Cost-Volume-Profit Analysis

Lesson Objectives:
At the end of this module, you should be able to:
1. Gain an understanding on the assumptions underlying cost-volume-profit (CVP) analysis.
2. Determine the breakeven point in sales and in pesos.
3. Gain an understanding on the concept of margin of safety and operating leverage.
4. Calculate the indifference point.

Lesson Objective 1
Cost-Volume-Profit (CVP) Analysis – the systematic examination of the relationships among
costs, cost driver (activity level – volume) and profit. It is used to measure the functional
relationship between the major factors affecting profits and to determine the profit structure of an
entity.

Factors Affecting Profit

Sales price Variable cost/unit Activity level Total Fixed costs Sales mix

Simplifying Assumptions (Limitations) of CVP Analysis

1. Relevant Range, Time and Linearity Assumptions are applicable to CVP analysis. When
represented graphically, the behavior of total revenues and total costs are linear (represented as
a straight line) in relation to output level within a relevant range and time period.
2. All costs are classifiable as either fixed or variable. Total costs can be separated into a fixed
component that does not vary with the output level and a component that is variable with respect
to the output level.
3. The selling price, variable cost per unit, and fixed costs are known and constant.
4. Changes in the level of revenues and costs arise only because of changes in the number of
product (or service) units produced and sold. Units produced is equal to units sold.
5. If the company sells multiple products, sales mix is constant as the level of total units sold
changes.
6. Time value of money is ignored.

Contribution Margin Statement Total Per Unit Rate

Sales (S) P xx P xx SP/unit 100%
Variable Costs (VC) (xx) (xx) VC/unit x% VC ratio (VC/S)
Contribution Margin (CM) P xx P xx CM/unit x% CM ratio (CM/S)
Fixed Costs (FC) (xx) x% FC ratio (FC/S)
Profit b4 tax (operating income) (OI) P xx x% Profit ratio (OI/S)

• Contribution Margin (Marginal income/Marginal profit/Profit contribution)

- the amount of sales that is not consumed by variable cost which will contribute to the
coverage of fixed costs and provide profits to owners.
- If selling price per unit and variable cost per unit is assumed constant, then contribution
margin per unit is also assumed constant. This is true when no specific changes in
selling price or variable cost per unit is stated in the problem.
• Per unit cost is computed as total costs divided by number of units sold.
• Ratios are based on sales. If selling price, variable cost per unit and contribution margin
 per unit is assumed constant, then variable cost ratio and contribution margin ratio will
also be constant even if there is a change in volume. Variable cost ratio and contribution
margin ratio can only change if there is a specific change in selling price or variable cost
per unit. Fixed cost ratio and profit ratio varies with changes in volume.

Break-even Point (BEP)

- the level of sales (in pesos or in units) where total revenue equals total costs, that is,
there is neither profit nor loss.

Under break-even point:

• Sales = Total Cost or Sales = Variable Cost + Fixed Cost
• Sales – Variable Cost – Fixed Cost = 0
• Sales – Variable Cost = Fixed Cost or Contribution Margin = Fixed Cost

Lesson Objective 2
Illustration:
Bebe Co. runs a manufacturing business that is involved in manufacturing and selling a single
product. The annual fixed expenses to run the business are ₱15,000 and variable expenses are
₱7.50 per unit. The selling price of the product is ₱15 per unit.

Requirement. Compute for:

1. BEP in units 2. BEP in pesos

Equation Method and Contribution Margin Approach

Break-even point in units

To compute for profit: S − VC − FC = P
At break-even: S − VC − FC = 0

To compute for break-even point in units:

S − VC − FC = 0
u(SP − VCu) − FC = 0
u(15 − 7.5) − 15,000 = 0
7.5u = 15,000
7.5u 15,000
=
7.5 7.5
𝐁𝐄𝐏𝐮 = 𝟐, 𝟎𝟎𝟎

The formula to compute break-even point in units can be derived as:

S − VC − FC = 0
u(SP − VCu) − FC = 0
u(SP − VCu) = FC
u(SP − VCu) FC
=
(SP − VCu) SP − VCu
𝐅𝐂
𝐁𝐄𝐏𝐮 =
𝐂𝐌𝐮

Using the derived formula, the break-even point in units can simply be computed as:
 𝐅𝐂
𝐁𝐄𝐏𝐮 =
𝐂𝐌𝐮
15,000
BEPu =
7.5
𝐁𝐄𝐏𝐮 = 𝟐, 𝟎𝟎𝟎
Break-even point in pesos
Break-even point in pesos can simply be computed as:
BEPp = BEPu ∗ SP
BEPp = 2,000 ∗ 15
𝐁𝐄𝐏𝐩 = ₱𝟑𝟎, 𝟎𝟎𝟎
Break-even point in pesos can also be computed using a formula:
𝐅𝐂
𝐁𝐄𝐏𝐩 =
𝐂𝐌𝐑
15,000
BEPp =
50%
𝐁𝐄𝐏𝐩 = ₱𝟑𝟎, 𝟎𝟎𝟎
The formula was based on the concept:
At breakeven point: CM – FC = 0 or CM = FC
CM CM
If: = 100% or =S
CMR CMR
𝐹𝐶 𝑭𝑪
Therefore, at break-even point: = 100% or = 𝐁𝐄𝐏𝐩
𝐶𝑀𝑅 𝐂𝐌𝐑
Legend:
S = Sales u = units BEPu = Break-even point in units
VC = Variable cost SP = Selling price / Sales price per unit BEPp = Break-even point in pesos
FC = Fixed cost VCu = Variable cost per unit CMR = Contribution margin ratio
P = Profit CMu = Contribution margin per unit

Graphical Approach
The graphical presentation of pesos and unit sales needed to break-even is known as break-
even chart or CVP graph:

Explanation of the graph:

1. The number of units have been presented on the X-axis (horizontally) whereas peso amounts
 have been presented on Y-axis (vertically).
2. The straight horizontal line in represents the total annual fixed expenses of ₱15,000.
3. The line that starts with ₱15,000 represents the total expenses. Notice that the line has a
positive or upward slope that indicates the effect of increasing variable expenses with the
increase in production.
4. The line that starts at 0 with positive or upward slope is the total revenue line. It indicates that
every unit sold increases the total sales revenue.
5. The total revenue line and the total expenses line cross each other. The point at which they
cross each other is the break-even point. The break-even point in the above graph is 2,000
units or ₱30,000 that agrees with the break-even point computed using the equation above.
6. The difference between the total expenses line and the total revenue line before the point of
intersection (BE point) is the loss area. Notice that this area reduces as the number of units
sold increases. It means every additional unit sold before the break-even point reduces the
loss.
7. The difference between the total expenses line and the total revenue line after the point of
intersection (BE point) is the profit area. Notice that this area increases as the number of units
sold increases. It means every additional unit sold after the break-even point increases the
profit of the business.

Required Sales (units and pesos) to Earn a Desired Profit (OI)

Illustration:
Meme Co. runs a manufacturing business that is involved in manufacturing and selling a single
product. The annual fixed expenses to run the business are ₱50,000 and variable expenses are
₱15 per unit. The selling price of the product is ₱25 per unit. The company’s tax rate is 30%.
Requirement. Compute for:
1. Sales in units and pesos to earn a target profit before tax of ₱25,000.
2. Revenue to earn a target profit after tax of ₱14,000.
3. Revenue to earn a target profit before tax of 20% of revenues

Exercise 1
Wow, Inc., in business since 2008, makes swimwear for professional athletes. Analysis of the
firm's financial records for the current year reveals the following:
Average swimsuit selling price ₱80
Variable swimsuit expenses: Annual fixed cost:
Direct material 30 Selling ₱16,000
Direct labor 12 Administrative 29,000
Variable overhead 8
The company's tax rate is 40 percent. Samantha Waters, company president, has asked you to
help her answer the following questions.
Required:
1. What is the break-even point (a) in number of swimsuits and (b) in pesos?
2. a. How much revenue must be generated to produce ₱45,000 of pre-tax earnings?
b. How many swimsuits would this level of revenue represent?
3. a. How much revenue must be generated to produce ₱45,000 of after-tax earnings?
b. How many swimsuits would this represent?
4. If the company wants the business to earn a pre-tax profit of 25 percent of revenues, how many
swimsuits must be sold?

Exercise 2
Sivin Even manufactures diapers. The company incurs average variable costs of ₱60. Sivin
Even has annual fixed costs of ₱702,000. The company currently sells an average of 10,000 units
and has break-even point of 7,800 units.
Required. Calculate:
a. Selling Price b. BEP in pesos

Lesson Objective 3
Margin of safety (MOS) - the level of sales (in pesos or in units) by which actual or budgeted
sales may be decreased without resulting into a loss. In other words, it is the cushion by which
actual or budgeted sales may be decreased without resulting in any loss.
- measure of the difference between the actual (or budgeted sales) and the break-even
Pesos Units Rate
Sales (S) P xx xx S/SP 100% Sales ratio (SR)
Break Even Sales (BES) (xx) (xx) BES/SP x% BES ratio (BESR)
Margin of Safety (MS) P xx xx MS/SP x% MS ratio (MSR)
sales.

Sensitivity analysis – “what-if” technique managers use to examine how a result will change if
original predicted data not achieved or if an underlying assumption changes

Under CVP analysis:

Selling price per unit, variable cost per unit and fixed costs is assumed constant. This is true when
no specific changes are stated in the problem.

What if there is a change in sales?

If it is stated that there is a change in sales, that change is referring to a change in volume
(units), not change in selling price. If there is a change in volume (units), total variable cost
will also change but fixed will remain constant. To summarize, if there is a 30% increase in
sales, there will also be a 30% increase in total variable cost. Total fixed cost will remain the
same.

What if there if a change in total variable cost, would this also mean a change in sales?
The answer would be yes. For example, if variable cost increases by 30%, the main reason
for that increase would be an increase in volume (units), not an increase in variable cost per
unit. Therefore, that increase in variable cost would also be reflected as a 30% increase in
sales. Total fixed cost remains constant. The same concept will apply as discussed above.

What if there is a change in selling price, would variable cost be affected?

The answer would be no. A change in selling price will be reflected as an increase or decrease
in sales but it would not affect variable cost because volume would not be affected. This would
also apply when there is a change variable cost per unit. When variable cost per unit changes,
only variable cost would increase or decrease because volume would not be affected.

When further analyzed, the following relationships can be observed:

Changes (Individual) CM/u & CMR BEP Operating Income MOS
1. Increase* in SP/u Increase Decrease Increase Increase
2. Increase* in VC/u Decrease Increase Decrease Decrease
3. Increase* in total FC No effect (NE) Increase Decrease Decrease
* and vice versa
Operating Leverage – measures the extent of change in profit before tax resulting from change
in sales.
• it basically answers the question: "By how many times will operating profit increase or
decrease in relation to the increase or decrease in sales?"
The degree of operating leverage (DOL) of operating leverage factor (OLF) can be computed as:
CM % change in operating income
DOL = or DOL =
OI % change in sales

• The higher the CM, the greater will be the degree of operating leverage (DOL) or operating
leverage factor (OLF).
• A company with high fixed costs will still have operating leverage if it has a very high
contribution margin (CM).

Illustration:
Beybi Co. is in business since 2008, makes swimwear for professional athletes. Analysis of the
firm's financial records for the current year reveals the following:
Average swimsuit selling price ₱80 Number of units sold 3,000 units
Variable swimsuit expenses: Annual fixed cost:
Direct material 30 Selling ₱26,000
Direct labor 12 Administrative 34,000
Variable overhead 8
Requirement:
a. Compute for the margin of safety in units and pesos.
b. What is the degree of operating leverage?
c. Using the DOL computed above, what will be amount of net income if the sales increase by
20%?.
d. Disregarding the information in requirement (c), a marketing consultant told Beybi Co.
managers that they could increase the sales by 30 percent if the selling price was reduced by 10
percent and the company spent ₱10,000 on advertising. How much would be the additional
profit/(loss) if the changes are made?

Lesson Objective 4
Indifference Point – the level of volume at which total costs, and hence profits, are the same
under both cost structures. If the company operated at that level of volume, the alternative used
would not matter because income would be the same in either way.

Illustration:
Model A: Variable costs, ₱8.00 per unit Model B: Variable costs, ₱6.40 per unit
Annual fixed costs, ₱1,971,200 Annual fixed costs, ₱2,227,200
The selling price is ₱32 per unit for each unit, which is subject to a 5 percent sales commission.
(In the following requirements, ignore income taxes.)

Required: At what volume level will management be indifferent between the acquisition of Model
A and Model B?
Exercise 1
Sivin Even manufactures diapers. The company incurs average variable costs of ₱60. Sivin
Even has annual fixed costs of ₱702,000. The company currently sells an average of 10,000 units
and has break-even point of ₱1,170,000 and 7,800 in units. Determine the net income if variable
costs per unit increase by ₱5 resulting to an increase in total sales by 10%.

Exercise 2
Thompson Company is considering the development of two products: no. 65 or no. 66.
Manufacturing cost information follows.
No. 65 No. 66
Annual fixed costs ₱220,000 ₱340,000
Variable cost per unit 33 25
Regardless of which product is introduced, the anticipated selling price will be ₱50 and the
company will pay a 10% sales commission on gross dollar sales. Thompson will not carry an
inventory of these items. At what unit-volume level will the profit/loss on product no. 65 equal the
profit/loss on product no. 66?

Exercise 3
Racine Tire Co. manufactures tires for all-terrain vehicles. The tires sell for P60 and variable cost
per tire is P30; monthly fixed cost is P450,000. The company current sells 20,000 tires monthly.
Requirement. Compute for:
1. Margin of safety in units and in pesos.
2. Degree of operating leverage
3. New net income if the company can increase sales volume by 15 percent above the current
level