COURSE MAS 5: STRATEGIC BUSINESS ANALYSIS

DEVELOPER AND Principal Author:

THEIR BACKGROUND Dr. Derick S. Figueroa, CPA, CTT.
Chairperson, Accountancy Department
Email address: [email protected]

Editor:
Dr. Henry D. Rufino, CPA.
Chairperson, Accounting Information System Department
Email address: [email protected]

COURSE This course is the culmination of Financial Management and Management Accounting and Services courses. The
DESCRIPTION course will start with the budgeting process: both operation and financial budgeting collectively known as the master
budget. The Cost-volume-profit analysis will then be reviewed and applied in-depth with business decision making
and strategy formulations. For the final term, the concept of capital structure and weighted average cost of capital will
be reviewed, and the concepts be applied in understanding leverages and business risks. Capital budgeting is the
last topic to be covered which will extensively tackle the different approaches and techniques. The final requirement
of this course is focused on the analysis of business strategies through business plan, a feasibility study, scenario
building or a consultancy service recommendation proposal.
COURSE OUTLINE 1. The Operational and Financial Budgeting Process: Master Budget
2. Cost-volume-profit analysis (an in-depth approach)
3. Capital Structure, Weighted Average Cost of Capital (WACC) and Leverages
4. Capital Budgeting Techniques

CHAPTER # 2
TITLE COST-VOLUME-PROFIT ANALYSIS (AN IN-DEPTH APPROACH)
RATIONALE This chapter focuses on the relationship between cost and volume in estimating/budgeting profit. Since the day-to-
day activities of a business organization focuses on selling, producing, and incurring costs, this topic is very practical
to study and learn for planning, controlling, and monitoring activities. This chapter established the importance of
understanding how decision-making will be easier by applying the CVP concepts.
INSTRUCTION TO THE This module is designed to be comprehensive yet concise enough to include all relevant principles, rules, and
USERS concepts. Students are expected to study the course on their own. Further readings as to items that are critical in
understanding the whole course shall be included here for student’s strong knowledge foundation.
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 The link for video lecture discussions (YouTube) to supplement the learning from this module is provided below.
Please have time to view it after you completed the module.

https://www.youtube.com/watch?v=17rqfXoqrxo (by Sir Chua’s Accounting Lessons PH)

The video lecture summarizes the concepts in CVP analysis in less than 25mins.

After completing the module and watching the video, students are expected to read the case studies provided. The
cases will help the students how to apply the concepts of CVP in decision making process.

Therefore, this is the proper sequence of activities the students should accomplish:
1. Complete this module.
2. Watch the video lecture discussion.
3. Read and understand the cases provided.

PRE-TEST
LEARNING At the end of this chapter, students are expected to explain and demonstrate mastery of the:
OBJECTIVES A. Importance of CVP analysis.
B. Limitations and assumptions in CVP analysis.
C. Computing break-even point, margin of safety, expected profit and planned sales.
D. The uses of CVP in sensitivity analysis.
CONTENT Cost Accounting and Strategic Cost Management courses had tackled the types and classification of costs and its
PREPARATORY behavior. As to behavior, costs are usually classified as variable, fixed, or mixed. These costs have their own
ACTIVITIES reaction/response as to the change in the activity level given in a specific case. The importance of having the
knowledge of the behavior of cost is crucial in understanding this chapter.

DEVELOPMENTAL ACTIVITIES

COST - the monetary amount of the resources given up to attain some objective such as acquiring goods and services. When notified by a term
that defines the purpose, cost becomes operational (e.g., acquisition cost; production cost; cost of goods; opportunity cost; out-of-pocket cost,
etc).

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COST BEHAVIOR- Costs are usually classified according to their reaction to changes in activity like production. This classification of costs is
proven to be useful and relevant in management decision – making.

Total amount Per unit amount

1. FIXED Constant Decrease as production increase
2. VARIABLE Increase as production increase Constant
3. MIXED Increase less proportionately (vs. total Decrease less proportionately
variable costs) as production increase (vs. fixed costs per unit) as
production increase

COST BEHAVIOR ASSUMPTIONS

1. Relevant Range Assumption

Relevant range refers to the range of activity within which the cost behavior patterns are valid. Any level of activity outside this range may show
a different cost behavior pattern.

2. Time assumption
The cost behavior patterns identified are true only over a specified period of time. Beyond this, the cost may show a different cost behavior
pattern.

3. Linearity assumption
The cost is assumed to manifest a linear relationship over a relevant range despite its tendency to show otherwise over the long run.

COST-VOLUME-PROFIT ANALYSIS
- a useful management tool that helps managers in planning for profit by way of a systematic examination of the interrelationship among
costs, volume (activity level) and profit.

- commonly referred to as Break-Even Analysis, is a way for companies to determine how changes in costs (both variable and fixed) and
sales volume affect a company’s profit. With this information, companies can better understand overall performance by looking at how
many units must be sold to break even or to reach a certain profit threshold or the margin of safety.

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 FACTORS AFFECTING PROFIT

If there is an increase in.. Then profit will…

1. SELLING PRICE Increase
2. UNIT VARIABLE COST Decrease
3. FIXED COST Decrease
4. VOLUME (UNIT SALES) Increase
5. SALES MIX Either increase or decrease

Underlying CVP assumptions (limitations):

1. Relevant range, time and linearity assumptions are also assumed in CVP analysis.
2. Selling price does not change as sales volume changes.
3. There is no change in the inventory levels during the period.
4. In case of a multi-product company, the proportions (sales mix) of units sold will not change.
5. Labor productivity, production technology and market conditions remain constant and stable.

CVP-RELATED TERMINOLOGIES

CONTRIBUTION MARGIN (CM) - is the difference between sales and variable cost. It is otherwise known as marginal income, profit contribution,
contribution to fixed cost or incremental contribution.

Contribution Margin= Sales – Variable Costs

Contribution Margin Ratio= Contribution Margin / Sales or Contribution Margin Ratio = (1- Variable Cost Ratio)

BREAKEVEN POINT (BEP) - a level of activity, in units (break-even volume) or in pesos (break-even sales), at which total revenues equal total
costs. At the break-even point, there is neither a profit nor a loss.

BEP in units = Fixed costs / CM per unit BEP peso sales = Fixed costs / CM Ratio
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Target Sales for Targeted Profit- refers to the amount of sales in which the company will attain a desired profit (not only to breakeven)

Unit Sales with Target Profit = (Fixed costs + Profit*) / CM per unit

*Profit must be expressed before tax: Profit after tax / (100% - tax rate)

SALES MIX- the relative combination of quantities of sales of various products that make up the total sales of a company.

BEP units = Fixed Costs / Weighted Average CM per unit

*Weighted average CM is computed as CM of every product multiply by the ratio of the sales mix of each products.

MARGIN OF SAFETY – the difference between actual sales volume and break-even sales. It indicates the maximum amount by which sales
could decline without incurring a loss.

Margin of Safety = Sales – Breakeven sales

Margin of Safety Ratio = Margin of Safety / Sales

SENSITIVITY ANALYSIS – a “what if” technique that examines the impact of changes on cost, volume, and profit level in the organization.
A. Increase/Decrease in Selling Price or Sales Volume
B. Increase/Decrease in Variable Cost or Fixed Cost
C. Increase/Decrease in Target Profit

DEGREE OF OPERATING LEVERAGE (DOL) – measures how a percentage change in sales level will affect company profits. It indicates how
sensitive the company is to sales volume increases and decreases. It is also known as operating leverage factor.

DOL = Contribution Margin / Profit before tax

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 Many might think that the higher the DOL, the better for companies. However, the higher the number, the higher the risk, because a higher
DOL also means that a 1% decrease in sales will cause a magnified, larger decrease in net income, ultimately decreasing its profitability.

Problem #1

XYZ Company has the following contribution margin income statement:

Total Per Unit

Sales (20,000) P 1,200,000 P 60
Less: Variable Cost 900,000 45
Contribution Margin 300,000 15
Less: Fixed Cost 240,000
Profit 60,000

Compute for the following:

A. Contribution Margin Ratio (CMR) and Variable cost ratio (VCR)
B. Breakeven point in units (BEP-U) and in peso (BEP-P)
C. If the company wants a profit of P100, 000, how many units must the company sell?
D. Margin of safety in peso and Margin of Safety ratio
E. Degree of operating leverage (DOL)

Suggested Solutions to Problem #1

A. CM Ratio = Contribution Margin / Sales = 300,000/ 1,200,000 = 25%

Variable Expense Ratio = Total Variable Costs / Sales = 900,000/ 1,200, 000 = 75%

B. BEP in units =Total Fixed Costs / CM per Unit = 240,000/15= 16,000 units

BEP in peso= Total fixed costs / CMR = 240,000/25%= P960,000

Or BEP in peso can also be computed as BEP in units multiplied by the selling price. That is 16,000 units X P60 = P960,000

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 C. For targeted profit of P100, 000, the company must sell

Sales in units = (Fixed Costs + Target Profit) / CMU = (240,000+100,000) / 15 = 22,666.67units

Sales in peso= (Fixed Costs + Target Profit) / CMR = (240,000+100,000) / 25% = P 1,360,000

D. Margin of Safety = Sales – Breakeven Sales = P1,200,000 – P960,000= P240,000

Margin of Safety Ratio = MOS/Sales = P240,000 / P1,200,000 = 20%

It means that, sales can drop by P240,000, or 20%, and the company is still not losing any money.

E. Degree of Operating Leverage (DOL) = CM / Profit = P300,000 / P60,000 = 5

The DOL number is an important number because it tells companies how net income changes in relation to changes in sales numbers.
More specifically, the number 5 means that a 1% change in sales will cause a magnified 5% change in net income.

Problem #2:

In planning its operations for 2020 based on a sales forecast of P 6,000,000, Zinc, Inc. prepared the following estimated data:

Cost and Expenses

Variable Fixed
Direct materials P 1,600,000
Direct labor 1,400,000
Factory overhead 600,000 900,000
Selling expenses 240,000 360,000
Administrative expenses 60,000 140,000
P 3,900,000 1,400,000

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Compute for the following:
A. Contribution Margin Ratio (CMR)
B. Breakeven point in peso (BEP-P)
C. Margin of safety
D. Target sales to earn a profit of P350,000
E. Degree of operating leverage (DOL)

Suggested Solutions to Problem #2:

A. CMR= CM/ Sales = (P6,000,000-P3,900,000) / P6,000,000 = 35%

B. BEP in peso = FC/CMR = P1,400,000 / 35% = P4,000,000

C. Margin of Safety= Sales - BE Sales = P6,000,000 - P4,000,000 = P2,000,000

D. Target Sales = (FC + Target Profit) / CMR = (P1,400,000 + P350,000) / 35% = P5,000,000

E. DOL = CM / Profit = P2,100,000 / P700, 000 = 3

Problem #3. Oxygen Company is planning to produce two products, Daredevil and Jewel. Oxygen is planning to sell 100, 000 units of
Daredevil at P4 a unit and 200, 000 units of Jewel at P3 a unit. Variable cost is 70% of sales for Daredevil and 80% of sales for Jewel. To
realize a total profit of P160, 000, what must be the total fixed cost?

Suggested Solution for Problem #3

Profit = Contribution Margin – Fixed Cost

Contribution Margin for Daredevil = 100,000 units * (P4*30%) = P 120,000

Contribution Margin for Jewel = 200, 000 units * (P3*20%) = 120,000
Total Contribution Margin 240,000

Fixed Cost = Contribution Margin – Profit

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 Fixed Cost = P240,000 – P160,000
Fixed Cost = P 80, 000

Problem #4: Neon Company’s break-even sales would increase from P300, 000 to P400, 000 if fixed costs would go up by P40, 000.
Assuming no change in the selling price and variable costs per unit, compute:
A. the company’s variable cost ratio.
B. the company’s fixed cost before and after the increase of P40,000.

Suggested Solution for Problem #4:

A. An increase in breakeven sales of P100, 000 is needed to recover the increase of P40, 000 in fixed cost. At breakeven point,
contribution margin is equal to fixed cost. Therefore, the contribution margin ratio is 40%. Ergo, variable cost ratio is 60%.

B. The company’s fixed costs before the increase is equal to the contribution margin before the increase.

CM = Sales * CMR = P300, 000 * 40% = P120, 000 (fixed cost before increase)

CM = Sales * CMR = P400, 000 * 40% = P160,000 (fixed cost after increase)

Problem #5: Nitrogen Company has fixed expenses of P200, 000, a variable cost ratio of 60% and a margin of safety ratio of 20%. Compute
for the company’s profit for the year is?

Suggested Solution for Problem #5:

Consider the following concepts in CVP:

A. Sales = Breakeven Sales + Margin of Safety
B. Contribution Margin at Breakeven point is equal to Contribution Margin.
C. Breakeven Sales @ 100% = Variable Cost Ratio + Fixed Cost Ratio.
D. Profit = Margin of safety * CMR

The P200, 000 fixed cost is equal to the contribution margin at breakeven point.

If the variable cost ratio is 60%, the CMR is 40% of sales at breakeven point. The breakeven sales is P200,000 / 40% = P500,000.
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 Therefore, if the breakeven sales is P500, 000, the total sale is P625, 000 (computed as P500,000 / 80%)

The margin of safety in peso is equal to P125,000 (computed as Total sales of P625,000 * 20%)

The profit is equal to P50,000 (computed as P125,00 * 40%)

CLOSURE To further supplement the learning of the students, case studies for the advanced application of CVP Analysis is
ACTIVITIES provided together with this module. Download and read them.
SYNTHESIS / ✓ CVP is a useful tool in budgeting and decision making
GENERALIZATION ✓ Break-even point, margin of safety, target profit, operating leverage are important concepts.
✓ CVP can be used from simple to complex decisions in an organization.
EVALUATION 1. Discuss importance of CVP analysis.
2. Explain the limitations and assumptions in CVP analysis.
3. Compute break-even point, margin of safety, expected profit and planned sales.
4. Apply the uses of CVP in sensitivity analysis.
ASSIGNMENT / 1. Review the concepts in capital structure.
AGREEMENT 2. Review the advantage and disadvantage of debt vs. equity financing.
3. Review how to compute for the cost of debt and cost of equity.
SUGGESTED Cost-volume-profit Analysis, Management Advisory Services, Roque, 2007e, or latest edition
READINGS Cost-volume-profit Analysis, Management Advisory Services, Balatbat- Cabrera 2016e, or latest edition

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