Cost Volume Profit Analysis

Additional Analysis

Although the end goal of Cost-Volume Profit Analysis (CVP Analysis) is to figure out the break-even point
(BEP), this is not the end of the analysis a company can perform. Additional information can be
determined from the data used to perform CVP Analysis.

Important analyses are the following:

 Margin of safety. This refers to the safety net; how many units the company can afford not to sell
before it breaks even. This can be expressed either as units or in peso/dollar amounts.

The margin of safety is always based on an actual or sales figure; it will differ for each level of
sales. There is no margin of safety if the company is operating at or below break-even.
 Operating Leverage. This refers to how well the company is using fixed costs to maximize profits
through savings in variable costs. Typical fixed cost investments include additional machinery,
specialized equipment, or automation of processes.

The operating leverage is measured through the Degree of Operating Leverage. A higher degree
of operating leverage means that the company is making good use of its fixed costs.
 Sensitivity Analysis. This is essentially a “what-if” analysis. Trial and error may be involved. This
may be performed to obtain what variables need to be changed to achieve a particular outcome.
Conversely, if a particular event is already predicted, then the effects of that event on the business
can be forecasted through sensitivity analysis.

This normally involves changing one of the variables in the data and then determining what the
effect is on the other variables. This is why trial and error may be involved; if the company is
looking for a specific outcome, it must continuously make changes and adjustments to achieve
that outcome.

The first two analyses have formulae for computation. The third one follows the same computation for
the BEP (Revenue – Cost = Profit) and involves changing one of the variables and recomputing the others.

Margin of Safety

Units sold – Break-even Quantity = Margin of Safety in Units

or Sales– Sales at Break-even = Margin of Safety in Revenue

Illustrations are as follows:

ABC Corp. currently sells ₱1,000,000 worth in merchandise. The company knows that its break-even sales
amount to ₱700,000. The selling price is ₱20. What is the company’s margin of safety?

Margin of Safety = ₱1,000,000 – 700,000 = ₱300,000

To obtain the margin of safety in units, convert the sales to units first (sales price divided by selling price).

Margin of Safety = (₱1,000,000 / ₱20) – (₱700,000 / ₱20) = 50,000 units – 35,000 units = 15,000 units
The above is interpreted as how much the company can afford to lose before it breaks even. Thus, ABC
Corp. can lose ₱300,000 in sales or 15,000 units before it breaks even. This information is important when
the company is aware that a decrease in sales will likely occur. The company can then determine whether
it has to take action or can safely absorb the losses.

In the above example, if the amount of sales increased by ₱100,000, then the margin of safety would also
increase by ₱100,000. This is because unless the selling price, variable cost per unit, or the fixed cost
change, the break-even point would not change. On the other hand, the contribution margin is computed
based on the actual/projected sales.

If the company lost ₱300,000 in sales, then it would end at break-even. Any more sales lost would result
in a net loss for the company.

In some cases, you must first compute the break-even point before you can compute the margin of safety.

Degree of Operating Leverage

DOL = Total contribution margin / profit

Remember that contribution margin is revenue less variable costs.

Illustrations are as follows:

ABC Corp. currently sells inventory at ₱50 each. The company requires ₱20 in variable costs to produce
each unit. At a production of 5,000 units, the company earns a profit of ₱120,000.

DOL = Total contribution margin / profit

DOL = [(50 – 20) x 5,000] / 120,000
DOL = 150,000 / 120,000
DOL = 1.25

Let’s compare the above to a different setup. Let’s say that the company invests in machinery which
leads to more efficient work. The fixed costs increase by ₱20,000 as a result, but the amount of direct
labor needed decreases, dropping variable costs per unit to ₱10.

First, compute for the fixed costs above.

Revenue – Variable Costs – Fixed Costs = Profit

Remember this is ₱150,000 – Fixed Costs = ₱120,000
just the contribution Fixed Costs = ₱30,000
margin

Compute the DOL under the new setup:

New fixed costs: ₱30,000+ 20,000= ₱50,000

Contribution Margin: (₱50 – ₱10) x 5,000 = ₱200,000
Profit: ₱200,000 – ₱50,000 = ₱150,000 Notice that the
profit is now higher
DOL: ₱200,000 / ₱150,000 = 1.33
for the same level of
production.
An analysis of the difference between the two setups can be seen below:

At 5,000 units Original setup New setup

DOL 1.25 1.33
Contribution Margin ₱150,000 (₱30 per unit) ₱200,000 (₱40 per unit)
Fixed Costs ₱30,000 ₱50,000
Break-even 1,000 units (₱50,000) 1,250 units (₱62,500)
Profit ₱150,000 ₱200,000
Margin of Safety 4,000 units (₱200,000) 3,750 units (₱187,500)

At the same level of production, the new setup earns more profits. Remember that the profit is essentially
the contribution margin for sales made above break-even. Since a higher DOL means a higher contribution
margin, this tends to mean that more profits are earned for less units sold.

The risk of a setup with a higher DOL, however, is that more units are needed to break-even. In
break-even, the contribution margin from units sold must cover the fixed costs. Since the fixed costs are
higher, more units need to be sold as well. This also means that the company has a smaller margin of
safety.

A higher DOL can usually be achieved with automated systems. Automated systems tend to decrease not
only labor costs, but also material costs, as increased efficiency can be achieved.

An important analyses of the difference between manual systems and automated systems follow.

At same production level Manual System Automated System

Price Same Same
Variable Cost Relatively Higher Relatively Lower
Fixed Cost Relatively Lower Relatively Higher
Contribution Margin Relatively Lower Relatively Higher
Break-even point Relatively Lower Relatively Higher
Margin of Safety Relatively Higher Relatively Lower
DOL Relatively Lower Relatively Higher