College of Accountancy

Subject Code: Module No./Title: 4 – COST VOLUME

PROFIT ANALYSIS

Subject Description: Cost Accounting and Control Period of Coverage:

Introduction:

Objectives:

1. To prepare a CVP income statement to determine contribution margin.

2. To compute the breakeven point and determine the sales required to earn target net income and
determine margin of safety.

Content:

Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume affect a
company's operating income and net income. In performing this analysis, there are several
assumptions made, including:

 Sales price per unit is constant.

 Variable costs per unit are constant.
 Total fixed costs are constant.
 Everything produced is sold.
 Costs are only affected because activity changes.
 If a company sells more than one product, they are sold in the same mix.

CVP analysis requires that all the company's costs, including manufacturing, selling, and
administrative costs, be identified as variable or fixed.

Contribution margin and contribution margin ratio

Key calculations when using CVP analysis are the contribution margin and
the contribution margin ratio. The contribution margin represents the amount of income or
profit the company made before deducting its fixed costs. Said another way, it is the amount
of sales dollars available to cover (or contribute to) fixed costs. When calculated as a ratio, it
is the percent of sales dollars available to cover fixed costs. Once fixed costs are covered, the
next dollar of sales results in the company having income.

The contribution margin is sales revenue minus all variable costs. It may be calculated using
dollars or on a per unit basis. If a company has sales of $750,000 and total variable costs of
$450,000, its contribution margin is $300,000. Assuming the company sold 250,000 units
during the year, the per unit sales price is $3 and the total variable cost per unit is $1.80. The
contribution margin per unit is $1.20. The contribution margin ratio is 40%. It can be
calculated using either the contribution margin in dollars or the contribution margin per unit.
To calculate the contribution margin ratio, the contribution margin is divided by the sales or
revenues amount.

Break-even point

The break‐even point represents the level of sales where net income equals zero. In other
words, the point where sales revenue equals total variable costs plus total fixed costs, and
contribution margin equals fixed costs. Using the previous information and given that the
company has fixed costs of $300,000, the break‐even income statement shows zero net
income.
This income statement format is known as the contribution margin income statement and
is used for internal reporting only.

The $1.80 per unit or $450,000 of variable costs represent all variable costs including costs
classified as manufacturing costs, selling expenses, and administrative expenses. Similarly,
the fixed costs represent total manufacturing, selling, and administrative fixed costs.

Break‐even point in dollars. The break‐even point in sales dollars of $750,000 is calculated
by dividing total fixed costs of $300,000 by the contribution margin ratio of 40%.

Another way to calculate break‐even sales dollars is to use the mathematical equation.
In this equation, the variable costs are stated as a percent of sales. If a unit has a $3.00
selling price and variable costs of $1.80, variable costs as a percent of sales is 60% ($1.80 ÷
$3.00). Using fixed costs of $300,000, the break‐even equation is shown below.

The last calculation using the mathematical equation is the same as the break‐even sales
formula using the fixed costs and the contribution margin ratio previously discussed in this
chapter.

Break‐even point in units. The break‐even point in units of 250,000 is calculated by dividing
fixed costs of $300,000 by contribution margin per unit of $1.20.
The break‐even point in units may also be calculated using the mathematical equation where
“X” equals break‐even units.

Again, it should be noted that the last portion of the calculation using the mathematical
equation is the same as the first calculation of break‐even units that used the
contribution margin per unit. Once the break‐even point in units has been calculated, the
break‐even point in sales dollars may be calculated by multiplying the number of break‐even
units by the selling price per unit. This also works in reverse. If the break‐even point in sales
dollars is known, it can be divided by the selling price per unit to determine the break‐even
point in units.
Targeted income

CVP analysis is also used when a company is trying to determine what level of sales is
necessary to reach a specific level of income, also called targeted income. To calculate the
required sales level, the targeted income is added to fixed costs, and the total is divided by
the contribution margin ratio to determine required sales dollars, or the total is divided by
contribution margin per unit to determine the required sales level in units.

Using the data from the previous example, what level of sales would be required if the
company wanted $60,000 of income? The $60,000 of income required is called the targeted
income. The required sales level is $900,000 and the required number of units is 300,000.
Why is the answer $900,000 instead of $810,000 ($750,000 [break‐even sales] plus
$60,000)? Remember that there are additional variable costs incurred every time an
additional unit is sold, and these costs reduce the extra revenues when calculating income.

This calculation of targeted income assumes it is being calculated for a division as it ignores
income taxes. If a targeted net income (income after taxes) is being calculated, then income
taxes would also be added to fixed costs along with targeted net income.

Assuming the company has a 40% income tax rate, its break‐even point in sales is
$1,000,000 and break‐even point in units is 333,333. The amount of income taxes used in the
calculation is $40,000 ([$60,000 net income ÷ (1 – .40 tax rate)] – $60,000).
 A summarized contribution margin income statement can be used to prove these calculations.

The margin of safety is a tool to help management understand how far sales could change before
the company would have a net loss. It is computed by subtracting break‐even sales from budgeted or
forecasted sales. To state the margin of safety as a percent, the difference is divided by budgeted
sales. If the Three M's, Inc., has budgeted sales of $800,000, its margin of safety is $50,000
($800,000 budgeted sales – $750,000 break‐even sales) or 6.7% ($50,000 ÷ $750,000), a rather low
margin of safety. If, however, its budgeted sales are $900,000, its margin of safety is $150,000
($900,000 budgeted sales – $750,000 break‐even sales) or 20% ($150,000 ÷ $750,000). The
competition, economy, and assumptions in the sales budget must be reviewed by management to
assess whether 20% is a comfortable margin of safety.

Sensitivity Analysis

A business environment can change quickly, so a business should understand how sensitive its
sales, costs, and income are to changes. CVP analysis using the break‐even formula is often used
for this analysis. For example, marketing suggests a higher quality product would allow the
company., to raise its selling price 10%, from $3.00 to $3.30. To increase the quality would increase
variable costs to $2.00 per unit and fixed costs to $350,000. If the company, followed this scenario,
its break‐even in units would be 269,231.

BEP in units = Total Fixed Costs/Contribution per unit

= $350,000/$1.30----($3.3 selling Price - $2.00 variable costs)
= 269,231 units
These changes in variable costs and sales result in a higher break‐even point in units than the
250,000 break‐even units calculated with the original assumptions. The critical question is, “Will the
customers continue to purchase, and are new or existing customers identified that will
purchase the additional 19,231 units of the product required to break even at the higher sales
price?”

SAMPLE Problem:

Preparation of Contribution Margin Format of Income Statement

Sales (8000 units x $16) $ 128,000

Less: Variable Costs (8000 units x $10) 80,000
Contribution Margin (8000 units x $ 6) $ 48,000
Less: Fixed Costs 48,000
Operating Income/Loss $ 0

APPROACHES IN COMPUTATION OF BREAK-EVEN POINT

1. CM Approach

BEP in units = Fixed Costs = $48,000 = 8000 units

Contribution Margin per unit (UCM) $ 6

BEP in Dollars or Pesos = Fixed Costs = $48,000 = $128,000

Contribution Margin Ratio .375

CM Ratio = $ 48,000 or $6
$128,000 $16
2. Equation Approach

BEP in units = USP (x) - UVC (x) - FC = OI / Loss

$16x - $10x - $48,000 = 0
$ 6x = $ 48,000
X = 8000 units

BEP in dollars = 8000 units x $16 = $128,000

3. Graphical Approach

- The relationship among revenue, cost, profit and volume are illustrated on a cost
volume profit graph.
 UNITS AND SALES DOLLARS NEEDED TO ACHIEVE A TARGET INCOME

1. Contribution Margin Approach:

Assuming Target Profit or Income is $6000

Required Sales in units = $48,000 + $6000 = 9000 units

$6

Required Sales in dollars = $48,000 + $6000 = $144,000

.375

2. Equation Approach:
Required Sales in units = $16x - $10x - $48,000 = $6,000
$ 6x = $54,000
x = 9,000 units

Required Sales in dollars = 9,000 units x $16 = $144,000

To check: Sales 9000 units x $16 $ 144,000

Less: VC 9000 units x 10 90,000
CM 9000 units x 6 $ 54,000
Less: FC 48,000
OI $ 6,000

Other Considerations in CVP Analysis

Margin of Safety or Safety Margin – difference between actual or expected sales and sales at the
Break-even point
-measures the “cushion” that a particular level provides

MS in Dollars = $144,000 - $128000 = $16000

MS Ratio = $16000 = 11%
$144,000

Operating Leverage - refers to the extent to which a company’s net income reacts to a given
change in sales.

Degree of Operating Leverage = CM = $54,000 = 9

NI $ 6,000
 Assuming the company expects to have a 10% increase in Sales next period:

Therefore NI next period will be: DOL x % change in Sales = 9 x 10% = 90% increase

$6,000 x 1.9 = $11,400 is the expected income next period

To Check: Sales $144,000 x 1.1 $158,400

Less: VC $ 90,000 x 1.1 99,000
CM $ 59,400
Less: FC 48,000
OI $ 11,400

Illustrative Problem for Multiple Products:

Sales Mix – refers to the relative proportions in which a company’s products are sold.

Product Price UVC UCM Sales Mix Package CM

A $500 - $300 = $200 x 2 = $400
B $1,000 - $500 = $500 x 1 $500
Package Total $900
Assuming FC = $90,000

BEP in Packages = $90,000 = Ā packages

$900
Product A , BEP = 100 x 2 = 200
Product B , BEP = 100 x 1 = 100

To check: Product A Product B Total

Sales $100,000 $100,000 $200,000
Less: VC 60,000 50,000 110,000
CM $ 40,000 $ 50,000 $ 90,000
Less: FC 90,000
OI 0

Prepared By:

Maria Corazon S. Guintu, CPA. MBA