Cost-Volume-Profit Analysis

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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.

Factors Affecting Profit

1. Increase in selling price = Increase in profit
2. Increase in unit variable cost = Decrease in profit
3. Increase in fixed cost = Decrease in profit
4. Increase in volume sold = Increase in profit
5. Increase in sales mix = Either increase or decrease in profit

Assumptions of Cost-Volume-Profit Analysis

1. Changes in the level of revenues and costs arise only because of changes in the number of
product (or service) units produced and sold.
2. 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. 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.
4. The selling price, variable cost per unit, and fixed costs are known and constant.
5. The analysis either covers a single product or assumes that the sales mix, when multiple
products are sold, will remain constant as the level of total units sold changes.
6. All revenues and costs can be added and compared without taking into account the time
value of money.
7. There is no change in the inventory levels during the period.
8. Labor productivity, production technology and market conditions remain constant and stable.

CVP Related Terminologies

Contribution Margin - is the difference between sales and variable cost. It is otherwise known as
marginal income, profit contribution, contribution to fixed cost or incremental contribution.

 CM Ratio = CM ÷ Sales = Unit CM ÷ Unit Selling Price

 CM ratio = Δ CM ÷ Δ Sales

Break-even Point – 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 profit nor loss.

 BEP units = Fixed costs ÷ CM per unit

 BEP sales = Fixed costs ÷ CM Ratio
 Unit sales with target profit = (Fixed cost + Profit) ÷ CM per unit
 Peso Sales with target Return on Sales = Fixed Costs ÷ (CM Ratio- Return on Sales)

*Profit must be expressed before tax

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

Indifference Point – the level of volume at which two alternatives being analyzed would yield
equal amount of total costs or profits.

Alternative A Alternative B
(Unit CM x Q) – Fixed cost = (Unit CM x Q) – Fixed Cost
Fixed cost + (Unit VC x Q) = Fixed cost + (Unit VC x Q)
Note: Q = number of units (indifference point)

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

 BEP peso = Fixed costs ÷ Weighted average contribution margin
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Operating Leverage – a measure of the extent to which fixed costs is 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 – 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

 Δ % sales x DOL = Δ% profit before tax

Sensitivity Analysis – a “what if” technique that examines the impact of changes on an answer.
For example, computer spreadsheets are used to analyze changes in prices, variable costs, and fixed
costs on expected profits.

Methods of Computing Break-even Point

1. Equation Method or Algebraic approach
2. Contribution margin method or formula approach
3. Graphical approach

Multiple product Analysis

When CVP analysis is used for a multiple-product firm, the product is defined as a package of
products. For example, if the sales mix is 3:1 for Product A and B, the package consists of 3 units of
product A and 1 unit of product B.

Break-even packages = Fixed costs / Weighted average contribution margin

Exercises:
1. Jazz Company, a manufacturer of quality rubber shoe that fits all sizes has had a steady growth
in sales for the past five years. However, increased competition has led the company president to
believe that an aggressive marketing campaign will be necessary next year to maintain the
company’s present growth. To prepare for next year’s marketing campaign, the company’s
controller has prepared and presented the president with the following data for the current year,
2022:

Variable cost/unit:
Direct materials P3.25
Direct manufacturing labor 8.00
Variable overhead (manufacturing, marketing
Distribution and customer service) 2.50

Fixed costs:
Manufacturing P25,000
Marketing, distribution, and customer service 110,000

Selling prize P25.00

Expected sales P500,000
Income tax rate 40%

Required:
a. Compute the company’s net income for 2022
b. Compute the company’s break-even point in both units and sales pesos for 2022
c. The president has set the revenue target for 2023 at a level of P550,000 (22,000 units). He
believes an additional marketing costs of P11,250 for advertising in 2023, with all other costs
remaining constant, will be necessary to attain the revenue target. What is the net income for
2023 if the additional P11,250 is spent and the revenue target is met?
d. What is the break-even point in revenues for 2023 if the additional P11,250 is spent for
advertising?
e. If the additional P11,250 is spent, what are the required 2023 revenues for 2023’s net
income to equal to 2022’s net income?
f. At a sales level of 22,000 units, what maximum amount can be spent on advertising if a 2023
net income of P60,000 is desired?

2. Jazz, Inc. sells rainy season products. The Baguio Division handles both umbrella and raincoat.
Historically, the firm has sold, on the average, 100 umbrellas and 300 raincoats. Each umbrella
has a P6 contribution margin and each raincoat has a P4 contribution margin. The fixed cost of
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operating the Baguio Division is P900 per period. Each umbrella sells for P20 on average and
each raincoat sells P10 on the average. The company pays corporate income taxes.

Required:
a. Compute the weighted average unit contribution margin and weighted average contribution
margin ratio.
b. How much revenue is needed to break-even? How many umbrella and raincoats does it
represent?
c. How much revenue is needed to earn pre-tax profit of P135?
d. How much revenue is needed to earn an after-tax profit of P196?
e. If the Baguio Division earns the revenue determined in (C), but in doing so, sells 2 umbrellas
for each raincoat, what would the pre-tax profit or loss be? Why is this amount not P135?

3. The following are data taken from the most recent income statement of Jazz Company:

Sales (45, 000 units) P450,000

Less: COGS
Direct materials P90,000
Direct labor 78,300
Manufacturing overhead 98,500 P266,800
Gross margin 183,200
Less: operating expenses
Selling expenses
Variable:
Sales commissions P27,000
Shipping 5,400 32,400
Fixed (advertising, salaries) 120,000
Administrative:
Variable (billing and other) 1,800
Fixed (salaries and other) 48,000 202,200
Net operating loss (P19,000)

All variable expenses in the company vary in terms of unit sold, except for sales commissions which
are based on peso sales. Variable manufacturing overhead is P0.30 per unit. There was no beginning
or ending inventories. Jazz Company’s plant has a capacity of 75,000 units per year.

The company has been at a loss for several years. Management is studying several possible courses
of action to determine what should be done to make next year profitable.

Required:
a. The president is considering two proposals prepared by his staff:
1. For next year, the vice president would like to reduce the unit selling price by 20%. She is
certain that this would fill the plant to capacity.
2. For next year, the sales manager would like to reduce the unit selling price by 20%,
increase the sales commission to 9% of sales, and increase advertising by P100,000.
Based on the marketing studies, he is confident this would increase unit sales by one-
third.

Compute the amounts of income, one under the vice president’s proposal and the other one
under the sales manager’s proposal.

b. Refer to the original data. The president believes it would be a mistake to change the unit
selling price. Instead, he wants to use less costly raw materials, thereby reducing unit costs
by P0.70. How many units would have to be sold next year to earn a target profit of P30,200?
c. Refer to the original data. Jazz Company’s board of directors believes that the company’s
problem lies in inadequate promotion. By how much can advertising be increased and still
allow the company to earn a target profit of 4.5% on sale of 60,000 units?
d. Refer to the original data. The company has been approached by an overseas distributor who
wants to purchase 9,500 units on a special price basis. There would be no sales commission
on these units. However, shipping costs would be increased by 50% and variable
administrative cost would be reduced by 25%. In addition, a P5,700 special insurance fee
would have to be paid by Jazz Company to protect the goods in transit. What unit price would
have to be quoted on the 9,500 units by Jazz Company to allow the company to earn a profit
of P14,250 on total operations? Regular business would not be affected by this special order.