COST VOLUME PROFIT

ANALYSIS

APRIL JEELEANE C.
RECIO
 COST VOLUME PROFIT ANALYSIS

INTRODUCTION

Cost-volume-profit (CVP) analysis is a method of cost accounting that scrutinizes the impact that

varying levels of costs and volume have on operating profit. It is also known as break-even analysis
which leaders use when determining short-term strategies for their businesses. CVP analysis makes
several assumptions which includes sales volume, variable costs, fixed costs, and/or selling price per unit
are constant.
Running a CVP analysis requires several equations for price, cost, and other variables, which it
then plots out on an economic graph. The results of these analyses help leaders make informed
decisions about the products or services they sell such as projecting profitability, such as setting selling
prices, selecting combinations of different products to sell and establish the feasibility of offering a
product or service for sale.

COST VOLUME PROFIT ANALYSIS (CVP)

Several companies use CVP analysis to determine how the changes in fixed costs, variable costs
and sales volume can contribute to the profits of a business. The CVP analysis is made up of several
components which involves various calculations and ratios.

The main components of CVP analysis are:

1. CM ratio and variable expense ratio
2. Break-even point (in units or dollars)
3. Margin of safety
4. Changes in net income
5. Degree of operating leverage

The following assumptions are made when performing a CVP analysis.

1. All costs are categorized as either fixed or variable.
2. Sales price per unit, variable cost per unit and total fixed cost are constant.
The only factors that affect costs are changes in activity.
3. All units produced are sold.
BREAKEVEN POINT
The break-even in a business is established by weighing ups the market price of an asset to the
original cost; it is reached when the two prices are equal. This means there is no loss or gain for your
business. In other words, you've reached the level of production at which the costs of production equal
the revenues for a product.

In corporate accounting, the break-even point formula is determined by dividing the total fixed
costs associated with production by the revenue per individual unit minus the variable costs per unit. In
this case, fixed costs refer to those which do not change depending upon the number of units sold. Put
differently, the break-even point is the production level at which total revenues for a product equal total
expense.
The break-even formula for a business provides a figure they need to break even. This can be
converted into units by calculating the contribution margin (unit sale price fewer variable costs). Dividing
the fixed costs by the contribution margin will provide how many units are needed to break even.

We can find all the information required to calculate a business’ BEP in their financial
statements. The first pieces of information required are the fixed costs and the gross margin percentage.
Assume a small business has PHP 100,000.00 in fixed costs and a gross margin of 37%. Its break-
even point is PHP 270, 270.00 (PHP 100,000.00/ 0.37). In this break-even point example, the business
must generate PHP 270, 270.00 in revenue to cover its fixed and variable costs. If it generates more
sales, the business will have a profit. If it generates fewer sales, there will be a loss.
We can also calculate the units that need to be sold which will cover the fixed costs, this will
result the company to break-even. To do this, calculate the contribution margin, which is the sale price
of the product less variable costs.
Assume a cosmetics business has a PHP 100.00 sale price for its lipstick product and variable
costs of PHP 20.00. The contribution margin is PHP 80.00 (PHP 100.00- PHP 20.00). Divide the fixed costs
by the contribution margin to determine how many units the business has to sell: PHP 100,000.00 / PHP
80.00= 1,250 lipsticks. If the company sells more units than this it will show a profit. If it sells fewer,
there will be a loss.

OPERATING LEVERAGE 
Operating leverage is a cost-accounting formula that measures the degree to which a firm or
project can increase operating income by increasing revenue. It boils down to an analysis of fixed costs
and variable costs. A business that generates sales with a high gross margin and low variable costs has
high operating leverage.
 Operating leverage arises when a business has fixed costs that must be attained regardless of
sales volume. The operating leverage formula is used to calculate a company’s break-even point and
help set appropriate selling prices to cover all costs and generate a profit. The higher the degree of
operating leverage, the greater the potential danger from forecasting risk, in which a relatively small
error in forecasting sales can be magnified into large errors in cash flow projections.

This can be restated as

Where:
Q = unit quantity
CM – Contribution Margin (price – variable cost per unit)
Example:
ABC cosmetics company sells 100,000 products for a unit price of PHP 100.00 each. The company’s fixed
cost is PHP20,000.00. it costs PHP 20.00 in variable costs per unit to make each product.

A 10% revenue increase should result in a 10% increase in operating income (10% x 1 = 10%).

MARGIN OF SAFETY
The margin of safety occurs when there is a reduction in sales before the breakeven point of a
business is reached. This data shows the risk of loss to which a business is subjected by changes in sales.
The concept is useful when a significant proportion of sales are at risk of decline or elimination, as may
be the case when a sales contract is coming to an end. It might trigger action to reduce expenses when a
minimal margin of safety is reached. Likewise, if the margin of safety is substantial that a business is
secured from sales variation.
 To calculate the margin of safety, subtract the current breakeven point from sales, and divide by
sales. The amount of buffer is expressed as a percentage. The formula is:

Below are the two alternative versions of the margin of safety:

1. Budget based. A company may want to project its margin of safety under a budget for a future
period. If so, replace the current sales level in the formula with the budgeted sales level.
2. Unit based. If you want to translate the margin of safety into the number of units sold, then use
the following formula instead (though note that this version works best if a company only sells
one product):

Here is an example of the Margin of Safety

ABC cosmetics company is planning to add a new packaging equipment to improve the design
and increase the production of its lipstick lines. The addition will increase PHP 100,000.00 per year, but
they are also seeing increase in sales. Relevant information is noted in the following table:

The table above conveys that if the company would continue the purchase of the packaging
equipment, both the margin of safety and profits worsen. This means expanding production capacity
through new equipment is not feasible.