Profit

Analysis

September 25, 2021

Gelyne E. Estrellado
Topics
2.4.1 StraightLine
Depreciation Method
2.4.2 Cost-Volume Profit Analysis
2.4.3 Profit/Volume Ratio
Straight Line
Depreciation Method
Brief Summary of Depreciation
•Concept
•Objectives
•Causes
•Depreciation Methods
 CONCEPT
✔Depreciation is the cost of lost usefulness or
cost of diminution of service yield from a use
of fixed assets.
✔A permanent fall in the value of fixed assets
arising through wear and tear from the use of
those assets in business.
DEFINITION
o Depreciation is a measure of the wearing out,
consumption or other loss of value of depreciation
asset arising from use, efflux ion of time or
obsolescence through technology and market changes.
o Depreciation is allocated so as to charge a fair
proportion of the depreciable amount in each
accounting period during the expected useful life of
the asset. Depreciation includes amortization of assets
whose useful life is predetermined.”
o Depreciation is the process of allocating the cost of a
Fixed asset to expense in the accounting periods
benefiting from its use.
 OBJECTIVES
✔To calculate proper profits.
✔To show the asset at its reasonable value.
✔To maintain the original monetary investment
of the asset intact.
✔Provision of depreciation results in some
incidental advantages also.
✔To provide for replacement of an asset.
✔Depreciation is permitted to be deducted from
profits for tax purposes.
 CAUSES
✔ Internal causes: wear and tear,
disuse, maintenance, change in
production, restriction of
production, reduced demand,
technical progress, deterioration
and depletion.

✔External causes: effluxion of time,

obsolescence, due to weather and
natural calamities and permanent
fall in the market value
Factors in measurement of
Depreciation
The original cost of purchasing the asset plus all other costs
Total
incurred in order to get the asset into a capacity and location to
cost of
asset earn revenue which will provide an economic benefit for the
life of the asset.

Residual
The estimated amount the asset will be sold or
Value
traded-in for at the end of its useful life (when it is
“scrapped”)

Useful The estimated period of time the asset will be used

Life for (in years)
Cost Allocation

Balance Sheet Income Statement

Cost
Acquisition
Cost Expense

Allocation
Unused Used
Methods of recording
Depreciation
• Straight line method or fixed installment
• Declining charge method or diminishing balance
method
• Sum of years digit method
• Inventory or revaluation method
• Machine hour method/ Production unit method
• Depletion method
Straight line method or fixed installment
• Under this method, the same amount of
depreciation is charged every year throughout
the life of the asset.
Depreciable
•The formula: Amount

Residual
Cost Value
Depreciation
Depreciation Expense
Expense

Useful
Life
•r =R/C * 100
•r = depreciation rate
•R = Amount of depreciation
•C = Acquisition cost
Illustration:
Assume that a company buys a machine at a cost of
P5,000. The company decides on a salvage value of
P1,000 and a useful life of five years. Calculate the
machine’s annual depreciation.

Answer:
Depreciable amount = 5,000 – 1,000 = P4,000
Annual Depreciation (SLM) = 4,000 ÷ 5 = P800
Depreciation rate = 800 ÷ 4,000 = 0.20 or 20%
 Straight-Line Method
Advantages
• Simple, easy to understand
and to apply
• It provides uniform charge
every year
• It’s calculated on original
cost over the lifetime
• Asset can be written off
completely
• To calculate tax deductions
Disadvantages:
• Depreciation is not related
to the usage factor
• It ignores the fact that in the
later years of the life of the
asset, efficiency of the asset
declines.
• Loss of interest on
investment in the asset is
not accounted for
• Illogical method
• Not useful for an asset with
a long life and more value
Cost-Volume-
Profit Analysis
 CONCEPT

✔ The conceptual foundation of CVP analysis is the

economics of breakeven analysis in the short run.

✔ A planning tool used to analyze the effects of changes in

volume, sales mix, selling price, variable expense, fixed
expense and profit.

✔ C.V.P analysis is used to identify the levels of operating

activity needed to avoid losses, achieve targeted profits,
plan future operations, and monitor organizational
performance.
 Main objectives of cost-volume-profit analysis
i. This analysis helps to forecast profit fairly and accurately
as it is essential to know the relationship between profits
and costs on the one hand and volume on the other.
ii. This analysis is useful in setting up flexible budget which
indicates costs at various levels of activity.
iii. This analysis assists in evaluation of performance for the
purpose of control. In order to review profits achieved and
costs incurred, it is necessary to evaluate the effect on
costs of changes in volume.
iv. This analysis also assists in formulating price policies by
showing the effect of different price structures on costs
and profits.
 Main objectives of cost-volume-profit analysis

v. This analysis helps to know the amount of overhead

costs to be charged to the products at various levels of
operation as we know that pre-determined overhead rates
are related to a selected volume of production.
vi. This analysis makes possible to attain target profit by
locating the volume of sales required for such profit and
finally achieving such sales volume.
vii. This analysis helps management in taking number of
decisions like make or buy, suitable sales mix, dropping
of a product etc.
 Assumptions Underlying Cost-Volume-Profit
Analysis:
i. Fixed and variable cost patterns can be established with
reasonable accuracy and that fixed costs remain static and
marginal costs are completely variable at all levels of
output.
ii. Selling prices are constant at all sales volumes.
iii. Factor prices (e.g. material prices, wage rates) are constant
at all sales volumes.
iv. Efficiency and productivity remain unchanged.
v. In a multi product situation, there is constant sales mix at
all levels of sales.
vi. Turnover level (volume) is the only relevant factor
affecting costs and revenue.
vii. The volume of production equals the volume of sales
How is CVP Analysis Used?
CVP analysis can determine, both in units and in
sales dollars:
• the volume required to break even
• the volume required to achieve target profit
levels
• the effects of discretionary expenditures
• the selling price or costs required to achieve
target volume levels
• CVP analysis helps analyze the sensitivity of
profits to changes in selling prices, costs, volume
and sales mix.
 The Contribution Margin
Income Statement
✔ Contribution Margin is the difference between sales and
variable expense. It is the amount of sales revenue left over
after all the variable expenses are covered that can be used
to contribute to fixed expense and operating income.

Sales ₱ xxx
Total Variable Cost (xxx)
Total Contribution Margin ₱ xxx
Total Fixed Cost (xxx)
Total Operating Income ₱ xxx

❖ CM Ratio = Total CM ÷ Sales or

CM per unit ÷ Selling Price per unit
Illustration:
ABC Company plans to sell 1,000 mowers at P400
each in the coming year. Product costs include:

Direct materials per mower P 180

Direct labor per mower 200
Variable factory overhead per mower 25
Total fixed factory overhead 15,000

Variable selling expense is a commission of P20 per

mower; fixed selling and administrative expenses
totals P30,000. Calculate the total variable expense
per unit, the total fixed expense for the year and
prepare a contribution margin income statement for
ABC company for the coming year.
Solution:
1. Total variable expense per unit
= DM + DL + Variable FOH + Variable Selling Expense
= 180 + 100 + 25 + 20
= P 325.00
2. Total Fixed Expense = Fx FOH + Fx S&A Expense
= 15,000 + 30,000
= P 45,000.00
3.
ABC Company
Contribution Margin Income Statement
For the Coming Year
Total Per Unit
Sales (P400 X 1,000) ₱ 400,000 ₱400
Total Variable Cost (P325 X 1,000) 325,000 325
Total Contribution Margin ₱ 75,000 ₱ 75
Total Fixed Cost 45,000
Total Operating Income ₱ 30,000
 CVP Analysis and the Breakeven Point
✔ CVP analysis is a technique that examines
changes in profits in response to changes in sales
volumes, costs, and prices.
✔ The breakeven point (BEP) is where total
revenue equal total costs.
Total Revenue

Total Costs
BEP in Fixed Costs
sales (₱)
Total Variable Costs

BEP in units
 Breakeven Point in Units
✔ At the break even point, operating income equals P0.
✔ The BEP in units is the number of units that need to be sold in order to
cover the costs required to make the product.

Breakeven Point in Units = Total Fixed Cost .

Price/unit – Variable Cost/unit

Using ABC Company’s contribution margin IS, the number of mowers

must sell to breakeven is:

Breakeven Point in Units = P45,000 = 600 mowers

P400 – P325

▪ Contribution Margin IS based on 600 mowers:

Sales (P400 X 600) ₱ 240,000
Total Variable Cost (P325 X 600) 195,000
Total Contribution Margin ₱ 45,000
Total Fixed Cost 45,000
Total Operating Income ₱ 0
 Breakeven Point in Sales
✔ The breakeven point in sales is the amount of sales revenue that has to
be generated, in order to cover the costs required to make the product.

Breakeven Point in Sales = Total Fixed Cost .

Contribution Margin Ratio

Using ABC Company’s contribution margin IS, the breakeven point in sales:

Breakeven Point in Units = P45,000 = 45,000 = P240,000.00

(P75 ÷ P400) 0.1875

o Contribution Margin Ratio = CM/unit ÷ SP/unit

CM/unit = SP/unit – VC/unit
= P400 – P325 = P75
Where; CM = Contribution Margin
SP = Selling Price
VC = Variable Cost
 Target Profit Analysis

▪ Target profit analysis is about finding out the estimated

business activities to perform to earn a target profit during a
certain period of time.

▪ Finding the desired profit involves:

a. revenue planning: determine the revenue required to
achieve a desired profit level.
b. cost planning: find the value of the required variable cost
or fixed cost to achieve the desired profit at the assumed
sales quantify.
c. c. accounting for the effect of income taxes.
 Target Profit Analysis
Equation method for target profit:

The target profit equation is given below:

SP × Q = Ve × Q + Fe + Tp
or
SpQ = VeQ + Fe + Tp
Where;
Sp = Sales price per unit.
Q = Number (quantity) of units to be manufactured and sold
during the period.
Ve = Variable expenses to manufacture and sell a single unit of
product.
Fe = Total fixed expenses for the period.
Tp = Target profit for the period.
Calculating Units Needed
to Achieve a Target Profit

Units required to = Tp + Fe
earn target profit Sp – Ve per unit

o Using ABC Company’s information, the number of units

must sell to earn an operating income of P37,500;

Units required to = P37,500 + P45,000 = 1,100

earn target profit P400 – P325
▪ Contribution Margin IS based on 1,100 mowers:
Sales (P400 X 1,100) ₱ 440,000
Total Variable Cost (P325 X 1,100) 357,500
Total Contribution Margin ₱ 82,500
Total Fixed Cost 45,000
Total Operating Income ₱ 37,500
Calculating Sales in Peso Needed
to Achieve a Target Profit

Sales in Peso required = Tp + Fe

to earn target profit CM Ratio

o Using ABC Company’s information, the sales must make

to earn an operating income of P37,500;

Units required to = P37,500 + P45,000 = P440,00

earn target profit 0.1875
▪ Contribution Margin IS based on 1,100 mowers:
Sales (P400 X 1,100) ₱ 440,000
Total Variable Cost (P325 X 1,100) 357,500
Total Contribution Margin ₱ 82,500
Total Fixed Cost 45,000
Total Operating Income ₱ 37,500
CVP Analysis for Multiple Product Firm

o For a company with more than one product, sales mix is the
relative combination in which a company's products are
sold. Different products have different selling prices, cost
structures, and contribution margins. A weighted-average
CM must be calculated (in this case, for two products). This
new CM would be used in CVP equations;

Multi-Product BEP = Fixed Costs

Weighted Average CM per unit
Multiple-Product Analysis

Illustration:
Suppose ABC Company has decided to offer two models of
lawn mowers: a mulching mower that sells for P400 and a
riding mower that sells for P800.The marketing department
is convinced that 1,200 mulching mowers and 800 riding
mowers can be sold during the coming year. The controller
has prepared the following projected income statement
based on the sales forecast:
Mulching Mower Riding Mower Total
Sales 480,000.00 640,000.00 1,120,000.00
Total Variable Cost 390,000.00 480,000.00 870,000.00
Contribution Margin 90,000.00 16,000.00 250,000.00
Direct Fixed Cost 30,000.00 40,000.00 70,000.00
Product margin 60,000.00 120,000.00 180,000.00
Common Fixed Cost 26,520.00
Operating Income 153,750.00
Sales Mix
o The sales mix is a calculation that determines the
proportion of each product a business sells relative to
total sales. It is the relative combination of products
being sold by a firm.
o The sales mix is measured in units sold

Illustration:
If ABC plans on selling 1,200 mulching mowers and 800
riding mowers, then the sales mix in units is 1,200:800 or
12:8 or 3:2.
per unit Mulching Mower Riding Mower
Sales 400.00 800.00
Total Variable Cost 325.00 600.00
Contribution Margin 75.00 200.00
Sales Mix 3 2
BEP units for a Multiple Product Firm
o Many firms produce and sell more than 1 product. In
that case, the firm needs to know how many units of
each product must be sold to break even.

Illustration:
Recall that ABC Company sells two products, mulching
mowers priced at P400 and riding mowers priced at P800.
The variable cost per unit is P325 per mulching mower and
P600 per riding mower. Total fixed cost is P96,250. ABC
Company's expected sales mix is three mulching mowers
to two riding mowers. Calculate the break-even in units for
mulching and riding mowers.
BEP units for a Multiple Product Firm
Total Fixed Cost
Break-even Package Contribution
Packages Margin or Weighted Ave.
CM per unit

= P96,250 = 154 packages

625
Mulching Mower Break-Even Units = 154 x 3 = 462
Riding Mower Break-Even Units = 154 x 2 = 308
Quick Check:
Mulching Riding Total
Sales 184,800 246,400 431,200
Total variable cost 150,150 184,800 334,950
Contribution margin 34,650 61,600 96,250
Total fixed cost 96,250
Operating income 0
 BEP sales for a Multiple Product Firm

o The multiple-product firm may not need to know how many

units of each product must be sold to break even, but instead,
may be fine with the overall sales revenue that achieves break
even.

Illustration:
Recall that ABC Company sells two products that are expected to
produce total revenue next year of P1,120,000 and total variable
cost of P870,000. Total fixed cost is expected to equal P96,250.
Calculate the break-even point in sales.
 BEP sales for a Multiple Product Firm

Solution:
= 250,000
Contribution margin ratio = 0.2232
1,120,000
= Fixed Cost
Break-Even Sales
CM Ratio
= 96,250
= P431,228
0.2232

In the preceding illustration, the BE in sales is P431,200, the 28 pesos

difference is due to rounding of the CM ratio.

Sales 431,228
Total variable cost (431,228 x 0.7768) 334,978
Contibution margin 96,250
Total fixed cost 96,250
Operating income 0
 Using CVP to Compare Alternatives
❖ CVP analysis can
compare alternative cost
structures or selling
prices.
❖ The indifference point
between alternatives is
the level of sales (in units
or sales ₱) where the
profits of the alternatives
are equal.
Illustration:
Suppose that ABC Company recently conducted a market study
of the mulching lawn mower that revealed three different
alternatives:
• Alternative 1: If advertising expenditures increase by
$8,000,then sales will increase from 1,600 units to 1,725 units.
• Alternative 2: A price decrease from $400 to $375 per lawn
mower will increase sales from 1,600 units to 1,900 units.
• Alternative 3: Decreasing price to $375 and increasing
advertising expenditures by S8,000 will increase sales from
1,600 units to 2,600 units.
Should ABC maintain its current price and advertising policies,
or should it select one of the three alternatives described by the
marketing study? Compute the volume of sales, in units, for
which it is indifferent between the 1st and 2nd alternative.
Alternative 1:
Before the Increased With the Increased
Advertising Advertising
Unit sold 1,600 1,725
Unit contribution margin x 75 x 75
Total contribution margin 120,000 129,375
Less: Fixed expenses 45,000 53,000
Operating income 75,000 76,375

Difference in Profit
Changes in volume 125
Unit contribution margin x 75
Change in contribution margin 9,375
Less: Changes in fixed expenses 8,000
Increase in operating income 1,375
Alternative 2:

Before the Increased With the Increased

Advertising Advertising
Unit sold 1,600 1,900

Unit contribution margin x 75 x 50

Total contribution margin 120,000 95,000

Less: Fixed expenses 45,000 45,000
Operating income 75,000 50,000

Diffrence in Profit
Changes in CM (25,000)

Less: Change in Fixed Expenses -

Decrease in operating income (25,000)

Alternative 3:
Before the Proposed With the Proposed Price
Price and Advertising and Advertising
Changes Increases
Unit sold 1,600 2,600
Unit contribution margin x 75 x 50
Total contribution margin 120,000 130,000
Less: Fixed expenses 45,000 53,000
Operating income 75,000 77,000

Diffrence in Profit
Changes in CM 10,000
Less: Change in Fixed
Expenses 8,000
Increase in operating income 2,000
Indifference Point of 1st and 2nd Alternative:
Solution:
A1 A2
Unit contribution margin 75 50
Fixed expenses 53,000 45,000
Profit (A1) = 75Q - 53,000
Profit (A2) = 50Q - 45,000
75Q - 53,000 = 50Q - 45,000
75Q - 50Q = 53,000 - 45,000
25Q = 8,000
Q = 320 units

To check:
A1 A2
Unit sold (Q) 320 320
Unit contribution margin x 75 x 50
Total contribution margin 24,000 16,000
Less: Fixed expenses 53,000 45,000
Operating loss (29,000) (29,000)
 Margin of Safety
▪ The margin of safety is a measure of how far past
the breakeven point a company is operating, or
plans to operate. It can be measured 3 ways:

Margin of = actual or estimated units of

Safety in units activity – BEP in units

Margin of = actual or estimated sales ₱

Safety in ₱ – BEP in units

Margin of = Margin of safety in units

Safety Actual or estimated units
percentage
= Margin of safety in ₱
Actual or estimated sales ₱
Illustration:
Recall that ABC plans to sell 1,000 mowers at P400 each in the
coming year. ABC has unit variable cost of P325 and total fixed
cost of P45,000. Break-even units were previously calculated at
600. What is the margin of safety in terms of units and sales
revenue.

Solution:
1. Margin of Safety in Units = 1,000 - 600 = 400 units
2. Margin of Safety in Sales Revenue
= (400 x 1000) - (400 x 600) = P160,000
Therefore;
Margin of Safety Percentage = 400 ÷ 1,000 = 40%
or, = P160,000 ÷ 400,000 = 40%
 Sensitivity Analysis
✔ CVP provides structure to answer a variety of
“what-if” scenarios.
“What” happens to profit “if”:
A. Selling price changes
B. Volume changes
C. Cost structure changes
1) Variable cost per unit changes
2) Fixed cost changes
Sensitivity Analysis is based on
1.Changes in Fixed Costs
2. Changes in Unit Contribution Margin
Cost Structure and Operating Leverage
The cost structure of an organization is the relative proportion
of its fixed and variable costs. Organizations with high
operating leverage incur more risk of loss when sales decline.
Operating Leverage (OL) : is the effect that fixed costs have on
changes in operating income as changes occur in units sold.

Operating leverage is:

a. the extent to which an organization uses fixed costs in its
cost structure.
b. greatest in companies that have a high proportion of
fixed costs in relation to variable costs.
 Degree of Operating Leverage

✔ The degree of operating leverage measures the

extent to which the cost function is comprised of
fixed costs.
✔ A high degree of operating leverage indicates a
high proportion of fixed costs.
✔ Businesses operating at a high degree of
operating leverage;
• face higher risk of loss when sales decrease,
• but enjoy profits that rise more quickly when
sales increase.
 Degree of Operating Leverage

The degree of operating leverage can be computed

3 ways:
Contribution Margin
Profit

Degree of
Fixed Cost
Operating Profit
+1
Leverage

1
Margin of Safety
Percentage
Illustration:

Recall that ABC Company plans to sell 1,000 mowers at P400

each in the coming year. ABC has unit variable cost per unit of
P325 and total fixed cost of P45,000. Operating income at that
level of sales was previously computed as P30,000. Calculate
the degree of operating leverage.
= Total contribution margin
The Degree of
Operating Leverage Operating Income
= (P400 - 325) (1,000 units)
= 2.5
30,000
✔ The degree of operating leverage can be used directly to
calculate the change in operating income that would result
from a given percentage in sales.
Percentage change in profits = DOL x % change in sales
Using the Degree of Operating
Leverage to Plan and Monitor
Operations

Managers need to consider the

degree of operating leverage when:
• they decide whether to incur
additional fixed costs, such as
purchasing new equipment or
hiring new employees.
• They need to consider the
degree of operating leverage for
potential new products and
services that could increase an
organization's fixed costs
relative to variable costs.
Profit-Vo
lume
Ratio
 Volume-Profit Ratio
✔ The profit/volume ratio (contribution or marginal
ratio) expresses the relation of contribution to sales
which helps determine the profitability of the
business. This ratio can be expressed as under:

Contribution Margin
P/V ratio
Sales

A high PVR indicates high

profitability. PVR also helps to
determine the break-even point
(BEP) profit at any volume of sales.
Other Formulas:
•Since Contribution = Sales – Variable Cost
= Fixed Cost + Profit, P/V ratio can also be
expressed as:
P/V Ratio = Sales – Variable cost/Sales (S – V/S)
or, P/V Ratio = Fixed Cost + Profit/Sales (F + P/S)
or, P/V Ratio = Change in profit or
Contribution/Change in Sales
The P/V ratio, which establishes the
relationship between contribution and sales,
is of vital importance for studying the
profitability of operations of a business. It
reveals the effect on profit of changes in the
volume.
Higher the P/V ratio, more will be the profit
and lower the P/V ratio, lesser will be the
profit. Thus, every management aims at
increasing the P/V ratio.
The ratio can be increased by increasing the
contribution. . .

(i) increasing the selling price per unit

(ii) Reducing the variable or marginal cost.

(iii) Changing the sales mixture and selling

more profitable products for which the P/V
ratio is higher.
 Uses of P/V Ratio:
i. It helps in the determination of Break-even-point
ii. It helps in the determination of profit at any volume
of sales
iii. It helps in the determination of sales to earn a
desired amount of profit
iv. It helps in the determining the required selling
price per unit
v. It helps in determining the variable cost for any
volume of sales
vi. It helps in determining margin of safety
Illustration 1:
Sales 100,000
Profit 10,000
Variable Cost 60%

Calculate the following:

1) P/V ratio
2) Fixed Cost
3) Sales Volume to earn a Profit of P30,000
Answers & Solutions:
1P/V Ratio Contribution Margin 40,000.00
Sales 100,000
0.40 or 40%

Contribution Margin = Sales - Variable Cost = 100,000 - 60,000

40,000.00
Variable Cost = 100,000 x 60%
60,000.00
2Fixed Cost
Contribution = Fixed Cost + Profit
so, Fixed Cost = Contribution Margin – Profit = 40,000 - 10,000
30,000.00

3Sales Volume to earn a Profit of P30,000

Sales Fixed Cost + Profit = 30,000 + 30,000

P/V Ratio 40%
150,000.00
Illustration 2:
Sale of a product amounts to 200 units per month at P10 per unit.
Fixed overhead cost is P400 per month and variable cost is P6
per unit. There is a proposal to reduce prices by 20%. Calculate
present and future P/V ratio. How many units must he sold to
earn the present total profits?
Answers & Solutions:
Present P/V Ratio P/V Ratio after reducing price by 10%
Sales= 200 x 10 = 2,000.00 Present price per unit 10
Variable Cost = 200 x 6 = 1,200.00 Less: Reducing 20% 2%
Contribution Margin = Sales - Variable Cost Future price per unit 8
= 2,000 - 1,2000 = 800.00 Variable cost per unit 6
Contribution margin per unit 2
P/V Ratio Contribution Margin
Sales Future P/V Ratio 2
800 8
2,000 0.25 or 25%

= 0.4 or 40%

Future Sales for Earning Present Profits Quick Check:

Present Profit = CM - Fx Cost Sales @ 400 units 3,200
= 800 - 400 = 400 Variable cost @ 400 units 2,400
Contribution Margin 800
Sales Fx Cost + Profit Fixed Cost 400
P/V Ratio Profit 400
400 + 400
0.25
Sales in pesos 3,200
Sales in units=3,200/8 = 400
GRAPHS OF CVP RELATIONSHIPS

Two basic graphs are the;

• Profit-Volume Graph - graphic that shows the
earnings (or losses) of a company in relation to
its volume of sales.
• Cost-Volume-Profit Graph - a graph that
shows the relationship between the cost of units
produced and the volume of units produced
using fixed costs, total costs, and total sales.
Profit-Volume Graph
CVP Graph
 THANK YOU! ☺

References:
• https://www.investopedia.com/terms/c/cost-volume-profit-analysis.asp
• https://www.slideshare.net/kamranqamar/cost-volume-profit-analysis-17100739
• https://www.accountingnotes.net/cost-accounting/marginal-costing/profit-volume-rati
o-with-formula-and-calculation/7718
• https://www.slideshare.net/vikasvadakara/depreciation-14165601