MANAGEMENT ADVISORY SERVICES

COST-VOLUME-PROFIT (CVP) ANALYSIS

OCTOBER 2019 BATCH

J.A. SIMBILLO

INTRODUCTION
Cost-Volume-Profit (CVP) Analysis examines the interaction of a firm’s sales volume, selling price, cost structure,
and profitability. It is a powerful tool in making managerial decisions including marketing, production, investment,
and financing decisions.
 How many units of its products must a firm sell to break even?
 How many units of its products must a firm sell to earn a certain amount of profit?
 Should a firm invest in highly automated machinery and reduce its labor force?
 Should a firm advertise more to improve its sales?

Key Assumptions of CVP Analysis

1. Selling price is constant.
2. Costs are linear and can be accurately divided into variable (constant per unit) and fixed (constant in total)
elements.
3. In multiproduct companies, the sales mix is constant.
4. In manufacturing companies, inventories do not change (units produced = units sold).

CONTRIBUTION MARGIN (CM)

- is the amount remaining from sales revenue after variable expenses have been deducted.

In using and understanding the Contribution Margin Income Statement, it is prerequisite to understand the
behavior of costs.
 Variable Costs - are costs whose total peso amount varies in direct proportion to changes in the activity
level.
 Fixed Costs - are costs whose total dollar amount remains constant as the activity level changes.

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity
level within the relevant range.
Total fixed cost remains the
same even when the activity
Fixed level changes within the
relevant range.
the same over wide ranges
of activity.
Fixed cost per unit goes
down as activity level goes up.

CONTRIBUTION MARGIN INCOME STATEMENT

- is helpful to managers in judging the impact on profits of changes in selling price, cost, or volume.

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Format:
X COMPANY
CONTRIBUTION INCOME STATEMENT
FOR THE MONTH OF JULY 2019

TOTAL PER UNIT

Sales ₱ xxxxxx.xx ₱ xx.xx
Less: Variable Costs and Expenses (xxxxxx.xx) (xx.xx)
Contribution Margin ₱ xxxxxx.xx ₱ xx.xx
Less: Fixed Costs and Expenses (xxxxxx.xx)
Net Operating Income ₱ xxxxxx.xx

CONTRIBUTION MARGIN RATIO

Formula:
Total Contribution Margin
CONTRIBUTION MARGIN RATIO =
Total Sales
or
Contribution Margin per unit
CONTRIBUTION MARGIN RATIO =
Total Sales

CONTRIBUTION MARGIN PER Total Contribution Margin

=
UNIT Total Sales in units

BREAK-EVEN POINT
- is the point where total revenue equals total cost (i.e., the point of zero profit).
- Also, the level of sales at which contribution margin just covers fixed costs and when operating income is
equal to zero.

BREAK-EVEN POINT ANALYSIS

- is a measurement system that calculates the margin of safety by comparing the amount of revenues or units
that must be sold to cover fixed and variable costs associated with making the sales.
- is a way to calculate when a project will be profitable by equating its total revenues with its total expenses.
There are several different uses for the equation.

The purpose of the break-even analysis formula is to calculate the amount of sales that equates revenues to
expenses and the amount of excess revenues, also known as profits, after the fixed and variable costs are met.

Formula:

Total Fixed Cost

BREAK-EVEN POINT =
Contribution Margin per unit

TARGET INCOME
 While the break-even point is useful information and an important benchmark for relatively young
companies, most companies would like to earn operating income greater than $0.
 CVP allows us to do this by adding the target income amount to the fixed cost.

Formula:
NUMBER OF UNITS TO Total Fixed Cost + Target Income
=
EARN TARGET INCOME Contribution Margin per unit

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 SALES PESO TO EARN Total Fixed Cost + Target Income
=
TARGET INCOME Contribution Margin Ratio

IMPACT OF CHANGE IN REVENUE ON CHANGE IN PROFIT

 If fixed costs remain unchanged, the contribution margin ratio can find the profit impact of a change in
sales revenue.
 To obtain the total change in profits from a change in revenues, multiply the contribution margin ratio
times the change in sales:

Formula:
CHANGE IN PROFITS = CONTRIBUTION MARGIN RATIO x CHANGE IN SALES

MARGIN OF SAFETY
- is the difference between the amount of expected profitability and the break-even point.
- This is the revenue earned after the company or department pays all of its fixed and variable costs
associated with producing the goods or services.
- the amount of sales a company can afford to lose before it stops being profitable.

Management uses this calculation to judge the risk of a department, operation, or product. The smaller the
percentage or number of units, the riskier the operation is because there’s less room between profitability and loss.
For instance, a department with a small buffer could have a loss for the period if it experienced a slight decrease in
sales. Meanwhile a department with a large buffer can absorb slight sales fluctuations without creating losses for
the company.

Formula:

MARGIN OF SAFETY IN PESOS = ACTUAL/BUDGETED SALES – BREAK-EVEN SALES

MARGIN OF SAFETY IN UNITS = ACTUAL/BUDGETED SALES IN UNITS – BREAK-EVEN SALES IN UNITS

Actual/Budgeted Sales – Break-even Sales

MARGIN OF SAFETY RATIO =
Actual/Budgeted Sales

OPERATING LEVERAGE
- is the use of fixed costs to extract higher percentage changes in profits as sales activity changes.
- Measure of the proportion of fixed costs in a company’s cost structure.
- Used as an indicator of how sensitive profit is to changes in sales volume.

Formula:

DEGREE OF OPERATING Contribution Margin

=
LEVERAGE (DOL) Operating Income

Summary of Operating Leverage

Operating
Leverage
HIGH LOW
% profit increase with sales increase Large Small
% loss increase with sales decrease Large Small

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MULTIPLE PRODUCT/SEGMENT CVP ANALYSIS
 When a company sells more than one product, break-even analysis becomes more complex since different
products have different selling prices, cost structures and contribution margin. Thus it is important to
understand the concept of sales mix and apply this concept to the CVP Analysis.

Sales Mix
- is the relative proportion in which a company’s products are sold.

Formula:

If the sales mix is constant, CVP problems with multiple products can be solved using the following equations:

OVERALL CONTRIBUTION Overall Contribution Margin

=
MARGIN RATIO Total Sales

BREAK-EVEN SALES (FOR Total Fixed Cost

=
MULTIPLE PRODUCTS) Overall CM Ratio

SALES PESO TO EARN TARGET Total Fixed Costs + Target Profit

=
INCOME Overall CM Ratio

CVP GRAPH

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