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CPAR

CPA REVIEW SCHOOL OF THE PHILIPPINES


Manila
MAS 8903
MANAGEMENT ADVISORY SERVICES

COST-VOLUME-PROFIT ANALYSIS
COST-VOLUME-PROFIT ANALYSIS (CVP analysis) examines the behavior 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.

Methods of Computing Break-even Point


1. Equation Method or algebraic approach
2. Contribution margin method or formula approach
3. Graphic approach

GRAPHS OF CVP RELATIONSHIPS


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

Pesos Total Revenue

Profit

Total Cost

Break-Even Point

Loss

Units Sold

The point where the total revenue line and the total cost line intersect is the break-even point.

Assumptions of Cost-Volume-Profit Analysis


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 behavior of total revenues and total costs are linear
(represented as a straight line) 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.
Break-even in packages for a multiple-product firm is then calculated as:
Break-even packages = Fixed Costs/Weighted average contribution margin
MAS 8903 COST-VOLUME-PROFIT ANALYSIS Page 2 of 9

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

CVP ANALYSIS AND RISK AND UNCERTAINTY:

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 results from
a percentage of change in sales.

Degree of Operating Leverage (DOL) or Operating Leverage Factor (OLF) – a measure, at a given
level of sales, of how a percentage change in sales volume will affect profits.
DEGREE OF OPERATING LEVERAGE (DOL)
OR = Contribution Margin / Operating income
OPERATING LEVERAGE FACTOR (OLF)

> The higher the degree of operating leverage, the greater the change in profit when sales
change.

PERCENTAGE CHANGE IN PROFIT = DOL × Percentage change in sales

SENSITIVITY ANALYSIS - a “what if” technique that examines the impact of changes on an answer. For
example, computer spreadsheets are used to analyze changes in prices, variable costs, and
fixed costs on expected profits.

Factors Affecting Profit


1. Selling price per unit 4. Fixed cost
2. Variable cost per unit 5. Sales mix
3. Volume or number of units

EXERCISES:
1. Feather Friends, Inc. distributes a high-quality wooden birdhouse that sells for P20 per unit.
Projected operating results for the coming year are as follows:

Sales (20,000 units) P400,000


Less: Variable expenses 160,000
Contribution margin P240,000
Less: Fixed expenses 180,000
Operating income P 60,000

REQUIRED:
1. Compute the contribution margin per unit and calculate the break-even point in units.
Calculate the contribution margin ratio and the break-even sales revenue.

2. The divisional manager plans to increase the advertising budget by P20,000. This will
increase the projected sales revenues by 40%. By how much will operating income
increase or decrease as a result of this action? Profit increase:

3. Refer to the original data.


a. How much sales must be generated to earn pre-tax profit of P180,000?
MAS 8903 COST-VOLUME-PROFIT ANALYSIS Page 3 of 9

b. How many units must be sold to earn an after-tax profit of P75,600? Assume a tax
rate of 30 percent.
c. How much must sales be to earn pre-tax profit of 20% of such sales?

4. Compute the margin of safety based on the original income statement showing the
projected operating results for the coming year.

5. Compute the degree of operating leverage based on the original income statement. DOL
If sales revenues are 20 percent greater than expected, what is the percentage increase
in profits?

2. Pampalakas Cpmpany makes a high-energy protein drink. The selling price per liter is P10.80,
and variable cost per liter is P6.48. Total fixed cost per year is P474,900. The company is
currently selling 120,000 liters per year.
a. What is the margin of safety in liters?
b. What is the degree of operating leverage?
c. If the company can increase sales in liters by 25 percent, what percentage increase will it
experience in income? Prove your answer using the income statement approach.

3. Zalucki Company is considering the development of either of two products: Product 1 or


Product 2. Manufacturing cost information follows.

Product 1 Product 2
Annual fixed costs P264,000 P408,000
Variable cost per unit 39.60 30

Regardless of which product is introduced, the anticipated selling price will be P60 and the
company will pay a 10% sales commission on gross peso sales. Zalucki will not carry an
inventory of these items.

REQUIRED:
At what unit-volume level will the profit/loss on Product 1 equal the profit/loss on
Product 2?

4. The Zapatos Company produces its famous shoe, the Walker, that sells for P3,000 per pair.
Operating income for this year is as follows:

Sales revenue P6,000,000


Variable cost (P1,200 per pair) 2,400,000
Contribution margin P3,600,000
Fixed cost 2,000,000
Operating income P1,600,000

Zapatos Company would like to increase its profitability over the next year by at least 25%. To
do so, the company is considering the following options:

1. Replace a portion of its variable labor with an automated machining process. This would
result in a 20% decrease in variable cost per unit, but a 10% increase in fixed costs.
Sales would remain the same.
2. Spend P300,000 on a new advertising campaign, which would increase sales by 20%.
3. Increase both selling price by P500 per unit and variable costs by P200 per unit by using
a higher quality leather material in the production of its shoes. The higher priced shoe
would cause demand to drop by approximately 10%.
4. Add a second manufacturing facility which would double Zapatos’ fixed costs, but would
increase sales by 50%.

REQUIRED:
Evaluate each of the alternatives considered by Zapatos. Do any of the options meet or exceed
Zapatos’ targeted increase in income of 25%?
MAS 8903 COST-VOLUME-PROFIT ANALYSIS Page 4 of 9

5. Rue’s Bagel Shop sells only coffee and bagels. Rue estimates that every time she sells one bagel,
she sells four cups of coffee. The budgeted cost information for Rue’s products for 2021 follows:

COFFEE BAGELS
Unit sales 4,000 1,000
Selling price P50 P80
Product ingredients 5 10
Hourly sales staff (cost per unit) 10 20
Packaging 5 10

Fixed costs:
Rent on store and equipment P100,000
Marketing and advertising costs 40,000

REQUIRED:
a. Calculate the breakeven points in units and in pesos for coffee and bagels.
b. If the sales mix is four cups of coffee to one bagel, how many units of each product does
Rue need to sell to earn operating income before tax of P40,000?

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

Sales (40,000 pairs at P35) P1,400,000


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 costs up P30,000

REQUIRED:
1. Compute the expected income for the coming year, assuming that all forecasts are
met. P17,200
2. Determine the number of units that Dackers will have to sell in the coming year to
earn the same profit as the current year. 51,754 units
3. Mr. Dackers is disturbed at the results of requirements 1 and 2. He asks you by how
much he must raise his selling price to earn P60,000 selling 48,000 units. P35.89 – P35 =
P0.89

7. Gosnell Company produces two products: squares and circles. The projected income for the
coming year, segmented by product line, follows:

Squares Circles Total


Sales P300,000 P2,500,000 P2,800,000
Less: Variable expenses 100,000 500,000 600,000
Contribution margin P200,000 P2,000,000 P2,200,000
Less: Direct fixed expenses 28,000 1,500,000 1,528,000
Product margin P172,000 P 500,000 P 672,000
Less: Common fixed expenses 100,000
Operating income P 572,000
MAS 8903 COST-VOLUME-PROFIT ANALYSIS Page 5 of 9

The selling prices are P30 for squares and P50 for circles.

REQUIRED:
1. Compute the number of units of each product that must be sold for Gosnell Company
to break even. 7,400; 37,000
2. Compute the revenue that must be earned to produce an operating income of 10
percent of sales revenues. P2,374,216
3. Assume that the marketing manager changes the sales mix of the two products so that
the ratio is three squares to five circles. Repeat Requirements 1 and 2. 18,786; 31,310;
P2,449,225
4. Refer to the original data. Suppose that Gosnell can increase the sales of squares with
increased advertising. The extra advertising would cost an additional P45,000, and
some of the potential purchasers of circles would switch to squares. In total, sales of
squares would increase by 15,000 units, and sales of circles would decrease by 5,000
units. Would Gosnell be better off with this strategy? P55,000 increase in profit. This is a
good strategy

8. 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:

Sales (15,000 units ) P450,000


Less variable expenses _315,000
Contribution Margin 135,000
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. 30%; 16,666.67; P500,000
2. The sales manager feels that a P20,000 increase in the monthly advertising
budget, combined with an 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? ↑P10,000
3. The president is convinced that a 10% reduction in the selling price, combined
with a 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? P20,000 loss
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 behavior, how many units would have to be sold each month to
earn a profit of P9,000? 26,500
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. 65%; 12,820.5 units; P384,615
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. Not, P30,000; Auto: P140,000
c. Would you recommend that the company automate its operations?
Explain. Automate

9. 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 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.
MAS 8903 COST-VOLUME-PROFIT ANALYSIS Page 6 of 9

The following information was compiled by the Accounting Department.


Per-Unit (Pair) Data
Mountaineering Touring
Selling price P88.00 P80.00
Variable costs 52.80 52.80

Fixed costs will total P369,600 if the mountaineering model is 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. 35.20 or 40%; 27.20 or 34%
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? 13,000
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? dec. 2.97
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. 10,729.06
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? 11,000
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? P880,000
g. If the Great Wall sales department could guarantee the annual sale of 12,000 pairs of
either model, which model would the company produce and why? M=52,800; T=9,600

10. Popoy Company and Basha Company both make wall clocks. They have the same production
capacity, but Popoy is more automated than Basha. At an output of 2,000 wall clocks per
year, the two companies have the following data:
Popoy Basha
Fixed costs P500,000 P300,000
Selling price 400 400
Variable cost per unit 100 200

REQUIRED:
By how much would each company’s income change if production and sales level
increase by 500 units per year? Increase by P150,000; P100,000

11. Following are data taken from the most recent income statement of Whitney Company:

Sales (45,000 units at P10 per unit) P450,000


Less cost of goods sold:
Direct materials P90,000
Direct labor 78,300
Manufacturing overhead 98,500 P266,800
Gross margin 183,200
Less operating expenses:
Selling expenses
Variable:
Sales commissions P27,000
Shipping 5,400 32,400
Fixed (advertising, salaries) 120,000
Administrative:
Variable (billing and other) 1,800
Fixed (salaries and other) 48,000 202,200
Net operating loss P(19,000)
MAS 8903 COST-VOLUME-PROFIT ANALYSIS Page 7 of 9

All variable expenses in the company vary in terms of unit sold, except for sales commissions
which are based on peso sales. Variable manufacturing overhead is P0.30 per unit. There were
no beginning or ending inventories. Whitney Company’s plant has a capacity of 75,000 units
per year.

The company has been at a loss for several years. Management is studying several possible
courses of action to determine what should be done to make next year profitable.

REQUIRED:
1. The president is considering two proposals prepared by his staff:
a. For next year, the vice president would like to reduce the unit selling price by
20%. She is certain that this would fill the plant to capacity. (4,000)
b. For next year, the sales manager would like to reduce the unit selling price by
20%, increase the sales commission to 9% of sales, and increase advertising by
P100,000. Based on marketing studies, he is confident this would increase unit
sales by one-third. Compute the amounts of income, one under the vice
president’s proposal and the other one under the sales manager’s proposal.
(168,200)

2. Refer to the original data. The president believes it would be a mistake to change the
unit selling price. Instead, he wants to use less costly raw materials, thereby reducing
unit costs by P0.70. How many units would have to be sold next year to earn a target
profit of P30,200? 48,000

3. Refer to the original data. Whitney Company’s board of directors believes that the
company’s problem lies in inadequate promotion. By how much can advertising be
increased and still allow the company to earn a target profit of 4.5% on sale of 60,000
units? 32,000

4. Refer to the original data. The company has been approached by an overseas distributor
who wants to purchase 9,500 units on a special price basis. There would be no sales
commission on these units. However, shipping costs would be increased by 50% and
variable administrative cost would be reduced by 25%. In addition, a P5,700 special
insurance fee would have to be paid by Whitney Company to protect the goods in transit.
What unit price would have to be quoted on the 9,500 units by Whitney Company to
allow the company to earn a profit of P14,250 on total operations? Regular business
would not be affected by this special order. 8.35

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:

Sales P16,000,000
Manufacturing costs:
Variable P7,200,000
Fixed overhead 2,340,000 9,540,000
Gross margin 6,460,000
Commissions to agents 2,400,000
Fixed marketing costs 120,000*
Fixed administrative costs 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 P1,120,000
*Primarily depreciation on storage facilities.
MAS 8903 COST-VOLUME-PROFIT ANALYSIS Page 8 of 9

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.”

The breakdown of the P2,400,000 cost follows:


Salaries:
Sales Manager P 100,000
Salespersons 600,000
Travel and entertainment 400,000
Advertising 1,300,000
Total P2,400,000

“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 even 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:
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%. 12M
b. That the agents’ commission rate is increased to 20%. 13,714,286
c. That the company employs its own sales force 15M
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. 18,285,714
3. Determine the volume of sales at which net income would be equal regardless of
whether Pittman Company sells through agents ( at a 20% commission rate) or employs
its own sales force. 18,600,000
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 agents’ commission rate remains unchanged at 15%. 6,400/1600=4
b. That the agents’ commission rate is increased to 20%. 5,600/800=7
c. That the company employs its own sales force. 7,600/475=16

13. ACR Company has fixed expenses of P200,000, a variable cost ratio of 60% and a margin of
safety ratio of 20% for a quarter’s operations.
MAS 8903 COST-VOLUME-PROFIT ANALYSIS Page 9 of 9

REQUIRED: Compute the company’s profit for the quarter

14. The accountant of ARZ Company is trying to prepare comparative income statements for the
first two months of the year. However, he obtained only the following information:

January February
Sales P1,200,000 -
Variable cost ratio 40% 75%
Break even sales ratio 85% 70%

Changes in the given ratios 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 P390,000. In the year 20B, sales increased by
20% from the 20A level of P3,000,000. Profit for the year 20B was P180,000 higher than in
20A.

REQUIRED:
1. If there is no need to expand the company’s capacity, how much should profit be in
the year 20C if the budgeted sales volume is P5,400,000?
2. What is the company’s break-even point?

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