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COST-VOLUME-PROFIT ANALYSIS

COST-VOLUME-PROFIT ANALYSIS (CVP analysis) examines the behaviour of total revenues, total costs

and operating income as changes occur in the output level, selling price, variable cost per unit or fixed

costs of a product.

BREAK-EVEN SALES – that point of activity level (sales volume) where total revenues equal total costs, i.e.

there is neither profit nor loss.

1. Equation Method or algebraic approach

2. Contribution margin method or formula approach

3. Graphic approach

The cost-volume-profit graph depicts the relationships among cost, volume, and profits.

Total Revenue

Pesos

Profit

Total Cost

Break-Even Point

Loss

Units Sold

1. Changes in the level of revenues and costs arise only because of changes in the number of product

(or service) units produced and sold.

2. Total costs can be separated into a fixed component that does not vary with the output level and

a component that is variable with respect to the output level.

3. When represented graphically, the behaviour of total revenues and total costs are linear

(represented as a straight lien) in relation to output level within a relevant range and time period.

4. The selling price, variable cost per unit, and fixed costs are known and constant.

5. The analysis either covers a single product or assumes that the sales mix, when multiple products

are sold, will remain constant as the level of total units sold changes.

6. All revenues and costs can be added and compared without taking into account the time value of

money.

MULTIPLE-PRODUCT ANALYSIS

When CVP analysis is used for a multiple-product firm, the product is defined as a package of

products. For example, if the sales mix is 3:1 for Products A and B, the package would consist of 3 units of

Product A and 1 unit of Product B.

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SALES MIX – the composition of total sales in terms of various products, i.e., the percentage of each

product included in total sales.

MARGIN OF SAFETY – indicates the amount by which actual or planned sales may be reduced without

incurring a loss. It is the difference between actual or planned sales volume and break-even sales.

OPERATING LEVERAGE – a measure of the extent to which fixed costs are being used in an organization.

The greater the fixed costs in relation to variable cost, the greater is the operating leverage

available and the greater is the sensitivity of income to changes in sales.

DEGREE OF OPERATING LEVERAGE (DOL) – a measure of the sensitivity of profit changes to changes in

sales volume. DOL measures the percentage of change in profit that result from a percentage of

change in sales.

Degree of Operating Leverage (DOL) or Operating Leverage (OLF) – a measure, at a given level of sales, of

how a percentage change in sales volume ill affect profits.

= Contribution Margin/Operating Income

OPERATING LEVERAGE FACTOR (OLF)

SENSITIVITY ANALYSIS –a “what if” technique that examines the impact of changes on an answer. For

example, computer spreadsheets are used to analyse changes in prices, variable costs, and fixed

costs on expected profits.

1. Selling price per unit

2. Variable cost per unit

3. Volume or number of unis

4. Fixed cost

5. Sales mix

EXERCISES:

1. Graham Company produces a variety of chemicals. One division makes agents for laboratories.

The division’s projected income statement for the coming year is as follows:

Less: Variable expenses 1,925,000

Contribution margin P 825,000

Less: Fixed expenses 495,000

Operating Income P 330,000

REQUIRED:

a. Compute the contribution margin per unit, and calculate the break-even point in units (round to

the nearest unit). Calculate the contribution margin ratio and the break-even sales revenue.

b. The divisional manager has decided to increase the advertising budget by P40,000. This will

increase sales revenues by P400,000. By how much will operating income increase or decrease as

a result of this action?

c. Suppose sales revenues exceed the estimated amount on the income statement by P315,000.

Without preparing a new income statement, by how much are profits underestimated?

d. Refer to the original data. How many units must be sold to earn an after-tax profit of P360,000?

Assume a tax rate of 40 percent.

e. Compute the margin of safety based on the original income statement.

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f. Compute the operating leverage, based on the original income statement. If sales revenues are

20 percent greater than expected, what is the percentage increase in profits?

2. Donnie Kyle has developed a new recipe for fried chicken and plans to open a take-out restaurant in

Manila. His father-in-law has agreed to invest P500,000 in the operation provided Donnie can

convince him that profits will be at least 20 percent of sales revenues. Donnie estimated that fixed

expenses would be P24,000 per year and that variable expenses would be approximately 40 percent

of sales revenue.

REQUIRED:

1. How much sales revenue must be earned to produce profits equal to 20 percent of sales

revenue? Prepare a contribution income statement to verify your answer.

2. If Donnie plans on selling 12-piece buckets of chicken for P10 each, how many buckets must

he sell to earn a profit equal to 20 percent of sales?

3. Suppose Donnie’s father-in-law meant that the after-tax profit had to be 20 percent of sales

revenue. Under this assumption, how much sales revenue must be generated by Donnie’s

chicken business? (Assume that the tax rate is 40 percent)

3. Zacarello Company produces a single product. The projected income statement for the coming year

is as follows:

Sales (50,000 units @50) P2,500,00

Less: Varianle costs 1,440,000

Contribution margin P1,060,000

Less: Fixed costs 816,412

Operating income P 243,588

REQUIRED:

1. Compute the unit contribution margin and the units that must be sold to break even. Suppose

that 30,000 units are sold above breakeven. What is the profit?

2. Compute the contribution margin ratio and the break-even point in dollars. Suppose that

revenues are P200,000 more than expected. What would the total profit be?

3. Compute the margin of safety.

4. Compute the operating leverage. Compute the new profit level if sales are 20 percent higher the

expected.

5. How many units must be sold to earn a profit equal to 10 percent of sales?

6. Assume that the tax rate is 40 percent. How many unit must be sold to earn an after-tax profit of

P180,000?

4. Rodjehec Company produces scientific and business calculators, for the coming year Rodjehec expects

to sell 20,000 scientific calculators and 100,000 business calculators. A segmented income statement

for the two product follows:

Sales P500,000 P2,000,000 P2,500,000

Less: Variable Cost 240,000 900,000 1,140,000

Contribution margin P260,000 P1,100,000 P1,360,000

Less: Direct fixed costs 120,000 960,000 1,080,000

Segment margin P140,000 P140,000 P280,000

Less: Common fixed costs 145,000

Operating income P135,000

REQUIRED:

1. Compute the number of scientific calculators and the number of business calculators that must

be sold to break even.

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2. Using information from only the “Total” column of the income statement, compute the sales

revenue that must be generated for the company to break even.

5. CVP exercises - the Doral Company manufacturer’s and sells pens. Currently, 5,000,000 units are sold

per year at P0.50 per unit. Fixed costs are P900,000 per year. Variable costs are P0.30 year

1. What is the current annual operating income?

2. What is the present breakeven point in revenues?

Compute the new operating income for each of the following changes:

3. A P0.04 per unit increase in variable costs

4. A 10% increase in fixed costs and a 10% increase in units sold

Compute the new breakeven point in units for each of the following changes:

5. A 10% increase in fixed costs

6. A 10% increase in selling price and a P20,000 increase in fixed costs

6. Dackers Company, a wholesaler of jeans, had the following income statement for last year:

Cost of sales 800,000

Gross margin P 600,000

Selling expenses P350,000

Administrative expenses 190,000 540,000

Income P 60,000

Mr. Dackers informs you that the only variables costs are cost of sales and P2 per unit selling costs. All

administrative expenses are fixed. In planning for the coming year, Mr. Dackers expects his selling price

to remain constant, with unit volume increasing by 20%. He also forecasts the following changes in costs

and is concerned about how they will affect profitability.

Variable costs:

Cost of goods sold up P1.50 per unit

Selling costs up P0.10 per unit

Fixed costs:

Selling costs up P40,000

Administrative up P30,000

REQUIRED:

1. Compute the expected income for the coming year, assuming that all forecasts are met.

2. Determine the number of units that Dackers will have to sell in the coming year to earn same

profit as the current year.

3. Mr. Dackers is disturbed at the results of requirements 1 and 2. He asks you how much he

must raise his selling price to earn P60, 000 selling 48,000 units.

7. Allen Cosmetics makes two facial creams, Allergy-free and Cleansaway. Data are as follows:

Allergy-free Cleansaway

Price per jar P18 P24

Variable cost per jar 9 6

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REQUIRED:

1. If the sales mix in pesos in 60% for Allergy-free and 40% for Cleansaway, what is the weighted

contribution margin percentage? What peso sales are needed to earn a profit of P60,000 per

month? At the level, how many units of each product, and the total units will the company sell?

2. If the sales mix in 50% for each product in units, what is the weighted average unit contribution

margin? What unit’s sales are needed to earn P60,000 per month? Why is this number of units

different from the answer you found in requirement 1? What are the total peso sales and why is

this figure different from your answer to requirement 1?

3. Suppose that the company is operating at the level of sales that you calculated in requirement 1,

earning a P60,000 monthly profit. The sales manager believes that it is possible to persuade

customers to switch to Cleansaway from Allergy-free by increasing advertising expenses. He

thinks that P8,000 additional monthly advertising would change the mix to 40% FOR Allergy-free

and 60% for CLeansaway. Total peso sales will not change, only the mix. What effect would the

campaign have on profit?

8. Indifference Point Samsonyt sells one of its products, a piece of soft-sided luggage, for P600. Variable

cost per unit is P340, and monthly fixed costs are P600,000. A combination of changes in the way

Samsonyt produces and sells this product could reduce variable cost per unit P40 but increase monthly

fixed cost to P1,000,000.

REQUIRED:

Determine the indifference point of the two alternatives.

9. Hay! Co. produces a single product. Sales have been very erratic, with irregular monthly operating

results. The company’s income statement for the most recent month is given below:

Less: variable expenses 315,000

Contribution margin P135,000

Less: Fixed expenses 150,000

Net Loss P(15,000)

REQUIRED:

1. Compute the company’s CM ratio and its break-even point in both units and pesos.

2. The sales manager feels that a P20,000 increase in the monthly advertising budget, combined

with intensified effort by the sales staff, will result in a P100,000 increase in monthly sales. If the

sales manager is right, what will be the effect on the company’s monthly net income or loss?

3. The president is convinced that a 10% reduction in the selling price, combine with P50,000

increase in the monthly advertising budget, will cause unit sales to double. What will the new

income statement look like if these changes are adopted?

4. Refer to the original data. The company’s advertising agency thinks that a new package for the

company’s product would help sales. The new package being proposed would increase packaging

costs by P3 per unit. Assuming no other changes in cost behaviour, how many unit would have to

be sold each month to earn a profit of P9,000?

5. Refer to the original data. By automating certain operations, the company could slash its variable

expenses to half. However, fixed costs would increase to P250,000 per month.

a. Compute the new CM ratio and the new break-even point in both units and pesos

b. Assume that the company expects to sell 20,000 units next month. Prepare two income

statements, one assuming that operations are not automated and one showing that they are.

c. Would you recommend that the company automate its operations? Explain.

10. Great Wall Ski Company recently expanded its manufacturing capacity, which will allow it to produce

up to 15,000 pairs of cross-country skis of the mountaineering model or the touring model. The Sales

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MAS 03

Department assures management that it can sell between 9,000 pairs and 13,000 pairs of either

product this year. Because the models are very similar, Great Wall will produce only one of the two

models.

Mountaineering Touring

Selling price P88.00 P80.00

Variable costs 52.80 52.80

Fixed costs will total P369,600 if the mountaineering model produced but will be only P316,800 if the

touring model is produced. Great Wall Ski is subject to a 40 percent income tax rate.

REQUIRED:

a. Compute the contribution margin for each product line.

b. If Great Wall desires an after-tax net income of P22,080, how many pairs of touring skis will the

company have to sell?

c. How much would the variable cost per unit of the touring model have to change before it had the

same break-even point in units as the mountaineering model?

d. Suppose the variable cost per unit of touring skis decreases by 10 percent, and the total fixed cost

of touring skis increases by 10 percent. Compute the new break-even point.

e. Suppose management decided to produce both products. If the two models are sold in equal

proportions, and total fixed costs amount to P343,200, what is the firm’s break-even point in

units?

f. Suppose that Great Wall decided to produce only one model of ski. What is the total sales revenue

at which Great Wall would make the same profit or loss regardless of the ski model it decided to

produce?

g. If the Great Wall sales department could guarantee the annual sale of P12,000 pairs of either

model, which model would the company produce and why?

11. Relax Company and Recline Company both making rocking chairs. They have same production

capacity, but Relax is more automated than Recline. At an output of 1,000 chairs per year, the two

companies have the following costs:

Relax Recline

Fixed cost P400,000 P200,000

Variable costs at P100 per chair 100,000

Variable costs at P300 per chair 300,000

Total cost P500,000 P500,000

Unit cost (1,000 units) P500 P500

Assuming that both companies sell chairs for P700 each and that there are no other costs or expenses

for the two firms,

a. Which company will lose the least money if production and sales fall to 500 chairs per year?

b. How much would each company lose at production and sales level of 500 chairs per year?

c. How much would each company make at production and sales levels of 2,000 chairs per year?

12. Pittman Company is a small but growing manufacturer of telecommunications equipment. The

company has no sales force of its own; rather, it relies completely on independent sales agents to

market its products. These agents are paid a commission of 15% of selling price for all items sold.

Barbara Cruz, Pittman’s controller, has just prepared the company’s budgeted income statement for

next year. The statement shows the following:

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MAS 03

Manufacturing costs:

Variable ₱7,200,000

Fixed overhead 2,340,000 9,540,000

Gross margin 6,460,000

Commisssions to agents 2,400,000

Fixed marketing costs 120,000

Fixed administrative cists 1,800,000 4,320,000

Net Operating income 2,140,000

Less; Fixed interest cost 540,000

Income before income taxes 1,600,000

Less: Income taxes (30%) 480,000

Net Income 1,120,000

As Barbara handed the statement to Karl Vega, Pittman’s president, she commented, “I went ahead

and used the agents 15% commission rate in completing these statements, but we’ve just learned

that they refuse to handle our products next year unless we increase the commission rate to 20%.

“That’s the last straw,” Karl replied angrily. “Those agents have been demanding more and more, and

this time they’ve gone too far. How can they possibly defend a 20% commission rate?”

“They claim that after paying for advertising, travel, and the other costs of promotion, there’s nothing

left over for profit,” replied Barbara.

“I say it’s just plain robbery,” retorted Karl. “And I also say it’s time we dumped those guys and got

our own sales force. Can you get your people to work up some cost figures for us to look at?”

“We’ve already worked hem up,” said Karl. Several companies we know about pay a 7.5% commission

to their own salespeople, along with a small salary. Of course, we would have to handle all promotion

costs, too. We figure our fixed costs would increase by P2,400,000 per year, but that would be more

than offset by the P3,200,000 (20% x P16,000,000) that we would avoid on agents’ commissions.”

Salaries:

Sales manage ₱100,000

Salespersons 600,000

Travel and entertainment 400,000

Advertising 1,300,000

Total ₱2,400,000

“Super,” replied Karl. “And I noticed that the P2,400,000 is just what we’re paying the agents under

the old 15% commission rate.”

“It’s ever better than that,” explained Barbara. “We can actually save P75,000 a year because that’s

what we’re having to pay the auditing firm now to check out the agent’s reports. So our overall

administrative costs would be less.

“Pull all of these numbers together and we’ll show them to the executive committee tomorrow,” said

Karl. “With the approval of the committee, we can move on the matter immediately.”

REQUIRED:

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MAS 03

1. Compute Pittman Company‘s break-even point in peso sales for next year assuming:

a. That the agent’s commission rate remain unchanged at 15%.

b. That the agent’s commission rate is increased to 20%.

c. That the company employs its own sales force.

2. Assume that Pittman Company decides to continue selling through agents and pays the 20%

commission rate. Determine the volume of sales that would be required to generate the same net

income as contained in the budgeted income statement for next year.

3. Determine the volume of sales at which net income would be equal regardless of whether Pittman

Company sales through agents (at a 20% commission rate) or employs its own sales force.

4. Compute the degree of leverage that the company would expect to have on December 31 at the

end of next year assuming:

a. That the agent’s commission rate remains unchanged at 15%.

b. That the agent’s commission rate is increased to 20%.

c. That the company employs its own sales force.

13. Snape Company has fixed expenses of P60,000, a contribution margin ratio of 40% and a margin of

safety ratio of 25% for a quarter’s operations.

14. The accountant of Sirus Company is trying to prepare comparative income statements for the first

two months of the year 2015. However, he obtained only the following information

January February

Sales P500,000 -

Variable cost ratio 60% 64%

Margin of safety ratio 30% 24%

Changes in the given ratio are due to the decrease in sales price and fixed costs.

REQUIRED:

1. Decrease in sales

2. Decrease in fixed costs

3. Compute the break-even point for February

15. Pomfrey Company has annual fixed costs of P180,000. In the year, sales increased by P225,000 from

the 2014 level of P675,000. Profit for the year 2015 was P135,000 higher than in 2014

REQUIRED:

1. If there is no need to expand the company’s capacity, how much should profit be in the year 2016

if the budgeted sales volume is P1,350,000?

2. What is the company’s break-even point?

16. Moris Company’s break-even sales would increase from P240,000 to P320,000 if fixed costs would go

up by P32,000.

REQUIRED: Assuming no change in the selling price and variable costs per unit, compute:

1. The company’s variable cost ratio.

2. The company’s fixed cost before and after the increase of P32,000;

--END--

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