Module 5: Cost Volume Profit Analysis

At the end of this module, you should be able to:

1. Define the relationship between cost, volume and profit
2. Determine the break-even point in a particular cost structure
3. Compute the level of sales required with a given target profit
4. Ascertain the margin of safety in a particular sales level
5. Establish the changes in the operating income using the degree of operating leverage
6. Distinguish the application of cost volume profit analysis concepts in a multi-product
environment

Relationship of Cost, Volume and Profit

Profit, as already been established in business and accounting subjects, is the main objectives of
business, and it is the result of the total revenues being higher than total cost. Generally, revenues
increases when the number of units sold (the volume) increases however as the number of units sold
increases, total variable cost also increases which eventually increases total costs since total fixed cost
will remain constant, which in turn decreases total profits. To a certain extent, increasing the volume of
units sold sometimes do not result to the maximization of profits, hence, the objective of cost-volume-
profit analysis is to determine the level of activity or the volume that will maximize profit in a given cost
structure – the balance between variable and fixed cost.

The Contribution Margin

The key factor in CVP Analysis is the contribution margin, as introduced in the previous module; it is the
amount left of total sales after deducting total variable cost that will contribute in covering fixed cost
and providing operating income. Diagram 5.1 illustrates the role of contribution margin in the analysis.

Fixed
Cost
Sales Variable Contribution
Cost Margin Operating
Income

It is to be pointed out that the contribution margin is a dependent variable, meaning, it cannot
determine its own value, it is dependent on the value of sales and total variable cost, hence, any
changes in sales and/or variable costs will have an effect in the contribution margin. Also, it is to be
highlighted that contribution margin is not proportionately allocated to fixed cost and operating income,
but rather, the fixed cost will be prioritized to be covered then if there is still excess, then that will be
the operating income.

What happen if there will be no excess? This occurs when the total fixed cost is greater than the
contribution margin wherein it will result to an operating loss. This is usually due to the volume of sales
not being enough to result in a contribution margin that will be higher than the total fixed cost. Hence,
the objective of CVP Analysis is to determine the minimum volume of sales that will provide enough
contribution margin to cover fixed cost and to avoid an operating loss.
The contribution margin can be expressed into three (3) different ways, either as per unit, in total or as a
ratio (as a percentage of sales). Assume the following information pertaining to Zambales Corporation:
Selling price per unit P100.00
Variable Cost per unit P 60.00
Total Fixed Cost P 500,000
Units sold 20,000 units

Contribution Margin per unit is simply the difference between the selling price and the variable cost per
unit. Hence,
Selling price per unit P 100.00
Less: Variable Cost per unit ( 60.00)
Contribution Margin per unit P 40.00
The contribution margin per unit of P40.00 means that every unit contributes P40.00 to cover fixed cost
and provide for operating income, eventually, it can also be said that the company’s operating income
increases by P40.00 for every additional unit sold.

Total Contribution Margin can be computed by deducting total variable cost to total sales or multiplying
the total units sold by the contribution margin per unit. Hence,
Total Sales (20,000 units @ P100) P 2,000,000
Less: Total Variable Cost (20,000 units @ P60) ( 1,200,000)
Total Contribution Margin (20,000 units @ P40) P 800,000
The P 800,000 total contribution margin means that it can cover the P 500,000 total fixed cost and
provide for a P 300,000 operating income for this operating level of 20,000 units.

Contribution Margin Ratio (CMR) or contribution margin as a percentage of sales can be determined by
either dividing contribution margin per unit by the selling price or the total contribution margin by the
total sales. Hence,

𝐶𝑀 𝑃𝑒𝑟 𝑢𝑛𝑖𝑡 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛

𝐶𝑀𝑅 = 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑢𝑛𝑖𝑡 𝐶𝑀𝑅 = 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠

𝑃 40.00 𝑃 800,000
𝐶𝑀𝑅 = 𝑃100.00 𝐶𝑀𝑅 = 𝑃 2,000,000

𝐶𝑀𝑅 = 40% 𝐶𝑀𝑅 = 40%

The contribution margin ratio of 40% means that 40% of total sales will go to contribution margin to
cover fixed cost and provide for operating income regardless of the sales level. Meaning, even if the
company will be able to sell 5,000, 10,000, or 40,000 units or more, 40% of the total sales will
automatically go to contribution margin. The table below shows this relationship.

Units Sold 5,000 units 10,000 units 40,000 units

Sales (@ P100 per unit) P 500,000 100% P 1,000,000 100% P 4,000,000 100%
Variable Cost (@ P60 per unit) (300,000) 60% (600,000) 60% (2,400,000) 60%
Contribution Margin P 200,000 40% P 400,000 40% P 1,600,000 40%

As you can see in the table above, regardless whether the sales is low or high, 40% will always go to
contribution margin.
The Break Even Point
As discussed in the previous section, the contribution margin is what is left of total sales after deducting
total variable cost. Whether the amount of contribution margin derived will be enough to cover fixed
cost will be depend on the number of units sold “contributing” to cover fixed cost. Using the probable
sales level that a company can have the operating income or loss will be as follows:

Units Sold 5,000 units 10,000 units 20,000 units 40,000 units
Sales (@ P100 per unit) P 500,000 P 1,000,000 P 2,000,000 P 4,000,000
Variable Cost (@ P60 per unit) (300,000) (600,000) (1,200,000) (2,400,000)
Contribution Margin P 200,000 P 400,000 P 800,000 P 1,600,000
Fixed Cost (500,000) (500,000) (500,000) (500,000)
Operating Income/(Loss) P (300,000) P (100,000) P 300,000 P 1,100,000

As you can see, if sales level is at 5,000 and 10,000 units, it will result to an operating loss while if the
sales level is at 20,000 and 40,000, it will result to an operating income. The question is what is the exact
sales level that will serve as the point of reference to determine whether a company will have an
operating income or loss? This can be answered by the break-even point. The Break-even Point, as
popularly defined, as the level of activity wherein there is no income or loss or total revenues equal total
costs. Another way of looking at the break-even point is that it is the minimum sales level that the
company needs to earn to avoid incurring an operating loss. There are three ways of determining the
break-even point: (1) graphical, (2) formula and (3) contribution margin approach.

The graphical approach

The break-even point is the point of intersection between the total revenue line and the total
cost (variable +fixed cost) line if both will be graphed in the same plot area. Using the data in the
table above:

2,100,000

Revenue Line
1,900,000

1,700,000 Cost Line

1,500,000
Total Sales/Total Cost

1,300,000
Break-Even
1,100,000 Point

900,000

700,000

500,000

300,000

100,000
0 1,000 5,000 10,000 15,000 20,000 25,000
Number of Units Sold
As you can see, the break-even point graph has two intersecting line, the first line, which starts
from point zero is the revenue line since there will be zero total sales if no units were sold and
increases by P100 (the selling price) as the number of units sold increases while the second line,
which starts at P 500,000 is the cost line since the P 500,000 represents total fixed costs which is
assumed to be still incurred even if there is no units sold and increased by the variable cost as
the number of units sold increases. As you can notice, the cost line is above the revenue line
before the intersection, this is called the loss area since the total cost is greater than total
revenue. After the point of intersection, the revenue line is now above the cost line which
means that total revenue is now greater than total cost hence this is called the profit area. The
point of intersection is called the break-even point which is determined to be at 12,500 units
(halfway between 10,000 and 15,000 units) or at total sales level of P 1,250,000 (the dot is just
below the P1,300,000 sales level) wherein total revenue is equal total cost, hence, there is no
profit or loss.

The formula approach

An easier approach of determining the break-even point is through the formula approach,
wherein we consider how operating income is computed using the contribution margin
approach income statement:

𝑆𝑎𝑙𝑒𝑠 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 − 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 = 𝑃𝑟𝑜𝑓𝑖𝑡

Total Sales is computed by multiplying the number of units sold to the selling price per unit with
variable cost per unit being multiplied to the same number of units sold to determine the total
variable cost. Hence, the formula would be revised as follow to reflect such observation:

(𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑥 𝑈𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑) − (𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑥 𝑈𝑛𝑖𝑡𝑠 𝑆𝑜𝑙𝑑) − 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 = 𝑃𝑟𝑜𝑓𝑖𝑡

In this formula, the goal is to determine the number of units to be sold that will result in zero
profit. Using the information used in the previous sections:
Selling price per unit P100.00
Variable Cost per unit P 60.00
Total Fixed Cost P 500,000
Let X represents the number of units to be sold; the formula will be stated as follow:

100𝑥 − 60𝑥 − 500,000 = 0

Solving for X:
100𝑥 − 60𝑥 = 500,000

40𝑥 = 500,000

500,000
𝑥=
40

𝑥 = 12,500
 The result of the formula approach coincide with the number of units derived using the
graphical approach. Proving if the 12,500 unit sales level will result to zero profit follows:

Sales (12,500 @ P100 per unit) P 1,250,000

Variable Cost (12,500 @ P60 per unit) (750,000)
Contribution Margin P 500,000
Fixed Cost (500,000)
Operating Income/(Loss) P -0-

The contribution margin approach

Under this approach, the objective is to determine the amount of total sales required that will
result to zero profit or loss. The amount of break-even sales is computed by simply dividing the
total fixed cost by the contribution margin ratio. Using the data in the previous section:

𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡

𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑆𝑎𝑙𝑒𝑠 =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑅𝑎𝑡𝑖𝑜

𝑃 500,000
𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑆𝑎𝑙𝑒𝑠 =
40%

𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑆𝑎𝑙𝑒𝑠 = 𝑃 1,250,000

In reference to the computation made in the previous section in proving whether the 12,500
units is the break-even point, total sale is equal to P 1,250,000. The question is, why is it that
fixed cost is being used in determining the required sales? The answer is simple, since the
required profit is zero, the total contribution margin should equal total fixed costs, thus, the
fixed cost in the formula does not really represent fixed cost itself but rather the desired
contribution margin at break-even point and knowing that the contribution margin ratio is the
contribution margin as a percentage of total sales, then in order to determine the total sales, we
divide the desired amount of contribution margin by its ratio to sales. The supporting
computation below will illustrate what is being explained.

Required profit P -0-

Fixed Cost 500,000
Desired Contribution Margin P 500,000
Contribution Margin as a Percentage of Sales 40%
Break-Even Sales (100%) P 1,250,000

Target Profit
After determining the required sales level that will result to a zero profit or loss, we can use the different
approach to determine the required sales level with respect to a given target profit or required profit.
But before that, it is wise to discuss what type of profit should be used in this analysis, after-tax or
before tax profit? If after tax profit will be used, then the amount to be arrive at will be inaccurate since
tax rate are constant and total tax expense changes as tax base changes (the operating income) hence, it
will be more appropriate to use a before-tax amount of target profit in the analysis to provide a more
accurate computation of the sales level required. In the following discussion, we will focus more on
formula and contribution margin approach.

Formula Approach
In this approach, the same objective exist, which is, to determine the number of units to be sold,
the only difference is that instead of zero profit, it will be replaced by the desired target profit.
Using the same information in the previous section:
Selling price per unit P100.00
Variable Cost per unit P 60.00
Total Fixed Cost P 500,000
Desired Before Tax Profit P 150,000
Knowing that the formula in computing for profit is as follow:

(𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑥 𝑈𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑) − (𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑥 𝑈𝑛𝑖𝑡𝑠 𝑆𝑜𝑙𝑑) − 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 = 𝑃𝑟𝑜𝑓𝑖𝑡

The formula will be modified as follow considering the given data:

100𝑥 − 60𝑥 − 500,000 = 150,000

Solving for X:
100𝑥 − 60𝑥 = 500,000 + 150,000

40𝑥 = 650,000

650,000
𝑥=
40

𝑥 = 16,250
Proving if the 16,250 unit sales level will result to a before tax profit of P 150,000 follows:

Sales (16,250 @ P100 per unit) P 1,625,000

Variable Cost (16,250 @ P60 per unit) (975,000)
Contribution Margin P 650,000
Fixed Cost (500,000)
Operating Income/(Loss) P 150,0000

What if the P 150,000 before tax profit will be change to after tax with a tax rate of 40%, what
will now be the required sales volume? In answering this problem, the first step is to convert the
after-tax target profit to before tax by simply dividing the amount of target profit by 1 minus the
tax rate. After determining the before tax target profit, we proceed in computing the required
sales level by the same process as what has already been discussed.

Step 1: Determining the before-tax target profit

𝐴𝑓𝑡𝑒𝑟 − 𝑇𝑎𝑥 𝑃𝑟𝑜𝑓𝑖𝑡

𝐵𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡 =
(1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)
 𝑃 150,000
𝐵𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡 =
(1 − 40%)

𝑃 150,000
𝐵𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡 =
(60%)

𝐵𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑃 250,000

Applying the new before tax profit to the formula used in the previous discussion, it will result to
a sales level of 18,750 units.

The Contribution Margin Approach

As what has already been discussed in the previous section, the contribution margin approach
focuses on determining the level of total sales required. The only difference now is that the
contribution margin will not only cover for fixed cost but also for the desired target profit hence,
the formula will be modified as follows:

𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 + 𝑇𝑎𝑟𝑔𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡

𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑆𝑎𝑙𝑒𝑠 =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑅𝑎𝑡𝑖𝑜

Using the same information:

Selling price per unit P100.00
Variable Cost per unit P 60.00
Total Fixed Cost P 500,000
Desired Before Tax Profit P 150,000

We compute for the required sales as follows:

𝑃 500,000 + 𝑃 150,000
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑆𝑎𝑙𝑒𝑠 =
40%

𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑆𝑎𝑙𝑒𝑠 = 𝑃 1,625,000

The computed required sales coincide with the amount of sales computed in proving the 16,250
unit sales level will result to a P 150,000 before tax target profit. Such computation can be
further explained by the following solution:

Required profit P 150,000

Fixed Cost 500,000
Desired Contribution Margin P 650,000
Contribution Margin as a Percentage of Sales 40%
Required Sales (100%) P 1,625,000

The same process will be done if the given target profit is an after-tax amount. We first
determine the before tax amount then proceed with the same process in determining the
required sales. Therefore, if the P 150,000 is an after-tax figure and using a 40% tax rate, the
before tax amount will still be P 250,000 and the required sales will be computed as follow:
 Required Before Tax profit P 250,000
Fixed Cost 500,000
Desired Contribution Margin P 750,000
Contribution Margin as a Percentage of Sales 40%
Required Sales (100%) P 1,875,000

Margin of Safety
The margin of safety is the excess of budgeted or actual sales over the break-even volume of sales. It is
the amount by which sale can decrease before operating losses begin to be incurred by a company. In
further analyzing the significance of the margin of safety, it is the portion of sales that will provide net
income. Since the break-even sales will be the amount that will cover for the fixed cost, any amount of
sales that is over the break-even sales will cover for the profit. To illustrate, assuming the same data in
the previous sections:
Selling price per unit P100.00
Variable Cost per unit P 60.00
Total Fixed Cost P 500,000
Units sold 20,000 units
Based on the discussion in the previous section, under this structure the company’s break-even point in
units and in peso are 12,500 units and P 1,250,000 respectively. Also, at the sales level of 20,000 units,
the company’s operating income is amounted to P 300,000. The margin of safety can be expressed in
terms of either peso or as a percentage of sales. We will focus first on margin of safety in peso, which is
simply, total sales less break-even sales or P 2,000,000 (20,000 units @ P100.00 each) less P 1,250,000
(the break-even sales) or the margin of safety is P 750,000. This mean that out of the P 2,000,000 total
sales, only P 750,000 has provided to cover for the profit while the rest cover for the fixed cost. The
following table will illustrate what is being explained:
At Actual Level At Break-Even Point Margin of Safety
(20,000 units) (12,500 units) (7,500 units)
Sales (@ P 100 per unit) P 2,000,000 P 1,250,000 P 750,000
Variable Cost (@ P60 per unit) 1,200,000 750,000 450,000
Contribution Margin P 800,000 P 500,000 P 300,000
Fixed Cost 500,000 500,000 -0-
Operating Income P 300,000 -0- P 300,000

Notice that at break-even sale level, the contribution margin is equal to the amount of fixed cost while
at margin of safety; the contribution margin is equal to the amount of operating income. Hence, if total
sales will decrease by 7,500 units or P 750,000, the profit will be equal to zero since the amount that
was providing for the operating income will be gone.

Margin of Safety expressed as a percentage of sales is simply the margin of safety in pesos divided by
the total sales or P 750,000/P 2,000,000 or 37.5%. This only highlights the extent how much can total
sales decrease without incurring an operating loss. So if sales will decrease by 40%, it will incur a net
loss.
At Current Level Expected Level
Decrease (40%)
(20,000 units) (12,000 units)
Sales (@ P 100 per unit) P 2,000,000 P 800,000 P 1,200,000
Variable Cost (@ P60 per unit) (1,200,000) 480,000 (720,000)
 Contribution Margin P 800,000 320,000 480,000
Fixed Cost (500,000) -0- (500,000)
Operating Income P 300,000 320,000 (20,000)

Degree of Operating Leverage

Operating leverage refers to the effect a given percentage increase or decrease in sales will have on net
income. It is a form of sensitivity analysis wherein we are trying to determine how operating income will
respond to changes in sales level. It can be defined as follows:

𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛

𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒

Using the contribution format income statement in the previous section, we know that total
contribution margin is P 800,000 and operating income is P 300,000. Thus, operating leverage can be
computed as follows:

𝑃 800,000
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
𝑃 300,000

𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 2.67 𝑡𝑖𝑚𝑒𝑠

The operating leverage of 2.67 times means that the operating income will move 2.67 times as
compared to the movement in total sales. Putting it in a different light, the percentage change in net
income can be determined by multiplying the percentage change in sales by the operating leverage
hence, if sales will increase by 30%, net income will increase by 80% or 30% x 2.67 (rounded off). To
prove the argument:

At Current Level Expected Level Percentage

(20,000 units) (26,000 units) Change*
Sales (@ P 100 per unit) P 2,000,000 P 2,600,000 +30%
Variable Cost (@ P60 per unit) (1,200,000) (1,560,000) +30%
Contribution Margin P 800,000 P 1,040,000 +30%
Fixed Cost (500,000) (500,000) -0-
Operating Income P 300,000 P 540,000 +80%
*Computed as (Expected Level – Current Level)/Current Level

This can be explained by the effect of fixed cost in the operating income, since fixed cost do not changes
regardless of the level of sales, operating income changes as the level of contribution margin changes. It
is also to be pointed out that the percentage change in sales will also be the same percentage change in
contribution margin since, as discussed earlier in the module; the contribution margin is dependent on
the level of sales. The operating leverage of 2.67 can also be interpreted as the ratio of contribution
margin and operating income, which means that for every P2.67 of contribution margin only P1.00 goes
to operating income and the remaining P 1.67 goes to fixed cost. Thus, if contribution margin increase
by 30%, the amount of increase, not the percentage, will all go to operating income since fixed cost
remains constant. Therefore, the P0.80 increase in the contribution margin will all go to operating
income. After the increase, the contribution margin will now be P3.47, since fixed cost will remain
constant at P1.67, then operating income will now be P1.80, increasing by 80%.

The degree of operating leverage is not constant. It changes as the sales level changes. This means that
the operating leverage of 2.67 is only applicable if the sales level is at P 2,000,000. A new operating
leverage will be computed as the level of sales changes.

Multi-Product Environment
When the Cost-Volume-Profit Analysis will be used in a company that has more than one product, the
analysis will be based on the over-all contribution margin or the weighted average contribution margin
to compute for the required sales with a given target profit or in the break-even analysis. The weighted
average contribution margin required to elements, the individual contribution margin, either per unit or
ratio, of each product of the company and the sales mix or the relative proportions in which the
company’s product are sold. Putting it lightly, sales mix is the composition of total sales in terms of
various products. The sales mix represents the percentages of the sales of each product included in total
sales. The sales mix can be based on unit sales or total sales. However, the basis of the sales mix
computation will also determine how the weighted average contribution margin will be computed.

Unit Sales Approach

Under this approach, the sales mix is determine with respect to the number of units sold for
each product, disregarding the product’s selling price. However, it is important that since we are
using units in our approach, the result of our computations will also be in units. In determining
the weighted average contribution margin, we need the individual contribution margin per unit,
since the basis is units. To illustrate, assuming that Batanes Corporation has the following
information pertaining to its two products, Choco and Gatas:
Choco Gatas
Units Sold 10,000 15,000
Selling Price per unit P 20 P8
Variable Cost per unit P 12 P4
Contribution Margin per unit P 8 P4

In computing Batanes’ break-even point, we need to compute the company’s weighted average
contribution margin per unit as follows:

Choco Gatas Total

Units Sold 10,000 15,000 25,000
Sales Mix Based on Unit Sold 10,000/25,000 15,000/25,000
Or 40% Or 60% 100%
Contribution Margin per unit xP8 xP4 -
Weighted Average CM per unit P 3.2 P 2.4 P 5.6

Assuming that Batanes’ total fixed cost amounted to P 84,000, then the break-even point will be
computed by dividing the total fixed cost by the weighted average contribution margin per unit
or P 84,000/P5.60 or 15,000 units. The 15,000 units will now be allocated to the two products
using their sales mix hence:
 Choco Gatas Total
Sales Mix (Units Sold) 40% 60% 100%
Break-Even Point in Units 6,000 9,000 15,000

To prove:
Choco Gatas Total
Break-Even Point in Units 6,000 9,000 15,000
Total Sales (6,000 x 20) 120,000
192,000
(9,000 x 8) 72,000
Total Variable Cost (6,000 x 12) 72,000
108,000
(9,000 x 4) 36,000
Total Contribution Margin 48,000 36,000 84,000
Total Fixed Cost - - 84,000
Operating Income -0-

Total Sales Approach

As the title suggest, a company’s sales mix will be computed based on the total amount of sales.
But this time, in computing for the break-even point, we will be using the weighted average
contribution margin ratio. Assuming the same information for Batanes Corporation:

Choco Gatas
Units Sold 10,000 15,000
Selling Price per unit P 20 P8
Variable Cost per unit P 12 P4
Contribution Margin per unit P 8 P4

We determine the sales mix as follows:

Choco Gatas Total
Total Sales (10,000 x 20) 200,000
320,000
(15,000 x 8) 120,000
Sales Mix (Total Sales) 200,000/320,000 120,000/320,000
100%
Or 62.5% Or 37.5%

We determine the weighted average contribution margin ratio as follows:

Choco Gatas Total
Contribution Margin Ratio 8/20 or 40% 4/8 or 50%
Sales Mix (Total Sales) 62.5% 37.5% 100%
Weighted Average CM Ratio 0.25 0.1875 43.75%

The break-even point will be computed by simply dividing the company’s total fixed cost of
P84,000 by the weighted average contribution margin ratio of 43.75% which result to a break-
even sales of P 192,000. The P 192,000 break-even sales will be allocated to the two product by
their respective sales mix based on total sales as follows:
Choco Gatas Total
Sales Mix (Total Sales) 62.5% 37.5% 100%
Break-Even Sales P 120,000 P 72,000 P 192,000
It is to be pointed out that regardless of the approach that will be used, it should result to the same
amount or level of break-even sales.

Assumptions and Usage of CVP Analysis

The cost-volume-profit analysis can be used my managers in a lot of ways from Pricing decisions to
product sales mix, determining whether to add or drop a product line to shutting down an entire
operation. It can also be used in determining whether to accept or reject a special order or determining
whether to further process a basic product.

However, the analysis has the following assumptions.

1. Costs can be reliably classified into fixed and variable costs
2. Variable costs changes at a linear rate and is proportional to increases in sales.
3. Fixed costs remain unchanged over the relevant range.
4. Selling prices do not change as sales volume changes
5. For the multi-product analysis, the sales mix remains constant.
6. Productive efficiency does not change.
7. Inventory levels remain constant, meaning whatever was produced is being sold.
8. Volume is the only relevant factor affecting costs
9. There is a relevant range for which all of the other underlying assumptions and concepts are
valid.

Chapter Summary
1. Define the relationship between cost, volume and profit
Profit results when revenues is greater than total cost, profit will increase if revenues increases
as total volume increases which also increases variable cost, thus increasing total cost which will
decrease profit. Therefore, it is very important to have a deep understanding of the company’s
cost structure and how volume influence the movement of cost in order to maximize profit.

2. Determine the break-even point in a particular cost structure

The break-even point is the level of sales wherein the total revenues is equal to total cost, thus,
there is no income or loss. It can be computed using the graphical, formula or the contribution
margin approach.

3. Compute the level of sales required with a given target profit

Since we can compute the level of sales required that will result to zero profit or loss, we can
adjust the formulas of the different approaches used in the break-even point analysis to
determine the required sales to earn a desired before-tax profit.

4. Ascertain the margin of safety in a particular sales level

The margin of safety is how much sales can decrease without incurring any loss. It can be
expressed either in peso or as a percentage of sales. It is computed by simply deducting the
break-even sales to the actual or budgeted sales.

5. Establish the changes in the operating income using the degree of operating leverage
The degree of operating leverage can be computed by simply dividing the total contribution
margin by the operating income. It is the number of times that net income will change with
respect to the changes in sales.
 6. Distinguish the application of cost volume profit analysis concepts in a multi-product
environment
In applying CVP Analysis in a multi-product environment, the process is the same except that
instead of the individual contribution margin being used in the analysis, a weighted average
contribution margin ratio will be computed which requires to item, the individual contribution
margin and the sales mix. The sales mix can be based either on the units sold or total sales.

Module Exercises

Problem 1: Theory Questions

1. If the company’s break-even point in unit sales is 500 and the variable costs were P300 and the
fixed costs were P400. What will be the 501st unit sold contribute to profit before taxes
a. P0 b. P1.00 c. P0.50 d. P0.80
2. Which of the following would decrease unit contribution margin the most?
a. A 15% decrease in the selling price c. A 15% increase in the variable cost
b. A 15% decrease in the variable cost d. A 15% decrease in the fixed expense
3. A higher degree of operating leverage compared with the industry average implies that the firm:
a. Has higher variable costs
b. Has profit that are most sensitive to changes in sales volume
c. Is more profitable
d. Is less risky
4. After the level of volume exceeds the break-even point
a. The contribution margin ratio increases.
b. The total contribution margin exceeds the total fixed costs.
c. Total fixed costs per unit will remain constant.
d. The total contribution margin will turn from negative to positive.
5. Which of the following is not one of the three approaches used in break-even analysis?
a. Equation method c. Contribution margin method
b. Graphical method d. High-low method
6. A cost-volume-profit graph reflects relationships;
a. Expected to hold over the relevant range.
b. Of results over the past few years.
c. That the company's managers would like to have happens
d. Likely to prevail for the industry.
7. Slattery Company sells three products: A, B and C. Product A's unit contribution margin is higher
than Product B's and Product B's is higher than Products C's. Which one of the following events
is most likely to increase the company's overall break-even point?
a. The installation of new automated equipment and subsequent lay-off of factory workers
b. A decrease in Product C's selling price
c. An increase in the overall market demand for Product B
d. A change in the relative market demand for the products, with the increase favoring
Product C relative to Product B and Product A.
8. The break-even point is that level of activity where:
a. variable cost equals fixed cost.
b. contribution margin equals fixed cost.
c. total contribution margin equals the sum of variable cost plus fixed cost.
d. sales revenue equals total variable cost.
9. CVP analysis can be used to study the effect of:
a. changes in selling prices on a company's profitability.
 b. changes in variable costs on a company's profitability.
c. changes in fixed costs on a company's profitability.
d. All of these.
10. Which of the following would take place if a company experienced an increase in fixed costs?
a. Net income would increase c. The break-even point would increase.
b. The contribution margin would increase d. The contribution margin would
decrease.

Problem 2: Comprehensive
The following information pertains to Cavite Corporation regarding its only product.
Selling Price P 20.00
Direct Materials 5.00
Direct Labor 4.00
Variable Overhead 2.00
Fixed Overhead* 4.00
Variable Selling and Administrative 1.00
Fixed Selling and Administrative* 2.00
*Based on the normal capacity of 10,000 units
Required:
1. Compute the contribution margin per unit and ratio.
2. Construct the company’s contribution approach income statement assuming that it was able to
sell 10,000 units.
3. Compute the company’s break-even point.
4. How many units does the company needed to sell if it wants to earn a before tax profit of
P20,000?
5. If the company is subject to a 30% tax rate, how many units does the company needed to sell if
it wants to earn an after tax profit of P17,500?
6. Compute the company’s margin of safety and degree of operating leverage under the three
income situations mentioned above.

Problem 3: Comprehensive
The following is Laguna Corporation's contribution format income statement for last month:
Sales P 2,000,000
Variable Costs 1,400,000
Contribution Margin 600,000
Fixed Costs 360,000
Net Income 240,000
The company has no beginning or ending inventories. A total of 40,000 units were produced and sold
last month.
Required:
1. The company's contribution margin ratio was:
2. To attain a targeted profit of P 300,000, the company's sales (in units) would need to be:
3. The company's break-even point (in sales units) is:
4. If sales increase by 200 units, net income would increase by:
5. The company's margin of safety in peso and as a percentage of sales is:
6. If the company’s sales will decrease by 10%, what will be the decrease in net income (use the
margin of safety)
7. The company's degree of operating leverage is:
 8. If the company’s sales will increase by 10%, what will be the percentage change in the net
income?

Problem 4: Comprehensive
Baguio, Inc. produces only one product, berry baskets, which it sells for P72 each. Unit variable costs are
P32 and total fixed expenses are P15,000. Actual sales for the month of June totaled 2,000 units.
Required:
1. How much is the current operating income of the company?
2. Compute the break-even point in peso and in units
3. To attain an after tax profit of P 40,000 with a tax rate of 20%, the number of units to be sold will
be?
4. Compute the margin of safety in units and peso for the company for June.
5. Compute the degree of operating leverage for the month of June.
6. If the company is expecting for units sale to increase by 20% in July, what is the expected
operating income?

Problem 5: Break-Even Point

Based on the potential sales of 1,000 units per year, a new product has an estimated total cost at the said
sales level of P 600,000, of which 60% are variable costs.
Required:
1. What should be the price of the product in order to have a 25% return on sales?
2. At the selling price determined in the previous item, what would be the break-even point of the
new product?

Problem 6: Break-Even Point

The Mandaluyong Company needs a machine with the capacity to produce 200,000 units of a particular
product. Two equipment suppliers have submitted bids. Machine 1 will generate P 100,000 fixed cost
per year, but if the capacity of 200,000 units is reached profit for this product will amount to P 60,000.
Machine 2 will have a fixed cost of only P 60,000 per year and will yield a profit of P 40,000 at 200,000
units. The product is priced at P2 per unit.
Required:
1. Determine the break-even point for each machine in sales pesos.
2. Determine the sales volume at which the two machine produce equals profits.
3. Determine the range in sales pesos in which
a. Machine 1 is more profitable than Machine 2
b. Machine 2 is more profitable than Machine 1

Problem 7: Break-Even Point

Ilocos Corporation is considering an advertising program which will add P 7,000 to fixed cost. Their
product, now selling for P10 has a variable cost of P3. The current fixed costs are P 35,000.
Required:
1. How many additional units must be sold to justify the advertising?
2. What is the new break-even point in units?

Problem 8: Target Profit

One of Zamboanga Corp.’s only products has the following information:
Selling Price P 15
Variable Cost per Unit 10
Total Fixed Cost P 25,000
 Tax Rate 40%
The following questions are independent of each other:
1. If the company would like to have an after tax net income of P 6,000 while only selling 30,000
units, how much should be its selling price?
2. If the company will reduce the current selling price by 20% and reduce per unit variable cost by
the same percentage while increasing Fixed cost by P 3,000, what would be the company’s after
tax net income (loss) if it will able to sell 5,000 units?
3. If the company’s fixed cost would be increased by 20% while reducing per unit variable cost by P
3.00, what would be the new break-even point (in units)?
4. If the company’s total current sale is at 12,000 units, what is the company’s operating leverage?
(Use before tax net income)

Problem 9: Target Profit

Cebu Corporation plans to earn P 140,000 after income taxes in 2014. The tax rate is 30% of net income
before income taxes. The fixed costs for the year are estimated at P 350,000. The contribution margin is
estimated at 20% of sales revenue.
Required:
1. Compute the sales revenue required to earn a net income after taxes of P 140,000.
2. If the contribution margin can be increased to 25%, how much sales revenue will be required to
earn a net income after income taxes of P 140,000?

Problem 10: Target Profit

Cavite Corporation has budgeted for 2014 fixed costs of P 50,000, sales of P 250,000 and a profit of
P80,000.
Required:
1. What was the company’s expected contribution margin ratio?
2. What is the required sale if the company wants to earn a return on sales of 12%?
3. If the company is subject to a 40% tax return and would like to earn an after-tax return on sale
of 9%, what should be its total sales?

Problem 11: Target Profit (Adapted_RP-CPA)

Ipil-ipil Corp. would like to market a new product at a selling price of P15 per unit. Fixed costs for this
product are P1,000,000 for less than 500,000 units of output and P1,500,000 for 500,000 or more units
of output. The contribution margin percentage is 20%.
Required: How many units of this product must be sold under the following ttarget operating income:
1. P 500,000
2. P1,000,000
3. P 2,000,000

Problem 12: Margin of Safety

Mindoro Corporation had sales of P 120,000 for the month of May. It has a margin of safety ratio of
25%, and after tax return on sales of 6%. The company assumes that Sales is constant every month.
Required:
1. If the tax rate is 40%, how much is the annual fixed costs?
2. What is the company’s contribution margin ratio?

Problem 13: Margin of Safety

A company has the following limited data for the current year:
Total Variable Cost at BEP P 30,000
 Margin of Safety 37.5%
Contribution Margin Ratio 40%
Required:
1. How much is the Company’s current year total sales?
2. How much is the Company’s current year total variable cost?
3. How much is the current year’s net income?

Problem 14: Degree of Operating Leverage

At the current sales volume of P 400,000, Davao Corporation return on sales is 10%. It is expected that in
the coming year, a P 600,000 sales volume will be attained by the company and will have a return on
sales of 20%.
Required:
1. What was the Davao Corporation’s current degree of operating leverage?
2. What was the company’s fixed cost?
3. What is the break-even point in peso sales?

Problem 15: Degree of Operating Leverage

The following information pertains to Jan Corp.
Operating Leverage 4
Fixed Costs P 30,000
Current Year Total Peso Sale P 125,000
Required:
1. How much is the company’s CM Ratio?
2. How much is the company’s total variable cost at break-even point?
3. How much would the company's net income be if total sales would increase by P 10,000?

Problem 16: Degree of Operating Leverage

Mindoro Corporation currently has an operating leverage of 4, sales is expected to increase by 12.5% in
the following year. The annual fixed cost amounted to P 100,000.
Required:
1. What is the expected operating income in the following year?
2. What is the expected degree of operating leverage in the following year?

Problem 17: Multi-Product

ABC Corporation has the following information about its two products and its operation:
Product A B
Selling Price P10 P20
Variable Cost 4 16
Units Sold 10,000 30,000
Total Fixed Costs P 90,000
Required:
1. What is the weighted average contribution margin per unit?
2. How many units of each product must the company be able to sell to break even?
3. How many units of each product must the company be able to sell to earn a target profit of P45,000?
4. If the Product A’s variable cost per unit will increased by P2.00, how much should product B’s
variable cost be to maintain the same level of break-even sales?

Problem 18: Multi-Product

XYZ Corporation’s current segmented contribution format income statement follows:
 X Y Total
Sales P 150,000 P 600,000 P 750,000
Variable Costs 60,000 450,000 510,000
Contribution Margin 90,000 150,000 240,000
Fixed Costs* 40,000 160,000 200,000
Net Income 50,000 (10,000) 40,000
Required: (*Fixed costs are allocated based on the product’s total sales.)
1. What is the weighted average contribution margin ratio?
2. How much is the total sales of each product at break-even point?
3. How much is the total sales of each product if the company’s target profit is P60,000?
4. If product X’s variable cost per unit will decrease by 10%, how much should be the increase or
decrease in product Y’s total variable costs as a result of a change in the variable cost per unit?

Problem 19: Multi-Product (Adapted RP-CPA)

Bulacan Corporation produces and sells three major chemicals: C1, C2, and C3. It sells to industrial users who
use and buy these chemicals in the following ratio: three (3) measures of C1 for one (1) measure of C3, two (2)
of C2 per one (1) of C1. The company makes the following contribution margin per measure:
C1 P30 C2 P45 C3 P90
Fixed costs amounted to P1.8million.
Required:
1. What is the weighted average contribution margin per unit?
2. At break-even point, the volume of C3 to be sold would be?
3. At a target profit of P400,000, the volume of C2 to be sold would be?
4. At a target profit of P600,000, total sales of C1 would be?

Problem 20: Multi-Product

Cavite Corporation currently produces and sells three products, Alpha, Beta, and Charlie. The current sales
mix is as follows: 2 Alpha for 1 Beta and 1 Beta is to 1 Charlie. Alpha’s selling price and variable cost is P10
and P6 respectively while Beta’s selling price is P20 and its contribution margin per unit amounted to P5.
Charlie’s Contribution Margin ratio is 30%. The company’s total fixed cost is P165,000 and the total break-
even point in units is 30,000.
Required:
1. What was the weighted average contribution margin per unit?
2. What is Charlie’s selling price?
3. If Alpha’s current unit sales are 20,000 units, how much was the company’ current operating income?
4. If the company’s target profit is P 55,000, how much would be the volume of Beta?

Problem 21: Changes in Structure

Match Company reports the following results for the month of November:
Units sold 10,000
Sales P 600,000
Variable costs ___420,000
Contribution margin 180,000
Fixed costs ___110,000
Net income P 70,000
Management is considering the following independent courses of action to increase net income.
1. Increase selling price by 6% with no change in units sold.
2. Reduce variable costs to 65% of sales.
3. Reduce fixed costs by P 20,000
 4. Reduce fixed costs by P 10,000 while increasing variable costs to P4.50 per unit
5. Reduce variable cost by 10% while increasing fixed costs to P140,000
Required: Determine the net income to be earned for each of the given alternative course of action.

Problem 22: Changes in Structure

Pagsanjan Corporation has the following revenue and cost characteristics on their only product:
Selling price per unit P 6.00
Variable cost per unit P 4.20
Annual fixed costs P 360,000
Annual volume 270,000 units
Required:
1. Determine the following:
a. Variable Cost Ratio
b. Contribution Margin per unit and ratio
c. Break-even point in units and in peso
d. Net profit at the current operating level
2. For each of the following independent cases, determine the new contribution margin ratio,
break-even point in pesos, and net profit.
a. 5% increase in selling price
b. 20% increase in variable costs
c. 50% increase in fixed costs
d. 5% increase in sales and production volume
e. Decrease of P30,000 in fixed costs
f. Decrease in variable costs of P0.20
g. Decrease in variable costs of P0.60 and 20% increase in selling price
h. 20% decrease in fixed costs and 20% increase in variable cost.