OPERATING AND FINANCIAL LEVERAGE

Cost Volume Profit (CVP) Analysis is a powerful tool and vital in many business decisions because it helps managers
understand the relationships among cost, volume & profit and focus on how profits are affected by

• Selling prices

• Sales volume

• Unit variable costs

• Total fixed costs

• Mix of products sold

Contribution Margin per unit

● Excess of unit selling price over unit variable costs and the amount each unit sold contributes toward

 Covering fixed costs and

 Providing operating profits

CM per unit = Unit selling price – unit variable costs

Contribution Margin ratio

● Percentage of contribution margin to total sales

● Affected by a given peso change in total sales

𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑴𝒂𝒓𝒈𝒊𝒏
CM Ratio = 𝑺𝒂𝒍𝒆𝒔

CVP Analysis for Breakeven Planning

● Break-even point – total revenues and total expenses are equal

𝑻𝒐𝒕𝒂𝒍 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕𝒔
Break-even point (units) = 𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑴𝒂𝒓𝒈𝒊𝒏 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕

𝑻𝒐𝒕𝒂𝒍 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕𝒔

Break-even point (pesos) = 𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝑪𝒐𝒔𝒕𝒔
𝟏−
𝑺𝒂𝒍𝒆𝒔

● Break-even sales
𝑻𝒐𝒕𝒂𝒍 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕𝒔
Multi-products firms (combined units) = 𝑾𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑴𝒂𝒓𝒈𝒊𝒏

𝑼𝒏𝒊𝒕 𝑪𝑴 𝒙 𝑵𝒐. 𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒑𝒆𝒓 𝒎𝒊𝒙+𝑼𝒏𝒊𝒕 𝑪𝑴 𝒙 𝑵𝒐. 𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒑𝒆𝒓 𝒎𝒊𝒙

Weighted Contribution Margin per unit =
𝑻𝒐𝒕𝒂𝒍 𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒑𝒆𝒓 𝑺𝒂𝒍𝒆𝒔 𝑴𝒊𝒙

𝑻𝒐𝒕𝒂𝒍 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕𝒔

Multi-products firm (combined pesos) = 𝑾𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑪𝑴 𝑹𝒂𝒕𝒊𝒐

𝑻𝒐𝒕𝒂𝒍 𝑾𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑪𝑴 (𝑷)

Weighted CM Ratio =
𝑻𝒐𝒕𝒂𝒍 𝑾𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑺𝒂𝒍𝒆𝒔 (𝑷)

CVP Analysis for Revenue and Cost Planning

-determines the level of sales needed to achieve a desired level of profit

𝑻𝒐𝒕𝒂𝒍 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕𝒔+𝑫𝒆𝒔𝒊𝒓𝒆𝒅 𝑷𝒓𝒐𝒇𝒊𝒕

Sales (units) =
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑴𝒂𝒓𝒈𝒊𝒏 𝒑𝒆𝒓 𝑼𝒏𝒊𝒕
𝑻𝒐𝒕𝒂𝒍 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕𝒔+𝑫𝒆𝒔𝒊𝒓𝒆𝒅 𝑷𝒓𝒐𝒇𝒊𝒕
Sales (P) =
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑴𝒂𝒓𝒈𝒊𝒏 𝑹𝒂𝒕𝒊𝒐
Assumptions & Limitations of CVP Analysis

1. Valid for a limited range of values - the “relevant” and a limited period of time
2. Variable or Fixed
3. Revenue
4. Constant product mix

5. Changes in volume

6. No significant changes in inventories

7. Operation leverage questions

8. Deterministic and appropriate data can be found

Sensitivity Analysis of CVP Result

Examine sensitivity of profits to change in sales.

Margin Of Safety

Indicates the amount by which sales could decrease before loses are incurred

Potential effect the risk that sales will fall short of planned levels
𝑴𝒂𝒓𝒈𝒊𝒏 𝒐𝒇 𝑺𝒂𝒇𝒆𝒕𝒚
Ratio= 𝑨𝒄𝒕𝒖𝒂𝒍 𝒐𝒓 𝑷𝒍𝒂𝒏𝒏𝒆𝒅 𝑺𝒂𝒍𝒆𝒔

Units= Actual or Budgeted Unit Sales – Breakeven Unit Sales

Operating Leverage

Degree of Operating Leverage (DOL)

● A measure, at a given level of sales, of how a percentage change in sales volume will affect profits
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑴𝒂𝒓𝒈𝒊𝒏
DOL =
𝑵𝒆𝒕 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑰𝒏𝒄𝒐𝒎𝒆

Degree of Operating Leverage (DOL) Alternative Approach

● Percentage change in operating income that occurs as a result of a percentage change in units sold
𝑷𝒆𝒓𝒄𝒆𝒏𝒕 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑰𝒏𝒄𝒐𝒎𝒆
DOL = 𝑷𝒆𝒓𝒄𝒆𝒏𝒕 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒖𝒏𝒊𝒕 𝒗𝒐𝒍𝒖𝒎𝒆