distances between the lines on the graph represent the profit or loss at a particular sales volume.

Target Net Income

Target net profit (or income) is simply the desired profit level of the management in a particular performance
of an activity. The way of computation for volume of sales required to earn a specific target net profit is very
similar to the process for determining the break-even point. Thus, we could recall that BEP is the number of
units of sales required to earn a target net profit of zero.
Using contribution margin approach, we will go back to TIMEX Company example. Suppose the desired
profit for next month is P150,000. The contribution margin is P150 (sales price P375 minus unit variable expense
of P225). One thousand five hundred of these P150 contributions will be just enough to cover the company fixed
expenses. Each additional unit to be sold will contribute P150 toward profit. Thus, modifying the formula given
in BEP topic:

Fixed expenses + Target Net Profit

No. of sales units required =
to earn target net profit Unit Contribution Margin

P225,000 + P150,000
=
P150
= 2,500 units

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If the company sells 2,500 units for next month, it can acquire its target profit of P150,000. Now we will compute
for the total peso sales required to earn target net income:

Fixed expenses + Target Net Profit

Peso Sales required =
to earn target net profit Contribution Margin ratio

P225,000 + P150,000
=
0.40*

= P937,500
*The contribution margin ratio is computed by dividing the unit contribution margin to unit selling price: P 150 ÷
P 375 = 0.40
This peso sale figure can also be achieved by multiplying the required sales of 2,500 units by the selling price
of P 375 (2,500 units x P 375 = P 937,500).
This time, considering the equation approach, we can use the modified formula:
Target Net Profit = (Unit sales price x Sales volume required to earn target net profit) – (Unit variable
expense x Sales volume required to earn target profit) – Fixed expenses
By substitution of the values from TIMEX Company, we will have:

P150,000 = [P375(X)] – [P225 (X)] – P225,000

Then to solve for X:
P375X – P225X – P225,000 = P150,000
P150X = P375,000
X = P375,000 / P150
X = 2,500
Or we can alternatively use the similar mathematical equation presented in BEP topic:
Required Sales = Variable Costs + Fixed Costs + Target Net Income
P375Q = P225Q + P225,000 + P150,000
Q = 2,500
Where: Q = sales volume
P375 = unit selling price
P225 = variable cost per unit
P225,000 = total fixed costs
P150,000 = target net income
Again, multiplying the required sales of 2,500 units by the unit selling price of P375 (2,500 units x P 375), we
can get the peso sale required P937,500 to achieve target net profit.
Finally, to graph the company target profit projection, we have to locate the target net profit P150,000 on the
vertical axis. Then move horizontally until the line is reached. Then move down from the profit line to the
horizontal axis to determine the required sales volume.

Margin of Safety
The margin of safety of an enterprise is the difference between the actual or budgeted sales revenue and the
break-even sales revenue (BEP). It is considered as the “cushion” by the management in case the expected
sale was not reached. The margin of safety may be expressed in peso or as a ratio.
The formula for stating the margin of safety in dollars/peso is actual (expected) sales minus break-even sales.
Assuming that actual sales for TIMEX Company is P1,150,000:

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Margin of Safety in Peso = Actual (Expected) Sales – Break-even Sales

= P1,250,000 – P937,500
= P212,500
TIMEX Company manager would then determine that the company sales could fall by P212,500 before it is
considered operating at a loss.
The margin safety ratio is computed by dividing the margin of safety in peso by actual (or expected) sales.
Applying the values to the formula:
Margin Safety Ratio =Margin of Safety in Peso ÷ Actual(Expected) Sales
= P212,500 ÷ P1,150,000
= 18%
This only means that the company sales could fall by 18 percent before it would be operating at a loss.
It shall be considered that margin of safety doesn’t guarantee a successful business operation at all times but
it does provide room for error in an analyst’s point of view.

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