Cost-Volume-Profit Analysis PDF

BM1915 COST-VOLUME-PROFIT (CVP) ANALYSIS Introduction to CVP Analysis Cost-volume-profit (CVP) analysis is the study of the effects that change in costs and volume have on a company’s profits (Weygandt, Kimmel, Kieso, & Aly, 2018). CVP analysis examines the behavi...

BM1915 COST-VOLUME-PROFIT (CVP) ANALYSIS Introduction to CVP Analysis Cost-volume-profit (CVP) analysis is the study of the effects that change in costs and volume have on a company’s profits (Weygandt, Kimmel, Kieso, & Aly, 2018). 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. It helps managers in making important decisions such as what products and services to offer, what prices to charge, what marketing strategy to use, and what cost structure to maintain. Definition of Terms (Hilton & Platt, 2017) Contribution margin (CM) – It is the excess of sales over all variable costs or sales revenue minus variable costs. This is the amount of revenue that is available to cover fixed expenses after all variable expenses have been covered. Contribution margin ratio – Contribution margin divided by sales revenue Contribution margin per unit – Selling price per unit less all variable costs per unit Margin of safety (MS) – It 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. Margin of safety ratio – Margin of safety divided by actual or budgeted sales, or profit margin ratio divided by contribution margin ratio Relevant range – It is the limit within which the volume of activity can vary where sales and costs relationships remain valid. Sales mix – It is the relative combination of products that compose a company’s total sales. Cost structure – It is the relative proportion of its fixed and variable costs. It varies among industries and among firms within the industry. Operating leverage – It is the extent to which an organization uses fixed costs in its cost structure. Higher fixed costs mean higher degree of operating leverage. Assumptions of Cost-Volume-Profit (CVP) Analysis 1. Changes in the level of revenues and costs arise only because of changes in the number of 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. 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 considering the time value of money. Break-Even Analysis The process of finding the break-even point is called break-even analysis. Knowledge of the break-even point is useful to management when it decides whether to introduce new product lines, change sales prices on established products, or enter new market areas. Break-even analysis indicates the amount of peso sales or unit sales that a company needs to cover its fixed costs (Weygandt et al., 2018). The break-even point is the volume of activity where the organization’s revenues and expenses are equal. At this amount of sales, the organization has no profit or loss; it breaks even (Hilton & Platt, 2017). Methods of Computing the Break-Even Point In CVP analysis, the contribution margin income statement is used in computing the break-even point: Sales (Selling price per unit x sales volume) P xxx Variable cost (Variable cost per unit x sales volume) (xxx) Contribution margin (Contribution margin per unit x sales volume) xxx Total fixed costs (xxx) Profit P xxx 04 Handout 1 *Property of STI  [email protected] Page 1 of 6  BM1915 The contribution margin income statement is prepared for management’s use and the format facilitates CVP analysis. The break-even point can be calculated using the following approaches (Weygandt et al., 2018): 1. Equation method – It shows a common profit equation used for CVP analysis. When profit is set to zero, this can be used to compute for the break-even point. 𝑆𝑎𝑙𝑒𝑠 = 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠 + 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 + 𝑃𝑟𝑜𝑓𝑖𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑆𝑎𝑙𝑒𝑠 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠 − 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 2. Contribution margin approach – Break-even point is calculated by using the contribution margin. 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 (𝐶𝑀) = 𝑆𝑎𝑙𝑒𝑠 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠 𝐶𝑀 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑇𝑜𝑡𝑎𝑙 𝐶𝑀 𝐶𝑀 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝐶𝑀 𝑟𝑎𝑡𝑖𝑜 = or 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 3. Graphic approach – An effective way to find the break-even point is to prepare a break-even chart. Because this graph also shows costs, volume, and profits, it is referred to as a cost-volume-profit (CVP) graph. Figure 1. CVP graph The point where the total cost line and the total revenue line intersect is the break-even point. Break-Even Point (BEP) for Single Product Line 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 𝐵𝐸𝑃 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 = 𝐶𝑀 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 𝐵𝐸𝑃 𝑖𝑛 𝑝𝑒𝑠𝑜𝑠 = 𝐶𝑀 𝑟𝑎𝑡𝑖𝑜 These formulas can also be used in determining the desired sales to earn a target profit. 04 Handout 1 *Property of STI  [email protected] Page 2 of 6  BM1915 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 + 𝑇𝑎𝑟𝑔𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 = 𝐶𝑀 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 + 𝑇𝑎𝑟𝑔𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑝𝑒𝑠𝑜𝑠 = 𝐶𝑀 𝑟𝑎𝑡𝑖𝑜 Margin of safety (MS) can be computed using the following formulas: 𝑀𝑆 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 = 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 − 𝐵𝐸𝑃 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 𝑀𝑆 𝑖𝑛 𝑝𝑒𝑠𝑜𝑠 = 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝑝𝑒𝑠𝑜𝑠 − 𝐵𝐸𝑃 𝑖𝑛 𝑝𝑒𝑠𝑜𝑠 𝑀𝑆 𝑖𝑛 𝑝𝑒𝑠𝑜𝑠 𝑀𝑆 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 𝑀𝑆 𝑟𝑎𝑡𝑖𝑜 = or 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝑝𝑒𝑠𝑜𝑠 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 Illustration: ABC Company plans to market a new product. Based on its market studies, ABC estimates that it can sell 150,000 units in a year. The selling price per unit is P5.00. The variable cost per unit is P2.00. Fixed costs are estimated to be P120,000. Assume that the company desires to earn a profit of P350,000. Required: a. BEP in units b. BEP in pesos c. MS in units d. MS in pesos e. Desired sales in units f. Desired sales in pesos a. 𝐵𝐸𝑃 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 = ____________________ b. 𝐵𝐸𝑃 𝑖𝑛 𝑝𝑒𝑠𝑜𝑠 = ___________________ Note: At break-even point, the total contribution margin is always equal to total fixed costs. c. 𝑀𝑆 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 = ____________________ d. 𝑀𝑆 𝑖𝑛 𝑝𝑒𝑠𝑜𝑠 = ___________________ Note: The contribution margin from the margin of safety sales will be the profit because at the break-even point, the total fixed costs have already been recovered and the contribution margin in the excess sales will become the profit. e. 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 = ___________________________ f. 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑝𝑒𝑠𝑜𝑠 = __________________________ 04 Handout 1 *Property of STI  [email protected] Page 3 of 6  BM1915 The contribution margin income statements are shown below: Actual or At BEP Margin of With Target Budgeted Safety Profit Sales (P5.00/unit) Variable cost (P2.00/unit) Contribution margin (P3.00/unit) Total fixed costs Profit Break-Even Point (BEP) for Multiple Product Line In a multiple product line, the company has to pre-determine the sales mix where such sales mix will be considered as one (1) package (composite unit) as in a single product line (Payongayong, 2014). The following steps should be done: 1. Determine the sales mix or set the planned sales mix. 2. Determine the contribution margin for each product. 3. Determine the Weighted Average Contribution Margin (WACM) per unit by multiplying the number of units in the mix for each product to the corresponding CM per unit. 4. Get the sum of the WACM to get the total WACM and consider that as the single CM per unit. 5. Determine the combined units or total sales in pesos by dividing the total fixed costs by the total WACM. 6. Multiply the combined units or total sales in pesos derived from Step 5 with the number of each product in the sales mix. Illustration: ABC Company sells two (2) types of products, X and Y. The company sells these products at the rate of two (2) units of X and four (4) units of Y. X has a contribution margin per unit of P6.00, while Y has P3.00. ABC has total fixed costs of P480,000. The selling price of X is P10.00, while Y is P8.00. Required: Determine the break-even point (a) in units and (b) in pesos. a. Break-even point in units Products Sales Mix CM per Unit Weighted Combined Break-even Point (Step 1) (Step 2) CM per Unit Units in Units (Step 3) (Step 5) (Step 6) X 2 P6.00 Y 4 3.00 Total WACM (Step 4) Total Sales Combined units = ______________________ To prove: Product Break-even Point CM per unit Total CM in Units X __________ ________ Y __________ ________ Total CM P480,000 Fixed Cost 480,000 Break-even P0 04 Handout 1 *Property of STI  [email protected] Page 4 of 6  BM1915 b. Break-even point in pesos Products Sales Mix CM Ratio Weighted CM Total sales in Break-even Ratio (Step 2) Ratio Pesos Point in Pesos (Step 1) (Step 3) (Step 5) (Step 6) X Y Total WACM ratio (Step 4) Total Sales Total sales in pesos = ____________________ To prove: Product Total Sales Sales Mix BEP sales CM Ratio Total CM X _____________ _______ ____________ _________ Y _____________ _______ ____________ _________ Total CM P480,000 Fixed Costs 480,000 Break-even P0 *Difference is due to rounding off. Operating Leverage Operating leverage is the extent to which a company uses fixed costs in its cost structure. Leverage is achieved by increasing fixed costs while lowering variable costs. Operating Leverage Factor (OLF) or Degree of Operating Leverage (DOL) It is used to measure the extent of the change in profit resulting from the change in sales. 𝑇𝑜𝑡𝑎𝑙 𝐶𝑀 %∆ 𝑖𝑛 𝑝𝑟𝑜𝑓𝑖𝑡 𝑂𝐿𝐹 𝑜𝑟 𝐷𝑂𝐿 = 𝑜𝑟 𝑃𝑟𝑜𝑓𝑖𝑡 %∆ 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 %∆ 𝑖𝑛 𝑝𝑟𝑜𝑓𝑖𝑡 = %∆ 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 𝑥 𝐷𝑂𝐿 Where: %∆ = percentage change Illustration: ABC Company has the following results of operations from its present sales level of 10,000 units: Sales (P10 per unit) P100,000 Variable Costs (P6 per unit) 60,000 Contribution Margin 40,000 Fixed Costs 24,000 Profit P16,000 Based on the above data: 1. The company has an OLF or DOL of ______. 𝑂𝐿𝐹 𝑜𝑟 𝐷𝑂𝐿 = __________________ 2. Assume that the company’s sales would increase by 20%, its profit would increase by ______. %∆ 𝑖𝑛 𝑝𝑟𝑜𝑓𝑖𝑡 = _________________________ 04 Handout 1 *Property of STI  [email protected] Page 5 of 6  BM1915 To prove: Actual Proposed %∆ Sales (P10 per unit) P100,000 20% Variable Costs (P6 per unit) 60,000 Contribution Margin 40,000 Fixed Costs 24,000 Profit P16,000 Notes: 1. Sales increased by 20%, but the profit increased 2.5 times the increase in sales or by 50%. 2. The increase of 20% in sales is due to the change in units. 3. Since units changed by 20%, both total variable costs and contribution margin increased by the same percentage of 20%. 4. Selling price, variable costs per unit, and total fixed costs are assumed to be constant. 5. If there is no change in the selling price and variable cost per unit, the contribution margin per unit, contribution margin ratio, and variable cost ratio will all remain the same. References: Hilton, R. W., & Platt, D. E. (2017). Managerial accounting: Creating value in a dynamic business environment. New York: McGraw-Hill Education. Payongayong, L. S. (2014). Management services part 1. Manila: Polytechnic University of the Philippines. Weygandt, J. J., Kimmel, P. D., Kieso, D. E., & Aly, I. M. (2018). Managerial accounting: Tools for business decision-making. Canada: John Wiley & Sons, Inc. 04 Handout 1 *Property of STI  [email protected] Page 6 of 6