Managerial Accounting

Assumptions of CVP Analysis

A number of assumptions commonly underlie CVP analysis:

1. Selling price is constant. The price of a product or service will not change as volume changes.
2. Costs are linear and can be accurately divided into variable and fixed elements. The variable
element is constant per unit, and the fixed element is constant in total over the entire relevant
range.
3. In multiproduct companies, the sales mix is constant.
4. The manufacturing companies, inventories do not change. The number of units produces equal
the number of unit sold.

While these assumptions may be violated in practice, the results of CVP analysis are often “good
enough” to be quite useful. Perhaps the greatest danger lies in relying on simple CVP analysis when a
manager is contemplating a large change in volume that lies outside of the relevant range. For example, a
manager might contemplate increasing the level of sales far beyond what the company has ever
experienced before. However, even in these situations the model can be adjusted as we have done in this
chapter to take into account anticipated changes in selling prices, fixed costs, and the sales mix that would
otherwise violate the assumptions mentioned above. For

CVP Analysis is based on simple model of how profits respond to prices, costs, and volume. This
model can be used to answer a variety of critical questions such as what is the company’s break-even
volume, what is its margin of safety, and what is likely to happen if specific changes are made in prices,
costs, and volume.

A CVP graph depicts the relationships between unit sales on the one hand and fixed expenses,
variable expenses, total expenses, total sales, and profits on the other hand. The profit graph is simpler
than the CVP graph and shows how profits depend on sales. The CVP and profit graphs are useful for
developing intuition about how costs and profits respond to changes in sales.

The contribution margin ratio is the ratio of the total contribution margin to total sales. This ration can
be used to quickly estimate what impact a change in total sales would have on net operating income. The
ratio is also useful in break-even analysis.

Target profit analysis is used to estimate how much sales would have to be to attain a specified target
profit. The unit sales required to attain the target profit can be estimated by dividing the sum of the target
profit and fixed expense by the unit contribution margin. Break-even analysis is a special case of target
profit analysis that is used to estimate how much sales would have to be a just break even. The unit sales
required to break even can be estimated by dividing the fixed expense by the unit contribution margin.

The margin of safety is the amount by which the company’s current sales exceed break-even sales.

The degree of operating leverage allows quick estimation of what impact a given percentage change
in sales would have on the company’s net operating income. The higher the degree of operating leverage,
the greater is the impact on the company’s profits. The degree of operating leverage is not constant it
depends on the company’s current level of sales.

The profits of multiproduct company are affected by its sales mix. Changes in the sales mix can affect
the break-even point, margin of safety, and other critical factors

Review Problem: CVP Relationships

Voltar Company manufactures and sells a specialized cordless telephone for high electromagnetic
radiation environments. The company’s contribution format income statement for the most recent year is
given below:

Total Per Unit Percent of Sales

Sales (20,000 units) ₱1,200,000 ₱60 100%
Variable expenses 900,000 45 ?%
Contribution margin 300,000 ₱15 ?%
Fixed expenses 240,000
Net operating income ₱ 60,000

Management is anxious to increase the company’s profit and has asked for an analysis of
a number of items.

Required:

1. Compute the company’s CM ratio and variable expense ratio.

2. Compute the company’s break-even point in both units and sales peso. Use the equation method.
3. Assume that sales increase ₱400,000 next year. If costs behavior patterns remain
unchanged, but how much will company’s net operating income increase? Use the CM
ration compute your answer.
4. Refer to the original data. Assume that next year management wants the company to earn
a profit of at least ₱90,000. How many units will have to be sold to meet this target
profit?
5. Refer to the original data. Compute the company’s margin of safety in both peso and
percentage form.
6. a. Compute the company’s degree of operating leverage at the percent level of sales.
b. Assume that through a more intense effort by the sales staff, the company’s sales increase by
8% next year. By what percentage would you expect net operating income to increase? Use the
degree of operating leverage to obtain your answer.
c. Verify your answer to (b) by preparing a new contribution format income statement showing
an 8% increase in sales.
7. In an effort to increase sales and profits, management is considering the use of a higher-quality
speaker. The higher-equality speaker would increase variable costs by ₱3 per unit, but
 management could eliminate one quality inspector who is paid a salary of ₱30,000 per
year. The sales manager estimates that the higher-quality speaker would increase annual
sales by at least 20%.
a. Assuming that changes are made as described above, prepare a projected
contribution format income statement for next year. Show data on a total, per
unit and percentage basis.
b. Compute the company’s break-even point in both units and peso of sales. Use
the formula method.
c. Would you recommend that the changes be made?

Solution to Review Problem

1. CM ratio = Unit contribution margin = ₱15 =25%

Unit selling sales ₱60

Variable expense ratio = Variable expense = ₱45 = 75%

Selling price ₱60
2. Profit = Unit CM × Q – Fixed expenses
₱0 = (₱60 - ₱45) × Q - ₱240,000
₱15Q = ₱240,000
Q = ₱240,000 ÷ ₱15
Q = 16,000 units; or at ₱60 per unit, ₱960,000
3.

Increase in sales ₱400,000

Multiply by the CM ratio ×25%
Expected increase in contribution margin ₱100,000

Because the fixed expenses are not expected to change, net operating income will increase by the
entire ₱100,000 increase in contribution margin computed above.

4. Equation method:
 Profit = Unit CM × Q – Fixed expenses
₱90,000 = (₱60- ₱45) × Q - ₱240,000
₱15Q = ₱90,000 + ₱240,000
Q = ₱300,000 ÷ ₱15
Q = 22,000 units

Formula method:

Unit sales to attain = Target profit + Fixed expenses = ₱90,000 + ₱240,000 = 22,000 units
the target profit Contribution margin per unit ₱15 per unit

5. Margin of safety in peso = Total sales – Break-even sales

= ₱1,200,000 - ₱960,000 = ₱240,000
Margin of safety percentage = Margin of safety in peso = ₱240,000 = 20%
Total sales ₱1,200,000

6. a. Degree of operating leverage = Contribution margin = ₱300,000 = 5

Net operating income ₱60,000

b. Expected increase in sales 8%

Degree of operating leverage. ×5
Expected increase in net operating income 40%

c. If sales increase by 8%, then 21,600 units (20,000 × 1.08 = 21,600) will be sold next
year. The new contribution format income statement would be as follows:

Total Per unit Percent of Sales

Sales (21,600 units) ₱1,296,000 ₱60 100%
Variable expenses 972,000 45 75%
Contribution margin 324,000 ₱15 25%
Fixed expenses 240,000
Net operating income ₱ 84,000
Thus, the ₱84,000 expected net operating income for next year represents a 40% increase over
the ₱60,000 net operating income earned during the current year:

₱84,000 - ₱60,000 = ₱24,000 = 40% increase

₱60,000 ₱60,000
Note from the income statement above that the increase in sales from 20,000 to 21,600 units has
increased both total sales and total variable expenses.
7. a. A 20% increase with sales would result in 24,000 units being sold next year: 20,000
units × 1.20 = 24,000 units.
 Total Per unit Percent of Sales

Sales (24,000 units) ₱1,440,000 ₱60 100%

Variable expenses 1,152,000 48* 80%
Contribution margin 288,000 ₱12 20%
Fixed expenses 210,000
Net operating income ₱ 78,000

*₱45 + ₱3 = ₱48; ₱48 ÷ ₱60 = 80%

+₱240,000 - ₱30,000 = ₱210,000

Note that the change in per unit variable expenses results in a change in both the per unit
contribution margin and the CM ratio.

b. Unit sales to break- even = fixed expenses

unit contribution margin
= ₱210,000 = 17,500 units
₱12 per unit

Peso sales to break-even = Fixed expenses

CM Ratio
= ₱210,000 = ₱1,050,000
0.20

c. Yes, based on these data the changes should be made. The changes increase the company’s net
operating income from the present ₱60,000 to ₱78,000 per year. Although the changes also result
in a higher break-even point (17,500 units as compared to the present 16,000 units), the
company’s margin of safety actually becomes greater than before:

Margin of safety in peso = Total sales – Break-even sales

= ₱1,440,000 - ₱1,050,000 = ₱390,000

As shown in (5) on the prior page, the company’s present margin of safety is only ₱240,000.
Thus, several benefits will result from the proposed changes.

Glossary
Break-even point The level of sales at which profit is zero.

Contribution margin ratio (CM ratio) A ration computed by dividing contribution margin by peso
sales.

Cost-volume-profit (CVP graph) A graphical representation of the relationships between an

organization’s revenues, costs, and profits on the one hand and its sales volume on the other hand.

Degree of operating leverage A measure, at a given level of sales, of how a percentage change in sales
will affect profits. The degree of operating leverage is computed by dividing contribution margin by net
operating income.

Incremental analysis An analytical approach that focuses only on those costs and revenues that change
as a result of a decision.

Margin of safety The excess of budgeted (or actual) peso sales over the break-even peso sales.

Operating leverage A measure on how sensitive net operating income is to a given percentage change in
peso sales.

Sales mix The relative proportions in which a company’s products are sold. Sales mix is computed by
expressing the sales of each product as a percentage of total sales.

Target profit analysis Estimating what sales volume is needed to achieve a specific target profit.

Variable expense ratio A ratio computed by dividing variable expenses by peso sales.

Problem 6-19 Basics of CVP Analysis

Feather Friends, Inc., distributes a high-quality wooden birdhouse that sells for ₱20 per unit. Variable
costs are ₱8 per unit, and fixed costs total ₱180,000 per year.

Required:

Answer the following independent questions:

1. What is the product’s CM ratio?

2. Use the CM ratio to determine the break-even point in sales peso.
3. Due to an increase in demand, the company estimates that sales will increase by ₱75,000 during
the next year. By how much should net operating income increase (or not less decrease)
assuming that fixed costs do not change?
4. Assume that the operating results for last year were:

Sales ₱400,000
Variable expenses 160,000
Contribution margin 240,000
Fixed expenses 180,000
Net operating income ₱ 60,000
 a. Compute the degree of operating leverage at the current level of sales.
b. The president expects sales to increase by 20% next year. By what percentage should net
operating income increase?
5. Refer to the original data. Assume that the company sold 18,000 units last year. The sales
manager is convinced that a 10% reduction in the selling price, combined with a ₱30,000
increase in advertising, would cause annual sales in units to increase by one-third.
Prepare two contribution format income statements, one showing the results of last year’s
operations and one showing the results of operations if these changes are made. Would
you recommend that the company do as the sales manager suggests?
6. Refer to the original data. Assume again that the company sold 18,000 units last year.
The president does not want to change the selling price. Instead, he wants to increase the
sales commission by ₱1 per unit. He thinks that this move, combined with some increase
in advertising, would increase annual sales by 25%. By how much could advertising be
increased with profits remaining unchanged? Do not prepare an income statement; use
the incremental analysis approach.

PROBLEM 6-20 Sales Mix; Multiproduct Break-Even Analysis

Gold Star Rice, Ltd., of Thailand exports Thai rice throughout Asia. The company grows three varieties
of rice – Fragrant, White, and Loonzain. (The currency in Thailand is the baht, which is donated by B.)
Budgeted sales by product and in total for the coming month are shown below:

Product
White Fragrant Loonzain Total
Percentage of total sales 20% 52% 28% 100%
Sales B150,000 100% B390,000 100% B210,000 100% B750,000 100%
Variable expenses 108,000 72% 78,000 20% 84,000 40% 270,000 36%
Contribution margin B 42,000 28% B312,000 80% B126,000 60% 480,000 64%
Fixed expenses 449,280
Net operating income B30,720

Peso sales to break-even = Fixed expenses = B449,280 = B702,000

CM ratio 0.64
As shown by these data, net operating income is budgeted at B30,720 for the month and break-
even sales at B702,000.

Assume that actual sales for the month total B750,000 as planned. Actual sales by product are:
White, B300,000; Fragrant, B180,000; and Loonzain, B270,000.

Required:

1. Prepare a contribution format income statement for the month based on actual sales data. Present
the income statement in the format shown on the prior page.
2. Compute the break-even point in sales peso for the month based on your actual data.
 3. Considering the fact that the company met its B750,000 sales budget for the month, the president
is shocked at the result shown on your income statement in (1) above. Prepare a brief memo for
the president explaining why both the operating results and the break-even point in sales peso are
different from what was budgeted.

PROBLEM 6-21 Basic CVP Analysis; Graphing

The Fashion Shoe Company operates a chain a women’s shoe shops around the country. The shops carry
many styles of shoes that are all sold at the same price. Sales personnel in the shops are paid a substantial
commission on each pair of shoes sold (in additional to a small basic salary) in order to encourage them to
be aggressive in their sales efforts.
The following worksheet contains cost and revenue data for shop 48 and is typical of the
company’s many outlets:

Required:

1. Calculate the annual break-even point in peso sales and in unit sales for Shop 48.
2. Prepare a CVP graph showing cost and revenue data for Shop 48 from zero shoes up to 17,000
pairs of shoes sold each year. Clearly indicate the break-even point on the graph.
3. If 12,000 pair of shoes are sold in a year, what should be Shop’s 48 net operating income or loss?
4. The company is considering paying the store manager of Shop 48 an incentive commission of 75
cents per pair of shoes (in addition to the salesperson’s commission). If this change is made, what
will be the new break-even point in peso sales and in unit sales?
5. Refer to the original data. As an alternative to (4) above, the company is considering paying the
store manager 50 cents commission on each pair of shoes sold in excess of the break-even point.
If this change is made, what will be the shop’s net operating income or loss if 15,000 pairs of
shoes are sold?
6. Refer to the original data. The company is considering eliminating sales commissions entirely in
its shops and increasing fixed salaries by ₱31,500 annually. If this change is made, what will be
the new break-even point in peso sales and in unit sales for Shop 48? Would you recommend that
the change be made? Explain.
PROBLEM 6-26 Break-Even Analysis; Pricing

Minden Company introduced a new product last year for which it is trying to find an optimal
selling price. Marketing studies suggest that the company can increase sales by 5,000 units for
each ₱2 reduction in the selling price. The company’s present selling price is ₱70 per unit, and variable
expenses are ₱40 per unit. Fixed expenses are ₱540,000 per year. The present annual sales volume (at the
₱70 selling price) is 15,000 units.

Required;

1. What is the present yearly net operating income or loss?

2. What is the present break-even point in units and in peso sales?
3. Assuming that the marketing studies are correct, what is the maximum profit that the company
can earn yearly? At how many units and at what selling price per unit would the company
generate this profit?
4. What would be the break-even point in units and in sales peso using the selling price you
determined in (3) above (e.g., the selling price at the level of maximum profits)? Why is this
break-even point different from the break-even point you computed in (2) above?

PROBLEM 6-27 Various CVP Questions: Break-Even Point; Cost Structure; Target Sales

Northwood Company manufactures basketballs. The company has a ball that sells for ₱25. At present, the
ball is manufactured in a small plant that relies heavily on direct labor workers. Thus, variable costs are
high, totaling ₱15 per ball, of which 60% is direct labor cost.

Last year, the company sold 30,000 of these balls, with the following results:

Sales (30,000 balls) ₱750,000

Variable expenses 450,000
Contribution margin 300,000
Fixed expenses 210,000
Net operating income ₱ 90,000

Required:

1. Compute (a) the CM ratio and the break-even point in balls, and (b) the degree of operating
leverage at last year’s sales level.
2. Due to an increase in labor rates, the company estimates that variables costs will increase by ₱3
per ball next year. If this change takes place and the selling price per ball remains constant at ₱25,
what will be the new CM ratio and break-even point in balls?
3. Refer to the data in (2) above. If the expected change in variable costs takes place, how many
balls will have to be sold next year to earn the same net operating income (₱90,000) as last year?
4. Refer again to the data in (2) above. The president feels that the company must raise the selling
price of its basketballs. If Northwood Company wants to maintain the same CM ratio as last year,
what selling price per ball must it change next year to cover the increased labor costs?
5. Refer to the original data. The company is discussing the construction of a new, automated
manufacturing plant. The new plant would slash variable costs per ball by 40%, but it would
cause fixed costs per year to double. If the new plant is built, what would be the company’s new
CM ratio and new break-even point in balls?
6. Refer to the data in (5) above.
a. If the new plant is built, how many balls will have to be sold next year to earn the same
net operating income, ₱90,000, as last year?
b. Assume the new plant is built and that next year the company manufactures and sells
30,000 balls (the same number as sold last year). Prepare a contribution format income
statement and compute the degree of operating leverage.
c. If you were a member of top management, would you have been in favor of constructing
the new plant? Explain.