UNIT 2: Cost-Volume-Profit (CVP) Analysis

Introduction

You and your friends head out to a favorite restaurant for dinner. The restaurant
serves a meat dish with three side dishes for a reasonable price. The combination of
good food at a good price has made this “meat and three” restaurant popular.
However, when you arrive at the restaurant this time, it is not as crowded as usual.
You also notice the restaurant has increased the price for a meal.

After you are seated and order, you and your friends discuss the changes. No one
seems surprised by the price increase. You’ve all noticed that food prices have
increased at the grocery store and speculate that the restaurant’s supplier has also
increased prices. If food costs increase, the business would have to increase the sales
price per meal in order for the meals to remain profitable. Is this what is keeping
some customers away? What will be the effect on profits if the restaurant charges more
per meal but serves fewer meals? At what point will the business begin to operate at a
loss rather than a profit? How long will the restaurant remain open if it loses a large
number of customers?

These are the type of questions asked by managers in every business—what is the
relationship among costs, volume, and profit? In this unit, you’ll learn about cost-
volume-profit (CVP) analysis, a tool managers use to answer these questions.

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 Unit Learning Objectives

By the end of this unit, you should be able to:

• Explain the definition, objectives, assumptions, and limitations of CVP
Analysis.
• Construct a contribution margin format income statement.
• Compute for breakeven points, target sales, margin of safety, indifference
points and operating leverage.
• Interpret the results of CVP analysis computations.

Timing

This unit is good for more than a week—8 days at maximum You can devote three
hours per day on the subject. Don’t worry, the content is abridged, which means it
only includes the most salient points you need to know relative to our module
learning outcomes (MLO).
For easier monitoring of your progress, you may use the study planner attached to
this module. Be sure to make use of your planner to have a more organized and
orderly studying. Plus, the planner is a PROCRASTINATION-beater!

Getting Started!

2.1 COST BEHAVIOR ANALYSIS

To manage any size of business, you must understand how costs respond to changes
in sales volume and the effects of costs and revenue on profits, hence, known as Cost-
Volume-Profit Analysis.

❖ VARIABLE COSTS

Variable costs will vary in direct proportion to changes in the level of an

activity. For example, direct material, direct labor, sales commissions, fuel
cost for a trucking company, and so on, may be expected to increase with each
additional unit of output.

The activity base is the item or event that causes the incurrence of a variable
cost. It is easy to think of the activity base in terms of units produced, but it
can be more than that. Activity can relate to labor hours worked, units sold,
customers processed, or other such "cost drivers."

For example, let’s assume that it costs a bakery $15.00 to bake a cake—$5.00
for raw materials such as sugar, milk, and flour, and $10.00 for the direct
labor involved in baking 1 cake. The table below shows how the variable
costs change as the number of cakes baked vary.

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 1 cake 2 cakes 7 cakes 10 cakes 0 cakes
Cost of sugar, flour, P 5.00 P 10.00 P 35.00 P 50.00 P 0.00
butter and milk
Direct labor P 10.00 P 20.00 P 70.00 P 100.00 P 0.00

Total variable cost P 15.00 P 30.00 P 105.00 P 150.00 P 0.00

As the production output of cakes increases, the bakery’s variable costs also
increase. When the bakery does not bake any cake, its variable cost drops to
zero.

❖ FIXED COSTS

The opposite of variable costs are fixed costs. Fixed costs do not fluctuate with
changes in the level of activity. Assume that GoSound leases the
manufacturing facility where the portable digital music players are
assembled. Assume that rent is P1,200,000 no matter the level of
production. The rent is said to be a "fixed" cost, because total rent will not
change as output rises and falls. Fixed cost per unit will decline with increases
in production. This attribute of fixed costs is important to consider in
assessing the scalability of a business proposition. There are numerous types
of fixed costs. Examples include administrative salaries, rents, property
taxes, security, networking infrastructure support, and so forth.

❖ MIXED COSTS

Many costs contain both variable and fixed components. These costs are
called mixed or semi-variable.

Factory overhead contains all your manufacturing costs except the direct
materials and direct labor. Some mixed manufacturing costs originate from
your leased factory equipment and machinery. A mixed cost contains a fixed
base rate and a variable rate that fluctuates with use.
For example, the fixed portion of your equipment lease is a flat $2,000 charge
to produce from zero to 10,000 units. You are charged a variable cost of $1.50
for each unit produced over the 10,000 production ceiling. Therefore, if you
produced 12,000 units, the total cost will be the sum of $2,000 fixed cost plus
$3,000 ($1.50 variable cost per unit X 2,000 units beyond the 10,000
production ceiling).

With a mixed cost, there is some fixed amount plus a variable component tied
to an activity. Mixed costs are harder to evaluate, because they change in
response to fluctuations in volume. But, the fixed cost element means the
overall change is not directly proportional to the change in activity.

2.2 CVP ANALYSIS

CVP (Cost-Volume-Profit Analysis) is used to determine how changes in costs and

volume affect a company's profit (operating income). It is a planning process that
management uses to predict the future volume of activity, costs incurred, sales made,
and profits received and it focuses on the interplay of pricing, volume, variable and
fixed costs, and product mix. However, it’s only reliable if costs are fixed within a
specified production level. Its starting point is the Contribution Margin.

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2.2.1 The BASIC CVP FORMULA

The basic CVP formula is the price per unit multiplied by the number of units sold
equals the sum of total variable costs, total fixed costs and accounting profit. Total
variable costs equal the number of units sold multiplied by the variable cost per unit.

(SP/u x Units sold = (VC/u x Units sold) + TFC + Accounting profit)

or
SALES = TVC + TFC + P/L

Where,
SP/u = selling price per unit TFC = total fixed cost
VC/u = variable cost per unit P/L = profit or loss

2.2.2 CONTRIBUTION MARGIN

Contribution Margin is the amount of revenue remaining after deducting variable

costs. It is often stated both as a total amount and on a per unit basis.

Contribution Margin = Sales - Variable Costs

CONTRIBUTION MARGIN RATIO is determined by dividing the contribution

margin by total sales; a.k.a. profit-volume ratio.

Below is the comparison of the Traditional Income Statement that we already

know how to prepare by heart and a new format which we’re going to call as
Contribution Margin Income Statement.

Traditional Income Statement Contribution Margin Income

Statement

Sales revenue Sales revenue

-Cost of goods sold, variable
-Cost of goods sold, fixed
=Gross margin
-Operating expenses, variable
-Operating expenses, fixed
=Operating income
-Cost of goods sold, variable
-Operating expenses, variable
=Contribution margin
-Cost of goods sold, fixed
-Operating expenses, fixed
=Operating income

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 In detail, here’s how each component of the contribution income statement
is computed:

Per unit As a Percentage of

Relationships Sales
Sales Revenue Sales price per unit x Sales revenue ÷
Units sold Sales revenue
Less Variable -Variable rate per unit x -Variable costs ÷
Costs Units sold Sales revenue
Contribution =Contribution margin per =Contribution margin ÷
Margin unit x Units sold Sales revenue
Less Fixed Costs -Total fixed costs -Fixed costs
Operating =$XXXXX =Operating income
Income

To Illustrate:

Assume the following data for Vagabond Inc.:

Sales 50,000 units

Sales price per unit $20
Variable cost per unit $12
Fixed Costs $300,000

Sales (50,000 units x $20)………………... $1,000,000

Variable Costs (50,000 units x $12)…… 600,000
Cont. Margin (50,000 units x $8)……….. $ 400,000
Fixed Costs……………………………………….. 300,000
Operating Income……………………………. 100,000

Note:

The maximum contribution a unit of product or service can make is its selling
price. After paying for itself (variable costs), a product or service provides a
contribution margin to help pay total fixed costs and then earn a profit.

2.2.3 ASSUMPTIONS OF CVP

Like most models, there are certain inherent assumptions. Violating the
assumptions has the potential to undermine the conclusions of the model. Some of
these assumptions have been touched on throughout the lesson:

1. Sales price, fixed cost and variable cost per unit are constant.
2. Costs can be classified accurately as either variable or fixed.
3. Changes in activity are the only factors that affect costs.
4. All units produced are sold.
5. When more than one type of product is sold, the sales mix will remain
constant. That is, the percentage that each product represents of total
sales will stay the same. Sales mix complicates CVP Analysis because
different products will have different cost relationships.
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 Also, always bear in mid the following basic components of CVP analysis.

Components of CVP analysis. Adapted from Managerial Accounting Tools for Business Decision Making (Sixth Edition)
by J.J. Weygandt, P.D. Kimmel and D.E. Kieso, 2012, p. 206. Copyright 2012 by John Wiley & Sons, Inc.

2.2.4 CONTRIBUTION MARGIN: AGGREGATED, PER UNIT, or RATIO

When speaking of the contribution margin, one might be referring to aggregated

data, per unit data, or ratios. This point is illustrated below for Leyland Sports, a
manufacturer of score board signs.

The production cost is P500 per sign, and Leyland pays its sales representatives
P300 per sign sold. Thus, variable costs are P800 per sign. Each signs sells for
P2,000. Leyland's contribution margin is P1,200 (P2,000 - (P500 + P300)) per
sign. In addition, assume that Leyland incurs P1,200,000 of fixed costs, regardless
of the level of activity. Below is a schedule with contribution margin information,
assuming 1,000 units are produced and sold:

Total Per Ratio

Unit
Sales (1,000 x P2,000) 2,000,000 2,000 100%
Variable costs (1,000 x (800,000) (800) (40%)
P800)
Contribution Margin 1,200,000 1,200 60%
Fixed Costs (1,200,000)
Net income -0-

What would happen if Leyland sold 2,000 units?

Total Per Unit Ratio

Sales (2,000 x P2,000) 4,000,000 2,000 100%
Variable Costs (2,000 (1,600,000) (800) (40%)
x P800)
Contribution Margin 2,400,000 1,200 60%
Fixed Costs (1,200,000)
Net Income 1,200,000

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 What would happen if Leyland sold only 500 units?

Total Per Unit Ratio

Sales (500 x P2,000) 1,000,000 2,000 100%
Variable Costs (500 x (400,000) (800) (40%)
P800)
Contribution Margin 600,000 1,200 60%
Fixed Costs (1,200,000)
Net Income (600,0000)

Notice that changes in volume only impact certain amounts within the "total
column." Volume changes did not impact fixed costs, or change the per unit or
ratio calculations. By reviewing the above data, also note that 1,000 units achieved
breakeven net income. At 2,000 units, Leyland managed to achieve a P1,200,000 net
income. Conversely, 500 units resulted in a P600,000 loss.

2.3 BREAKEVEN ANALYSIS

Photo Credits: Google Images

❖ BREAK EVEN
- (n.) It resulted when sales equals the sum of total variable cost
and total fixed cost.
- (v.) To make the sales or revenues necessary to cover costs and
prevent a firm from operating at a loss.

❖ BREAKEVEN POINT
- The point at which total revenues equal total costs.
- The level of activity at which total revenues equal total costs
(both fixed and variable).
- It is the point at which an organization can begin to earn a profit.

❖ BREAKEVEN ANALYSIS
- The process of finding the break-even point
- An analysis of a product or a company’s sales required to neither
lose money nor make a profit, but simply to cover costs.

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2.3.1 BREAK-EVEN CALCULATIONS

❖ GRAPHICAL PRESENTATION

As they say, a picture is worth a thousand words, and that is certainly true for
the CVP graphical presentation. However, everyone is not an artist, and you may
find it more precise to do a little algebra to calculate the break-even point. This
is method is called MATHEMATICAL APPROACH.

The graph below is an example of a completed graphical presentation showing

the breakeven point. (Sales amount and number of units sold were just assumed to
be so for the sake of presenting the finished graph.)

BreakEven Point Chart. SlideShare, https://www.slideshare.net/seemakavatkar/break-even-analysis-7279513

We can make a rough estimate of the breakeven point using a scatter diagram.
This method is less exact (and more inefficient), but it does yield meaningful
data. As you can see, the graph has five (5) parts:

1. A horizontal axis for units of output.

2. A vertical axis for sales or revenue.
3. A line running horizontally from the vertical axis at the level of fixed costs.
4. A total cost line that begins at the point where the fixed cost line crosses the
vertical axis and slopes upward to the right (the slope of the line depends on
the variable cost per unit.)
5. A total revenue line that begins at the origin of the vertical and horizontal
axes and slopes upward to the right (the slope depends on the selling price
per unit.)

❖ MATHEMATICAL APPROACH

Break-even results when:

Sales = Total Variable Costs + Total Fixed Costs

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 For Leyland (in our previous illustration in pages 26-27), the math turns out this
way:
(No. of units x P2,000) = (No. of units x P800) + P1,200,000

To solve:

(No. of units x P800) +

Step a: (No. of units x P2,000) =
P1,200,000

Step b: (No. of units X P1,200) = P1,200,000

Step c: Units = 1,000 units

Now, it is possible to "jump to step b" above by dividing the fixed costs by the
contribution margin per unit. This approach of solving the break-even-point is
termed as CONTRIBUTION MARGIN APPROACH.

❖ CONTRIBUTION MARGIN APPROACH

Break-Even Point in Units = Total Fixed Costs / Contribution

Margin per Unit

1,000 units = P1,200,000 / P1,200

Sometimes, you may want to know the break-even point in dollars of sales
(rather than units). This approach is especially useful for companies with
more than one product, where those products all have a similar contribution
margin ratio:

Break-Even Point in Sales = Total Fixed Costs / Contribution Margin

Ratio

P2,000,000 = P1,200,000 / 0.60

2.4 TARGET PROFIT ANALYSIS

How much would we have to sell to make a profit of P_______ per month or how
much would we have to sell to avoid incurring a loss?

❖ TARGET PROFIT
- The net operating income or profit that management desires to
achieve at the end of a business period.
- It indicates the sales necessary to achieve a specified level of income.

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 Photo Credits: Google Images

❖ TARGET PROFIT ANALYSIS

- Estimation of sales volume is needed to achieve a specific target
profit.

2.4.1 TARGET INCOME CALCULATIONS

Breaking even is not a bad thing, but hardly a satisfactory outcome for most
businesses. Instead, a manager may be more interested in learning the necessary
sales level to achieve a targeted profit. The approach to solving this problem is to
treat the "target income" like an added increment of fixed costs. In other words, the
margin must cover the fixed costs and the desired profit:

Target Income results when:

Sales = Total Variable Costs + Total Fixed Costs + Target Income

Assume Leyland (in our previous illustration in pages 21-22) wants to know the level
of sales to reach a P600,000 income:

Again, it is possible to "jump to step b" by dividing the fixed costs and target income
by the per unit contribution margin: (CONTRIBUTION MARGIN APPROACH)

Units to Achieve a Target Income = (Total Fixed Costs + Target Income)

/ Contribution Margin per Unit

1,500 Units = P1,800,000 / P1,200

If you want to know the dollar level of sales to achieve a target net income:

Sales to Achieve a Target Income = (Total Fixed Costs + Target Income)

/ Contribution Margin Ratio

P3,000,000 = P1,800,000 / 0.60

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To illustrate:

Please consider the following information:

Sales price per unit = $250

Variable cost per unit = $150
Total fixed expenses = $35,000
Q = Number (Quantity) of units sold

Find the target sales in units and target dollar sales for Hang Ah Co. if it has a target
profit of $ 40,000.

Solution:

Alternative 1 (Mathematical Approach)

Sales = Variable expenses + Fixed expenses + Profit

$250 = $150Q + $35,000 + $40,000
$100 = $75,000
Q = $75,000/$100 per unit
Q = 750 units

Alternative 2 (Contribution Margin Approach)

Sales to attain the target profit = [(Fixed expenses + Target profit) ÷CM ratio]
= ($35,000 + $40,000) ÷ 0.40
= $187,500

Number of units to be sold = Sales to attain the target profit / SP per unit
= $187,500 / $250
= 750 units

Self-Check:
01

Instructions: This self-check will not be graded and will not be submitted. You may
try to answer the questions asked and check the answers afterwards in Appendix A at
the end of the module.

(See suggested answers on the appendices)

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 You may use the following formulas as guide.

2.5 MARGIN OF SAFETY ANALYSIS

CVP is more than just a mathematical tool to calculate values like the break-even point. It
can be used for critical evaluations about business viability.

For instance, a manager should be aware of the "margin of safety." The margin of safety is
the degree to which sales exceed the break-even point. For Leyland (in our previous
illustration in pages 26-27), the degree to which sales exceed P2,000,000 (its break-even
point) is the margin of safety. This will give a manager valuable information as they plan
for inevitable business cycles.

Photo Credits: Google Images

❖ MARGIN OF SAFETY
- It is the difference between actual or expected sales and sales at the break-
even point.
- It is the amount by which sales or other revenue can fall before it reaches
the breakeven point.

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 - It indicates the possible decrease in sales that may occur before an
operating loss results.
- May be expressed in the following ways: Dollar of sales, Units of sales &
Percent of sales

To illustrate:

Sales $ 250,000
Sales at the break-even point 200,000
Unit selling price $ 25

Compute for the following:

a. Margin of Safety in Peso Sales

MOS = Actual or Budgeted Sales - Break-even Sales

= $250,000 - $200,000
= $50,000

b. Margin of Safety in Units

MOS in units = Margin of Safety / Unit selling price

= $50,000 / $25
= 2,000 units

c. Margin of Safety Ratio

MOS ratio = Margin of Safety / Actual or Budgeted Sales

= $50,000 / $250,000
= 20%

The current sales may decline $50,000, 2,000 units, or 20% before an
operating loss occurs.

2.6 INDIFFERENCE POINT ANALYSIS

Photo Credits: Google Images

The indifference point analysis tool determines the point at which there is no
difference in cost or profit between two alternative methods.

Used to compare two strategies, this analysis can be used to decide between
different cost structures or selling prices.

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 Alternative A Alternative B
(CM/u x Q) – FC = (CM/u x Q) – FC
OR
FC + (VC/u x Q) = FC + (VC/u x Q)

Where:
CM/u = contribution margin per unit
FC = total fixed costs
VC/u variable cost per unit
Q = quantity/no. of units/indifference point in units

To illustrate:
Compute the volume of sales, in units, for which ABS is indifferent between the two
alternatives.
Current Plan Proposed Plan
(Alternative A) (Alternative B)
Contribution Margin per Unit $120 $90
Total Fixed Costs $360,000 $315,000

Solution: (See the CVP formula)

Profit (Current Plan) = $120 Q - $360,000

Profit (Proposed Plan) = $90 Q - $315,000

Alternative A = Alternative B (see formula above)

$120 Q - $360,000 = $90 Q - $315,000
$120 Q - $90 Q = $360,000 - $315,000
$30 Q = $45,000
Q = 1,500 units

The indifference point in units is 1,500 units. This is the level of volume at which
total costs, and hence profits, are the same under both cost structures—
Alternative A and Alternative B. Above or below the indifference point, one of
the alternatives will yield lower cost or be more favorable.

2.7 CVP FOR MULTIPLE PRODUCTS

How many businesses sell only one product? The reality is that firms usually offer a
diverse product line, and the individual products will have different selling prices,
contribution margins, and contribution margin ratios. Yet, the firm’s total fixed cost
picture may be the same, no matter the mix of products sold. This can cloud the
ability to perform simple CVP analysis. To lift this cloud requires some knowledge
of the product mix.

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 Note:

A product is an item produced or procured by the business to satisfy the needs of the
customer. It is the actual item which is held for sale in the market. A company usually sells
different types of products. For example, Coca-Cola has around 3500+ product brands in its
portfolio. These different product brands are also known as product lines. A combination
of all these product lines constitutes the product mix.
(https://www.feedough.com/product-mix-explanation-examples/)
A product line is a group of related products all marketed under a single brand name
that is sold by the same company. Companies sell multiple product lines under their
various brand names, seeking to distinguish them from each other for better usability for
consumers. The picture below shows some of Nestlé’s product lines.

Photo Credits: Google Images

Companies often expand their offerings by adding to existing product lines because
consumers are more likely to purchase products from brands with which they are already
familiar.

2.7.1 SALES MIX

The sales mix is a calculation that determines the proportion of each product a
business sells relative to total sales or the ratio of sales for each product compared
with the overall sales volume of all products. The sales mix is significant because some
products or services may be more profitable than others, and if a company's sales
mix changes, its profits also change. Managing sales mix is a tool to maximize
company profit.
Profits will be greater if high-margin rather than low-margin items make up a
relatively large proportion of total sales. The idea is to achieve the combination, or
mix, that will yield the greatest amount of profits.

To illustrate:

Let’s assume that My Media Place sells to types of websites: standard and express.
If the company sells 500 units, of which 300 units are standard and 200 units are
express, the sales mix would be 3:2. For every three (3) standard websites sold,
two (2) express websites are sold. The sales mix can also be stated in percentages.
Of the 500 units sold, 60% (300 units/500 units) are standard sales, and 40% (200
units/500 units) are express sales.

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 Sales Mix for My Media Place. Adapted from Managerial Accounting (Ninth Edition) by S.V. Crosson and B.E.
Needles, Jr., 2011, p. 223. Copyright 2011 by Cengage Learning

Assume further that you were required to find the breakeven point for multiple
products. How can you compute for it? You should follow these three (3) simple
steps:

1) Compute the weighted average contribution margin.

2) Calculate the weighted average breakeven point.
3) Calculate the breakeven point for each product.

Note:

How to compute for the “weighted average” contribution margin?

(Assume that ACE Co. has 3 products—Products A, B, & C)

Solution:

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2.8 LEVERAGE ANALYSIS

Photo Credits: Google Images

Where:
A – Load a.k.a. Operating Income (or PROFITS)
B – Lever (FORCE/EFFORT) a.k.a. % CHANGE IN SALES
C – FULCRUM…the point on which a lever rests or is supported
And on which it pivots… a.k.a. FIXED COSTS

❖ OPERATING LEVERAGE

- Measures how sensitive net operating income is to a given percentage

change in dollar sales. Operating leverage acts as a multiplier.

- Companies that have higher fixed costs relative to variable costs have
higher operating leverage.

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 - If operating leverage is high, a small percentage increase in sales can
produce a much larger percentage increase in net operating income.

❖ DEGREE OF OPERATING LEVERAGE (DOL)

The degree of operating leverage (DOL) is a multiple that measures how much
the operating income of a company will change in response to a change in sales.

To illustrate:

To illustrate operating leverage, assume the following data for Jones Inc. and
Wilson Inc.:

JONES WILSON
INC. INC.
Sales $400,000 $400,000
Variable Costs 300,000 300,000
Contribution Margin 100,000 100,000
Fixed Costs 80,000 50,000
Income from Operations 20,000 50,000

Compute for the Degree of Operating Leverage or DOL

(See formula on the next pages).

Solution:

✓ Jones Inc.

DOL = CM/OI = $100,000/ $20,000 = 5x

✓ Wilson Inc.

DOL = CM / OI = $100,000/$50,000 = 2x

Jones Inc. has a high operating leverage which means that it has a large proportion
of fixed costs—therefore, a big increase in sales can lead to outsized changes in
profits. On the other hand, Wilson, Inc. has a low operating leverage which means
that it has a large proportion of variable costs—therefore, it earns a smaller profit
on each sale, but does not have to increase sales as much to cover its lower fixed
costs.

OBSERVATION:
As shown above, Jones Inc. and Wilson Inc. have the same sales, the same
variable costs, and the same contribution margin. However, Jones Inc.
has larger fixed costs than Wilson Inc. and, thus, a higher operating
leverage.

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2.9 SUMMARY OF CVP-RELATED TERMINOLOGIES

FACTORS AFFECTING PROFIT

Selling Price Unit Variable Cost Volume (Units) Sales Mix

CVP-related Terminologies
1. Contribution Margin

➢ It is the difference between sales and variable cost.

➢ Also known as Marginal Income, Profit Contribution,
and Contribution to Fixed Cost or Incremental
Contribution.

➢ Computed as:
Sales xx
- Variable Costs (xx)
Contribution Margin xx

CM ratio = CM ÷ Sales or Unit CM ÷ Unit Selling Price

CM ratio = ∆ CM ÷ ∆ Sales.

Note: The sign ‘∆’ denotes “change” or “difference”. Given the

underlying CVP assumptions, CM ratio is constant regardless of
the number of units sold or produced.

2. Break-Even Point (BEP)

➢ A level of activity, in units (break-even in volume) or in

pesos (break-even in sales), at which total revenues
equal total costs. At break-even point, there is neither
profit nor loss.
➢ Computed as follows:

Sales = Variable costs + Fixed costs

BEP units = Fixed Cost ÷ CM per unit.
BEP peso sales = Fixed Cost ÷ CM ratio

3. Target Net Income

➢ The objective net income set by the management.

➢ Computed as follows:

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 Unit Sales with Target Profit = (Fixed Cost + *Profit) ÷
CM per unit.

Note: *Profit must be expressed before tax: Profit after

tax ÷ (100% - tax rate)

Peso Sales with Target Return on Sales = Fixed Costs ÷

(CM ratio–Return on Sales)

4. Margin of Safety

➢ The difference between actual sales volume and break-

even sales.
➢ This indicates the maximum amount by which sales
could decline without incurring a loss
➢ Computed as follows:

Margin of Safety = Sales – Breakeven Sales

Margin of Safety Ratio = Margin of Safety ÷
Sales

5. Indifference Point

➢ The level of volume at which two alternatives being

analyzed would yield equal amount of total costs or
profits.
➢ Computed as follows:

Alternative A Alternative B
(CM/u x Q) – FC = (CM/u x Q) –FC
FC + (VC/u x Q) = FC + (VC/u x Q)
Note: Q – number of units (indifference point).

6. Sales Mix

➢ The relative combination of quantities of sales of various

products that make up the total sales of a company.
➢ Computed as follows:

BEP in units = Fixed Cost ÷ Weighted Average CM per unit.

BEP in pesos = Fixed Cost ÷ Weighted Average CM ratio.

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 7. Degree of Operating Leverage (DOL)

➢ Measures how a percentage change in sales from the

current level will affect company profits.
➢ This indicates how sensitive the company is to sales
volume increases and decreases known as operating
leverage factor.
➢ Computed as follows:

DOL = CM ÷ Profit before tax

% ∆ Sales x DOL = % ∆ profit before tax

2.10 Using CVP for Sensitivity Analysis

Managers often want to predict how changes in sale price, costs, or volume affect
their profits. Managers can use CVP relationships to conduct sensitivity analysis.
Sensitivity analysis is a “what if” technique that asks what results are likely if
selling price or costs change, or if an underlying assumption changes. So
sensitivity analysis allows managers to see how various business strategies will
affect how much profit the company will make and thus empowers managers
with better information for decision making.

❖ CHANGES IN FIXED COSTS

Fixed costs do not change in total with changes in the level of activity.
However, fixed costs may change because of other factors such as changes
in property tax rates or factory supervisors’ salaries.

Effect of changes in fixed costs. Adapted from Managerial Accounting (10th Edition) by C.S. Warren, J.M. Reeve
and J.E. Duchac, 2009, p. 142. Copyright 2009 by South-Western, a part of Cengage Learning

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 To illustrate:
Assume that Bishop Co.is evaluating a proposal to budget an additional
$100,000 for advertising. The data for Bishop Co. are as follows:

✓ Before additional advertising expense of $100,000, break-even sales in

units is 30,000 units.

BES in units = FC/CMu

= $600,000/20
= 30,000 units

✓ After additional advertising expense of $100,000, break-even sales in

units is 35,000 units.

BES in units = FC/CMu

= $700,000/20
= 35,000 units

❖ CHANGES IN UNIT VARIABLE COSTS

Unit variable costs do not change with changes in the level of activity. However,
unit variable costs may be affected by other factors such as changes in the cost
per unit of direct materials.

Effect of changes in variable costs. Adapted from Managerial Accounting (10th Edition) by
C.S. Warren, J.M. Reeve and J.E. Duchac, 2009, p. 142. Copyright 2009
by South-Western, a part of Cengage Learning

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 To illustrate:
Assume that Park Co. is evaluating a proposal to pay an additional 2%
commission on sales to its salespeople as an incentive to increase sales. The data
for Park Co. are as follows:

✓ Before the additional 2% commission, break-even sales in units is 8,000

units.
✓ After the additional 2% commission, break-even sales in units is 8,400
units.

❖ CHANGES IN UNIT SELLING PRICE

Changes in the unit selling price affect the unit contribution margin and, thus, the
break-even point.

Effect of changes in selling prices. Adapted from Managerial Accounting (10th Edition)
by C.S. Warren, J.M. Reeve and J.E. Duchac, 2009, p. 142. Copyright 2009
by South-Western, a part of Cengage Learning

To illustrate:
Assume that Graham Co. is evaluating a proposal to increase the unit selling
price of its product from $50 to $60. The data for Graham Co. are as follows:

✓ Before the price increase, the break-even sales in units is 30,000 units.
✓ After the price increase, the break-even sales in units is 20,000 units.

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 Unit Summary

• Variable costs will vary in direct proportion to changes in the level of an

activity. Activity can relate to labor hours worked, units sold, customers
processed, or other such "cost drivers.
• The opposite of variable costs are fixed costs. Fixed costs do not fluctuate
with changes in the level of activity.
• Mixed or semi-variable contain both variable and fixed components.
• CVP (Cost-Volume-Profit Analysis) is used to determine how changes in
costs and volume affect a company's profit (operating income).
• Basic CVP formula: SALES = TVC + TFC + P/L
• Contribution Margin is the amount of revenue remaining after deducting
variable costs.
• Basic components of CVP analysis: volume or level of activity, unit selling
prices, variable cost per unit, total fixed costs and sales mix.
• Breakeven point is the point at which total revenues equal total costs.
Formula: BEP in units = TFC/CMu; BEP in sales = TFC/CMR
• Target profit is the net operating income or profit that management desires
to achieve at the end of a business period.
Formula: TS in units = (TFC + TP)/CMu; TS in pesos = (TFC + TP)/CMR
• Margin of safety is y is the degree to which sales exceed the break-even point.
Formula: MOS = Actual or Budgeted Sales – Breakeven Sales
• Indifference point is the point at which there is no difference in cost or profit
between two alternative methods:
Formula: (CM/u x Q) – FC = (CM/u x Q) – FC; FC + (VC/u x Q) = FC + (VC/u x
Q)
• A product line is a group of related products all marketed under a single
brand name that is sold by the same company.
• The sales mix is a calculation that determines the proportion of each product
a business sells relative to total sales or the ratio of sales for each product
compared with the overall sales volume of all products.
• If you want to compute for the breakeven point of multiple products, you
need to follow these steps: (1) Compute the weighted average contribution
margin; (2) Calculate the weighted average breakeven point; and (3)
Calculate the breakeven point for each product.
• The degree of operating leverage (DOL) is a multiple that measures how
much the operating income of a company will change in response to a change
in sales.
Formula: DOL = CM ÷ Profit before tax
• Summary of effect of changes on break-even point:

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