Cost-Volume-Profit

Analysis

Professor: John Anthony M. Labay, CPA, MBA

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454 GRC Bldg. Rizal Ext. cor. 9th Avenue Grace Park, Caloocan City

TITLE: Cost-Volume-Profit (CVP) Analysis

I. Learning Outcomes
1. Definition and Concept of CVP Analysis
2. Definition and Concept of Break-Even Analysis
3. Definition and Concept of Margin of Safety and Degree of Operating Leverage

II. Discussion

Cost-Volume-Profit (CVP) analysis is a managerial accounting technique that is concerned with

the effect of sales volume and product costs on operating profit of a business. It deals with how
operating profit is affected by changes in variable costs, fixed costs, selling price per unit and the
sales mix of two or more different products.

CVP analysis has following assumptions:

1. All cost can be categorized as variable or fixed.
2. Sales price per unit, variable cost per unit and total fixed cost are constant.
3. All units produced are sold.

The basic formula used in CVP Analysis is derived from profit equation:
Sales = Variable Cost + Fixed Cost + Profit

Contribution Format Income Statement:

Sales xx
Variable Cost (xx)
Contribution Margin xx
Fixed Cost (xx)
Net Operating Income xx

Break-even is the point of zero loss or profit. At break-even point, the revenues of the business
are equal its total costs and its contribution margin equals its total fixed costs. Break-even point
can be calculated by equation method, contribution method or graphical method.

At break-even point, the profit is zero therefore the CVP formula is simplified to:
Sales = VC + FC

Solving the break-even point in sales units:

FC .
Break-even Sales in Units =
SP – VC/u

Break-even point in number of sales pesos is calculated using the following formula:
Break-even Sales in Pesos = Price per Unit × Break-even Sales Units
OR
Break-even Sales in Pesos = Fixed Costs Contribution Margin Ratio

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Sales mix is the proportion in which two or more products are sold. For the calculation of break-
even point for sales mix, following assumptions are made in addition to those already made for
CVP analysis:
1. The proportion of sales mix must be predetermined.
2. The sales mix must not change within the relevant period.

The calculation method for the break-even point of sales mix is based on the contribution
approach method. Since we have multiple products in sales mix therefore it is most likely that we
will be dealing with products with different contribution margin per unit and contribution margin
ratios. This problem is overcome by calculating weighted average contribution margin per unit
and contribution margin ratio. These are then used to calculate the break-even point for sales
mix.

Target income sale is the amount/units of sales needed to cover the variable costs, fixed costs
and the target income in a given accounting period. Target income is the net income which a
company wants to achieve during the period.

Every business wants to be able to not only cover the variable and fixed costs, but to be able to
generate some return on its investment. Finding target sales is an important part of the decision-
making process.

Target income sales can be calculated using any of the following formulas:
Fixed Costs + Target Income
Target Income Sales in Units =
Contribution Margin per Unit
Fixed Costs + Target Income
Target Income Sales in Pesos =
Contribution Margin Ratio

Margin of safety is the extent by which actual or projected sales exceed the break-even sales. It
may be calculated simply as the difference between actual or projected sales and the break-even
sales. However, it is best to calculate margin of safety in the form of a ratio. Thus, we have the
following two formulas to calculate margin of safety:

MOS (peso) = Budgeted Sales − Break-even Sales

Budgeted Sales − Break-even Sales
MOS (percentage) =
Budgeted Sales

The margin of safety is a measure of risk. It represents the amount of drop in sales which a
company can tolerate. Higher the margin of safety, the more the company can withstand
fluctuations in sales. A drop in sales greater than margin of safety will cause net loss for the
period.

Degree of operating leverage is the multiple by which operating income of a business changes
in response to a given percentage change in sales. It is a measure of the extent of operating
leverage i.e. the relationship between operating income and sales of a business. If operating
income is more sensitive to changes in sales, the business is said to have high operating leverage
and vice versa. Similarly, if operating profit margin is higher, the business is said to have high
operating leverage and vice versa.
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Degree of operating leverage can be calculated using any of the following formulas:
change in operating income
Degree of operating leverage =
changes in sales
contribution margin
Degree of operating leverage =
operating income
sales − variable costs .
Degree of operating leverage =
sales − variable costs − fixed costs
contribution margin percentage
Degree of operating leverage =
operating margin percentage

III. Learning Exercises

1. In August, the Corporation sold 8,300 units of its only product. Its total sales were P664,000,
its total variable expenses were P415,000, and its total fixed expenses were P204,000.

Required:
a. Construct the company's contribution format income statement for August in good form.
b. Redo the company's contribution format income statement assuming that the company sells
8,600 units.

2. The following is the Corporation's contribution format income statement for last month:
Sales ………. P 1,400,000
Variable Cost ………. (900,000)
Contribution Margin ………. 500,000
Fixed Cost ………. (300,000)
Net Operating Income ………. P 200,000
The company has no beginning or ending inventories and produced and sold 10,000 units during
the month.

Required:
a. What is the company's contribution margin ratio?
b. What is the company's break-even in units?
c. If sales increase by 100 units, by how much should net operating income increase?
d. How many units would the company have to sell to attain target profits of P225,000?
e. What is the company's margin of safety in pesos?
f. What is the company's degree of operating leverage?

3. The contribution income statement last month for the Corporation, a manufacturing company,
follows:

Sales (500 units@P5,000) P2,500,000

Less variable costs 1,500,000
Contribution margin P1,000,000
Less fixed costs 800,000
Net operating income P 200,000
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Required:
a. Contribution margin per unit
b. Variable cost per unit
c. Contribution margin ratio
d. Variable cost ratio
e. Break-Even Point in pesos
f. Break-Even Point in units
g. Assume that the Corporation’s sales increase by P1,500,000 next month. What will be the
effect on (1) the contribution margin and (2) net operating income?
h. Assume that the Corporation’s target profit is P700,000 per month. How many units must it sell
each month to reach this goal?

4. The following monthly data are available for the Company and its only product, Product X:
Total Per Unit
Sales (400 units) ………. P 110,000 P 275
Variable Cost ………. (44,000) (110)
Contribution Margin ………. 66,000 P 165
Fixed Cost ………. (52,800)
Net Operating Income ………. P 13,200
Required:
a. Without resorting to calculations, what is the total contribution margin at the break-even point?

b. Management is contemplating the use of plastic gearing rather than metal gearing in Product
X. This change would reduce variable costs by P15. The company's marketing manager predicts
that this would reduce the overall quality of the product and thus would result in a decline in sales
to a level of 350 units per month. Should this change be made?

c. Management wants to increase sales and feels this can be done by cutting the selling price by
P25 per unit and increasing the advertising budget by P20,000 per month. Management believes
that these actions will increase unit sales by 50%. Should these changes be made?

d. Management wants to automate a portion of the production process for Product X. The new
equipment would reduce direct labor costs by P20 per unit but would result in a monthly rental
cost for the new robotic equipment of P10,000. Management believes that the new equipment will
increase the reliability of Product X thus resulting in an increase in monthly sales of 12%. Should
these changes be made?

5. A Company sells Products A, B, and C. Data about the three products are as follows:
Product A Product B Product C Total
Selling price P100 P120 P50
Variable costs per unit 60 90 40
CM per unit P 40 P30 P10

Sales in units 1,000 2,000 5,000 8,000

Total fixed costs P101,680

Required:
a. Break-Even Point in pesos
b. Break-Even Point in units

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6. The following monthly budgeted data are available for the Company:

Product X Product Y Product Z

Sales 500,000 300,000 900,000
Variable Cost (300,000) (210,000) (720,000)
Contribution Margin 200,000 90,000 180,000

Budgeted net operating income for the month is P220,000.

Required:
a. Calculate the break-even peso sales for the month.
b. Calculate the margin of safety.
c. Calculate the operating leverage.

IV. Assessment

1. The Corporation produces and sells a single product. Data concerning that product appear
below:

Per Unit % of Sales

Selling Price 200 100%
Variable Cost 120 60%
Contribution Margin 80 40%

Fixed expenses are P303,000 per month. The company is currently selling 5,000 units per month.

Required:
The marketing manager believes that a P9,000 increase in the monthly advertising budget would
result in a 120 unit increase in monthly sales. What should be the overall effect on the company's
monthly net operating income of this change?

2. The Corporation produces and sells a single product. Data concerning that product appear
below:
Per Unit % of Sales
Selling Price 190 100%
Variable Cost 114 60%
Contribution Margin 76 40%

Fixed expenses are P387,000 per month. The company is currently selling 7,000 units per month.

Required:
Management is considering using a new component that would increase the unit variable cost by
P3. Since the new component would improve the company's product, the marketing manager
predicts that monthly sales would increase by 300 units. What should be the overall effect on the
company's monthly net operating income of this change if fixed expenses are unaffected?

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3. The Corporation produces and sells a single product. Data concerning that product appear
below:
Per Unit % of Sales
Selling Price 170 100%
Variable Cost 102 60%
Contribution Margin 68 40%

Fixed expenses are P220,000 per month. The company is currently selling 4,000 units per month.

Required:
The marketing manager would like to cut the selling price by P15 and increase the advertising
budget by P11,000 per month. The marketing manager predicts that these two changes would
increase monthly sales by 1,500 units. What should be the overall effect on the company's
monthly net operating income of this change?

4. The Corporation produces and sells a single product. Data concerning that product appear
below:
Per Unit % of Sales
Selling Price 180 100%
Variable Cost 54 30%
Contribution Margin 126 70%

Fixed expenses are P505,000 per month. The company is currently selling 5,000 units per
month.

Required:
The marketing manager would like to introduce sales commissions as an incentive for the sales
staff. The marketing manager has proposed a commission of P16 per unit. In exchange, the
sales staff would accept an overall decrease in their salaries of P65,000 per month. The
marketing manager predicts that introducing this sales incentive would increase monthly sales
by 100 units. What should be the overall effect on the company's monthly net operating income
of this change?

5. The Company produces and sells a single product. The product sells for P110.00 per unit and
its variable expense is P37.40 per unit. The company's monthly fixed expense is P188,034.

Required:
Determine the monthly break-even in total peso sales.

6. The Corporation produces and sells a single product. Data concerning that product appear
below:
Selling Price per unit P 120.00
Variable Cost per unit 50.40
Fixed Cost per month 257,520

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Required:
a. Assume the company's monthly target profit is P20,880. Determine the unit sales to attain that
target profit.
b. Assume the company's monthly target profit is P6,960. Determine the peso sales to attain that
target profit.

7. The Corporation makes a product that sells for P110 per unit. The product's current sales are
35,900 units and its break-even sales are 26,566 units.

Required:
Compute the margin of safety in both pesos and as a percentage of sales.

8. The Corporation has provided its contribution format income statement for June.
Sales ………. P 863,300
Variable Cost ………. (427,200)
Contribution Margin ………. 436,100
Fixed Cost ………. (352,400)
Net Operating Income ………. P 83,700

Required:
a. Compute the degree of operating leverage to two decimal places.
b. Using the degree of operating leverage, estimate the percentage change in net operating
income that should result from a 14% increase in sales.