Review Materials

Prepared by:
Junior Philippine Institute of
Accountants UC-Banilad Chapter
F.Y. 2019-2020
Cost-Volume-Profit Analysis
 NATURE of CVP Analysis

Cost-Volume-Profit (CVP) Analysis – estimates how changes in costs (both variable and fixed),
sales volume, and price affect a company’s profit. CVP is a powerful tool for planning and decision
making. It is used by the management in order to help them understand the interrelationship
among cost, volume and profit in an organization by focusing on interactions between five CVP
components.

Components of CVP Analysis

1. volume or level of activity(within a relevant range)
2. unit selling prices
3. variable cost per unit
4. total fixed costs
5. sales mix

Additionally, CVP analysis allows managers to do sensitivity analysis by examining the

impact of various price or cost levels on profit.
The relevant range is the range of activity in which a company expects to operate during a
year. It is important in CVP analysis because the behavior of costs is assumed to be linear throughout
the relevant range.
 APPLICATION of CVP Analysis
CVP Analysis may be applied to the planning and decision-making function
of the management,

which may involve choosing the

“▪ type of product to produce

and sell;
• pricing policy to follow;
• marketing strategy to use;
and
• type of productive facilities
to acquire.

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 Simplifying Assumptions of CVP Analysis

o All costs are classifiable as either variable or fixed (components of mixed

costs are already segregated).
o Cost and revenue relationships are predictable and linear over a relevant
range of activity and a specified period of time.
o Variable costs per unit and total fixed costs remain constant over the relevant
range.
o Unit sales price and market conditions remain unchanged.
o Changes in costs in revenue are brought about by changes in volume alone.
o There is no significant change in the level of inventory (Production = Sales).
o Sales mix remains constant (for a company that sells multiple products)
o Technology, as well as productive efficiency, is constant.
o Time value of money concept is ignored.
Using Operating Income in Cost-Volume-Profit Analysis

In CVP analysis, the terms “cost” and “expense” are often used interchangeably. This is because
the conceptual foundation of CVP analysis is the economics of breakeven analysis in the short run. For
this, it is assumed that all units produced are sold. Therefore, all product and period costs do end up
as expenses on the income statement. Remember that operating income is total revenue minus total
expense:
Operating income = Total revenue - Total expense

For CVP analysis, it is much more useful to organize costs into fixed and variable components. The
focus is on the firm as a whole. Therefore, the costs refer to all costs of the company— production,
selling, and administration. So variable costs are all costs that increase as more units are sold,
including:
• direct materials
• direct labor
• variable overhead
• variable selling and administrative costs
Similarly, fixed costs include:
• fixed overhead
• fixed selling and administrative expenses
The income statement format that is based on the separation of costs into fixed and variable
components is called the contribution margin income statement.

Contribution margin is the difference between sales and variable expense. It is the amount of
sales revenue left over after all the variable expenses are covered that can be used to contribute to
fixed expense and operating income
 EXAMPLE PROBLEM.
Illustration on how to calculate the variable and fixed expenses and prepare the contribution margin statement.

Whittier Company plans to sell 1,000 mowers at $400 each in the coming year. Product costs include:
Direct materials per mower $ 180
Direct labor per mower 100
Variable factory overhead per mower 25
Total fixed factory overhead 15,000

Variable selling expense is a commission of $20 per mower; fixed selling and administrative expense
totals $30,000.
Required:
1. Calculate the total variable expense per unit.
2. Calculate the total fixed expense for the year.
3. Prepare a contribution margin income statement for Whittier for the coming year.

Solution:
1. Total variable expense per unit
= Direct materials + Direct labor +Variable factory overhead +Variable selling expense
= $180 $100 $25 $20
= $325
 EXAMPLE PROBLEM.
Illustration on how to calculate the variable and fixed expenses and prepare the contribution margin statement.

2. Total fixed expense = Fixed factory overhead + Fixed selling and administrative expense
= $15,000 + $30,000
= $45,000

Notice that the contribution margin income statement shows a total contribution
margin of $75,000. The per-unit contribution margin is $75 ($400 − $325). That is, every mower
sold contributes $75 toward fixed expense and operating income.
What does Whittier’s contribution margin income statement show? First, we see that
Whittier will more than break even at sales of 1,000 mowers, since operating income is $30,000.
Clearly, Whittier would just break even if total contribution margin equaled the total fixed cost.
Let’s see how to calculate the break-even point.
 Break-Even Analysis and Target Profit Analysis
in a Single-Product Company

Definition of Break-Even Point

Break-Even Point – the sales volume (in pesos or in units) where total revenues equal total
costs (TR = TC). Thus, at this point, the entity experiences neither profit nor loss (TR –TC = 0).

Methods of Computing Break-Even Point

Break-even sales can be computed using any of the following methods:

1. Graphic Approach
2. Equation Method or Algebraic Approach
3. Formula or Contribution Margin Approach
 1. Graphic Approach
CVP Graph – also called break-even chart, it depicts the relationship of cost, volume,
and profit in a graphical form. In this graph, the point where the total cost line intersects with the
total revenue/sales line represents the break-even point.
Steps in preparing the break-even chart:
1. Draw a line parallel to the volume axis to represent total fixed expense.
2. Choose some volume of unit sales and plot the point representing total expense (fixed
and variable) at the sales volume you have selected. After the point has been plotted, draw a line
through it back to the point where the fixed expense line intersects the dollars axis.
3. Again choose some sales volume and plot the point representing total sales dollars
at the activity level you have selected. Draw a line through this point back to the origin.
 2. Equation Method or Algebraic Approach
computed from a mathematical equation

This method uses the profit equation and applies algebraic techniques in computing the break-even point.

Profit Equation:
NI = TR – TC where: NI = profit/net income
TR = total revenue (sales)
TC = total cost

TR = SP/u X Saleu where: SP/u = sales price per unit

Salesu = units sold

TC = TVC + TFxC where: TVC = total variable costs

TFxC = total fixed costs

TVC = VC/u X Salesu where: VC/u = variable cost per unit

Salesu = units sold

Thus, expanding the Profit Equation:

NI = (SP/u X Salesu) – [(VC/u X Salesu) + TFxC]
NI = [(SP/u X Salesu) – (VC/u X Salesu)] – TFxC
NI = [(SP/u – VC/u) X Salesu] – TFxC
NI = (Unit CM X Sales) – TFxC
3. Contribution Margin Method or Formula Approach

This method uses directly the formula in finding Break-even point (in units or in pesos).

Break-Even Point in PESOS (BEPP )

When the BEP in units is already known, the BEPP can be computed as
BEPP = BEPu X Sales Price per Unit (SP/u)

Break-Even Point in UNITS (BEPu )

Calculating the Break-Even Point in UNITS
Information:
Refer to the Whittier Company first example problem. Recall that mowers sell for $400 each, and
variable cost per mower is $325. Total fixed cost equals $45,000.
Calculating the Break-Even Point in SALES (pesos or
dollars)
Now, let’s turn to the equation for calculating the break-even point in sales dollars. One way of
calculating break-even sales revenue is to multiply the break-even units by the price. The operating
income equation can be used to solve for break-even sales for Whittier as follows:

So, Whittier Company has sales of $240,000 at the break-even point.

Just as it was quicker to use an equation to calculate the break-even units directly, it is helpful to have
an equation to figure the break-even sales dollars. This equation is:
Target Profit Analysis
At certain instances, entities need to determine the volume of sales (in pesos or in units) that they need
in order to achieve a specified amount of desired/targeted profit. In determining the targeted sales for
a desired profit, the formula in finding for the BEP will still be used, substituting the zero-value for
profit with the amount of the desired profit. Thus,

After-tax Desired Profit

When the amount of the desired is expressed in an after-tax amount, said amount would have to be
grossed-up/converted into its before-tax equivalent before added to the amount of the total fixed cost.
To compute for the before-tax profit, the formula is:
 Margin of Safety

Margin of Safety – is the difference between actual or expected sales and sales at the break-even
point. The formulas for margin of safety are:
Actual (expected) sales – Break-even sales = Margin of safety in pesos;
Margin of safety in pesos ÷ Actual (expected) sales = Margin of safety ratio.

Where: MSP = Margin of sales in pesos

MSu = Margin of sales in units
SP = Sales in pesos
Su = Sales in units
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 Operating Leverage

Operating Leverage – a measure of how sensitive net operating income is to a given percentage
change in sales. It is also considered as the extent to which a company uses fixed costs in its cost
structure.

Degree of Operating Leverage (DOL) – also called as Operating Leverage Factor (OLF), this
serves as multiplier in measuring the extent of the change in profit before tax resulting from the
change in sales.
CM
DOL =
PBT

Where: PBT = Profit before tax

To compute for the percentage change in profit:

%Δ in P = %Δ in S X DOL
 End of Topic
Please see complementary test bank for
practice problems and theories.

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 Dear, you.
Always be in pursuit for
the one you have not yet
become. Keep going!
Love,
Your UCB-JPIA family

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Reference:

Management Advisory Services. (n.d.). Retrieved August 14, 2020,

from https://kupdf.net/download/management-advisory-
services_5af4292ee2b6f5b566e73bd8_pdf

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