THE RELATIONSHIP OF COST, VOLUME AND PROFIT Fixed Cost

BEP in Units =
Cost-volume-profit analysis shows how changes in cost, prices, and unit volumes CM per Unit
impact the profitability of a business

Components of the CVP Analysis: Fixed Cost

BEP in Peso =
1) Activity Level - The activity level is the total number of units sold in the CM Ratio
measurement period.
2) Price per Unit - The price per unit is the average price per unit sold 3) The graphical method - With the graphical method, the total costs and total
3) Variable Cost per Unit – a cost per unit which changes with the change in the revenue lines are plotted on a graph
level of production
4) Total Fixed Cost - This is the total fixed cost of the business within the
measurement period.
5) Sales Mix - the proportion of sales a single product accounts for in a company's
total sales

Usage of CVP Analysis:

1) Setting the Selling Price
2) Determining the Product mix
3) Determine the level of sales to break even or to reach a certain profit
4) Evaluate the impact of changes in costs

CONTRIBUTION FORMAT INCOME STATEMENT

In order to properly implement CVP analysis, the contribution margin format of the
income statement should be constructed which classifies cost according to its
behavior – fixed and variable costs. It does not matter if your expenses are
production costs or selling and administrative expenses. Contribution margin income
statements refer to the statement which shows the amount of contribution arrived
after deducting all the variable costs from the total revenue amount and further fixed TARGET SALES IN RELATION TO TARGET PROFIT
expenses are deducted from the contribution to get the net profit/loss of the
business entity. CVP analysis is also used when a company is trying to determine what level of sales
(Target Sales) is necessary to reach a specific level of income (Target Profit).
To calculate the required sales level, the equation method and the contribution
method can be used just like in BEP. The difference as compared to BEP is that in
determining the Target Sales, the target profit is added to fixed costs, which will be
the total amount that the contribution margin needs to cover.

1. Equation Approach:
(Sales – VC – FC = Target Profit)
The amount of sales goes either to contribution margin or to variable cost. The
amount apportioned to contribution margin will be used to cover the fixed costs and
2. Contribution Approach:
the remaining will be the profit/loss.

Target sales in Fixed Cost + Target Profit

=
units CM per Unit

Target sales in Fixed Cost + Target Profit

=
Pesos CM Ratio

Note: the target profit in the formula should be the before-tax profit. In case the after
tax profit is given, the before-tax profit can be calculated as follows:

After Tax Profit

Before tax Profit =
THE BREAK-EVEN POINT (1-tax rate)
Break‐Even Point represents the level of sales (in peso or in units) where net
income equals zero. MARGIN OF SAFETY
Margin of safety - is the difference between your breakeven point and the budgeted
At BEP: sales or actual sales that have been made.
Sales = Total VC + Total FC ● Any revenue above the BEP shall be considered the safe margin – because at
Total CM = Total FC BEP all the costs, fixed and variable, are already covered.
Profit = 0 ● Margin of safety acts as a cushion. It is the amount of sales that a company can
lose before it starts being unprofitable.
Methods for ascertaining this break-even point: ● The part of total sales that provides for profit.
1) The Equation Method
Formula:
(Sales – VC – FC = Profit; where profit = 0) Margin of Safety = Budgeted or Actual Sales – Break even Sales

2) Contribution Approach Margin of Safety = Budgeted actual sales –

 breakeven sales Breakdown of the breakeven = (BEP in peso x Sales
ratio
Budgeted or actual sales sales in peso revenue ratio)

ASSUMPTIONS IN CVP ANALYSIS

Budgeted actual sales – Assumptions underlying CVP analysis are:
Margin of Safety
= breakeven sales ● Selling price, variable cost per unit, and total fixed costs remain constant through
in units
Selling Price per unit the relevant range
● In multi-product situations, the product mix is known in advance.
OR ● Costs can be accurately classified into their fixed and variable portions.
Budgeted or actual sales in units – BEP in units ● When represented graphically, the behaviors of both total revenues and total costs
are linear (straight lines) in relation to the units sold within a relevant range (and time
DEGREE OF OPERATING LEVERAGE period).
● Technology, as well as productive efficiency, is constant
Degree of Operating Leverage (DOL) measures the sensitivity of company’s
operating income with changes in sales. Problem 1: Cauayan Corporation has the following information about its single
● The concept of DOL revolves around the proportion of fixed costs and variable product:
costs in the overall cost structure of a company. Selling Price per unit ₱ 20
● A company with a higher proportion of fixed costs has a higher DOL as compared Variable Cost per unit ₱ 12
to a company with a higher proportion of variable costs. Annual Fixed Costs ₱ 40,000
● If in case the DOL is high, then the earnings before interest and taxes (EBIT) is Expected Units to be sold 6,000 units
more sensitive to the percentage change in sales while all other variables remaining
the same, and vice versa. Required:
1. Compute the contribution margin per unit and ratio.
Formula: 2. Construct the Contribution Approach Income Statement
3. Determine the Break-Even Point
% Change in operating
4. Compute the target sales level (in units and in peso) need to earn a before tax
DOL = income
% change in sales profit of ₱20,000
5. Compute the target sales level (in units and in peso) need to earn an after-tax
profit of ₱18,000 if the tax rate is 40%
Change in operating 6. Determine the margin of safety and compute the profit or loss if sales will
DOL = income decrease by a. 15% & b. 18%
Change in sales 7. Determine the degree of operating leverage and determine the level of profit if
sales will (a) Increase by 20% and (b) Decrease by 10%

Contribution Margin PROBLEM 2: In its budget for next month, Waray Company has revenues of
DOL =
Operating Income P500,000, variable costs of P350,000, and fixed costs of P135,000.
Required:
1. Compute contribution margin percentage.
Contribution Margin ratio
DOL = 2. Compute total revenues needed to break even.
Operating margin ratio
3. Compute total revenues needed to achieve a target operating income of P45,000.
4. Compute total revenues needed to achieve a target net income of P48,000,
MULTI-PRODUCT FIRM
assuming the income tax rate is 40%.
If an entity sells more than one product, and each of the product’s fixed cost can be
5. Compute total revenues needed to achieve a target profit equal to 10% of sales.
separately determined, analysis may be performed for each product.
However, fixed costs are normally incurred for all the products, hence a need to
PROBLEM 3: Zamboanga Company is currently selling a single product for P25.
compute for the composite or multi-product break-even point by using the weighted
Variable cost per unit amounted to P15 while total fixed costs amounted to
average unit contribution margin and weighted average contribution margin ratio.
P100,000. For the current year, Zamboanga is expecting to sell 12,000 units.
Required:
Formula:
1. Determine the contribution margin per unit and in ratio and the operating income.
Total Fixed cost 2. Compute the break-even sales in units.
BEP in Units = Weighted average CM per 3. How many units should the company be able to sell in order to achieve a target
unit profit equal to 20% of sales?

PROBLEM 4: Palawan Corporation has a contribution margin ratio of 25% while

Total fixed cost total fixed costs amounted to P20,000. For the year just ended, its margin of safety
BEP in Peso = Weighted average CM was 20%.
ratio Required: Construct the contribution format income statement.

PROBLEM 5: Bacolod Corporation had sales of P120,000 for the month of May. It
Weighted average CM per unit = Σ(Product CM per unit x has a margin of safety ratio of 25 percent, and after-tax return on sales of 6 percent.
Sales mix in units) The company assumes its sales constant every month. If the tax rate is 40 percent,
Weighted average CM ratio = Σ(Product CMR x Sales how much is the annual fixed costs?
mix in peso)

Breakdown of the break even = (BEP in units x Unit sales

sales in units mix ratio)