MODULE 2: PROFIT PLANNING AND COST- Condensed Format Expanded Format

VOLUME-PROFIT ANALYSIS
Introduction
Sales Px Sales Px
Managers are constantly faced with decisions about selling
prices, variable costs and fixed costs. To be able to choose Less: Variable costs and x Less: Variable cost of x
from among the alternative actions, it is necessary to have a expenses goods sold
good estimate of the probable costs that would result from
Contribution margin x Manufacturing Margin x
each choice. Furthermore, management needs to know the
costs that are likely to be incurred under normal operating Less: Fixed costs and x Less: Var marketing and x
conditions and how they might vary if conditions change. expenses admin exp

Profit Px Contribution margin x

Profit Planning === Less: Fixed costs and x
expenses
Profit planning is the process of anticipating profit under
varying conditions and analyzing the effects of variables Profit P x
affecting it. It directly relates to the normal operating activities
and is short- term in nature.

For purposes of profit analysis and control, managers give

Variable costing and profit planning
The Variable Costing system is preferred as a managerial tool
in profit planning. Variable costing is straight forward, stresses
the importance of quantity and price to sales and profit, and
follows the foundation of economic principles. In this model,
costs are classified as fixed and variable. Total fixed costs are
related to normal capacity and are independent from the
changes in the level of sales volume. Variable costs change
directly in relation to the change in volume of sales. Variable
costing system (also known as the marginal costing system or
contribution margin approach) determines profit as follows
(values are assumed).
emphasis to the contribution margin. To avoid operating loss,
contribution margin should be at least equal to fixed costs. Any
amount of contribution margin in excess of fixed costs is profit.
A peso increase in contribution margin is a peso increase
operating profit.
In this learning module, we will use the term “costs” to include
all the costs of production, marketing, distribution, and general
expenses. And we will use the condensed format for purposes
of introductory learning.
Assumptions in profit planning and CVP analysis

Quantity Price Amount Management has to control costs. The process of

understanding the relationships of costs, sales price, and
Sales 10,000 P200 P 2,000,000 sales volume, and sales mix to profit in order to identify the
level of optimal operating performance in achieving the overall
Variable costs 10,000 120 (1,200,000) goal of an enterprise is profit planning.
Fixed costs Profit (500,000) The variables of profit are the unit sales, unit variable costs,
total fixed costs, sales volume (or volume), and the sales mix.
P300,000
Sales mix happens when a business sells two or more
products. The assumptions to these variables as they relate
to units sold, are as follows:
Contribution Margin
Table 2.2. Profit Planning Assumptions
Sales and variable costs directly relate with sales volume. The
difference in sales and variable costs is originally called as Basic Sensitivity
profit/volume, but is now popularly referred to as the Assumptions Assumptions
contribution margin. This amount is used to absorb fixed
costs. The difference between contribution margin and fixed Sales volume Changes Changes
costs is profit. The format to determine profit using the variable
costing system is as follows: Unit sales price Constant Changes

Unit variable costs Constant Changes

Table 2.1. The contribution margin format Total fixed costs Constant Changes

Sale mix Constant Changes

Basic Assumptions

The sales price is considered constant for planning purposes.

It is influenced by competition, variability in supply and
demand, laws, technology, distribution channels, emerging
practices, production input prices, taxes subsidies,
seasonality, and other determinants. However, once set by
the marketing and planning department, the sales price is
considered constant, hence, considered outside the
controllable domain of the expense management. The most
the management accountant can do is to influence the setting
of the sales price.
The variable costs rate is considered constant for planning
purposes. It is affected by a change in the prices of suppliers,
labor, rentals, telecommunications, fuel, warehousing,
distribution, taxes and licenses, agency costs, and such other
determinants. The total fixed costs and expenses are also
considered constant for planning purposes.
The basic CVP analysis is based on the following
assumptions:
Table 2.3. CVP Analysis Basic Assumptions
Areas Basic Assumptions
Cost classification Segregated as to fixed and variable costs
Linearity and The behavior of sales and costs is linear
behavior within the relevant range. Total fixed
costs remain constant, but unit fixed cost
inversely changes in relation to volume
(i.e., unit fixed costs decreases as
production increases).
Total variable costs change, but unit
variable cost is constant Unit sales price
is constant
Product There is only one product or, in case of
multi-product operations, the sales mix is
constant.
Work-in-process There is no work-in-process inventory.
inventory
Production equals There is no change in the finished goods
sales inventory, that means, production equals
sales.
Cost-volume-profit analysis also assumes that labor
productivity, production technology, and market conditions will
not change. Or if they change, their impact shall be covered
in the sensitivity analysis. Also, it is assumed that there is no
inflation, or if it can be forecasted, it is already included in the
CVP analysis data.
CVP sensitivity assumptions
The assumptions that sales price, unit variable costs, and total
fixed costs are constant are used to establish the “standard
costs”. Thes costs serve as the “ballpark figures” or initial
points of understanding the results of business operations.
The assumptions used in the basic CVP Analysis are stiff,
unreal and are not reflective of the practical business
conditions. In the real world, changes abound and their
impacts are sometimes profound. Sales prices change. Unit
variable costs and total fixed costs also change. Sales mix
changes as well. The process of considering the impact and
the results to profit of the changes in its variables is called
CVP Sensitivity Analysis.
Levels of profit planning
The four (4) levels of learning in profit planning are as follows:
1. Basic cost-volume-profit analysis
2. Cost-volume-profit sensitivity analysis
3. Multi-product cost-volume-profit analysis
4. Degree of operating leverage
The basic CVP analysis operates within the context of the
basic assumptions used in the profit planning and controlling
system. Sensitivity CVP analysis incorporates possibilities of
changes in the assumptions underlying profit planning. Multi-
product CVP analysis considers the occurrence of two or more
products produced and distributed by an enterprise as it
impacts portfolio profit. Operating leverage unfolds the secret
of managing change in profit.
The Basic of CVP Analysis
The basic CVP analysis covers the study on contribution
margin, breakeven point, margin of safety, profit setting, sales
mix analysis, and degree of operating analysis.
The contribution margin is the heart of variable costing
analysis (i.e., marginal analysis, profitability analysis,
differential costing analysis). Its relevance is based on the
premise that “an increase in contribution margin means an
increase in profit”.
To illustrate a “walk-through” of the techniques applied in the
CVP analysis, let us consider the following illustrative
problem.
Sample Problem 2.1 - The contribution Margin, Breakeven
Point, and Margin of Safety
Pilot Company establishes the following information for its
profit planning activities:
Unit sales price P 200 Total fixed costs
P400,000
Unit variable 120 Unit sold 8,000
costs units
Determine the following for Pilot Company’s profit planning
analysis:
1. Unit contribution margin, contribution margin
rate, and variable cost rate.
2. Breakeven point in units and in pesos.
3. Margin of safety in units and in pesos, and the
margin of safety rate.
Solution/Discussions:
1. Unit contribution margin (UCM), contribution
margin rate (CMR), and variable cost rate (UCV)
If : CM = Sales - Variable costs
And : UCM = USP - UCV
Then : The unit contribution margin is P80, ie, The breakeven point in pesos is P1,000,000.
P200 - P120. The contribution margin rate is 40%, ie, P80 /
P200 The variable cost rate is 60%, ie, P120 / P200 ● The breakeven point formulas are as follows:

BEP (units) = TFC / UCM

● The basic interrelationships
From this, we could say:
Let’s use this problem to discover the intriguing relationships
of contribution margin, fixed costs, and profit. Using the FC = BEPU x UCM
variable costing income statement, we will have the following
tabular information: UCM = FC / BEPU and,
Unit Unit Amount Percent BEP (pesos) = FC/ CMR
Prices age

Sales 8,000 P 200 P1,600,000 100 Sales

rate
To derive the BEP formula, we have”
Less: 8,000 120 960,000 60 VC
Variable rate Total sales = Total costs
costs
Total sales = Fixed costs + Variable costs
Contribution 8,000 20 640,000 40 CM
Margin rate
QS (USP) = FC + QS (UVC)
Less Fixed 400,000
costs QS (USP) - QS (UVC) = FC
P 240,000
Profit QS (USP - UVC) = FC

QS = FC/USP - UVC

Note that net sales is the base, ie, total sales is 100%, unit QS = FC/UCM
sales price is also 100%.

● Now, focus on the power of the contribution margin.

Inasmuch as the total fixed costs is constant, then, an
increase in the contribution margin is automatically an
increase in profit. This gives us an understanding of the first
approach to control profit: that is, manage the contribution
margin to control profit!
Applying the formulas in our illustrative problem, we have:
BEP (units) = P 400,000 / P 80 = 5,000 units
BEP (pesos) = P 400,000 / 40% = P 1,000,000
At BEP, total contribution margin equals total fixed costs.

● Further, you should have noticed that contributed

margin may be computed is at least four (4) important ways,
as follows:

1. CM = Sales - Variable Costs

2. CM = Fixed costs + Profit

3. CM = Units sold x UCM

3. Margin of safety in units and in pesos, and the
4. CM = Sales x CMR margin of safety rate.

Likewise, you should have observed the following important ● Margin of safety is the difference between budgeted
relationships: sales and breakeven sales. It is the maximum amount of
reduction in sales before loss happens.
Profit = CM- Fixed costs ● The margin of safety in units is 3,000, the margin in
Variable Cost rate = Variable cost/ Sales safety pesos is P 600,000, and the margin of safety rate is
37.5%.
= unit variable cost/ Unit sales price
● The margin of safety expressions and computations
CM Rate = Contribution margin/ Sales are tabulated below:

= Unit CM / Unit sales price Units Amount Rate

= 100% - VCRation Budgeted 8,000 P 1,600,000 100.00 Budgeted

sales % Sales Rate
(8,000
2. Breakeven point in units and in pesos units x P
200)
● Breakeven point (BEP) is where total sales equal
total costs. At this point of sales level, there is no profit or loss. Less: 5,000 1,000,000 62.50 Breakeven
Also, at breakeven point, contribution margin equals total fixed Breakeve % Sales Rate
costs. n sales

● The breakeven point in units is 5,000.

 Margin of 3,000 P 600,000 37.50 Margin of Solutions/ Discussions
safety % Safety Rate
● The profit is expressed in many ways - profit before
tax, profit after tax, profit percentage, or profit rate per unit.
The formula and applications for each of the expressions of
Margin of safety ratio (MSR) is margin of safety over budgeted profit are presented below:
sales. The MSR may be determined based in units or in
pesos. Expression of Formulas Applications
profit
● The presence of a margin of safety indicates profit. 1. Profit Sales (units) = (FC + PBT) Sales (units) = (800,000 + 400,000)
Since margin of safety is the amount of sales in excess of before tax UCM P 160
breakeven point, it means that in every peso of margin of = 7,500 units
safety there is a profit. And profit is the incremental Sales (pesos) = (FC + PBT)
contribution margin after the breakeven point because all fixed CMR Sales (pesos) = (800,000 + 400,000)
40%
costs have already been covered by the contribution margin = P 3,000,000
by then. Managing the margin of safety is the second
2. Profit after Sales (units) = (FC + PBT) Sales (units) = (800,000 + 800,000)
approach in controlling economic profit.
tax UCM P 160
= 10,000 units
● From this understanding, we can say that:
Sales (pesos) = (FC + PBT)
CMR Sales (pesos) = (800,000 + 800,000)
40%
Profit = Margin of Safety x It also means that: PBT = [PAT / (1- Tax Rate)] = P 4,000,000
CMRate NPRatio = MSR x CMR

Applying it, we have: Therefore: 3. Profit % Sales (pesos) = FC/ (CMR - PRBT) Sales (pesos) = P 800,000/(40%- 20%)
before tax = P 4,000,000
Profit = P 600,000 x 40% MSR = NPR / CMR
Sales (units) = FC/ (UCM - UPM) Sales (units) = P 800,000 / P 80
Profit = P 240,000 CMR = NPR/ MSR
= 10,000 units

UPM = P 400 x 20% = P 80

Now, refer to preceding discussion Sample Problem 2.1,
solution/ discussions no. 1, we can find the profit amount to P 4. Profit per Sales (units) = FC/ (UCM - UPM) Sales (units) = P 800,000/(P 160-P 25)
unit = 5,926 units
240,000. before tax

Sales with Profit 5. After-tax Sales (pesos) = FC/ (CMR - PRBT) Sales (pesos) = P800,000
profit as a (40% - 33.33333%)
Business organizations should operate with profit. Otherwise, % of sales = P 12,000,000
they are not in business. The question is: how much sales PRBT = [PRAT / (1-Tax Rate)]
PRBT = 20%/60% = 33.3333%
should a business generate to achieve a target profit?
6. Pre-tax Sales (pesos) = FC/(CMR- PRBT) Sales (pesos) = P 800,000/ 40%(1-20%))
This query necessitates the business to establish a profit. profit as a = P 2,500,000
% of CMR
Profit may be expressed in various ways as exemplified in the
next sample problem. 7. Post-tax Sales (pesos) = FC/(CMR- PRBT) Sales (pesos) = P 800,000
profit as a [40%{1-(20%/60%)]
% of CMR = P 3,000,000

Sample Problem 2.2 - Estimating Sales with Profit CMR = Contribution Margin Ratio PRBT = Profit Rate Before Tax
FC = Fixed Costs UCM = Unit Contribution Margin
Mayaman Company determines its sales price and costs PBT = Profit Before Tax UPM = Unit Profit Margin
PAT = Profit After Tax PPAT = Profit Percentage After Tax
structure as follows: PR = Profit Rate ATR = 1 - Tax Rate

Unit sales price P 400

Unit variable costs 240 ● Profit is added to the fixed costs in the numerator.
Unit profit margin is deducted from the unit contribution margin
Total fixed costs 800,000 in the denominator. Contribution margin rate is deducted from
the contribution margin rate in the denominator.
Tax rate 40%

How much is the required sales, units and amount, if the profit
is targeted as follows:

1. Profit before tax of P 400,000.

2. Profit after tax of P 480,000.

3. Profit before tax is 20% of sales.

4. Profit before tax is P 25 per unit.

5. After-tax profit is 20% of sales.

6. Pre-tax profit is 20% of CMR.

7. Post-tax profit is 20% of CMR.

 Products
● The profit to be added or deducted is the profit before
tax (PBT). If the post-tax profit is given, then, the PBT is (PAT X Y Z Total
- 1- Tax Rate).
Unit sales price P 400 P 600 P 700
● If the profit given is a percentage based on sales, it
Unit variable 100 350 500
is deducted from the CMR in the denominator. Sales with costs
profit in pesos equals fixed costs divided by the fixed cost rate
(i.e., CMR - Profit Rate). Sales with profit in units equals fixed Unit contribution 300 250 200
costs divided by the fixed costs rate per unit (i.e., unit margin
contribution margin less unit profit margin).
CM rate 75% 41.67% 28.57%
● Always remember the mathematical RULE, “any
Budgeted sales 5,000 3,000 2,000 10,000
number divided by its corresponding percentage is equal to in units
100% of that number.” In the profit/ loss statement
relationships, sales are always equal to 100%. So, if we divide Budgeted sales P 2,000,000 P1,800,000 P 1,400,000 P 5,200,000
fixed costs by its percentage, we get its 100% base which is in pesos
the sales value.
Total fixed costs P 795,000
● The formulas used in this illustration are derived as
follows:

IF THEN Required: Calculate the following:

CM = FC + Profit QS(UCM) = FC + Profit 1. Composite breakeven point (CBEP) in units and in pesos.

QS = (FC + Profit) / UCM 2. Allocated CBEP

CM = FC + Profit S(CMR) = FC + Profit 3. Sales per mix

S = (FC + Profit) / CMR 4. Composite sales profit before tax is P 2,000,000.

CM = FC + Profit QS(UCM) = FC + QS(UPM) Solutions/ Discussions:

QS = FC / (UCM-UPM) The formulas and their applications are shown in the following
table:
CM = FC + Profit S(CMR) = FC + S(PR)
Required Formulas Applications
S = FC/ (CMR-PR)
1. Composite CBEP (units) = FC / Average UCM 1
CBEP (units) = P 795,000 / P 265
BEP (units) CBEP (pesos) = FC / Average CMR2 = 3,000 units

Composite CBEP(pesos) = P 795,000 /50.9612%

Multi-Product CVP Analysis BEP (pesos) = P 1,560,000

2. Allocated Allocated CBEP (units) = CBEPU x CBEPU allocation:

In many instances, businesses produce and sell more than CBEP (units) Sales Mix Ratio in units X = 3,000 x 5/10 = 1,500
one product, hence, the multi- product sales situation. If there Y = 3,000 x 3/10 = 900
are two or more products to be considered, the composite (the allocation of CBEPU is made Z = 3,000 x 2/10 = 600
based on the sales mix ratio in units CBEP 3,000
breakeven point (CBET) is determined to establish the overall used in computing the average UCM)
breakeven point situation of the enterprise.

The basic breakeven point formula (i.e., FxC/UCM) is to be

CBEPP allocation:
used. Except that in the multi- product sales, the denominator Allocated Allocated CBEP (pesos) = CBEPP x X = P 1,560,000 x 2,000/5,200
CBEP Sales Mix Ratio in = P 600,000
is the average unit contribution margin (average UCM) and (pesos) amounts Y = P 1,560,000 x 1,800/5,200
the average contribution margin rate (Average CMR). = P 540,000
(The allocation of CBEPP is made Z = P 1,560,000 x 1,400/5,200
based on the sales mix ratio in = P 420,000
Average UCM is the sum of individual product UCM times their amounts used in computing the CBEP = P 1,560,000
sales mix ratio based on units. Average CMR is the sum of average CMR)

individual product CMR times their sales mix ratio based on 3. Sales per Sales per Mix = FC / Composite UCM Sales per mix = P 795,000 / P 2,650
mix3 = 300 units
amount. and, using the Sales Per Mix; the
CBEPU is computed, as follows: The composite breakeven in units
Average UCM = Σ (Product UCM x Sales mix ratio in units) would be:
CBEPU = Sales per mix x X = 3,000 x 5 = 1,500
Average CMR = Σ (Product CMR x Sales mix ratio in amount) No. of Sales Mix Y = 3,000 x 3 = 900
Z = 3,000 x 2 = 600
CBEP 3,000 units
Sales mix is the standard relationship of the products sold in
a given period of time. In themulti- product sales analysis, the
4. Composite CSP = FC + Profit CSP = P 795,000 + P 2,000,000
sales mix ratio is assumed to be constant. sales pesos Ave. CMR 58.9612%
(CSP)4 = P 5,484,465

Sample Problem 2.3 - Composite Breakeven Point 1 Average UCM

Analysis (Multi-Product) Sales
Nagadu Corporation produces and sells three products and
has provided you the following operating data:
● The given sales mix (5:3:2) is derived based on the
relationships of the budgeted sales in units, i.e., 5,000, 3,000,
and 2,000 for products X, Y, and Z, respectively. The sales
mix also means that when there are 10 products produced, 5
would be X, 3 would be Y and 2 would be Z. If there are 30
products produced in a given production run, 15 would be X Average CMR = Composite CM / Composite Sales
(i.e., 5/10 x 30 units), 9 would be Y (i.e., 3/10 x 30), and 6
would be Z (i.e., 2/10 x 30). X Y Z Composite Ratio
Sales P 200,000 P 180,000 P 140,000 P 520,000 100.00%
● The average UCM is computed as follows:
-Variable cost 50,000 105,000 100,000 255,000
Average UCM = Σ (UCM x Sales mix ratio in units) … sum CM P 150,000 P 75,000 40,000 P 265,000 50.9612%
of individual UCM times their respective SMx RAtio in units

Product UCM Sales Mix Ratio Average UCM Average CMR = P 265,000 / P 520,000 = 50.9612%
in Units

X P 300 5/10 P 150

Proving the composite breakeven point
Y 250 3/10 75
To prove the accuracy of the computed composite breakeven
Z 200 2/10 40 point in units, we determine the composite contribution margin
by getting the sum of the allocated BEP units multiplied by the
Average UCM P 265
respective UCM of each product, and then compare it with the
total fixed costs as follows:

2 Average CMR Composite CM:

There are three (3) ways to compute the average CMR. X = 1,500 units x P 300 P 450,000

a. Firstly, the average CMR or (composite CMR) is Y = 900 units x P 250 225,000
computed as follows:
Z = 600 units x P 200 120,000 P 795,000
Average CMR = Σ (CMR x Sales Mix Ratio in Pesos) … sum
- Composite fixed costs and expenses 795,000
of individual CMR times their respective SMx Ratio in amount
Profit P0
Sales Product CMR Sales Mix Average
Ratio in CMR
Amount
3 Sales per mix
P 2,000,000 X 75.00% 2,000/5,200 28.8462%
Another way to compute the composite BEPU is by using the
1,800,000 Y 41.67% 1,800/5,200 4.4231% composite sales per mix. It equals the fixed costs divided by
the composite UCM, where:
1,400,000 Z 28.57% 1,400/5,200 7.6919%
Composite UCM = Σ (UCM x Sales Mix) … sum of individual
P 5,200,000 50.9612%
UCM times sales mix in units

The composite UCM and the sales per mix, are as follows:
b. Secondly, the average CMR may also be determined Product X = P 300 x 5 = P 1,500
as follows: Product Y = 250 x 3 = 750
Average CMR = Average UCM / Average USP Product Z = 200 x 2 = 400
Average UCM is determined above to be P 265. Composite UCM P 2,650
Average USP = Σ (USP x Sales Mix Ratio) …sum of
individual USP times their respective SMx Ratio in units
Sales per mix = Fixed costs/ Composite UCM
Product USP Sales Mix Ratio Average UCM
in Units = P 795,000/ P 2,650

X P 400 5/10 P 200 = P 300 per unit

Y 600 3/10 180

Z 700 2/10 140 ● The Composite UCM serves as the denominator of

the total fixed costs to get the sales per mix. The sales per mix
Average USP P 520 is multiplied by the product sales mix contribution to get the
allocated sales per product and if added together will be the
composite breakeven point in units. The application of the
Therefore, the Average CMR = Average UCM / Average USP composite UCM is presented in requirement no. 3 of this
= P 265 / P 520 = 50.9612%. sample problem.

c. Thirdly, the average CMR may also be computed as

follows:
4 Composite sales with profit

It is determined by applying the same formula used in ● The new CMR, BEP (pesos), and profit are shown
determining the sales with profit discussed in the previous below:
Sample Problem 2.2. Save that the denominator to be used is
Case Adjusted data CMR BEP (pesos) Profit
the average contribution margin.
A USP (P80 x 120%) P 96 CMR = P 46 / P 96 BEP = P 600,000/ 47.92% CM (45,000 x P 46) P 2,070,000
UVC 50 = 47.92% = P 1,252,087 - FC 600,000
UCM P 46 Operating profit P 1,470,000

B USP P 80 CMR = P 25 / P 80 BEP = P 600,000/ 31.25% CM (45,000 x P 25) P 1,125,000

CVP Sensitivity Analysis UVC (P 50 x 110%) 55 = 31.25% = P 1,920,000 - FC 600,000
UCM P 25 Operating profit P 525,000
The assumptions that sales price, variable costs rate, and total C FC P 450,000 CMR = P 30 / P 80 BEP = P 450,000/ 37.50% CM (45,000 x P 30) P 1,350,000
fixed costs are invariable serve as the initial points in = 37.50% = P 1,200,000 - FC 450,000
Operating profit P 900,000
understanding profit planning. These basic assumptions are
D Units sold CMR = 37.50% BEP = P 600,000/ 37.50% CM (54,000 x P 30) P 1,620,000
stiff, unreal, and are not reflective of practical business (45,000 x 120%) 54,000 = P 1,600,000 - FC 600,000
Operating profit P 1,020,000
conditions. In the real world, changes abound and their
impacts are sometimes profound. E USP P 100.00 CMR=P42.50/P 100 BEP = P 630,000/ 42.50% CM (45,000 x P 42.50)P1,912,500
UVC(P50 x115%) = 42.50% = P 1,482,353 - FC 630,000
57.50 Operating profit P 1,282,500
Sales prices change, as well as the variable costs rate, total UCM P 42.50
FC (P 600T x 105%)
fixed costs, sales volume, and sales mix. The process of P 630,000

considering the impact of these changes to profit and its

related outcome is called the CVP Sensitivity Analysis. Not
only is the effect of these changes in profit determined but also
that of contribution margin, margin of safety, breakeven point,
and operating leverage.
The key in sensitivity analysis is to follow the basic
assumptions as discussed in Table 5.2 unless a specific
variable of profit is told have changed.
The following observations are derived from the analysis
above:
● The variables of profit discussed above are the unit
sales price, variable costs rate, total fixed costs, units sold,
and sales mix. In sensitivity analysis, a change in any of these
profit variables does not affect the other variables, unless
stated otherwise.

● The effects of the changes in sales price, variable

Sample Problem 2.4 - CVP Sensitivity Analysis - 1 costs, and fixed costs are shown below:

Timoteo Enterprises produces and sells product KE and

CHANGE CMR BREAKEVEN OPERATING MARGIN OF
makes available to you the following data:
POINT INCOME SAFETY
Unit sales price P 80
Increase in Increase Decrease Increase Increase
USP Decrease Increase Decrease Decrease
Unit variable costs 50
Decrease in Decrease Increase Decrease Decrease
Total fixed costs 600,000
USP Increase Decrease Increase Increase
Units sold 45,000 Increase in No effect No Increase Decrease Decrease
UVC Decrease effect Decrease Increase Increase
What would the new CMR, BEP (pesos), and operating profit
in UVC
be, if: Increase in FC
Case A. Unit sales price increases by 20%?
Case B. Unit variable costs increase by 10%?
Case C. Total fixed costs decrease to P 450,000? Now, refer to the analyses in case letter “C” where the total
Case D. Units sold increase by 20%? fixed costs decreases to P 450,000. This means there is a
Case E. Unit sales price increases to P 100; unit variable 25% decrease in fixed costs [i.e., (P 600,000 - P 450,000) / P
costs increase by 15%; and total fixed costs increase by 5%? 600,000]. Because of this, the BEP decreases from P 1.6
million to P 1.2 million or, also, a 25% decrease. This is not
coincidental but shows the direct and positive relationship
Solutions/ Discussions between fixed costs and breakeven point. Say, if fixed costs
increase by 12% BEP also increases by 12% and if fixed costs
● The unit contribution margin is P 30 (i.e., P 80-50). decrease by 9% BEP also decreases by 9%.
The original CMR, BEP (pesos), and operating profit are as
follows: A change in the number of units sold does not affect unit sales
price, unit variable costs and fixed costs but affects
CMR = P 30/ P 80 = P 37.50% contribution margin, profit and margin of safety.

BEP (pesos) = P 600,000/ 37.5% = P 1,600,000 Sample Problem 2.5. CVP Sensitivity Analysis - 2

Visayas Corporation, which is subject to a 40% income tax

rate, had the following data for the period just ended:
● Operating profit = ?
Selling price per unit P 60
Contribution margin (45,000 units x P 30) P 1,350,000
Variable cost per unit 22
- Fixed Costs 600,000
Fixed costs 472,000
Operating profit P 750,000
Management is contemplating to improve the quality of its Required:
product sold by (1) replacing a component that costs P 3.50
with a higher-grade unit that costs P 6.00 and (2) acquiring P 1. The breakeven point graph.
765,000 packing machine to be depreciated over a 10-year 2. The cost-volume-profit graph.
life. The company wants to earn after-tax income of P
172,800. The applicable income tax rate is 40%.
Solutions/ Discussions:
Required: The number of units the company must sell to
maintain the same profit before the improvement. 1. The breakeven graph (amounts in thousands)
Solutions/ Discussions:

● The number of units to be sold equals fixed costs plus profit

before tax divided by the unit contribution margin.

● The profit before tax is P 288,000 [i.e., 172,800 / 1 - .40)].

● The unit variable cost increases by P 2.50 (i.e., P 6.00 - P

3.50).

● The total fixed cost increases by the increase in depreciation

expense amounting to P 76,500 (i.e., P 765,000 / 10 years).

● In cases where there are changes in the variables used in

the analysis, the “before-after analysis” would give clearer
data, as shown below:
Before After
Unit sales price P 60.00 P 60.00
Unit variable costs (22.00) (24.50) (P 22.00 +2.50)
Unit contribution margin P 38.00 P 35.50 ● Total sales equal units sold times unit sales price. Total
Fixed costs P 472,000 P 548,500 (P 472,000+76,500) variable cost is units sold times unit variable cost. Total fixed
Profit P 288,000 P 288,000 cost is constant regardless of the level of production and
No. of units to sell sales. Total cost is the sum of total variable costs and total
fixed costs. Profit (loss) is the difference between total sales
and total costs.
(i.e., FC + IBIT / UCM)
● The point at which the total sales line meets with the total
(P 472,000 + 288,000 / P 38) 20,000 23,563 (P
cost line is the breakeven point. It is the point where profit or
548,500 + P 288,000 / P 35.50)
loss is zero. Before the breakeven point is the loss area and
● The unit sales price is held constant because there is no above the breakeven point is the profit area.
expressed stipulation on the data provided.
● Fixed cost is horizontally flat, it is constant. Total sales line
diagonally increases in relation to units while total variable
costs line also increases in relation to units sold. Total costs
The BEP Graph and CVP Graph line originates from the fixed cost level and it increases as
units sold increases due to variable costs.
There are two important graphs in cost-volume-profit analysis;
namely, the breakeven point (BEP) graph and the cost- ● Contribution margin is the difference between sales and
volume-profit (CVP) graph. The BEP graph assumes that the variable costs. The amount of contribution margin increases
production and sales level are within the relevant range as as units sold increases.
discussed in Chapter 2. One basic assumptions in the relevant
range is the linearity behavior of revenues and costs. BEP ● Margin of safety is the difference between budgeted sales
graph is used for short-term planning and controlling and breakeven sales. The margin of safety is delineated in
purposes. pesos and in units.

● Using the BEP graph, the effects of a change in the variables

of profit would be easily highlighted by shifting the lines
Sample Problem 2.6. The Profit Planning Graphs upward or downward.

Catriona Company expects to sell 200,000 units of its product

Lava Walk priced at P 20 per unit. The product’s variable cost
per unit is P 12 and its total fixed costs and expenses is P 2. The CVP Graph (amount in thousands)
800,000. Given the varying production levels, sales, costs and
● Economists believe that the behavior of revenues
profit are estimated as follows:
and costs is non-linear which is a direct contradiction with the
Production Total Sales TFC TVC Total Costs Profit (loss) linearity assumption assumed in the relevant range.
0 P 0 P 800,000 P 0 P 800,000 P (800,000)
● The economists viewpoint is captured in the CVP
100,000 2,000,000 800,000 1,200,000 2,000,000 0
graph. Its emphasis is not on the behavior of costs and
200,000 4,000,000 800,000 2,400,000 3,200,000 800,000
revenues but on the behavior (or trend) of profit over different
300,000 6,000,000 800,000 3,600,000 4,400,000 1,600,000
levels of production.
400,000 8,000,000 800,000 4,800,000 5,600,000 2,400,000
Fig 2.2. The CVP Graph

Solutions/ Discussions:

● If sales increase by 40%, EBIT will increase by 128%.

● First, let us determine the DOL ratio. The contribution

margin and profit are determine below:

Contribution margin (10,000 units x P 80) P 800,000

- Fixed costs 550,000

EBIT P 250,000

Therefore:
● The CVP graph (or “profit-volume graph”) emphasizes the Degree of Operating Leverage = P 800,000/ P 250,000 = 3.2
profit (loss) line. The sales line is presented diametrically
opposing the vertical line representing the profit (or loss) line. Then, the percentage change in EBIT is:

● The peso sales where profit is zero is the breakeven point.

The profit (or loss) line originates from a loss of P 800,000
which is the amount of fixed costs and expenses. The loss
gradually diminishes as peso sales increase because of the
increase in contribution margin. As the contribution margin
meets the fixed costs, the breakeven point is reached. Beyond
the breakeven point, any increase in contribution margin is
already an increase in profit.

● The CVP graph is used for long-term analysis.

Sales (after) = P 2 million x 140% = P 2.8 million
Variable costs (after) = P 1.2 million x 140% = P 1.68 million
The Degree of Operating Leverage (DOL) Percentage change in EBIT = Amount of change in EBIT /

As discussed in the previous sections, profit is controlled by Original EBIT balance

managing the contribution margin and the margin of safety.
The next level would be the management of the change in = P 320,000 / P 250,000 = 128%
profit. This is covered by the degree of operating leverage
● Had the operating leverage ratio been higher than 3.2, the
(DOL).
percentage change in profit would have been much higher.
In physics, a lever is a small tool used to move a bigger object.
● In case of the increasing pattern in sales, it would be better
The operating leverage of profit is the contribution margin. The
to have a higher DOL. In case of decreasing trend in sales, it
degree of operating leverage refers to the ability of the
is better to have a lower DOL. Let us summarize it below:
business to increase its profit powered by its contribution
margin. Profit, as used in this topic means EBIT or the
earnings before interest and taxes. When sales DOL Should To
are Be

Increasing Higher Maximize the Percentage Change

in EBIT
Further, DOL is also equal to “1 divided by the margin of safety
rate”. Decreasing Lower Minimize the Percentage Change
in EBIT
Let us discover the power of the operating leverage by
considering the following problem.

Sales are expected to increase in times of economic upswing,

industry expansion or tremendous acceptance of the product
Sample Problem 2.7. Operating Leverage
in the market. During these times, the operating leverage ratio
The DOL signifies the percentage change in EBIT (earnings should be increased.
before interest and tax) given a certain percentage change in
Sales are expected to slow down in times of economic
net sales. To amplify this premise, let us say:
contraction, industry maturity, product maturity or introduction
Unit sales price P 200 of a new technology that makes the old product obsolete.
Such have an adverse effect on the sales of the product. As
Unit variable costs 120 such, in these times the degree of operating leverage should
be decreased.
Total fixed costs 550,000
To increase the DOL, the unit sales price should be increased,
Units sold 10,000 units or the unit variable costs should be decreased, or the fixed
What would happen to EBIT if sales increase by 40%? costs should be increased. Increasing the sales price would
engage the enterprise to adopt the “product differentiation”
strategy, decreasing the unit variable costs would lead to
“cost-focus” strategy, while increasing the fixed costs would
result to applying the “growth” strategy. Defining the strategy
of an enterprise sets the mode of the organizational structure,
standards, and systems to be used and have an ultimate
impact on its operating and investing results.
Consolidating the learning points!
3. Based on the data presented in the above table, the
following comments are derived:
a. Profit is the measure of short-term performance. The DOL
reflects the medium term performance.
b. Profit and DOL relate inversely. When profit increases, DOL
tends to decrease, and vice-versa. This suggests that what
may be good for the business in the short-term will not result
to better performance in the medium term.

After learning the principles and techniques used in the cost-
volume-profit analysis, sensitivity analysis, and degree of
operating leverage, let us consider the following sample
problem to find out their interrelationships.
c. For example, an increase in unit sales price immediately
pumps up profit but reduces DOL. A decrease in unit variable
cost increases profit and increases DOL.
d. On the other hand, an increase in fixed costs reduces profit
and increases DOL.

Sample Problem 2.8. CVP Sensitivity Analysis - 3

Tsunami Corporation based its profit planning on the following

operating data: Unit sales price, P 400; unit variable costs, P
240; total fixed costs, P 8 million; and sales volume, 80,000
units.

Required:

1. Based on the original data, determine the CMR, BEP in

pesos, operating profit, MSR, and the DOL.

2. Based on the following changes in the variables of profit,

determine the new CMR, BEP in pesos, operating profit, MSR,
and DOL.

a. Unit sales price increases by 10%.

b. Unit variable costs decrease by 5%.

c. Total fixed costs and expenses increase by P 500,000.

d. Quantity sold increases by 10,000.

e. Unit sales price decreases by P 20, unit variable costs

increase by 10%, total fixed costs decrease by 5%, and units
sold increases to 100,000.

3. Comment on the data determined in requirement 2.

Solutions/ Discussions:

Let us first be reminded on the following formulas: