CA51014 – STRATEGIC COST MANAGEMENT

Cost-Volume-Profit & Break-Even Analysis

Variable Costing Income Statement

VARIABLE COSTING INCOME STATEMENT:

Sales xx
Less: Variable cost of goods sold xx
Manufacturing margin xx
Less: Variable selling & administrative cost xx
Contribution margin xx
Less: Fixed costs:
Fixed factory overhead xx
Fixed selling & administrative costs xx xx
Profit (Loss) xx

• Not all Manufacturing Costs are product costs

o Manufacturing Costs:
▪ Direct Materials – Product
▪ Direct Labor – Product
▪ Variable FOH – Product
▪ Fixed FOH – Period

• FFOH VC Inventory < FFOH AC Inventory

CONTRIBUTION FORMAT INCOME STATEMENT:

Sales xx
Less: Variable Cost xx
Contribution Margin xx
Less: Fixed Costs: xx
Fixed Factory Overhead xx
Fixed Selling and Admin. Cost xx
Profit (Loss) XX

Cost Volume Profit (CVP) Analysis Definition

• Is a useful management tool that helps managers in planning for profit by way of a systematic examination of the
interrelationship among costs, volume (activity level) and profit.
• Relationship of
o Cost – classify according to behavior i.e., Variable and Fixed
o Volume - units
o Profit
• What would be the reaction of the change of one to the others

Factors affecting profit

Ceteris paribus, if there is an increase in… Then profit will…

1. Selling Price Increase
2. Variable Cost Per Unit Decrease
3. Fixed Cost Decrease
4. Unit Sales (Volume) Increase

CVP Assumptions
1. Production = Sales

2. Constant Selling Price, VC/Unit, Contribution Margin per unit, Contribution Margin Ratio
• CM Ratio = Contribution Margin / Sales
If the problem is silent and no changes have been stated, they will remain constant regardless of the cost
driver

3. At breakeven point, CM = Fixed Cost

CVP Related Terminologies

Contribution Margin
• Is the difference between sales and variable cost. It is otherwise known as marginal income, profit contribution,
contribution to fixed cost or incremental contribution.

• CM Ratio = CM ÷ Sales; or
CM per unit ÷ SP per unit; or
∆ CM ÷ ∆ Sales

Note: Under CVP assumptions, CM ratio is constant regardless of the number of units sold or produced.

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Break-Even Point
• Is a level of activity, in units (break-even volume) or in pesos (breakeven sales), at which total revenues equal total
costs, i.e., there is neither a profit nor a loss.
• BEP unit = Total Fixed costs ÷ CM per unit
• BEP peso sales = Total Fixed costs ÷ CM ratio or
= BEP Unit x Sales Price

Illustration: Break-even point computations

Clark Company manufactures and sells a single product. The company’s sales and expenses for a recent month follow:
Sales (15,000 units) P 600,000
Less: Variable costs 420,000
Contribution Margin P 180,000
Less: Fixed costs 150,000
Profit P 30,000

Required:
1. Determine the following:
a. Selling price per unit
600,000 ÷ 15,000 = P40

b. Variable cost per unit

420,000 ÷ 15,000 = P28

c. CM ratio
40 – 28 = 12 ÷ 40 = 0.3 or 30% or 180,000 ÷ 600,000 = 0.3 or 30%

2. What is the monthly break-even point in units sold and in pesos?

150,000 ÷ 12 = 12,500 units

150,000 ÷ 0.3 = P500,000 or 12,500 units x 40 = P500,000

3. Without resorting to computation, what is the total contribution margin at the break-even point?
P150,000 because at breakeven point, Total Fixed Cost = Total Contribution Margin

Illustration: Impact of Operating Changes

Moderna Company is studying the impact of the following:

1. An increase in sales price on the break-even point. Decrease

2. A decrease in fixed costs on the contribution margin. NO EFFECT
3. An increase in the contribution margin per unit on the break-even point. DECREASE
4. A decrease in the variable cost per unit on the sales volume needed to achieve the company’s P68,000 target profit.
DECREASE

* All values in the table except for P68,000 are hypothetical

Per Unit
Per Unit
Assuming the
(98K ÷ 2) = In Pesos In Pesos
Variable Cost
49K units
Decreased
Sales 10 490,000 9 441,000
Variable Cost 8 392,000 7 343,000 ↑
Contribution Margin 2 98,000 2 98,000
Less: Fixed Cost - 30,000 ↑ - 30,000 ↑
Profit - 68,000 - 68,000

5. An increase in sales commissions on the break-even point and the contribution margin. INCREASE, DECREASE
6. A decrease in anticipated advertising outlays on fixed cost and the break-even point. DECREASE, DECREASE

Required: Determine the impact of these operating changes (increase, decrease, no effect) on the item(s) noted.

Margin of Safety
• Is the difference between actual sales volume and break-even sales.
• It indicates the maximum amount by which sales could decline without incurring a loss.
• Margin of Safety = Actual sales – Breakeven sales
o In the absence of Actual Sales, Budgeted Sales
• MS Ratio = MS ÷ Actual sales

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Illustration:

Kent Company’s break-even sales are P528,000, the variable cost ratio is 60%, while the profit ratio is 8%.

Required: Compute the following:

1. Fixed Costs 211,200
2. Actual Sales 660,000
3. Profit 52,800
4. Margin of Safety
660,000 – 528,000 = P132,000

5. Margin of Safety Ratio

132,000 ÷ 660,000 = 0.2 or 20%

Indifference Point
• Is the level of volume at which two alternatives being analyzed would yield equal amount of total costs or profits.
• Whether the management chooses Alternative A or Alternative B, their would have equal levels of profit

Alternative A Alternative B

• (CM per unit x Q) – FC = (CM per unit x Q) – FC

o Note that the CM per unit and the FC of both alternatives differ from each other

OR;

• FC + (VC per unit x Q) = FC + (VC per unit x Q)

o Again, the VC and the FC are not the same with each other

Note: Q = number of units (indifference point)

Illustration: Indifference Point

Tony Co. sells its only product at P32 per unit. Variable costs are P24 per unit and fixed costs amounted to P100,000 per month.

Required:

1. If Tony can sell 15,000 units in a particular month, what will be its income? P20,000

2. What is the break-even point in units and in pesos? 12,500 units and P400,000

3. What amount of unit sales is required to earn after-20% tax profit of P32,000 for the month? 17,500 units

4. What sales, in pesos, are required to earn after-20% tax profit of P32,000 for the month? 560,000

5. Suppose that Tony is currently selling 10,000 units per month. The marketing manager believes that sales would
increase if advertising were increased by P5,000. By how much would unit sales have to increase to give Tony the
same income or loss that is currently earning? Increase of 625

6. If Tony is selling 20,000 units per month at P32, what is its margin of safety? 240,000

7. Tony currently pays its salespeople salaries for a total of P40,000 per month, but no commissions. The sales
department is considering a plan whereby the salespeople would receive a 5% commission, but their salaries would fall
to a total of P25,000 per month. At what sales level is the company indifferent between the two compensation plans?
300,000

8. How much is the profit of Tony at 12,501 units? 8

9. How much is the loss of Tony at 12,499 units? (8)

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Sales Mix
• Is the relative combination of quantities of sales of various products that make up the total sales of a company.
• For multiproduct companies
o Two or more Selling Prices
o Two or more Variable Costs
o Two or more Contribution Margins
• BEP units = Fixed costs ÷ Weighted average CM per unit
• BEP peso sales = Fixed costs ÷ Weighted average CM ratio
o The weighted average is based on the sales mix
o Percentage of Unit Sales to the Total Sales

Illustration: Sales Mix

Alpha Corporation sells three products: J, K, and L. The following information was taken from a recent budget:

J K L TOTAL
Unit sales 40,000 130,000 30,000 200,000
Selling price P60 P80 P75
Variable cost 40 65 50
Contrib. Margin P20 P15 P25
CM Ratio 33.33% 18.75% 33.33%

Total fixed costs are anticipated to be P2,450,000.

Required:
a. Determine Alphabet's sales mix. 20% ; 65% ; 15%
b. Determine the weighted-average contribution margin. 17.5
c. Calculate the number of units of J, K, and L that must be sold to break even. 140,000 units
d. If Alphabet desires to increase company profitability, should it attempt to increase or decrease the sales of product K
relative to those of J and L? Briefly explain.

Sales Mix J = 40,000 ÷ 200,000 = 20%

Sales Mix K = 130,000 ÷ 200,000 = 65%
Sales Mix L = 30,000 ÷ 200,000 = 15%

Weighted Average CM per Unit = (P20 x 0.2) + (P15 x 0.65) + (25 x 0.15) = 4 + 9.75 + 3.75 = 17.5

BEP units = 2,450,000 ÷ 17.5 = 140,000 units

Weighted Average CM Ratio = (33.33% x 20%) + (18.75% x 65%) + (33.33% x 15%) = 23.8575%

BEP pesos = 2,450,000 ÷ 23.8575 = P10,269,307.35

PROOF OF CORRECT COMPUTATION

CM J: (140,000 x 20%) x P20 = P560,000
K: (140,000 x 65%) x P15 = P1,365,000
L: (140,000 x 15%) x P25 = P525,000 P2,450,000
FC P2,450,000
P/L -0-

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Degree of Operating Leverage | Operating Leverage Factor
• Measures how a percentage change in sales from the current level will affect company profits.
• It indicates how sensitive the company is to sales volume increases and decreases. It is also known as operating
leverage factor.
• What would be the effect of the percentage change in sales to the profit of the company
o If there is 20% increase in sales, how much would the company’s profit change
• DOL = Contribution Margin ÷ Earnings Before Interest and Taxes

Illustration:

Russell has recently opened a gym for malnourished individuals. Actual operating results for the shop’s first year of operations
are presented as follows:
Sales P 250,000
Variable Costs (100,000)
Contribution Margin P 150,000
Fixed Costs (120,000)
Income P 30,000

Russell is unhappy about the results of his shop’s first year of operations. He observed that despite the very high contribution
margin, income was still low because of the very high fixed costs. He feels that an increase in sales would not yield a
satisfactory increase in profit.

Required:
1. Compute the leverage factor.
DOL = 150,000 ÷ 30,000 = 5 times
▪ Whatever happens to sales, it would have 5x effect on the profit
2. If sales increase by 10%, then how many percent would income increase, ceteris paribus? (Determine the percentage
∆ by using the operating leverage factor.)

Increase in Sales 10%

x DOL 5
Inc. in Profit 50%

PROOF OF CORRECT COMPUTATION

CM (150,000 x 110%) 165,000
FC 120,000
Profit – After 10% increase 45,000
Profit – Before 10% increase 30,000
Increase in Income 15,000
The P15,000 increase in income is 50% of the old
income

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Comprehensive Illustration:

Knicks Corporation operates a chain of stores around the country. The stores carry many styles of shoes that are sold at the
same price. To encourage sales personnel to be aggressive in their sales efforts, the company pays a substantial sales
commission on each pair of shoes sold. Sales personnel also receive a small basic salary.

The following cost and revenue data relate to New York sales outlet and are typical of the company’s many sales outlets:

Selling price P 800

Variable expenses:
Invoice costs P 360
Sales commission 140
Total P 500
Fixed expenses per year:
Rent P 1,600,000
Advertising 3,000,000
Salaries 1,400,000
Total P 6,000,000

1. How many units are required for the company’s New York sales outlet to breakeven?

2. If 18,000 pairs of shoes are sold in a year, what would be New York sales’ outlet’s net income?

3. The company is considering paying the store manager of New York sales outlet an incentive commission of P75 per
pair of shoes (in addition to the salesperson’s commission). If this change is made, what will be the new breakeven in
pairs of shoes?

4. Instead of paying the manager a straight P75 per pair of shoes commission on all pairs of shoes sold, the company is
considering paying the store manager of P50 commission on each pair of shoes sold in excess of the breakeven point.
If this change is made, what will be the sales outlet’s net income or loss if 25,000 pairs of shoes are sold?

5. If the company would pay the manager P50 commission on each pair of shoes sold in excess of the breakeven point,
how many pairs of shoes are required to earn P900,000 profit?

6. The company is considering eliminating sales commissions entirely in its stores and increasing fixed salaries by
P2,142,000 annually. If this change is made, what will be the number of pairs of shoes to be sold by New York outlet to
be indifferent to commission basis?

REVIEW QUESTIONS (TRUE OR FALSE; MULTIPLE-CHOICE)

1. At the break-even point, total contribution margin is

a. Zero c. Equal to totals costs
b. Equal to total fixed costs d. Equal to total variable costs

2. An increase in contribution margin ratio reduces the break-even point. TRUE

3. If the tax rate increases, then the break-even point also increases. FALSE

4. An increase in the income tax rate

a. Raises the break-even point
b. Lowers the break-even point
c. Decreases sales required to earn a particular after-tax profit
d. Increases sales required to earn a particular after-tax profit

5. An increase in actual sales also increases the margin of safety. TRUE

6. A company that has a negative margin of safety necessarily operates at a loss. TRUE

7. Under CVP analysis, which of the following is not assumed to be constant?

a. Unit variable cost b. Unit fixed cost c. Unit selling price d. Sales mix

8. The operating leverage factor is equal to

a. Gross margin ÷ profit after tax c. Contribution margin ÷ profit after tax
d. Gross margin ÷ profit before tax d. Contribution margin ÷ profit before tax

9. If the DOL is 2, then a 3% change in quantity sold should result in a 5% change in profit before tax. FALSE

10. If inventories are expected to change, the type of costing that provides the best information for breakeven analysis is
a. Job order costing b. Variable costing c. Joint costing d. Absorption costing

11. If a company’s variable costs are 70% of sales, which formula represents the computation of peso sales that will yield a
profit equal to 10% of the contribution margin when S equals sales in dollars for the period and FC equals fixed costs
from the period?
a. S = 0.2 ÷ FC b. S = FC ÷ 0.2 c. S = 0.27 ÷ FC d. S = FC ÷ 0.27

12. If a company desires to increase its safety margin, it should:

a. increase fixed costs.
b. decrease the contribution margin.

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 c. decrease selling prices, assuming the price change will have no effect on demand.
d. stimulate sales volume.
e. attempt to raise the break-even point.

13. All other things being equal, a company that sells multiple products should attempt to structure its sales mix so the
greatest portion of the mix is composed of those products with the highest:
a. selling price d. fixed cost
b. variable cost e. gross margin
c. contribution margin

14. The assumptions on which cost-volume-profit analysis is based appear to be most valid for businesses:
a. over the short run d. in periods of sustained profits
b. over the long run e. in periods of increasing sales
c. over both the short run and the long run

15. The contribution income statement differs from the traditional income statement in which of the following ways?
a. The traditional income statement separates costs into fixed and variable components.
b. The traditional income statement subtracts all variable costs from sales to obtain the contribution margin.
c. Cost-volume-profit relationships can be analyzed more easily from the contribution income statement.
d. The effect of sales volume changes on profit is readily apparent on the traditional income statement.
e. The contribution income statement separates costs into product and period categories.