Module 10 CVP Analysis

MODULE 10
COST VOLUME PROFIT ANALYSIS
Cost Volume Profit (CVP) Analysis – the systematic examination of the relationships among
costs, cost driver (activity level – volume) and profit. It is used to measure the functional
relationship between the major factors affecting profits and to determine the profit
structure of an entity.
Elements of CVP Analysis

1. Sales price 4. Activity level (sales volume)
2. Total fixed costs 5. Sales mix (in case of multiple products)
3. Variable cost/unit
Applications of CVP Analysis – used for planning and decision making like in the ff. area:
1. Optimization of the use of scarce resources – type of product to produce and sell
2. Marketing strategy to apply (Ex. Pricing, promotion and distribution)
3. Type of productive facilities to acquire
4. Non routine decisions (Ex. Special orders, sell or process further, add or delete a product
line)
Simplifying Assumptions of CVP Analysis

1. All costs are classifiable as either fixed or variable.
2. Relevant Range and Linearity Assumptions – cost and revenue relationships are
predictable and linear over a relevant range of activity and a specified period of time.
3. Sales price/unit and market conditions remain unchanged.
4. Inventory level remains constant. (Production = Sales)
5. Technology and production efficiency is constant.
6. Time value of money ignored.
7. If the company sells multiple products, sales mix is constant.
Contribution Margin (also called as marginal income or marginal profit) refers to the
amount generated from sales which will be used to recover fixed costs and provide profits
to owners.
To address the needs of management for better planning and controlling of activities,
income statement provided to them is prepared according to the behavior of expense
(costs) incurred in the different functions of management.
Such report called Marginal Income Statement (Contribution Margin Income Statement),
as well as the major terms and concepts relevant for planning operations, are presented
below:
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Marginal Income Statement Total Per Unit Rate Term
Sales (S) P xx P xx 100% Sales ratio (SR)
Variable costs (VC) ( xx) (xx) x% VC ratio (VCR)
Contribution Margin (CM) P xx P xx (100-x)% CM ratio (CMR)
Fixed Costs (FC) (xx)
Profit before tax (operating
income) P xx
**Note: Ratio is based on sales. If based on cost, VC is 100%.
Break Even Analysis and Profit Planning

Break Even Point (BEP) refers to the level of sales (in pesos or in units) where total revenue
equals total costs, that is, there is neither profit nor loss.
Profit Planning is the process of determining the level of sales (in pesos or in units) required in
order to earn the desired level of profit (before or after tax).
A. For Single Product

Objective Required Sales in Units Required Sales in Pesos
1. To break even (BEP) FC FC
CM/u CMR
2. To earn desired Profit (OI) FC + DP FC + DP

(DP = desired profit) CM/u CMR
3. To earn desired Profit after FC + NP FC + NP

tax (net profit = NP) 1-tax rate 1-tax rate
CM/u CMR
4. To earn desired profit ratio FC FC

(Profit as % of sales) CM/u – P/u CMR – PR
P/u = profit per unit PR = profit ratio
B. For Multiple Products – same computation applies. However, the CM/u and CMR must
be converted to weighted average (waCM/u and waCMR) of the products.
Ex. Weighted average CM for 3 products can be computed as follows:
Product 1 Product 2 Product 3 Total
CM/u P xx P xx P xx
Sales Mix Ratio % % %
waCM/u P xx P xx P xx P xx
Margin of Safety (MOS) – is the level of sales (in pesos or in units) by which actual or
budgeted sales may be decreased without resulting into a loss.
Pesos Units Rate** Term
Sales (S) P xx xx 100% Sales Ratio (SR)
Break Even Sales (BS) (xx) (xx) x%
Margin of Safety (MS) P xx xx (100-x)% MS ratio (MSR)
Operating Leverage – measures the extent of change in profit before tax resulting from
change in sales. A company with fixed costs will still have operating leverage if it has a very
high contribution margin (CM).
The higher the CM, the greater will be the degree of operating leverage (DOL) or
operating leverage factor (OLF).
DOL (OLF) = Total CM = % change in profit before tax

Profit before tax (OI) % change in sales
Sensitivity Analysis
The process of determining the change (effect) on profit caused by changes in any or any
combination of the profit factors, which refers to the 5 elements of CVP analysis above.
Analyzing the BEP formula, the marginal income statement and MOS formula will lead us to
the following effects of changes in a given profit factor:
Changes (Individual) CM/u & CMR BEP Operating Income MOS

1. Increase* in SP/u Increase Decrease Increase Increase
2. Increase* in VC/u Decrease Increase Decrease Decrease
3. Increase* in total FC No effect (NE) Increase Decrease Decrease
Changes (Combination) CM/u CMR BEPu BEPp O.I MOSu MOSp

4. Inc. in SP/u = Inc. in VC/u NE Dec NE Inc NE NE Inc
5. % Inc. in SP/u = % Inc. in VC/u Inc NE Dec NE Inc Inc Inc
Note:
BEPu = BEP in units Dec = decrease
BEPp = BEP in pesos Inc = increase
MOSu = MOS in units
MOSp =MOS in pesos
O.I = operating income = profit before tax
SP/u = Sales price per unit
VC/u = Variable costs/unit
Problems and Exercises
1. Guadalupe Company has a product that sells for P20 per unit. The variable expenses are P12
per unit, and fixed expenses total P30,000 per year.
Required:
a. What is the total contribution margin at the break-even point?
b. What is the contribution margin ratio for the product?
c. If total sales increase by P20,000 and fixed expenses remain unchanged, by how much
would net operating income be expected to increase?
d. The marketing manager wants to increase advertising by P6,000 per year. How many
additional units would have to be sold to increase overall net operating income by
P2,000?
Answer:
a. At the break-even, the total contribution margin equals total fixed expenses. Therefore,
the total contribution margin would be P30,000.
b. Contribution margin ratio =Unit contribution margin ÷ Selling price

= (P20 - P12) ÷ P20 = 40%
c. Increase in sales ...................................... P20,000

CM ratio ................................................. 40%
Increase in net operating income ............ P8,000
d. Increase in advertising expenses .................. 6,000

Desired increase in net operating income .... 2,000
Total required contribution margin .............. 8,000
÷ Contribution margin per unit..................... P8
Required unit sales ....................................... 1,000
2. Hagibis Corporation has decided to introduce a new product. The product can be
manufactured using either a capital-intensive or labor-intensive method. The manufacturing
method will not affect the quality or sales of the product. The estimated manufacturing costs
of the two methods are as follows:
Capital Labor
-intensive -intensive
Variable manufacturing cost per unit .................... P14.00 P17.60
Fixed manufacturing cost per year ........................ P2,440,000 P1,320,000
The company's market research department has recommended an introductory selling price
of P30 per unit for the new product. The annual fixed selling and administrative expenses of
the new product are P500,000. The variable selling and administrative expenses are P2 per
unit regardless of how the new product is manufactured.
Required:
a. Calculate the break-even point in units if Hagibis Corporation uses the:
1. capital-intensive manufacturing method.
2. labor-intensive manufacturing method.
b. Determine the unit sales volume at which the net operating income is the same for the
two manufacturing methods.
c. Assuming sales of 250,000 units, what is the degree of operating leverage if the company
uses the:
1. capital-intensive manufacturing method.
2. labor-intensive manufacturing method.
d. What is your recommendation to management concerning which manufacturing method
should be used?
Answer:
a.
1. Capital-intensive:
Break-even in units = Fixed expenses ÷ Unit contribution margin
= (P2,440,000 + P500,000) ÷ (P30 - 14 – 2)
= P2,940,000 ÷ P14 per unit
= 210,000 units
2. Labor-intensive:
Break-even in units = Fixed expenses ÷ Unit contribution margin
= (P1,320,000 + P500,000) ÷ (P30 – P17.60 – P2)
= P1,820,000 ÷ P10.40 per unit
= 175,000 units
b. Profit = Sales - Variable expenses - Fixed expenses
Capital-intensive:
Profit = P30Q – P16Q – P2,940,000
= P14Q – P2,940,000
Labor-intensive:
Profit = P30Q – P19.60Q – P1,820,000
= P10.40Q – P1,820,000
The profits are equal when:
P14Q – P2,940,000 = P10.40Q – P1,820,000
P3.60Q = P1,120,000
Q = P1,120,000 ÷ P3.60
Q = 311,111
c.
1. Capital-intensive:
Sales (250,000 × P30) ............................... P7,500,000
Variable expenses (250,000 × P16) .......... 4,000,000
Contribution margin .................................. 3,500,000
Fixed expenses .......................................... 2,940,000
Net operating income ................................ P 560,000
Degree of operating leverage = Contribution margin ÷ Net operating income

= P3,500,000 ÷ P560,000 = 6.25
2. Labor-intensive:
Sales (250,000 × P30) ............................... P7,500,000
Variable expenses (250,000 × P19.60) ..... 4,900,000
Contribution margin .................................. 2,600,000
Fixed expenses .......................................... 1,820,000
Degree of operating leverage = Contribution margin ÷ Net operating income

= P2,600,000 ÷ P780,000 = 3.33
d. The decision hinges upon the expected sales of the new product. If management is
confident that sales will be in excess of 311,111 units, then the capital-intensive method
should be used. If sales are likely to fall below this number, then the labor-intensive
method should be used. Management should also be aware that net operating income will
be more volatile with the capital-intensive method since it has higher operating leverage.
3. Legarda Company has developed a new product that will be marketed for the first time
during the next fiscal year. Although the Marketing Department estimates that 35,000 units
could be sold at P36 per unit, Legarda's management has allocated only enough
manufacturing capacity to produce a maximum of 25,000 units of the new product annually.
The fixed expenses associated with the new product are budgeted at P450,000 for the year.
The variable expenses of the new product are P16 per unit.
Required:
a. How many units of the new product must Legarda sell during the next fiscal year in order
to break even on the product?
b. What is the profit Legarda would earn on the new product if all of the manufacturing
capacity allocated by management is used and the product is sold for P36 per unit?
c. What is the degree of operating leverage for the new product if 25,000 units are sold for
P36 per unit?
d. The Marketing Department would like more manufacturing capacity to be devoted to the
new product. What would be the percentage increase in net operating income for the new
product if its unit sales could be expanded by 10% without any increase in fixed expenses
and without any change in the unit selling price and unit variable expense?
e. Legarda's management has stipulated that the new product must earn a profit of at least
P125,000 in the next fiscal year. What unit selling price would achieve this target profit if
all of the manufacturing capacity allocated by management is used and all of the output
can be sold at that selling price?
Answer:
a. Break-even in units = Fixed expenses ÷ Unit contribution margin
= P450,000 ÷ P20 = 22,500
b.
Sales (25,000 × P36) ................................. P900,000
Variable expenses (25,000 × P16) ............ 400,000
Contribution margin .................................. 500,000
Fixed expenses .......................................... 450,000
c. Degree of operating leverage = Contribution margin ÷ Net operating income

= P500,000 ÷ P50,000 = 10
d. Percentage increase in net operating income

= Degree of operating leverage × Percentage change in sales
= 10 × 10% =100%
Or,
Sales (25,000 × 1.1 × P36)........................ P990,000

Variable expenses (25,000 × 1.1 × P16) ... 440,000
Contribution margin .................................. 550,000
Fixed expenses .......................................... 450,000
Net operating income ................................ P100,000
Percentage increase in net operating income
= (P100,000 – P50,000) ÷ P50,000= 100%
e. Sales = Variable expenses + Fixed expenses + Target profit

25,000P = (P16 × 25,000) + P450,0000 + P125,000
where P is the selling price
25,000P = P400,000 + P450,000 + P125,000
P = P975,000 ÷ 25,000 = P39
4. Harrison Company produces and sells a single product. The company's income statement for
the most recent month is given below:
Sales (6,000 units at P40 per unit) ............. P240,000

Less manufacturing costs:
Direct materials ...................................... P48,000
Direct labor (variable) ............................ 60,000
Variable factory overhead ...................... 12,000
Fixed factory overhead ........................... 30,000 150,000
Gross margin ............................................. 90,000
Less selling and other expenses:
Variable selling and other expenses ....... 24,000
Fixed selling and other expenses ............ 42,000 66,000
There are no beginning or ending inventories.
Required:
a. Compute the company's monthly break-even point in units of product.
b. What would the company's monthly net operating income be if sales increased by 25%
and there is no change in total fixed expenses?
c. What dollar sales must the company achieve in order to earn a net operating income of
P50,000 per month?
d. The company has decided to automate a portion of its operations. The change will reduce
direct labor costs per unit by 40 percent, but it will double the costs for fixed factory
overhead. Compute the new break-even point in units.
Answer:
a. The company's income statement in contribution format would be:
Sales.................................................. P240,000 P40 100%

Less variable expenses:
Direct materials ............................. P48,000
Direct labor .................................... 60,000
Variable factory overhead ............. 12,000
Variable selling and other
expenses ..................................... 24,000 144,000 24 60%
Contribution margin ......................... 96,000 P16 40%
Less fixed expenses:
Fixed factory overhead .................. 30,000
Fixed selling and other expense .... 42,000 72,000
Net operating income ....................... P 24,000
The break-even point in units would be:

P72,000 ÷ P16 = 4,500 units.
b. 6,000 × 125% = 7,500 units
Sales (7,500 units at P40) ................................................ P300,000

Less variable expenses (7,500 units at P24) .................... 180,000
Contribution margin ........................................................ 120,000
Less fixed expenses ......................................................... 72,000
Net operating income ...................................................... P 48,000
c. (P72,000 + P50,000) ÷ 0.40 = P305,000
d. Direct labor costs are presently P10 per unit (P60,000 ÷ 6,000 units) and will decrease by
P4 per unit (P10 × 40%). Therefore, the company’s new cost structure will be:
Selling price ..................................................... P40 100%

Less variable expenses (P24 – P4) .................. 20 50%
Contribution margin ........................................ P20 50%
(2 × P30,000 + P42,000) ÷ P20 per unit = 5,100 units
5. Hidalgo Corporation manufactures and sells a single product; cordless telephones. Hidalgo is
considering upgrading its current manufacturing facilities with more modern equipment.
Relevant cost data under the current facility and the upgraded facility is provided below:
Current Upgraded
Manufacturing costs:
Direct materials cost per unit ................. P20.00 P20.00
Direct labor cost per unit ........................ P18.00 P10.00
Variable overhead cost per unit .............. P34.00 P24.00
Fixed overhead cost in total ................... P43,000 P160,000
Selling and administrative expenses:
Variable expense per unit ....................... P5.00 P5.00
Fixed expense in total ............................. P12,000 P12,000
Under either system, Hidalgo will sell the cordless phones for P125 per phone.
Required:
a. What is the break-even point (in number of phones) of each option?
b. At what level of sales (in number of phones) will it start being more profitable for
Hidalgo to have the upgraded facilities?
6. Hilario Company offers two products. At present, the following represents the usual results
of a month's operations:
Product K Product L
Per Per Combined
Amount Unit Amount Unit Amount
Sales revenue ..................... P120,000 P1.20 P80,000 P0.80 P200,000
Variable expenses .............. 60,000 0.60 60,000 0.60 120,000
Contribution margin .......... P 60,000 P0.60 P20,000 P0.20 80,000
Fixed expenses .................. 50,000
Net operating income ........ P 30,000
Required:
a. Find the break-even point in terms of peso.
b. Find the margin of safety in terms of peso.
c. The company is considering decreasing product K's unit sales to 80,000 and increasing
product L's unit sales to 180,000, leaving unchanged the selling price per unit, variable
expense per unit, and total fixed expenses. Would you advise adopting this plan?
d. Refer to (c) above. Under the new plan, find the break-even point in terms of peso.
e. Under the new plan in (c) above, find the margin of safety in terms of peso.
7. Lobo, International has two divisions, Manufacturing and Retail which had the following
operating results over the last two years:
Manufacturing Division Retail Division

Year 1 Year 2 Year 1 Year 2
Sales (in units) ......................... 5,000 6,500 2,000 2,400
Sales (in peso) .......................... P400,000 P520,000 P250,000 P300,000
Less cost of goods sold ............ 290,000 353,000 160,000 192,000
Gross margin............................ 110,000 167,000 90,000 108,000
Less selling and administrative
expenses ............................... 50,000 59,000 52,000 56,000
Net operating income............... P 60,000 P108,000 P 38,000 P 52,000
Assume that the cost structure in each division above did not change over the two years. Use
the high-low method as needed to estimate variable and fixed expenses.
Required:
a. Calculate the break-even point in sales peso for each division.
b. Calculate the degree of operating leverage for the Manufacturing Division for each year.

Module 10 CVP Analysis

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MODULE 10

COST VOLUME PROFIT ANALYSIS

Elements of CVP Analysis

Simplifying Assumptions of CVP Analysis

**Note: Ratio is based on sales. If based on cost, VC is 100%.

Break Even Analysis and Profit Planning

A. For Single Product

2. To earn desired Profit (OI) FC + DP FC + DP

3. To earn desired Profit after FC + NP FC + NP

4. To earn desired profit ratio FC FC

P/u = profit per unit PR = profit ratio

DOL (OLF) = Total CM = % change in profit before tax

Changes (Individual) CM/u & CMR BEP Operating Income MOS

Changes (Combination) CM/u CMR BEPu BEPp O.I MOSu MOSp

b. Contribution margin ratio =Unit contribution margin ÷ Selling price

c. Increase in sales ...................................... P20,000

d. Increase in advertising expenses .................. 6,000

Degree of operating leverage = Contribution margin ÷ Net operating income

Degree of operating leverage = Contribution margin ÷ Net operating income

c. Degree of operating leverage = Contribution margin ÷ Net operating income

d. Percentage increase in net operating income

Sales (25,000 × 1.1 × P36)........................ P990,000

e. Sales = Variable expenses + Fixed expenses + Target profit

Sales (6,000 units at P40 per unit) ............. P240,000

There are no beginning or ending inventories.

Sales.................................................. P240,000 P40 100%

The break-even point in units would be:

b. 6,000 × 125% = 7,500 units

Sales (7,500 units at P40) ................................................ P300,000

c. (P72,000 + P50,000) ÷ 0.40 = P305,000

Selling price ..................................................... P40 100%

(2 × P30,000 + P42,000) ÷ P20 per unit = 5,100 units

Manufacturing Division Retail Division

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