MODULE 4: PROFIT PLANNING & COST-VOLUME PROFIT ANALYSIS

profit using the variable costing system

is as follows:
PROFIT PLANNING - Profit planning is
the process of anticipating profit under
varying conditions and analyzing the
effects of variables affecting it. It
directly relates to the normal operating
activities and is short-term in nature.

VARIABLE COSTING AND PROFIT

PLANNING

The Variable Costing system is preferred

as a managerial tool in profit planning.
Variable costing is straight forward,
For the purpose of profit analysis and
stresses the importance of quantity and
control, managers give emphasis to the
price to sales and profit and follows the
contribution margin. To avoid operating
foundation of economic principles. In
loss, contribution margin should be at
this model, costs are classified as fixed
least equal to fixed costs. Any amount
or variable. Total fixed costs are related
of contribution margin in excess of fixed
to normal capacity and are
costs is profit. A peso increase in
independent from the changes in the
contribution margin is a peso increase
level of sales volume. Variable costs
in operating profit.
change directly in relation to the
change in volume of sales. Variable ASSUMPTIONS IN PROFIT PLANNING
costing system (also known as marginal AND CVP ANALYSIS
costing system or contribution margin
approach) determines profit as follows: Management has to control costs. The
process of understanding the
relationships of costs; sales price and
sales volume as they impact profit is
known as Cost-Volume Profit analysis,
e.g., CVP

analysis. The process of understanding

CONTRIBUTION MARGIN
Sales and variable costs directly relate
with sales volume. The difference in
sales and variable
costs are originally called profit/volume,
but is now popularly referred to as
contribution margin. This amount is used
to absorb fixed costs. The difference
between contribution margin and fixed
costs is profit. The format to determine
and controlling the impact of changes
in costs, sales price, volume and sales
mix to profit in order to identify the level
of optimal operating performance in
achieving the overall goal of an
enterprise is profit planning.
The variables of profit are the unit sales
price, unit variable costs, total fixed
costs, sales volume (or volume) and the
sales mix. Sales mix is happening when
a business sells two or more products.

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The assumptions to these variables as
they relate to units sold, are as follows:
PROFIT PLANNING ASSUMPTIONS
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 cost 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
FOLLOWING ASSUMPTIONS:
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 assumption that sales price, unit
variable costs, and total fixed costs are
constant are used to establish the
“standard costs”. These 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 practical business
conditions. In the real world, changes
abound and their impacts are
sometimes profound. Sales price
change. Unit variable costs and total
fixed costs also change. Sales mix
changes as well. The process of
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 MODULE 4: PROFIT PLANNING & COST-VOLUME PROFIT ANALYSIS

considering the impact and the results
of the profit of the changes in its
variables is called CVP sensitivity
analysis.
THE BASIC CVP ANALYSIS
The Basic CVP analysis covers the study
on contribution margin, break-even
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”.
1. Unit contribution margin (UCM),
contribution margin rate (CMR),
and variable cost rate (UVC)
If: Contribution Margin = Sales –
Variable costs
And: Unit Contribution Margin = Unit
Selling Price – Unit Variable Cost
Then: The unit contribution margin is
P80, i.e., P200-P120
The contribution margin rate is 40%
i.e., P80/P200
The variable cost rate is 60% i.e.,
P120/P200
The basic interrelationships.

Sample Problem – The Contribution

Margin, Break-even Point, and Margin
of Safety

Pilot Company establishes the following

information for its profit-planning Note: that net sales is based, i.e.
activities: total sales is 100%., unit sales price is
also 100%.
Unit sales price P200
Unit variable costs 120
Total fixed costs 400,000 • Now, focus in the power of
Units sold 8,000 units contribution margin. In as
much as the total fixed costs
Determine the following for Pilot is constant, then as increase
Company’s profit planning analysis: in the contribution margin is
automatically an increase in
1. Unit contribution margin,
profit.
contribution margin rate and
variable cost rate.
Contribution Margin may be computed
2. Break-even point in units and in
in at least (4) important ways, as follows:
pesos.
1. CM = Sales – Variable Costs
3. Margin of safety in units and in
2. CM = Fixed costs + Profit
pesos, and the margin of safety
3. CM = Unit sold x Unit
rate.
contribution margin
4. CM = Sales x Contribution
Solutions/Discussions:
margin rate

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2. Break-even point in units and in
pesos
• Break-even point (BEP) is where total
sales equal total costs. At this point of
sales level, there is no profit or loss. Also,
at breakeven point, contribution margin
equals total fixed costs.
• The break-even point in units is P5,000.
• The break-even point in pesos is
P1,000,000
The break-even point formulas are as
follows:
Break-even point units = Total Fixed
Cost/Unit Contribution Margin
Fixed Cost = Break-even point in Units x
Unit Contribution Margin
Unit Contribution Margin = Fixed
Cost/Break-even Point in units
Break-even points in pesos = Fixed
Cost/Contribution Margin Rate
To derive break-even point formula, we
have:
Total sales = Total costs
Total sales = Fixed Costs + Variable Cost
Applying the formulas in our illustrative
problem, we have:
BEP (units) = P400,000/P80 = 5,000 units
BEP (pesos) = P400,000/40% = P1,000,000
Note: At Break-even point, total contribution margin equals total
fixed costs.
3. Margin of Safety in units and in
pesos, and the margin of safety
rate.
• Margin of Safety is the difference
between budgeted sales and break-
even sales. It is the maximum amount of
reduction in sales before loss happens.
• The margin of safety in units is 3,000,
the margin in safety pesos is P600,000
and the margin of safety rate is 37.50%.
• The margin of safety expressions and
computations are tabulated below:
Margin of Safety Ratio (MSR) is margin
of safety over budgeted sales. The MSR
may be
determined based in units or in pesos.
• The presence of a margin of safety
indicates profit. Since margin of safety is
the amount of sales in excess of break-
even point, it means that in every peso
of margin of safety, there is a profit. And
profit is the incremental contribution
margin after the break-even point
because all fixed costs have already
been covered by the contribution
margin by then. Managing the margin
of safety is the second approach in
controlling the economic profit.
From this understanding: Applying it, we
have:
Profit = P600,000 x 40%
Profit = P240,000
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