COST VOLUME PROFIT RELATIONSHIP

Cost Volume Profit Analysis is one of the most powerful tools that managers have at their command.
- It helps them understand the interrelationship between cost, volume, and profit in an organization by focusing on
interactions between the following five elements:
1. Prices of products
2. Volume or level of activity within the relevant range
3. Variable cost per unit
4. Total fixed costs
5. Mix of products sold

Contribution Margin per Unit / Marginal Income per Unit

 The excess of unit selling price over unit variable costs and the amount each unit sold contributes towards
o Covering fixed costs and
o Providing operating profits
 CM per Unit = Unit Selling Price – Unit Variable Costs

Contribution Margin Ratio

 The percentage of contribution margin to total sales.
 It is very useful in that it shows how the contribution margin will be affected by a given peso change in total sales.
o If a company’s CM ratio is 40%, it means that for each peso increase in sales, total contribution margin will increase
by P0.40.
o Net income likewise will increase by P0.40 assuming that there are no changes in fixed costs.
 CM Ratio = Contribution Margin
Sales

CVP Analysis for Break-Even Point

 The level of sales volume where total revenues and total expenses are equal, that is, there is neither profit or loss.
o This point can be determined by using CVP analysis.
 FORMULAS:

Break-Even Point (Units) = Total Fixed Costs

Contribution Margin per Unit

Break-Even Point (Pesos) = __Total Fixed Costs__ OR Total Fixed Costs

1 – Variable Costs Contribution Margin Ratio
Sales

Break-Even Sales for Multi-Products firm = Total Fixed Costs___________

(Combined Units) Weighted Average Contribution Margin

Weighted Contribution Margin per Unit = (Unit CM x No. of Units per Mix) + (Unit CM x No. of Unit per Mix)
Total number of units per Sales Mix

Break-even Sales for Multi-products Firm = Total Fixed Costs___

(Combined Pesos) Weighted CM Ratio

Weighted CM Ratio = Total Weighted CM (P)__

Total Weighted Sales (P)

CVP Analysis for Revenue and Cost Planning

 In revenue planning, CVP analysis assists managers in determining the revenue required to achieve a desired profit level.
 FORMULAS:

Sales (Units) = Total Fixed Costs + Desired Profit or Sales (P) = Total Fixed Costs + Desired Profit

Contribution Margin per Unit Contribution Margin Ratio

Assumptions and Limitations of CVP Analysis

 Whenever the underlying assumptions of CVP analysis do not correspond to a given situation, the limitation, of the analysis
must be clearly recognized if the break-even tool is to be useful and educational.
ASSUMPTIONS/LIMITATIONS COMMENT
1. The analysis is valid for a limited range of values –  Failure to observe these limits would lead to
the “relevant” and a limited period of time working with unrealistic data.
2. All costs can be categorized as Fixed or Variable  Semi-variable costs present a problem that can be
solved by segregating fixed and variable portion.
a. Variable costs are change proportionately with a. There is a danger that linear cost and revenue
volume within the relevant volume range. relationship may be used when nonlinearities are
significant.
b. Fixed costs are constant within the relevant b. Non-liner curves often have optimum quantities;
volume range linear ones do not.
3. Revenues change proportionately with volumes with  Price is constant for all volumes within the relevant
selling price remaining constant. range.
4. There is a constant product mix.  Data should be adjusted for any shifts in product
mix
5. Changes in volume alone are responsible for  There are other factors affecting costs and
changes in costs and revenues. revenues, but they are lessened if narrow time and
volume limits are applied.
6. There is no significant change in inventories.  Data should be adjusted if inventories change
markedly.
7. Operation leverage questions can be dealt with in  This should be supported with capital budgeting
the CVP framework. approached that consider the time value of money.
8. The analysis is deterministic and appropriate data  Uncertainty and a probabilities approach can be
can be found. introduced. This will change decisions in some
cases
Sensitivity Analysis for CVP Results
 Margin of Safety measures the potential effect of the risks that sales will fall short of planned levels.
o This is the excess of actual or budgeted sales over break-even sales and indicates the amount by which sales could
decrease losses are incurred.
o It can also be used as a ration, a percentage of sales:

Margin of Safety Ratio = Margin of Safety____

Actual or Planned Sales
o The Margin of Safety Ratio is useful for comparing the risk of two alternative products, or for assessing the riskiness
in any given product.
 The product with relatively low margin of safety ratio is the riskier of the two products and usually requires
more of management’s attention.

 Operating Leverage also measures the potential effect of the risks that sales will fall short of planned levels as influenced
by the relative proportion of fixed to variable manufacturing costs.
o Operating Leverage is the ratio of the contribution margin to profit.
o A higher value of operating leverage indicates a higher risk in the sense that a given change in sales will have a
relatively greater impact on profit.
o When sales volume is strong, it is desirable to have a high level of leverage, but when the sales begin to fall, a
lower level of leverage is preferable

Operating Leverage = Contribution Margin______

Profit or Net Operating Income

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ILLUSSTRATIVE PROBLEM: BREAK-EVEN ANALYSIS
The Income statement for one of Manhattan Company’s product shows:
Sales (100 units @ P100 a unit) P 10,000
Costs of goods sold:
Direct Labor P 1,500
Direct Materials Used 1,400
Variable Factory Overhead 1,000
Fixed Factory Overhead 500 4,400
Gross Profit P 5,600
Marketing Expenses
Variable P 600
Fixed 1,000
Administrative Expenses
Variable 500
Fixed 1,000 3,100
Operating Income P 2,500

Compute the break-even point in units

Direct Labor P 1,500 Fixed Factory Overhead 500
Direct Materials Used 1,400 Fixed 1,000
Variable Factory Overhead 1,000 Fixed 1,000
Variable 600 Total Fixed Costs P 2,500
Variable 500
Variable Cost P 5,000
Divide by no. of Units / 100
Variable Cost per Unit P 50

Break-Even Point (Units) = Total Fixed Costs = P 2,500__ = 50 units

Contribution Margin per Unit P100 – P50

If sales increase by 25%, how much will be the new operating income?
Current Income 2, 500
Add: Incremental contribution margin (25 units x P50) 1, 250
Operating Income 3, 750

Compute the new break-even point in pesos if fixed factory overhead will increase by P1,700.

Break-Even Point (Units) = Total Fixed Costs = P 2,500 + P1,700__ = P 8,400

Contribution Margin Ratio 50%
ILLUSTRATIVE PROBLEM: CVP ANALYSUS WITH CHANGES IN COST STRUCTURE
The Don Company sold 100,000 units of its products at P20 per unit. Variable costs are P14 unit (manufacturing costs of P11 and
marketing costs of P3). Fixed costs are incurred uniformly throughout the year and amount to P792,000 (manufacturing costs of
P500,000 and marketing costs of P292,000).

Compute the number of units must be sold to earn an income of P60,000 before income tax.

Sales (Units) = Total Fixed Costs + Desired Profit = 792,000 + 60,000 = 142,000 units
Contribution Margin per Unit 20 – 14

Compute the number of units that must be sold to earn an after-tax income of P90, 000. Income tax rate is 40%.

Sales (Units) = Total Fixed Costs + Desired Profit = 792,000 + (90,000 / 60%) = 157,000 units
Contribution Margin per Unit 20 – 14

Compute the number of units required to break-even if there is a 10% increase in wages and salaries. Labor cost
constitutes 50% of variable costs and 20% of fixed costs.
Materials, Overhead and marketing (P14 x 50%) P 7.00
Labor (50% x P14 x 110%) 7.70
Variable Costs per unit P14.70

Break-Even Point (Units) = Total Fixed Costs = P792,000 + [(20% x 792,000) x 10%]__ = 152,423
units
Contribution Margin per Unit P20 – P14.70
ILLUSTRATIVE PROBLEM: CVP ANALYSIS FOR A MULTI-PRODUCTS FIRM
Lor, Inc. produces only two products, A and B. These account for 60% and 40% of the total sales pesos of Lor’s respectively. Variable
costs as a percentage of sales pesos are 60% for A and 85% for B. Total fixed costs are P150,000. There are no other costs.
Compute for the weighted contribution margin ratio.
A B
Sales Mix Ratio 60% 40%
Multiplied by: Contribution margin ratio 40% 15% (note: sales = 100%; so 100% - 60% and 100% - 85%)
Weighted Contribution Margin Ratio 24% + 6% = 30%

Compute the break-even point in sales pesos

Break-Even Point (Units) = Total Fixed Costs = P 150,000 = P500,000

Contribution Margin Ratio 30%

Compute the sales pesos necessary to generate a net income of P9,000 if total fixed costs increase by 30%.

Sales (Units) = Total Fixed Costs + Desired Profit = [150,000 + (150,000 x 30%)] + 9,000 = P680,000
Contribution Margin per Unit 30%

ILLUSTRATIVE PROBLEM: CVP ANALYSIS FOR MULTI-PRODUCTS FIRM

The Insular Corporation sells two products, D and W at a rate of 2 units and 3 units respectively. The following data are available:
D W
Unit Selling Price P10 P5
Unit Variable Costs 6 3
Total Fixed Costs P 420,000

Determine the weighted contribution margin per unit.

D W
Sales Mix Ratio ( 2 + 3 = 5 units) 40% 60% (Note: D= 2/5 and W=3/5)
Multiplied by: Contribution margin P 4 P 2
Weighted Contribution Margin per unit 1.60 + 1.20 = P2.80

Determine the break-even point in units (combined)

Break-Even Point (Units) = Total Fixed Costs = P 420,000 = 150,000 units

Contribution Margin P2.80

Determine the Weighted contribution margin ratio

D W
Sales Mix Ratio 57% 43% (Note: D= P1.6/P2.80 and W=P1.20/P2.80)
Multiplied by: Contribution margin ratio 40% 40%
Weighted Contribution Margin per unit 22.8% + 17.2% = 40%

Determine the break-even point in sales pesos combined

Break-Even Point (Units) = Total Fixed Costs = P 420,000 = P1,050,000

Contribution Margin Ratio 40%

Determine the break-even point in sales pesos for Product D and Product W
Product D = P1, 050,000 x (1.6/2.8) = P600,000
Product W = P1, 050,000 x (1.2/2.8) = P450,000

ILLUSTRATIVE PROBLEM: MARGIN OF SAFETY

Amflor Manufacturing Company’s budget for the coming year revealed the following unit data:
Budgeted Net Income for the year P 875,000
Unit costs:
Variable Fixed
Manufacturing Cost P 14.00 P 12.00
Selling Cost 2.50 5.50
General Cost 0.25 7.00
Unit Selling Price P 50

Determine the budget sales volume in units.

Unit Selling Price P 50.00
Manufacturing Cost P 14.00
Selling Cost 2.50
General Cost 0.25 16.75
Contribution Margin/Unit P 33.25
Less: Unit Fixed Costs (12 + 5.5 + 7) 24.50
Net Income/unit P 8.75

Budgeted Sales Volume (Units) = Total Budgeted net Income = P875,000 = 100,000 units
Net Income/unit P8.75

Determine the margin of safety in peso amount and percentage.

Margin of Safety = Budgeted Sales – Break-even Sales = (100,000 x P50) – (P24.50 x 100,000) = P 1, 315,789
66.5%

Margin of Safety Ratio = Margin of Safety____ = P 1,315,789 = 26%

Actual or Planned Sales P 5,000,000

ILLUSTRATIVE PROBLEM: OPERATING LEVERAGE

These sales and cost data (000s) are for two companies in the transportation industry:

Company A Company B
 Amount Percent of Amount Percent of
Sales Sales
Sales P100,000 100% P100,000 100%
Variable Costs 60,000 60% 30,000 30%
Contribution margin P 40,000 40% P 70,000 70%
Fixed costs 30,000 60,000
Net Income P 10,000 P 10,000

Calculate the operating leverage for each company.

Operating Leverage = Contribution Margin______

Profit or Net Operating Income

A’s Operating Leverage = P 40,000 = 4 B’s Operating Leverage = P 70,000 = 7

P10,000 P10,000

Assume sales price rise 10% in the next year. Calculate the percentage increase in profit for each company.

Company A Company B
Amount Percent of Amount Percent of
Sales Sales
Sales P110,000 100% P110,000 100%
Variable Costs 66,000 60% 33,000 30%
Contribution margin P 44,000 40% P 77,000 70%
Fixed costs 30,000 60,000
Net Income P 14,000 P 17,000

A’s change in profits = 14 – 10 = 40% B’s change in profits = 17 – 10 = 70%

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