COST-VOLUME-PROFIT

ANALYSIS
Topic 2
Basics of Cost-Volume-Profit Analysis

-The contribution income statement is helpful

to managers in judging the impact on profits
of changes in selling price, cost, or volume.
The emphasis is on cost behavior.
-Contribution margin (CM) is the amount
remaining from sales revenue after variable
expenses have been deducted.
Basics of Cost-Volume-Profit Analysis

Example: Racing Bicycle Company

Contribution Income Statement
For the Month of June
Sales (500 bicycles) P 250,000
Less: Variable expenses 150,000
Contribution margin 100,000
Less: Fixed expenses 80,000
Net operating income 20,000
Basics of Cost-Volume-Profit Analysis
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Sales (500 bicycles) P 250,000
Less: Variable expenses 150,000
Contribution margin 100,000
Less: Fixed expenses 80,000
Net operating income 20,000

CM is used first to cover fixed expenses. Any

remaining CM contributes to net operating income.
Contribution Approach

Sales, variable expenses, and contribution

margin can also be expressed on a per unit
basis.
Contribution Approach
If RBC sells an additional bicycle, P200 additional
CM will be generated to cover fixed expenses and
profit. Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bicycles) P 250,000 P 500
Less: Variable expenses 150,000 300
Contribution margin 100,000 P 200
Less: Fixed expenses 80,000
Net operating income 20,000
Contribution Approach
Each month, RBC must generate at least P80,000 in
total contribution margin to break-even.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bicycles) P 250,000 P 500
Less: Variable expenses 150,000 300
Contribution margin 100,000 P 200
Less: Fixed expenses 80,000
Net operating income 20,000
Contribution Approach
If RBC sells 400 units in a month, it will be
operating at the break-even point.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (400 bicycles) 200,000 500
Less: Variable expenses 120,000 300
Contribution margin 80,000 200
Less: Fixed expenses 80,000
Net operating income -
Contribution Approach
If RBC sells one more bike (401 bikes), net
operating income will increase by P200.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (401 bicycles) 200,500 500
Less: Variable expenses 120,300 300
Contribution margin 80,200 200
Less: Fixed expenses 80,000
Net operating income 200
CVP Relationships in Equation Form

The contribution format income statement

can be expressed in the following equation:

Profit = (Sales – Variable expenses) – Fixed expenses

CVP Relationships in Equation Form

When a company has only one product we can

further refine this equation as shown below:
Profit = (Sales – Variable expenses) – Fixed expenses

Quantity sold (Q) Quantity sold (Q)

× Selling price per unit (P) × Variable expenses per unit (V)
= Sales (Q × P) = Variable expenses (Q × V)
CVP Relationships in Equation Form

It is often useful to express the simple profit equation in

terms of the unit contribution margin (Unit CM) as
follows:

Unit CM = SP/unit – Variable cost/unit

Profit = (P × Q – V × Q) – Fixed expenses
Profit = (P – V) × Q – Fixed expenses
Profit = Unit CM × Q – Fixed expenses
CVP relationships in Graphic Form
The relationships among revenue, cost, profit,
and volume can be expressed graphically by
preparing a CVP graph. RBC developed
contribution margin income statements at 0,
200, 400, and 600 units sold. We will use this
information to prepare the CVP graph.
CVP relationships in Graphic Form
Units Sold
0 200 400 600
Sales - 100,000 200,000 300,000
Total variable expenses - 60,000 120,000 180,000
Contribution margin - 40,000 80,000 120,000
Fixed expenses 80,000 80,000 80,000 80,000
Net operating income (loss) (80,000) (40,000) - 40,000
CVP relationships in Graphic Form
$350,000

$300,000

$250,000

$200,000

$150,000

$100,000 In a CVP graph, unit volume is usually represented

$50,000
on the horizontal (X) axis and amount on the vertical
(Y) axis.
$0
0 100 200 300 400 500 600

Units
CVP relationships in Graphic Form
$350,000

$300,000 
$250,000
Draw a line parallel to the volume axis
to represent total fixed expenses.
$200,000

Fixed expenses
$150,000

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units
 
Choose some sales volume, say 400 units, and plot the point
representing total expenses (fixed and variable). Draw a line through
$350,000

the data point back to where the fixed expenses line intersects the y
$300,000

axis. $250,000

$200,000

Total expenses

$150,000 Fixed expenses

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units
 
Choose some sales volume, say 400 units, and plot the point
representing total sales. Draw a line through the data point back to the
$350,000

$300,000 point of origin.

$250,000

$200,000
Sales
Total expenses
$150,000
Fixed expenses

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units
 $350,000
Break-even point Profit Area
(400 units or P200,000 in sales)
$300,000

$250,000

$200,000
Sales
Total expenses
$150,000 Fixed expenses

$100,000

$50,000

$0
0 100 200 300 400 500 600

Loss Area Units

Contribution Margin Ratio
The CM ratio is calculated by dividing the total
contribution margin by total sales.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit CM Ratio
Sales (500 bicycles) 250,000 500 100%
Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 200 40%
Less: Fixed expenses 80,000
Net operating income 20,000
P100,000 ÷ P250,000 = 40%
Contribution Margin Ratio
The CM ratio can also be calculated by dividing the
contribution margin per unit by the selling price
per unit.

CM per unit 200

CM Ratio = = = 40%
SP per unit 500
Contribution Margin Ratio
The CM ratio can also be calculated by dividing the
contribution margin per unit by the selling price
per unit.

CM per unit 200

CM Ratio = = = 40%
SP per unit 500
Case 1

If RBC increases sales by P50,000, how much

is the effect on the contribution margin?
Case 2

If Racing Bicycle increased its sales volume to

500 bikes, what would management expect
profit or net operating income to be?
The Variable Expense Ratio

The variable expense ratio is the ratio of

variable expenses to sales. It can be computed
by dividing the total variable expenses by the
total sales, or in a single product analysis, it
can be computed by dividing the variable
expenses per unit by the unit selling price.
The Variable Expense Ratio
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit CM Ratio
Sales (500 bicycles) 250,000 500 100%
Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 200 40%
Less: Fixed expenses 80,000
Net operating income 20,000
Case 3

What is the profit impact if RBC can increase

unit sales from 500 to 540 by increasing the
monthly advertising budget by P10,000?
Case 4

What is the profit impact if RBC can use

higher quality raw materials, thus increasing
variable costs per unit by P10, to generate an
increase in unit sales from 500 to 580?
Case 5

What is the profit impact if RBC: (1) cuts its

selling price P20 per unit, (2) increases its
advertising budget by P15,000 per month,
and (3) increases sales from 500 to 650 units
per month?
Case 6

What is the profit impact if RBC: (1) pays a

P15 sales commission per bike sold instead of
paying salespersons flat salaries that
currently total P6,000 per month, and (2)
increases unit sales from 500 to 575 bikes?
Case 7

If RBC has an opportunity to sell 150 bikes to

a wholesaler without disturbing sales to other
customers or fixed expenses, what price
would it quote to the wholesaler if it wants to
increase monthly profits by P3,000?
Target Profit Analysis

1. Equation method
2. Formula method
Equation Method

The equation method is based on the

contribution approach income statement.
Profit = Unit CM × Q – Fixed expenses
Case 8

Suppose RBC’s management wants to know

how many bikes must be sold to earn a target
profit of P100,000.
Formula Method
Target profit expressed in units sold. For this
equation we divide the sum of the desired target
profit plus total fixed expenses by the contribution
margin per unit.
Unit sales to attain Target profit + Fixed expenses
the target profit == CM per unit
Breakeven Analysis

-Breakeven analysis is a financial calculation

that determines the point at which a
business will neither lose nor make a profit.
Breakeven Analysis

Peso sales to = Fixed expenses

break even CM ratio

Units to = Fixed expenses

break even CM per unit
 Margin of Safety

The margin of safety in peso is the excess of

budgeted (or actual) sales over the break-
even volume of sales.

Margin of safety in peso = Total sales - Break-even sales

Margin of Safety

If we assume that RBC has actual sales of

P250,000, given that we have already
determined the break-even sales to be
P200,000, the margin of safety is P50,000 as
shown:
Margin of Safety

Break-even
sales Actual sales
400 units 500 units
Sales 200,000 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income - 20,000
Margin of Safety
RBC’s margin of safety can be expressed as 20% of
sales (P50,000 ÷ P250,000).
Break-even
sales Actual sales
400 units 500 units
Sales 200,000 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income - 20,000
Margin of Safety
The margin of safety can be expressed in terms of
the number of units sold. The margin of safety at
RBC is P50,000, and each bike sells for P500;
hence, RBC’s margin of safety is 100 bikes.

Margin of P50,000
= = 100 bikes
Safety in units P500
Cost Structure and Profit Stability

Cost structure refers to the relative

proportion of fixed and variable costs in an
organization. Managers often have some
latitude in determining their organization’s
cost structure.
Cost Structure and Profit Stability

There are advantages and disadvantages to high

fixed cost (or low variable cost) and low fixed cost
(or high variable cost) structures.

-An advantage of a high fixed cost structure is that

income will be higher in good years compared to
companies with lower proportion of fixed costs.
Cost Structure and Profit Stability

- A disadvantage of a high fixed cost structure is

that income will be lower in bad years compared
to companies with lower proportion of fixed costs.

- Companies with low fixed cost structures enjoy

greater stability in income across good and bad
years.
Operating Leverage
Operating leverage is a measure of how sensitive
net operating income is to percentage changes in
sales. It is a measure, at any given level of sales, of
how a percentage change in sales volume will affect
profits.

Degree of Contribution margin

operating leverage = Net operating income
Operating Leverage
Actual sales
500 Bikes
Sales 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income 20,000

Degree of
Operating P100,000
= P20,000 = 5
Leverage
The Concept of Sales Mix

- Sales mix is the relative proportion in which

a company’s products are sold.
- Different products have different selling
prices, cost structures, and contribution
margins.
The Concept of Sales Mix
Bicycle Carts Total
Sales 250,000 100% 300,000 100% 550,000 100.0%
Variable expenses 150,000 60% 135,000 45% 285,000 51.8%
Contribution margin 100,000 40.0% 165,000 55% 265,000 48.2%
Fixed expenses 170,000
Net operating income 95,000

Sales mix 250,000 45% 300,000 55% 550,000 100%

Compute the breakeven point in sales.

The Concept of Sales Mix
Product A B
SP 500 400
VC 300 180
CM 200 220

Assume that in every two units of product A, three

units of product B is sold. Compute the breakeven
point in units.
Key Assumptions of CVP Analysis

1. Selling price is constant.

2. Costs are linear and can be accurately divided
into variable (constant per unit) and fixed
(constant in total) elements.
3. In multiproduct companies, the sales mix is
constant.
4. In manufacturing companies, inventories do
not change (units produced = units sold).
End.