Module 9
COST VOLUME PROFIT ANALYSIS
Learning Objectives:
At the end of this lesson, the student should be able to:
1. Identify the different elements that influence profit;
2. Discuss break-even analysis; and
3. Perform a CVP analysis
Basic Concepts
The study of the interrelationships between costs, volume, and profit at various levels of
activity is known as cost-volume-profit (CVP)/break-even analysis.
CVP analysis associates revenues and costs in an economic model that allows managers to
forecast profits at various levels of sales and production volume.
Internal Elements affect the profitability level of a business
1. Prices of the product sold
2. Volume of sales
3. Variable cost per unit - is a cost that changes in total but remains fixed in unit cost.
4. Fixed cost - is a cost that remain constant in total but changes inversely to the
volume of unit cost
5. Product mix
Mixed Cost is the cost that carries the behavior of both fixed and variable cost.
The break-even point is defined as the point at which revenues equal total costs.
Break-even Analysis is a tool that determines the break event point.
Assumptions:
1. Depending on how the cost behaves, all costs can be classified as either variable or fixed.
2. The only relevant factor influencing cost is volume.
3. All costs behave in a linear fashion in relation to production volume.
4. Cost behaviors are expected to remain constant over the relevant range of production
volume because it is assumed that production efficiency does not change.
5. Costs show greater variability over time. The percentage of variable costs increases as
the time period lengthens. The percentage of fixed costs increases as the time period
shortens.
6. Although CVP analysis can be performed for multiple products, the model in its most basic
form assumes that the product mix remains constant. This produces the economic dynamic
of a single product.
7. Break-even analysis is performed using the contribution approach to the income
statement. The determination of whether a cost element is fixed or variable defines its
relationship to volume and the calculation of break-even point.
8. The volume of transactions results in a uniform contribution margin per unit and a
predictable projected contribution margin based on volume.
Break-even charts are visual representations of the results of a break-even analysis. We will
use a basic example to demonstrate how to draw a breakeven chart.
The data is:
Selling price P50 per unit
Variable cost P30 per unit
Fixed costs P20,000 per month
Forecast sales 1,700 units per month
Single product CVP analysis
At the break-even point, sales revenue equals total costs, and there is no profit.
At the break-even point, total contribution margin = fixed costs.
The breakeven analysis can be extended to calculate the required sales pesos or unit sales
to generate the desired profit.
Break-even point formula:
Break-even Point in units = Total Fixed Costs / Contribution Margin Per Unit
Break-even revenue = Break-even Point in Units x Unit Selling Price
OR
Break-even revenue = Total Fixed Costs / Contribution Margin Ratio
Target sales formula:
Target Sales in units = (Fixed Cost + Target Profit) / Contribution Margin per Unit
Target Sales Revenue = Fixed Costs + Variable Costs + Profit.
OR
Target Sales Revenue = (Fixed Cost + Target Profit) / Contribution Margin Ratio
Margin of safety
The margin of safety is the excess of the budgeted or actual sales of a company over its
break-even sales; it can be calculated in units or pesos or as a percentage; it is equal to (1 ÷
degree of operating leverage).
The margin of safety is the amount that sales can drop before reaching the break-even point
and, thus, provides a certain amount of “cushion” from losses.
The following formulas are applicable:
Margin of safety in units = Actual units – Break-even units
Margin of safety in P = Actual sales P – Break-even sales in P
Margin of safety % = Margin of safety in units ÷ Actual unit sales
OR
Margin of safety % = Margin of safety in P ÷ Actual sales P
The margin of safety calculation allows management to determine how close to a danger
level the company is operating, and thus provides an indication of risk.
Operating Leverage
Operating leverage is the proportionate relationship between a company’s variable and fixed
costs. A company’s cost structure, or the relative composition of its fixed and variable costs,
strongly influences the degree to which its profits respond to changes in volume.
The degree of operating leverage is a factor that indicates how a percentage change in
sales, from the existing or current level, will affect company profits; it is calculated as
contribution margin divided by net operating income or it is equal to 1 ÷ margin of safety
percentage.
The calculation assumes that fixed costs do not increase when sales increase.
The degree of operating leverage decreases the farther a company moves from its
break-even point; when the margin of safety is small, the degree of operating leverage is
large.
Low operating leverage and a relatively low break-even point are found in companies that
are highly labor-intensive, have high variable costs, and low fixed costs. Companies with low
operating leverage can experience wide swings in volume levels and still show a profit.
High operating leverage and a relatively high break-even point are found in companies that
have low variable costs and high fixed costs. Companies will face this type of cost structure
and become more dependent on volume to add profits as they become more automated.
Companies with high operating leverage also have high contribution margin ratios.
Illustration Sample
The following data relate to Product NQ:
Selling price P250 per unit
Variable cost P200 per unit
Fixed costs are P500,000.
Required:
(a) Calculate the number of units that must be made and sold in order to break even.
(b) Calculate the break-even point again, this time expressed in terms of sales revenue.
(c) Calculate the level of activity that is required to generate a profit of P400,000.
(d) Calculate the sales revenue that is required to generate a profit of P400,000.
(e) The company budgets to sell 13,000 units of Product NQ. Calculate the margin of safety.
Answer:
a. BEu = Fixed Cost / Contribution Margin per unit
= P500,000 /(250-200)
= P500,000/50
= 10,000 units
b. BEP = Fixed Cost / Contribution Margin Ratio
= P500,000/(50/250)
= P500,000/20%
= P2,500,000
c. BEu = (Fixed Cost + Profit) / Contribution Margin per unit
= (P500,000 + 400,000) / 50
= P900,000 / 50
= 18,000 units
d. BEP = (Fixed Cost + Profit) / Contribution Margin Ratio
= (P500,000 + 400,000) / 20%
= P900,000 / 20%
= P4,500,000
e. Margin of Safety(units) = Actual or Budgeted Sales(units) - Break-even sales (unit)
= 13,000 - 10,000
= 3,000 units
Margin of safety (pesos) = margin of safety x selling price
= 3,000 x 250
= 750,000 or
= budgeted sales - breakeven sales
= (13,000 x 250) - (10,000 x 250)
= 750,000
Margin of Safety ratio = Margin of safety (units) / Actual or Budgeted sales
= 3,000 / 13,000
= 23.08% or
= margin of safety in (peso) / actual or budgeted sales (peso)
= 750,000/3,250,000
Multi-product CVP analysis
The basic breakeven model can be used satisfactorily for a business operation with only one
product. However, most companies sell a range of different products, and the model has to
be adapted when one is considering a business operation with several products.
CVP analysis assumes that, if a range of products is sold, sales will be in accordance with a
pre-determined sales mix.
When a pre-determined sales mix is used, it can be depicted in the CVP analysis by
assuming average revenues and average variable costs for the given sales mix.
However, the assumption has to be made that the sales mix remains constant. This is
defined as the relative proportion of each product’s sale to total sales. It could be expressed
as a ratio such as 2:3:5, or as a percentage as 20%, 30%, 50%.
The calculation of breakeven point in a multi-product firm follows the same pattern as in a
single product firm. While the numerator will be the same fixed costs, the denominator now
will be the weighted average contribution margin ratio
(Weighted average CM ratio).
In multi-product situations, a weighted average CM ratio is calculated by using the formula:
Weighted average CM ratio = Total contribution / Total revenue
The weighted average CM ratio is useful in its own right, as it tells us what percentage each
Peso of sales revenue contributes towards fixed costs; it is also invaluable in helping us to
quickly calculate the breakeven point in sales revenue:
Breakeven revenue = Fixed cost / Weighted average CM ratio
Illustration Sample
Company A produces Product X and Product Y. Fixed overhead costs amount to P2,000,000
every year. The following budgeted information is available for both products for next year.
Product X Product Y
Sales price P500 P600
Variable cost P300 P450
Contribution per unit P200 P150
Budgeted sales (in units) 20,000 10,000
In order to calculate the breakeven revenue for the next year, using the budgeted sales mix,
we need the weighted average CM ratio as follows:
Weighted average CM ratio = Total contribution / Total revenue
= (20,000 × P200) + (10,000 × P150) / (20,000 × P500) +
(10,000 × P600)
= 34.375%
The breakeven revenue can now be calculated this way for company A:
Breakeven revenue = Fixed costs / Weighted average CM ratio
= P2,000,000 / 0.34375
= P5,818,182
Calculations in the illustration above provide only estimated information because they
assume that products X and Y are sold in a constant mix of 2X to 1Y. In reality, this constant
mix is unlikely to exist and, at times, more Y may be sold than X. Such changes in the mix
throughout a period, even if the overall mix for the period is 2:1, will lead to the actual
breakeven point being different than anticipated.
Establishing a target profit for multiple products
The approach is the same as in single product situations, but the weighted average
contribution margin ratio is now used
so that:
Sales revenue required to earn a target profit = (Fixed costs + Required profit) / Weighted
average CM ratio
Example 2
To achieve a target profit of P3,000,000 in Company A:
Sales revenue required for profit of P3,000,000 = (P2,000,000 + P3,000,000) / 0.34375
= P14,545,455
Margin of safety calculations
The basic breakeven model for calculating the margin of safety can be adapted to
multi-product environments.
Calculating the margin of safety for multiple products is exactly the same as for single
products, but we use the standard mix.
Example 3
XYZ Company produces and sells two types of sports equipment items for children, balls (in
batches) and miniature
racquets.
A batch of balls sells for P80 and has a variable cost of P50. Racquets sell for P40 per unit
and have a unit variable cost of P26.
For every 2 batches of balls sold, one racquet is sold. Murray budgeted fixed costs are
P4,070,000 per period. Budgeted sales revenue for next period is P12,500,000 in the
standard mix.
To calculate the margin of safety, the following steps must be followed:
Step 1 – Calculate CM per unit:
Balls Racquets
Selling price per unit P80 P40
Variable cost per unit P50 P26
CM per unit P30 P14
Step 2 – Calculate CM per mix:
(P30 × 2 balls) + (P14 × 1 racquet) = P74
Step 3 – Calculate the breakeven point in terms of the number of mixes:
Breakeven point = Fixed costs/CM per mix
= P4,070,000/P74
= 55,000 mixes
Step 4 – Calculate the breakeven point in terms of the units of the products:
55,000 mixes × 2 = 110,000 balls
55,000 mixes × 1 = 55,000 racquets
Step 5 – Calculate the breakeven point in terms of revenue
(P80 × 110,000 balls) + (P40 × 55,000 racquets) = P11,000,000
Step 6 – Calculate the margin of safety:
Budgeted sales – breakeven sales = P12,500,000 – P11,000,000 = P1,500,000
Or, as a percentage, (P12,500,000 – P11,000,000)/P12,500,000 = 12%
Illustration Problem
ABC Company produces and sells the following three products:
Product X Y Z
Selling price per unit P160 P200 P100
Variable cost per unit P50 P150 P70
CM per unit P110 P50 P30
Budgeted sales volume 50,000 units 10,000 units 100,000 units
The company expects the fixed costs to be P4,500,000 for the coming year. Assume that
sales arise throughout the year in a constant mix.
Required:
(a) Calculate the weighted average CM ratio for the products.
(b) Calculate the break-even sales revenue required.
(c) Calculate the margin of safety required.
(d) Calculate the revenue required to achieve a target profit of P9,000,000.