OLUME-PROFIT AND BREAK-EVEN ANALYSIS. CHAPTER OBJECTIVES This chapier should enable you to know and understand: * The different cost behavior patterns and their importance in cost analysis, profit planning and decision making. * How to identify mixed costs and separate them into fixed and variable components. ° The nature and uses of cost-volume-profes analysis, * Break-cven analysis using algebraic formulaand graphical approaches, « How to determine break-even point when mul- viple products ave sold in combination. © The different assumptions underlying cost- volume-profit and break-even analyses.The ultimate goal of every businessman is maximization of profit, without necessarily disregarding the firm's social responsibilities. Hence, whenever financial statements, particularly the income statement, are prepared, it is a Common pracice to first look at the so-called "bottom—figure” to find out whether the company earned profit or incurred loss during the period. COMPUTATION OF PROFIT For the accountant, profit is the excess of revenue over the total costs and expenses incurred in generating such r. venue during an accounting period. This can be expressed in the following mathematical equation: Profit = Sales - Total Costs and Expenses The sales figure in the above equation, oftentimes referred to as peso sales volume, is a result of multiplying the units sold (sales volume in units) by the selling price per unit. The total costs and expenses is the sum of all the costs to produce’ and sell the product, as well as all the other expenses incurred to administer the operations of the business. ‘The manufacturing firm, instead of the service or trading firms shal! be used in most of the illustrations in this chapter.Chepter 5/Cost-Volume-Profit & preak-Even Analy 167 profit during the period. Howeyer, 2 g00d businessman should not be contented with this fact, still, some questions have to be asked: * Was the company able to realize its profit objective? * Is there 2 possibility of gurther increasing the amount earned, or is this the maximum arnount that the company can possibly earn? / Should the company desire ro increase this amount further, what courses Of action should be taken? PROFIT PLANNING In most cases, profit does not just come. Its realization cannot be left to chance. Businessmen cannot just stay in their office, wait for customers, then hope and pray that enough sales volume be generated to yield the desired profit Actually, profit can be planned. A certain amount of profit may be set as the goal for a period, and strategies may be thought of to attain the goal set. Theoretically, it seems not too difficult to do. We just have to reconsider the formula to compute for profit, Profit = Sales - Total Costs and Expenses and. from there we can observe that increasing profit merely requires an increase in sales and/or a decrease in costs and expenses. In other words, if sales and costs are to be regarded as factors affecting profit, then maximization of profit can be accomplished by carefully manipulating these factors. COST-VOLUME-PROFIT ANALYSIS One of the analytical tools that managers can use in profit planning is cost-volume-profit analysis, which is a systematic examination of the relationships among costs, activity levels or volume, and profit.niques for Analyais, Planning & Controt Using the conventional income starement format, profit may be calculated as followsr Sales (Units Sold x Selling Price Per Unit) Less Cost of Goods Sold (Cost of Materials, Labor and Overhead incurred to manufacture the units sold) Gross Profit Less Operating Expenses (Selling and Adrninistrative Expenses) Profit (Loss) 7 For example, a company was able to produce and sell 10,000 units of a product during a certain period. This product was sold for PI.50per unit. Production costs of P7,000 were incurred for the 10,000 units, while selling and administrative expenses amounted to P5,090. Using the above income statement format, profit may be calculated as follows: Sales (10,000 x P1.50) P15,000 Cost of Goods Sold 7,000 Gross Profit P 38,000 elling and Administrative Expenses 5,000 Profit P_ 3,000 in the above example, it is clear that the company earnedChapter _5/Cost-Volume-Profit & presk-Even Analysis profit during the period. However, 2 good businessman should not be contented with this fact, still, some questions have to be asked: * Was the cornpany able to realize its profit objective? * Is there a possibility of further increasing the amount earned, or is this the maximum amount that the company can possibly earn? - Should the company desire 10 increase this amount further, what courses of action should be taken? PROFIT PLANNING In most cases, profit does not just come. Its realization cannot be left to chance. Businessmen cannot just stay in their effice, wait for customers, then hope and pray that enough sales volume be generated to’ yield the desired profit. Acwally, profit can be planned. A certain amount of profit may be set as the goal for a period, and strategies may be thought of to attain the goal set. Theoretically, it seems not too difficult to do. We just have to reconsider the formula to compute for profit, Prof: Sales - Total Costs and Expenses and- from there we can observe that increasing profit merely requires an increase in sales and/or a decrease in costs and expenses. In other words, if sales and costs are to be regarded as factors affecting profit, then maximization of profit can be accomplished by carefully manipulating these factors. COST-VOLUME-PROFIT ANALYSIS One of the analytical tools that managers can use in profit Planning is cost-volume-profit analysis, which is a systematic examination of the relationships among costs, activity levels or volume, and profit.MOY require much elaborate e Btt 2/Systems & Techniques for Analysis, Planning & Contro) ing the above-mentioned factors, seles and volume do soussions to illustrete how profir ey DE mamimized by maerupuizting the same. Obviously, if these an - sek level ancreese, ing Cees the other ne, the 107 peso sales vohume will wit Teese. What requ: a +s the cost factor, for this Consists of different varying Characteristics and Berevicx. COST CONCEPT & CLASSIFICATIONS used accounting term may heave OOD, it an exctarge for ways, cepeirg om the For ou purpowes an uct: 2s merntac toring (composed esemerts oh prubctem racmety, fectry grereect), willing and - Gromes m serail in the prot There are om payor: are discusses sn the wurceesicg5/Cost-Volume-Profit 4 greak-Ewen Anal change erns can i Coat total » (units, Sctivity Level e170 Part 2/Systems & Techniques for Analysis, Planning & Control level on the horizontal axis (x) and the total cost in pesos on the vertical exis (y), the total fixed cost, as represented by a is plotted as @ horizontal straight line. This indicates that the amount of fixed cost remains constant for all levels of activity. Fixed costs may be assigned to specific cost objectives such as a product, a department, an activity, or a business segment. When fixed costs are assigned to a. product, and the unit cost of such product is determined, the. amount of fixed cost assigned to each unit of product depends on the number of units produced during the period. If production activity is high, each product shares a relatively small amount of fixed cost. On the other hand, if volume of production is low, fixed cost per unit is relatively high. This is so because the total amount of fixed cost being allocated to the number of units remains constant regardiess of the change in volume, hence, fixed cost per unit changes in an indirect or inverse pattern, depending on the direction of the change in the activity level. For instance, if the P25,000 monthly rental for the factory building in the previous example is allocated to the units of product manufactured during the period, unit fixed cost will vary in an opposite direction with the change in volume. Assuring that the normal production level is 25,000 units, unit fixed cost is P1,00 (P25,000/25,000 units). If production volume soe, down to 10,000, fixed cost per unit will increase to P2.50 »29,000/10,000). However, if volume is increased to 26,000 aits, fixed cost per unit will decrease to P0.96 (P25,000/26,000). This is summarized as follows: With the activity FIXED Cost PRODUCTION TOL _IN_UNITS FIXED COST PER UNIT 10,000, 25,000 2.50 {000 25,005 1.00 000 0.96 26,000 25, <Chapter _5/Cost-Volume-Profit @ greak-Ever Analysis an It can therefore be said that fixed costs possess the following characteristics: CHANGE IN FIXED COST ACTAVaAy PER ACTIVTY LEVEL LEVEL TOTAL __ 4 (units, houre, ete.) [anencas | CONSTANT | DECREASE DECREASE CONSTANT INCREASE | Variable Costs Variable costs are costs that change directly and proportion- ately with the level of activity. In this case, the total variable cost increases as the activity level increases, and the total variable cost decreases as the activity level decreases but the variable cost per activity level remains constant. Examples of variable cost include direct materials, direct labor, some variable overhead items like indirect materials, indirect labor, factory supplies, employee fringe benefits on direct labor, sales commissions, office supplies, etc. To illustrate, if the cost of material per Unit of a certain product is 5.00, and each product requires one unit of material, production of 1,000 units of product will require 1,000 units of material at a total cost of P5,000. If production is increased to 1,500 units, the same quantity of materials will be used at a total cost of P7,500. However, if production is reduced to 800 units, materials will cost P4,000. Observe that despite the changes in the total cost of materials, the cost per unit remained constant at P5.00. To summarize, consider the following tabulation: UNITS OF MATERIALS TOTAL MATERIALS COST PER UNIT MATERIALS COST @00 P5.00 4,000 1,000 5-00 5,000 1,500 5.00 7,500i 172 Part 2/Systems & Techniques for Analysis, Planning & Control Based on the tabulation, the Characteristics of variable costs may be restated as follows: VARIABLE COST (units, nours, etc.) TOTAL iene enero InREASE further the cOSt behavior pattern of variable To illustrate zi he graph in Figure 5-2 shown below: costs, consider t () FIGURE 5-2 y Total Variable Cost Total Cost x (units, hours, etc.) 0 Activity LevelChapter_5/Cost-Volume-Profit & en Analysis 173 With the activity level on the horizontal axis (x) and the total cost in pesos on the vertical axis (y)y the total variable costs are graphed as a straight line ghat starts at the origin (x = 0 and y = 0) and slopes upward to the right. Note that for every unit of increase in activity Jevel, there is a proportionate increase in the cost. If we shall get the ratio of y to x, proportional relationship between the variable cost and activity level may be established. This ratio, which repre sw ts the variable cost per activity level, is the same for all levels of activity. Hence, a one unit change in activity level causes te same total cost change anywhere within the company's operating, capacity. In Figure 5-1 on page 169, fixed cost is expressed in equation form as: In the case of variable cost, the general equation form is: y = bx where: the total variable cost the variable cost per activity level the actavaty level measured in terms of units, labor hours, ete. ¥ 5 Assuming, therefore, that the company's total only of variable and fixed costs, equation form as follows: costs consist the same may be expressed in y = a+ bx where y = total cost a = total fixed cost variable cost per unit, hour, ete. ~ x = number of units, hours, etc.174 Part 2/Systems & Techniqueé for Anasyais, Planning &Contro) a Mixed Costs Some costs cannot be described by a single cost behavior pattern. These are called mixed costs, which possess both fixed and variable components. To illustrate, assume that Silahis Corporation pays its factory workers a basic monthly salary of P1,000 plus jncentive pay of P0.20 per unit of production. Assume further that the company's records showed the following data for Employee A for the first quarter of the year: January February March Production TOTAL In Units LagoR Cost 3,000 1,600 5,600 1,760 2.600 1.520 An examination of the above production and labor cost figures will show that such costs have the following characteristics: TOTAL COST COST PER UNIT - the total labor cost varies directl with production. When. production Increased from 3,000 to 3,800 units, total labor cost increased from P1,600 to P1,760. When production decreased to 2,600 units, total labor cost likewise decreased to P1,520. Note that this is one of the characteristics of variable costs. er unit Jabor cost varies inversel ith production. When _ production increased from 3,000 to 3,800 units, Jabor cost per unit decreased from P0.53 [P1,600/3,000] to P0.46 [1,760/ 3,800]. When production decreased to 2,600 units, labor cost per unit Increased to P0,58 [P1,520/2,600]. Note that this is one of the characteristics of fixed costs.Chapter 5/Cost-Volume-Profit & grook-E ve! vs If we shall compare . s example with those of var discussed in the previous up with the followir (_ [.s~*«Stwta T VARIABLE [Increanes an v T cost decreases am vo Fixeo T cost ‘ua LABOR i COST EXAMPLE : et = Based on the above study, we can cor cost in our example cannot be called not possess all the characteristics Neither can it be called fixed cos it has the characteristics of both variab more appropriately called mixed cost Figure 5-3 illustrates a mixed cost. T is shown by a straight line horizontal ¢ axis. The mixed cost or total cost line, w variable costs, is shown by the line whic y (total cost) axis and slopes upward to the y (PD Mixed Cost (Total Cost) = Fixed Coat + Variable Cost Fines Cont TOTAL COST Fined cost Total Cout of Mixed Coot x (unite, Rowrs, ete) ACTIVITY LEVEL176 Part 2/Systems & Techniques for Analysis, Planning & Control In equation form, a mixed cost may be expressed by simply combining the equations for a fixed cost and variable cost: For purposes of planning, analysis and decision making, the above forrnula may be used to determine the amount of mixed (total) cost for any level of activity. Using our previous example, we can project labor cost payments to employee A. Considering again that Silahis Corporation pays him a basic salary of P1,000 per month (Fixed, a) plus incentive ray of P0.20 per unit (variable cost per unit, b), total labor cost (y) for 4,000 and 5,000 units may be determined as follows: x = 5,000 unite = a bx x = 4,000 unite yr asx y y * P1,000 + P0.20 (4,000) y = P1,000 + P0.20 (5,000) y = P1,000 + PaO y = P1,000 + 91,000 y = P1.p00 y = 22,000 Some accountants use the term semivarlable cost inter- changeably with mixed cost. However, in this chapter, semi- variable costs will be regarded separately, as discussed in the following sections. Semivariable Costs In some cases, we encounter cost items which vary directly with the change in activity level. However, unlike in purely variable costs, the rate of change in these cost items with the change in activity level is not constant. These costs are called semivariable costs. Instead of increasing at a constant rate, ee —Semivariable costs increase nereas An example of type of tr ctricity. Our electric bills computed on a ket, which means of tricity, a hig! one, his hh per kilowatt- illustrate, study 5-1 shown below. O} charge per kilowatt-hour, which hours are consume electric bili in distribution kilowatr- | a ae J} Semivariable costs that increase at a decreasing rate: A typical example of this cost item is the learning curve cost. This results from improving labor efficiency as employees become more familiar with a new job. For instance, it may require eight hours to make a chair for the first production run of a new model of chair. On the next production run, however, employees may produce the same model of chair in only 6 hours, and perhaps 5 hours only in the third run. If these employees were paid in an hourly basis, note that the labor cost to produce the chairs in this example will tend to increase at a decreasing rate as more chairs are produced. This is so because as the employees become familiar with the production process, they require less hours (and costs) to produce more units.176 Part 2/Systems & Techniques For Analysis, Planning & Control Graphical Presentation The two types of semivartable costs described above are illustrated. in graphical form in Figure 5-4 The graph for purely variable costs is hkewise shown in Figure 5-4 $0 we can have an idea of how it differs from semivariable costs. Ys _— Co tre mee Semifixed Costs costs are often called step function costs or step possess some characteristics of both variable and Like variable costs, semifixed costs increase with pe activity Jevel, although not proportionately, and like fixed costs, they remain constant for stretches of activity levels, Sithough not for all levels of activity. be more The cost behavior pattern of semifixed costs may clearly understood by illustrating the same in graphical form. In Figure 5-5, the graph of the cost is represented by solid lines. The vertical broken lines, labeled S, F, C | horizontal represent the increase in total cost at each step as the level of Semifixed costs. They fixed costs. activity increases. Assume, for example that a company uses one machine with a capacity of 5,099 units. The seme is being depreciated at P2,000 per period. As long as the production level is within the range of 0 to 5,000 units, depreciation cost remains constant at _-P2,000. However, should production increase above 5,000 units, there will be a need for another machine. Hence, assuming that a ai Chapter _9/Cost-Volume-Profit & g E e-Profit & pr the additional machine has the same features as the other in terms of capacity and depreciation cost, total depreciation cost will increase from P2,000 to py.go9 when production 15 at the range of 5,001 to 10,000 units, Tne same trend will continue in case of further increases in the acitivity level. This example is illustrated in graphical form in Figure 5-6- = — | | = L Note that the semifixed depreciation cost jumps intermittently from one level to another. It remains constant until another jump occurs at a higher level of activity. This explains why the graph of semifixed cost is not continuous; it 1s broken whenever the amount of cost shifts from onc level to another. Because of this behavior pattern, it is difficult to describe sernifixed cost in simple mathematical equation. This limitation, however, should not prevent managers from considering semifixed cost in planning and decision making. COST BEHAVIOR ASSUMPTIONS Two important assumptions are considered in the discussion of cost behavior patterns: the relevant range assumption and the time assumption. The Relevant Range Assumption Relevant range refers to the band of activity within which the identified cost behavior patterns are valid. Any level of activity outside this range may have different cost behavior patterns. For example, consider the graphs in Figure 5-7.180 Part 2/Systems & lechni@¥2S For Analysis, Planning & Control Fro Sy ef: | | | In grapi 1, the cost is semivariable when production 1s below the activity level D. At the range indicated by levels D to E, the cost is directly or purely variable. Above this ramge the cost 1s again semivariable. In graph 2, the cost is mixed when the production jevel is below and/or above the range indicated by activity levels F & G. Within this range, the cost is purely fixed. For purposes of planning and decision making, the cost behavior patterns and the production level within the relevant range (D to E and F to G in graphs 1 and 2, respectively) are considered. It is assumed that such level wiil most likely occur during the period. Extremely high and low activity levels or production levels above and below the relevant ranges considered abnormal, hence unimportant. The Time Assumption The time assumption states that the cost behavior patterns identified are true only over a specific period of time. Beyond this, the cost may show a different behavior. Some costs classified as fixed may no longer be fixed in the long run. A show a semivariable cost directly/purely variable cost may behavior pzttern beyond a period of time under consideration. Or a variable cost may even shift to be a fixed cost or vice- arehapter_5/Cost-Volume-Profit_& Break-Even Ane » 181 versa at a time, duc to some circumstances that may occur in the business. For example, a worker paid on a per output basis during his 6- month probationary period may eventually be paid on @ semi- monthly fixed salary basis upon successful completion of his probation - a shift from variable to fixed cost. Similarly, payments for lease on a building may be fixed during the period covered by the lease contract, but the amount may change upon expiration or renewal of the contract - 4 Change in the amouns of total fixed cost. SEGREGATION OF FIXED AND VARIABLE ELEMENTS OF MIXED COSTS In making a cost analysis, it is best to identify specific cost items as cither variable or fixed. To do this, the best tool to use is experience. Some personne! with extensive service and exposure to the operations of the firm can expertly handle this task of identitying cost petterns and predicting production and cost levels. However, it is not unusual for these personnel to encounter mixed costs, and this gives rise to the problem of determining how much of these mixed costs are fixed and how much are variable. To isolate the fixed and variable Components of mixed costs, the following techniques may be used: the high-low method, the statistical scatter graph method and the method of least squares. High-Low Method~ A simple and widely used technique of segregating mixed costs components is the high-low method. This technique can be best explained through an illustrative example. Consider, for instance, the following monthly cost data for a period of six months. Month Cost: Lebor Hours Cost Per Hour January 4,400 1,200 nes. 3.67 February 4,700 1,350 brs. 3148 March ano 1,100 hrs. 3lez April 3,800 900 hrs. 4.22 May 4000 1,000 hrs: cao June ayere 1,400 hrs. Silas182 Part_2/Systems & TechniqveS for Analysis, Planning & Contro} Definitely, the above cost data cannot be considered fixeg since the total amounts af© not constant. The data indicate + labor hours), some cost variability with the activity level (direct | However the same cannot be considered as _directly/purely variable costs since the variable rates per hour are not uniform, Actually, the above cost data are mixed costs, having the characteristics of both variable and fixed costs. To segregate the fixed and variable elements using the high-low method, the Procedures are: Direct + Choose the representative highest Lal a and lowest activity levels (direct Gost Labor Houre abor hours in our example) with their corresponding costs. Highest P4,900 1,400 bre, Lowest 3,800 900 2. Get the differences (or changes) panini between the highest and lowest Cost Labor Hours cost and direct labor hours. These differences represent the | yighest p4,800 1,400 hrs. change in cost with the change : 3,800 900 in direct labor hours. Lee a pifferences 1,000 500 hrs. Difference _in Cost 3. Determine the rate of cost b ny = ence in Activity Leve. variability with activity level patter (the variable rate per hour in fa toe our example). The change 1n cost = $00 direct labor hrs. with the change in direct labor hours obtained in No. 2 above = 72.00 per_direct labor hour represents change in variable = £2.00 per direct shor nour cost only because this cost is where b = variable rate per hour expected to vary with the activity level. No change in Fixed cost is included in such difference since fixed costs are assumed to be constant for. all levels of activity. Once the variable rete is known, the total v. for any level ‘otal variable cost for any AeKe of activity may be dete’ Simply multiplying this variable185 IN rate to the number of direct labor hours. In equation fora, this may be expressed as Follows: Total Variable Cost = Variable Rate (Actavity Lever) la. Determine the total amount of fixed cost by subtracting the total variable cost Crom the total cost for any activity Tevel. (Uoth the highest and lowest activity levels ore used in Lhe computations. Note that on both levels, fixed costs remained constant).| Total Cost fy) fess Variable Cost (bx) Total Fixed Cost (a) y= a+ be Total (Mixed) € 4 5 3 4 a < a = Faxed Cost b = Variable rate per activity level x = activity level, fixed cost may be determined sot a zy - ox + 2,800 = 1,800 hr. x P2.00 +> P1,800 900 hes. x P2.06 The highest and lowest activity levels usually (although not necessarily) correspond with the highest and lowest costs during the period under review. However, should there be cases where the highest or lowest activity levels do not correspond with the highest or lowest costs, the activity level should govern in selecting the highest and lowest points. Moreover, periods with extraordinarily high or low activity levels and costs should not be included in the selection process, for these points may have been caused by abnormal or unusual situations. For example, consider the following dat 4\y- Ny 4184 Part 2/systems & Technigu®S for Analysis, Planning & Control Month Cost Labor Hours July P 400 200 August 300 10 Septenber 475 350 October 500 400 November 425 250 34500 5,000 December In choosing the highest and lowest points, data for the month of August should not be included. Obviously, it is extraordinarily low as compared with the other data. This very low point could have been caused by the occurrence of a typhoon, or any other reasons which prevented the Company from carrying out its normal operations. Likewise, data for should be excluded in the analysis, for it is extraordinarily high, hence it does not properly represent normal data for the cost and activity level being analyzed. December Other Techniques The high-low method is a simple technique of segregating variable and fixed costs elements of a mixed cost. Though the method is, as already mentioned, simple, yet it is not precise. Some analysts even describe it as a crude method, and consider it inferior to other more sophisticated, statistical techniques. These 'better' segregation techniques will be dealt with in a more detailed manner in Chapter 14. THE VARIABLE COSTING INCOME STATEMENT Consider again the income statement presented in a previous section of this chapter where the costs and expenses are classified as to elements and functions: Meterials Sales Cost of Goods Sold —- Labor Fectory Overhead Gross Profit ;— Selling Expenses Operating Expenses ———J . ere Administrative Expenses Profit= of Te = chapter 5/Cost-Volume-Profit & greak-Even Analysis 185 1f we shall Classify the cost ejements in the statement as to cost behavior, and if we shall assume that all such costs and expenses Can be identified as either fixed and variable, and that if ever there were Mixed costs jn such iterns, the same can be broken into their fixed and variable components, we can come up with the following: Samperaucr esies Matervals, Varia tcost_of Goods Sold bavor — varttte ‘cost of Goods Sold Variable Factory Overneas Factory Overheag ————€ Fined Factory Overnead /— Vartite Seti tapenees Scting Expeneey — _ Fined Selling Exparaen Brotis______— Admitieive ne {wets Nemenercns Cope | Gross Profit Fined Administrative Expenses Finally,” if we shall combine all the variable costs and expenses together, as well as all the fixed costs and expenses, our income statement can be presented as follow: Sales - Variable Costs and Expenses (manufacturing, selling and administrative) = Fixed Costs and Expenses (manufacturing, selling ond administrative) Profit In accounting, when the variable costs and expenses are deducted from sales, the difference is called contribution margin. In other words, contribution margin is the excess of revenue over all the variable costs, and this is the amount available for the recovery of fixed costs and generation of profit.a anal — 186 Part 2/Systems & TechniqeS for Analysis, Planning & Contro} Note the sequence of cost 'ecovery, Whenever sales are made, the variable costs are autoMatically recovered, and whateve, amount is left (the contribution margin), it will be used to recover fixed costs. Once fixed costs have been fully recovered, that is the only time when the company can start generating profit. Injecting the concept of contribution margin, our income statement can now be refined and restated as? Sales Variable Costs Contribution Margin Fixed Costs Profit The above format is called variable costing income statement, Others call it marginal income statement or direct Costin, income statement. One distinguishing characteristic of _ this format is that“it highlights the amount of contribution margin which can possibly be done because the costs are identified as variable and fixed. As earlier discussed, sales and variable costs vary with units. Since contribution margin is merely the difference between sales and variable costs, expect contribution margin to show the same behavior pattern. This is why the three items can be conveniently expressed in per unit terms and the total figures can be determined by multiplying the number of units by the amount per unit: Total Sales = (Selling Price Per Unit x No. of Units) {Versable Cost Per Unit x No. of Unite) - Total Var. Cost Tol Margin = (Contr; n_Marain Per Us f_Units) Fan extensive discussion on direct costing 1e done in Chapter 7- I= eee Chapter _9/Cost-Volume-Profit_& greak-Even Analysis 187 BREAK-EVEN ANALYSIS Cost behavior information plays an important role in our topic Cost-Volume-Profit (C-V-P) Analysis which, a5 Mentioned earlier, refers to the study of the relationships #fmong Costs, volume ang profit. One of these C-V-P relationships 15 Break-even analysis. The focal point in Break-even analysis is the computation of Break-even sales, which is that point of @¢tivity level (sales volume) where total revenues equal tota! costs (or expenses), le., there 1s neither profit nor loss. The break-even sales (or break-even point) can be computed using three methods: 1. Equation method or algebraic approach 2. Contribution margin method or formula approach 3. Graphic approach Example: Fermay Company produces und sells rubber bal variable costs to produce and sell one unit of rub! amount to P4.00, while the torsl faxed manufactur selling and administrative costs per period are 12,900. rubber balls are sold at P10.00 per unit. Determine break-even sales in units end in pesos. Equation Method or Algebraic Approach Our variable costing income statement on page 186 may be expressed in equation form as follows: Sales - Variable Costs - Fixed Costs = Profit If the variable costs and fixed costs were transposed to the other side, the equation will appear as follows: Sales = Variable Costs + Fixed Costs + Profit Knowing that: Sales = Units x Selling Price Per Unit end Variable Costs = Units x Variable Cost Per Unit;= 188 Part 2/Systems & TechniqueS for Analysis, Planning & Contro) then: Let x = the number of units to be sold to break. even, where at break-even point, profit = 9 a P10x = Pax + P12,000 +0 (2) P10x ~ P 4x = P12,000 + 0 © P 6x = P12,000 +0 (@) x = £12,000 + 0 : 5 Pe. © * = 2,000 units Cor P20,000 (2,000 units x P10 per unit)] Break-even sales L Break-even sales in units in pesos Contribution Margin Method or Formula Approach Let us rewrite here our equation No. (4) in the previous section: P12,000 + 0 @) x = pe Recall that: = Number of Units to be Sold to Break-even Fixed Cost Profit P6 = Contribution Margin Per Unit, (Selling Price Per Unit of P10 Lease Variable Cost Per Unit of PA) Using the same equation and substituting the terms’ cited above, we can come up with a formula: : Fixed Cost + Profit Sales in Unite = contribution Margin Per Unil When profit equals zero, the sales in units represent the break- even sales in units. Since at this point, profit is zero, it can be deleted from the formula, thus we shall have: Fixed Cost Cepek eyed per iaiutrce =Chapter 5/Cost-Volume-Profit & Break-Even Analysis 189 Once the break-even safes in units [BES(u)] is known, the break-even sales in pesos [BES(P)] can easily be determined by simply multiplying the BES(u) by the unit selling price. Or, better still, another formula can be used. To derive this, let us reconsider our formula to compute the contribution margin: Contribution Margin = Sales - Variable Cost which can be expressed as: | Sales = Variable Cost + Contribution Margin Considering sales as the base representing 100%, we can develop ratios to express both the variable cost and contribution margin as a percentage of sales. These relationships can be presented in formula form as follows: Variable Cost Variable Cost Ratio = Sales and Contribution Margin Ath : wot = Contribution Margin Ratio* = ae Based on the above formulas, sales can be determined: Variable Cost “ Variable Cost Ratio or _ Contribution Margin = Coneribution Margin Ratio —_—_———_ “contribution margin ratio is also called profit volume ratio. TTT |190 Part 2/Systems & Techniques for Analysis, Planning & Control At this point, let us get back to our variable income statement, focusing our attention on its lower half: Sales Variable Cost Contribution Margin - Fixed Cost = Profit Contribution Margin - Fixed Cost Profit or Contribution Hargin = Fixed Cost + Profit) Luce this with the other formul. = contribution Margin Sales = tontribution Margin Ratio Gales = fixed Cost + Profit = Contribution Margin Ratio We can have: If profit were zero, then the sales figure represents the break- even sales in pesos: Fixed Cost Break-even Sales in Pesos = in Pesos = Contribution Margin Ratio, In our rubber balls example, contribution margiri ratio equals 60% ae = GWunit, With fixed costs at P12,000, break-even sales An pesos Ist . Fixed Cost _ P12,000 _ BES(P) = “tirRatio * — dy = £20,000 Profit Planning & Break-Even Sales Formulas Observe that the break-even sales formulas just came from the basic formulas to compute for sales. In other words, when we use such formulas to determine the break-even point, we are actually computing for sales. We just delete profit from the formula, anyway, its value is zero (0). Hence, for profit-planning purposes, sales with desired profit can be determined using the following formulas: Fixed Cost + Profit}caies in Pesos. = Fixed Cost + Profit Sales in Units = Contribution Margin Tontribution Margin| Ratio Per UnitChapter 5/Cost-Volume-Profit_ & Break-§ Example: Assume that Fermay Company wants to know the req sales volume in units and in pesos to carn a desired prof P6,000. The answer can easily be obtained with the following computations: a _ Fixed Cost + Profit Sales in Units = “Contribution Margin Per Unit Sales in Pesos _ 212,000 + P6,090 P12,000 + 6 7 ‘P6.00 ar oe = 2,096 units, £20,006 Desired Profit After Tax The profit figure in the formulas above is understood to be profit before tax. What if the desired profit figure is net of tax? In this case, the desired after-tax profit should be converted to profit before tax. To do this, the tax rate must be known. Since this tax rate is based on profit before tax (which represents 100%), then profit after tax is equal to 190 Tax Rate. The after tax profit can therefore be converted to profit before tax by dividing the former by 100% - Tax Rate. ‘0 clarify consider the following: Protis Before Tax = 09%, Tax [Protie Before T3x x Tax Rate} Rate (w=) Brofis Atser Tox £ this will be used with our formulas to determine sales with desired profit, we shall have:192 Part 2/Systems & Techniques for Analysis, Planning & Contro) Example: Fermay Company pays corporate income tax rate of 35%, What should sales volume be (in units and in pesos) to earn a, after-tax-profit of P1,950? Solution: Profit Atter Tax vont» Peott After Tax Sates in Units » Fe COM + (9086 = Tax Rate Sates in Pesos » Fixed © = Tax Rate 712,00 + flee 7123000 + P1928 ge re oo 2.500-unis = 22.000 Desired Profit Expressed as a Certain Percentage When the desired profit is expressed not as an amount in pesos, but as a certain percentage, say, of sales, the formula to compute for the required sales can be derived based on the formula to compute of required sales with desired peso profit. If we let PR = Profit ratio or desired profit percentage, then PR(S) = desired profit ., . Fixed Cost + Desired Profit S with desired profit = CMR where CMR = contribution margin ratio Using PR(S) in lieu of desired profit, the formula will be: = Fixed Cost _+ PR(S) ° CMR by cross-multiplying, we. shall get: CMR(S) = Fixed Cost + PR(S) then transpose PR(S) to the other side:Chapter _5/Cost-Volume-Profit & Break-Even Analysis 193 CMR(S) - PR(S) = Fixed Cost (CMR - PRS) = Fixed Cost Solving for S, we shall haver _ Fixed Cost = CMR - PR. The formula derived above is for required sales in pesos. If the required sales figure is in units, the formula will be: Ss ; ; Fixed Cost Required Sales in Units = Gays—pya where CM/u = contribution margin per unit Pfu = profit per unit, computed ast Pfu = PR x Selling Price Per Unit To reiterate, note that the basic formula is: Fixed Cost + Profit Sales = Contribution Margin* * contribution margin per unit when the requirement is sales in units * contribution margin ratio when the requirement is sales in pesos When profit is zero, the same is deleted from the formula, and the resulting sales figure will represent the break-even point. . From that basic formula, other formulas may be derived as shown in the preceding sections.