Module 3

COST- VOLUME –
PROFIT
RELATIONSHIPS
The Basics of CVP Analysis
CVP Analysis
Among the most frequent asked questions that require cost estimates and short term
decisions are:

1. How many units will be manufactured?

2. What is the company’s break-even sales?
3. Should selling price be changed?
4. Should the company spend more on advertising?
5. What profit contribution can be realized if the organization performs as expected for the
period?
6. Should the product be sold as is or should it be processed further?
7. What would be the effects of the following changes in the next period?
a) Increase or decrease in the cost of materials?
CVPb) analysis is one
Increase of the most
or decrease powerful
in the tools
efficiency of that managers have at their command.
production?
It helps them understand the interrelationship among cost, volume and profit in an
organization by focusing on interactions among the following five elements:

1. Prices of the products

2. Volume or level of activity within the relevant range
3. Variable costs per unit
4. Total Fixed costs
5. Mix of products sold BEST FOR
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Cost Concept and Cost Behavior
Cost can either be classified as:
1. Functional Classification
2. Behavioral Classification

Cost Behavior – refers to the way costs change with respect to a change
in the activity level.

Cost Behavioral Patterns can be classified as follows:

1. Fixed Costs
2. Variable Costs
3. Mixed Costs
4. Semi-variable Costs
5. Semi-fixed Costs

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FIXED COSTS
Do not change with changing levels of
activity.
Remain constant regardless of the change
in activity levels
Fixed Cost per unit changes in an
indirect or inverse pattern, depending on
the direction of the change in the activity
level.
Examples:
Monthly rental cost of a factory building
Property taxes
Insurance BEST FOR
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VARIABLE
COSTS
Costs that change directly and
proportionately with the level of
activity.
Variable cost per unit remains
constant.

Examples:
Direct materials
Direct labor
Sales commissions
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MIXED COSTS
Possesses both fixed and variable
components.
Example:
The company pays its factory workers
a basic monthly salary of P1,000 plus
incentive pay of P0.20 per unit of
production. Production Total Labor
Lets say; in Units Cost
January 3,000 P1,600
February 3,800 1,760
March 2,600 1,520

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 COST BEHAVIOR ASSUMPTIONS

RELEVANT RANGE ASSUMPTION TIME ASSUMPTION

» Relevant range refers to the band of activity States that the cost behavior
within which the identified cost behavior
patterns are valid. patterns identified are true
» For the purposes of planning and decision
only over a specific period of
making, the cost behavior patterns and time.
production level within the relevant range
are considered. Beyond, this the cost may show
» Extremely high and low activity levels or
a different behavior.
production levels above and below the Some costs classified as fixed
relevant range, are considered abnormal,
hence unimportant. may no longer be fixed in the
long run.
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 VARIABLE COSTING INCOME STATEMENT

TRADITIONAL INCOME VARIABLE INCOME STATEMENT

STATEMENT
Sales Pxxx Sales Pxxx
Less: Cost of Goods xxxx Less: Variable Cost xxxx
Sold
Contribution Margin Pxxx
Gross Profit Pxxx
Less: Fixed Cost xxx
Less: Operating xxx
Expenses Profit Pxxx
Profit Pxxx
COGS includes Materials, Direct
Labor and Factory Overhead

Operating Expenses composed

of Selling expenses and
administrative expenses
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 CONTRIBUTION MARGIN
 The difference between sales and variable costs.
 Expect to show the same behavior patterns with sales and variable cost that vary with
units.
 Thus,
Total sales = (Selling Price per unit x No. of units)
Less: Variable Cost = (Variable cost per unit x No. of units)
Total Contribution Margin = (Contribution margin per unit x No. of units
 This is the excess of unit selling price over unit variable costs and the amount each unit
sold contributes toward:
1. Covering fixed costs and
2. providing operating profits
 Contribution Margin Ratio – this is the percentage of CM to Total Sales. This ratio is
computed as follows
CM ratio = Contribution Margin
Sales
 The CM ratio is very useful in that it shows how contribution margin will be affected by
a given peso change in total sales. BEST FOR
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 Problem
Kylie Company’s income statement for the year 2020 on production and sales of 200,000
units is as follows:
Revenue P2,600,000.00
COGS 1,600,000.00
Gross Margin 1,000,000.00
Marketing and distribution 1,150,000.00
costs
Operating income (loss) P(150,000.00)

Kylie’s fixed manufacturing cost were P500,000.00 and variable marketing and distribution
costs were P4.00 per unit.

Required:
1.What is Kylie’s variable manufacturing cost per unit in 2020?
2. What is Kylie’s fixed marketing and distribution costs in 2020?

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 Solution
Required:
1.What is Kylie’s variable manufacturing cost per unit in 2020?
COGS – 1,600,000.00 (variable and fixed
manufacturing costs)
Less – Fixed Manufacturing cost 500,000.00
Variable MC 1,100,000.00

Simply - P1,100,000 / 200,000 = P5.50 per unit

2. What is Kylie’s fixed marketing and distribution costs in 2020?

Total Marketing and Distribution Costs 1,150,000.00
Variable MDC 800,000.00
Fixed MDC 350,000.00

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BREAK –EVEN ANALYSIS

One of the C-V-P relationships

The focal point of Break-even analysis is the
computation of break-even sales.
Where total revenues equal total costs
There is neither profit nor loss

The Break-even sales (or break-even point) can be

computed using three methods:
1.Equation method or algebraic approach
2.Contribution margin method or formula approach
3.Graphic approach
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Illustrative Example

Organic Company produces and sells rubber

balls. The variable costs to produce and sell
one (1) unit of rubber ball amount to P4.00,
while the total fixed manufacturing, selling
and administrative costs per period are
P12,000. The rubber balls are sold at P10.00
per unit. Determine the break-even sales in
units and in pesos.
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SOLUTION:
Equation Method or Algebraic Approach

Variable income statement express in equation

Sales – Variable Cost – Fixed Cost = Profit
Then, Transposed VC and FC to other side of the equation
Sales = Variable Cost + Fixed Cost + Profit

Thus, let x = the number of units to be sold to break-even,

where at break even point, profit = zero (0)

Compute:
P10x = 4x + P12,000 + 0 P10x2,000= P20,000 sales
P10x – 4x = P12,000 +0 P4x2,000 = P8,000 VC
P6x = P12,000 +0 p12,000 FC
x = P12,000 + 0 P0.00 PROFIT
6
x = 2,000 units ( or P20,000 (P2,000 x P10 per unit)
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SOLUTION:
Contribution Margin or Formula Approach

BEP = Fixed Cost + 6,000 .

Contribution Margin

BEP = P12,000 . = 2,000 units

P6

To get the break even peso sales, we use the CM percentage that is

Sales P10 100%

Less VC 4 40%
CM P6 60%
FC P6
PROFIT P0
Therefore, BEP = FC .
CM %
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DESIRED PROFIT

Assume that Organic Company wants to know the required sales volume
in units and in pesos to earn a desired profit of P6,000.

Sales in units = FC + Profit Sales in pesos = FC

+ Profit P30,000 sales
CM per unit
CM % 60% CM%

P18,000
= P12,000 + P6,000 =
18,000
P6.00
60%

= P18,000 =
P30,000
P6.00 BEST FOR
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DESIRED PROFIT AFTER TAX

Assume that Organic Company pays corporate income tax rate of 35%.
What should sales volume be (in units and in pesos) to earn an after-
tax profit of P1,950.00

Sales in units = FC + Profit After Tax Sales in

pesos = FC + Profit After Tax
100% - tax rate
100% - tax rate
CM per unit
CM %

= P12,000 + P3,000 =
15,000
P6.00
60%

= P15,000 BEST FOR =

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PROBLEM (5 minutes)

Grange Company had a net loss of P100,000 in 2019 when

the selling price per unit was P20, the variable costs per
unit were P12, and the fixed costs were P400,000.
Management expects per unit data and total fixed costs to
be the same in 2019. Management has set a goal of earning
net income of P100,000 in 2020.
Required:
a. Compute the units sold in 2019.
b. Compute the number of units that would have to be sold
in 2020 to reach management’s desired income level.
c. Assume that Grange Company sells the same number of
units in 2020 as they did in 2019. what should the selling
price have to be in order to reach the target net income?
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SOLUTION

A. Units sold in 2019: Data: Loss – P100,000; SP-P20/unit;

vc-P12/unit; FC-P400,000

SP P20 100%
VC (12) 60%
CM P8 40% 300,000 = 300,000/ P8 = 37,500
units
FC 400,000
Net Loss (P100,000)

OR

Sales Volume = FC + Profit thus, P400,000 + (P100,000)

= 37,500 units BEST FOR
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SOLUTION

B. Units would have to be sold in 2020 at a desired net

income level: Data: SP-P20/unit; vc-P12/unit; FC-P400,000;
desired income- P100,000

SP P20 100%
VC (12) 60%
CM P8 40% 500,000 = 500,000/ P8 = 62,500
units
FC 400,000
Desired Profit P100,000

OR
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SOLUTION

C. Units would have to be sold in 2020 at a desired net

income level:

SP P25.33 100% @ 37,500 = P950,000

VC 12.00 60% @ 37,500 = 450,000
CM P13.33 40% 500,000 =
P500,000/ 37,500 units = P13.33
FC 400,000
Desired Profit P100,000

OR
Sales –VC = TCM thus,
x(37,500) – 12 (37,500) = 500,000 37,500SP =
950,000 BEST FOR
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MARGIN OF SAFETY

 Measures the potential effect of the risk that sales will fall short of
planned levels.
 Difference between actual or planned sales volume and break-even
sales
 Indicates the amount by which actual or planned sales may be reduced
without incurring a loss.
 Can be expressed in units, in pesos of sales, or as a ratio called the
margin of safety ratio.
 MSR, the planned or actual sales volume is generally used as the base.

Expressed as:

Margin of Safety = Actual or Planned Sales - Break-even Sales

Margin of Safety Ratio = Margin

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Illustrative Example
PM operate a bed and breakfast hotel in a resort area in the Smoky
Mountains. Depreciation on the hotel is P60,000 per year. Kelly employs a
maintenance person at an annual salary of P30,000 per year and a
cleaning person at an annual salary of P24,000 per year. Real estate
taxes are P10,000 per year. The rooms rent at an average price of P50
per person per night including breakfast. Other costs are laundry service
at P4.00 per person per night and the cost of food which is P6.00 per
person per night.

a. Determine the number of rentals and the sales revenue Kelly needs to
break even using the contribution margin technique.
b. If the current level of rentals is 4,000, by what percentage can rentals
decrease before Kelly has to worry about having a net loss?
c. Kelly is considering upgrading the breakfast service to attract more
business and increase prices. This will cost an additional P5.00 for
food costs per person per night. BEST FOR
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O R G A N I C S C O M PA N Y
Solution:
a. Determine the number of rentals and the sales revenue Kelly needs to
break even using the contribution margin technique.

BEP = FC .
CM
Sales Price = P50 – Rooms rent
Unit No. of
VCu = Laundry service + Food Cost rental
= P4 + P6 s
= P10 SP P50 3,100 P155,000
TFC = Depreciation + Salary + Real Estate
VC
Taxes (10) 3,100 (31,000)
= P60,000+30,000+24,000+10,000
CM 40 3,100 124,000
= P124,000
FC (124,000)
Profit -Zero-

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Solution:
b. If the current level of rentals is 4,000, by what percentage can rentals
decrease before Kelly has to worry about having a net loss?

MS = Actual or Planned Sales – BEP Sales MSR = Margin of

Safety .

Actual or Planned Sales

MS = 4,000 (P50) – P155,000

MS = P200,000 – P155,000
= P45,000

MSR = P45,000 = 22.50%

200,000

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Solution:
c. Kelly is considering upgrading the breakfast service to attract more
business and increase prices. This will cost an additional P5.00 for food
costs per person per night. Kelly feels she can increase the room rate to
P65 per person per night. Determine the number of rentals and the
sales revenue Kelly needs to break even if the changes are made.
BEP = FC
Unit Addition New No. of CM
Cost al Cost Unit rental = 124,000 = 2,480 no. of
Cost s rentals
SP P50 To P65 P65 2,48 P161,200 P50
0
VC (10) By P5 (15) 2,48 (37,200)
0
CM 40 - 50 2,48 124,000
0
FC (124,000
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Profit O R G A N I C S C O M PA N Y -Zero-
MULTIPLE PRODUCT BREAK-EVEN ANALYSIS

 Manufactures or sells more than one product.

 Each product has its own sales price and variable cost and contribution
margin.
 Fixed cost cannot usually be identified with the specific products the
company produces and sells.

Procedures in solving BEP for multiple products:

Alternative 1
1. Determine the composite contribution margin.
2. Determine the number of sales (or mixes) to break-even
3. Determine the individual break-even point in units and in pesos.

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MULTIPLE PRODUCT BREAK-EVEN ANALYSIS
Alternative 2
1. Determine the composite contribution margin. This can be obtained by
dividing the composite contribution margin by composite sales price
(individual selling price x sales mix ratio)
2. Compute the mixed break-even sales in pesos.
3. Determine the number of sales to break-even. This can be done by
dividing the mixed break-even sales in pesos by the composite sales
price.
4. Determine the individual break-even point in units and in pesos.

Alternative 3
1. Determine the average contribution margin per mix by multiplying the
individual unit contribution margin figures by the sales mix ratio (%)
2. Determine the mixed break-even sales in units by dividing the total
fixed cost by the average CM
3. Determine the individual BEP (units) and in Pesos.
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Illustrative Example
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 Cost 6 3
Total Fixed Cost P420,000

Required. Determine:
1. Weighted contribution margin per unit.
2. Break-even point in units (combined)
3. Weighted contribution margin ratio
4. Break-even point in sales pesos (combined)
5. Break-even point in sales pesos for:
1. Product D
2. Product W

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Solution:
1. Weighted contribution margin per unit. D W
Unit Selling Price P10 P5
Unit Variable Cost 6 3
Total Fixed Cost P420,000
Sales mix 2 3

D W Total
Unit Contribution P4 P2
Margin
Multiplied by sales mix
ratio
D: 2/5 40%
W: 3/5 60%
Weighted CM per P1.6 P1.2 P2.80
unit 0 0
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Solution:
2. Break-even point in units (combined)

BEP = FC divided by Weighted CM per unit

= P420,000 ÷ P2.80 = 150,000 units
3. Weighted contribution margin ratio
D W
Sales Mix Rate
D: 1.60/2.80 57%
W: 1.20/2.80 43%
Multiplied by: CM 40% 40%
Ratio
Weighted CMR 22.8 17.2
% %
Total Weighted CMR 40%

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Solution:
4. Break-even point in pesos (combined)

BEP = FC divided by Weighted CM Rate

= P420,000 ÷ 40% = P1,050,000
5. BEP for:
In Pesos
Product D (P1,050,000 x 57%) P600,000
Product W (P1,050,000 x 43%) P450,000

In units
Product D (150,000 x 40%) 60,000
Product W (P150,000 x 60%) 90,000
Total 150,000

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OPERATING LEVERAGE

 Measures the potential effect of the risk that sales will fall short
of planned levels as influenced by the relative proportion of fixed
to variable manufacturing costs.
 Is the ratio of the contribution margin to profit

Expressed as:

Operating Leverage = Contribution Margin .

Profit or Net Operating Income

 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.
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 Illustrative Example
The sales and cost data are for two companies in the
transportation industry:
Company A Company B
Amount Percentag Amount Percentag
e of Sales e of Sales
Sales P100,000 100% Sales P100,000 100%
Variable Costs (60,000) 60% Variable Costs (30,000) 30%
Contribution P40,000 40% Contribution P70,000 70%
Margin Margin
Fixed Costs (30,000) Fixed Costs (60,000)
Net income P10,000 Net income P10,000
Required:
a. Calculate the operating leverage for each company. If sales increase,
which company benefits more?
b. Assume sales rise 10% in the next year. Calculate the percentage
increase in profit for each company.
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 Solution
a. Calculate the operating leverage for each company. If sales increase, which
company benefits more?
Operating Leverage = Contribution
Margin
Net
income
Observation:
Company A
If the sales increase, Company B will benefit
more. Company B has a higher proportion of fixed
Operating Leverage = P40,000 =
costs in relation to variable costs, therefore it
4
has a higher operating leverage than does
Company A.
10,000

Company B

Operating Leverage = P70,000 =

7
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 Solution
b. Assume sales rise 10% in the next year. Calculate the percentage increase in profit
for each company.
Company A Company B
Amount Percentage Amount Percentage
of Sales of Sales
Sales P110,000 100% Sales P110,000 100%
Variable Costs (66,000) 60% Variable Costs (33,000) 30%
Contribution Margin P44,000 40% Contribution Margin P77,000 70%
Fixed Costs (30,000) Fixed Costs (30,000)
Net income P14,000 Net income P17,000
% Change in profit = Projected - Observation:
Current
Operating leverage indicates what change in net
Current
income can be expected from a change in sales
Company A
% Change in profit = 14-10 volume. An operating leverage of 4 implies that
= 40% the change in net income will be 4 times as large
as the change in volume.
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CVP Analysis
Assumptions and Limitation of CVP Analysis:

1. The Analysis is valid for a limited range of values – the

relevant – and a limited period of time.
2. All costs can be categorized as fixed or variable.
3. Revenues change proportionately with volumes with selling
price remaining constant.
4. There is a constant product mix
5. Changes in volume alone are responsible for changes in costs
and revenues.
6. There is no significant change in inventories.
7. Operation leverage questions can be dealt with in the CVP
framework.
8. The analysis is deterministic and appropriate data can be
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USE OF CVP ANALYSIS
Usefulness to Management in:

 Planning
 Planning for future operations

 Controlling
 Actual results are studied, analyzed and compared with the
projected or planned data.

 Analysis
 Both projected and actual data may be analyzed using CVP
relationships.
 CVP analysis is a very useful tool in studying and
evaluating past performance.
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Thank You