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MAS-LECTURE NOTES ARMIN GLENN ARANETA, CPA

Cost-Volume-Profit Analysis

Cost-Volume-Profit Analysis (CVP Analysis) – examines the behavior of total revenues, total
costs, and operating income as changes occur in the output level, selling price, variable costs per
unit, or fixed costs of a product.

Break-even Sales – that point of activity level (sales volume) where total revenues equal total
costs.

Methods of computing Break-even Point

1. Equation Method or algebraic approach


2. Contribution Margin Method or formula approach
3. Graphic Approach

GRAPHS OF CVP RELATIONSHIPS

The Cost-Volume-Profit graph depicts the relationships among cost, volume, and profits.

Pesos Total Revenue


Profit

Total Cost

Break-even Point

Loss

` Units Sold

Assumptions of Cost-Volume-Profit Analysis

1. Changes in the level of revenues and costs arise only because of changes in the number of
product (or service) units produced and sold.

2. Total costs can be separated into a fixed component that does not vary with the output level
and a component that is variable with respect to the output level.

3. When represented graphically, the behavior of total revenues and total costs are linear
(represented as a straight line) in relation to output level; within the relevant range and time
period.

4. The selling price, variable cost per unit, and fixed costs are known and constant.
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5. The analysis either covers a single product or assumes that the sales mix, when multiple
products are sold, will remain constant as the level of total units sold changes.

6. All revenues and costs can be added and compared without taking into account the time value
of money.

Multiple-Product Analysis

When CVP analysis is used for a multiple-product firm, the product is defined as a
package of products. For example, if the sales mix is 3:1 for Products A and G, the package
would consist of 3 units of Product A and 1 unit of Product G.

Break-even in packages for a multiple-product firm is then calculated as:

Break-even packages = Fixed Costs/weighted average contribution margin

Sales Mix – the composition of total sales in terms of various products, i.e., the percentage of
each product included in total sales.

CVP Analysis and Risk and Uncertainties

Margin of Safety – indicates the amount by which actual or planned sales may be reduced
without incurring a loss. It is the difference between actual or planned sales volume and break-
even sales.

Operating Leverage – a measure of the extent to which fixed costs is being used in an
organization. The greater the fixed costs in relation to variable cost, the greater is the operating
leverage available and the greater is the sensitivity of income to changes in sales.

Degree of Operating Leverage (DOL) – a measure of sensitivity of profit changes to changes in


sales volume. DOL measures the percentage of change in profit that results from a percentage of
change in sales.

DOL = CM/Operating Income

The higher the degree of operating leverage, the greater the change in profit when sales change.

Percentage Change in Profit = DOL x % change in Sales

Factors affecting Profit

1. Selling price per unit


2. Variable cost per unit
3. Volume or number of units
4. Fixed costs
5. Sales mix
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Practice Problems:

Problem 1. Mr. Coolhands Company produces a single product. The projected Statement of
Financial Performance for the coming year follows:

Sales (50, 000 units @ P45) P 2, 250, 000


Less: Variable cost 1, 305, 000
Contribution margin P 945, 000
Less: Fixed costs 812, 700
Operating income P 132, 300

Requirements:

1. Compute contribution margin per unit and the units that must be sold to break even.
2. Suppose that 30, 000 units are sold above breakeven. What is the operating income?
3. Compute the contribution margin ratio and the breakeven point in pesos. Suppose that
revenues are 200, 000 more than expected, what would be the total operating income be?

Refer to the original data in answering each of the following questions:


4. Determine the number of units that must be sold to earn before tax profit of P 158, 760.
5. Compute the amount of peso sales that must be generated to earn after tax profit of P 138, 915.
(The income tax rate is 30%)
6. Compute the amount of peso sales that must be generated to earn before tax profit of 22% of
sales.
7. How many units must be sold to earn before tax profit per unit of P 3.90?
8. Compute the margin of safety in units and in pesos. What is the margin of safety ratio?
9. Compute the degree of operating leverage (rounded to two decimal places). Compute the new
profit level if sales are 20% higher than expected.

Problem 2. Eggcell (EC) is a top-selling electronic spreadsheet product. EC is about to release


version 9.0. It divides its customers into two groups: new customers and upgrade customers
(those who previously purchased EC, 8.0 or earlier versions). Although the same physical
product is provided to each customer group, sizable differences exist in selling prices and
variable marketing costs:

New Customers Upgrade Customers


Selling price P 275 P 100
Variable cots:
Manufacturing P 35 P 35
Marketing 65 100 15 50
Contribution margin P 175 P 50

The fixed costs of EC, 9.0 are P 15 million. The planned sales mix in units is 60% new
customers and 40% upgrade customers.

Requirements:

1. What is the EC, 9.0 breakeven point in units, assuming that the planned 60%:40% sales mix is
attained?
2. If the sales mix is attained, what is the operating income when 220, 000 total units are sold?
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3. Show how the breakeven point in units changes with the following customer mixes:
a. New 40% and Upgrade 60%
b. New 80% and Upgrade 20%

Problem 3. Anne Cosmetics makes two facial creams, Dirty-Alis and Totalinis. Data are as
follows:

Dirty-Alis Totalinis
Price per unit P 18 P 24
Variable cost per unit 9 6

Requirements:

1. If the sales mix in pesos is 60% for Dirty-Alis and 40% for Totalinis, what is the weighted
average contribution margin percentage? What peso sales are needed to earn a profit of P 60, 000
per month? At that level, how many units of each product, and total units, will the company sell?

2. If the sales mix is 50% for each product in units, what is the weighted average unit
contribution margin? What unit sales are needed to earn a profit of P 60, 000 per month? Why is
this number of units different form the answer you found in requirement 1? What are the total
peso sales and why is this figure different from your answer to requirement 1?

3. Suppose that the company is operating at the level of sales you calculated in requirement 1,
earning a P 60, 000 monthly profit. The sales manager believes that it is possible to persuade
customers to switch to Totalinis from Dirty-Alis by increasing advertising expenses. He thinks
that P 8, 000 additional monthly advertising would change the mix to 40% to Dirty-Alis and 60%
to Totalinis. Total peso sales will not change, only the mix. What effect would the campaign
have on profit.

Problem 4. Indifference Point. Poreber sells one of its products, a piece of soft-sided pillow,
for P 600. Variable cost per unit is P 340, and monthly fixed costs are P 600, 000. A combination
of changes in the way Poreber produces and sells this product could reduce variable cost per unit
by P 40 but increase monthly fixed cost to P 1, 000, 000.

Requirement: Determine the indifference point of the two alternatives.

Problem 5. Plant Cha Company recently expanded its manufacturing capacity, which will allow
it to produce up to 15, 000 units of Irons of the Classic model or the Upgraded model. The Sales
Department assures management that it can sell between 9. 000 units and 13, 000 units of either
product this year. Because the models are very similar, Plant Cha will produce only one of the
two models.

The following information was compiled by the Accounting Department.


Classic Upgraded
Selling price P 88.00 P 80.00
Variable Costs 52.80 52.80

Fixed costs will total P 369, 600 if the Classic model is produced but will be only P 316, 800 if
the Upgraded model is produced. Plant Cha Company is subject to a 40% income tax rate.
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Requirements:

1. Compute the contribution margin for each product line?

2. If Plant Cha Company desires an after-tax net income of P 22, 080, how many units of
Upgraded model will the company have to sell?

3. How much would the variable cost per unit of the Upgraded model have to change before it
had the same break-even point in units as the Classic model?

4. Suppose the variable cost per unit of the Upgraded model decreases by 10%, and the total
fixed cost of Upgraded model increases by 10%. Compute the new break-even point in units.

5. Suppose management decided to produce both products. If the two models are sold in equal
proportions, and total fixed costs amount to P 343, 200, what is the firm’s break-even point in
units?

6. Suppose that Plant Cha Company decided to produce only one model of Iron. What is the total
sales revenue at which plant Cha Company would make the same profit or loss regardless of the
model it decided to produce?

7. If the Plant Cha sales department could guarantee the annual sale of 12, 000 units of either
model, which model would the company produce and why?

Problem 6. Relax Company and Recline Company both make rocking chairs. They have the
same production capacity, but Relax is more automated than Recline. At an output of 1, 000
chairs per year, the two companies have the following costs:

Relax Recline
Fixed costs P 400, 000 P 200, 000
Variable costs at P 100 per chair 100, 000
Variable costs at P 300 per chair 300, 000
Total cost P 500, 000 P 500, 000

Assuming both companies sell chairs for P 700 each and that there are no other costs or expenses
for the two firms,

Requirements:

1. Which company will lose the least money if production and sales fall to 500 chairs per year?

2. How much would each company lose at production and sales level of 500 chairs per year?

3. How much would each company make at production and sales level of 2, 000 chairs per year?
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Problem 7. Following are the data taken form the most recent SFPer of Cleene Corporation:

Sales (45, 000 units @ P10 per unit) P 450, 000


Less: Cost of goods sod:
Direct materials P 90, 000
Direct Labor 78, 300
Manufacturing overhead 98, 500 P 266, 800
Gross margin 183, 200
Less: Operating Expense:

Selling expenses:
Variable:
Sales commissions P 27, 000
Shipping 5, 400 32, 400
Fixed (advertising, salaries) 120, 000

Administrative:
Variable (billing and other) 1, 800
Fixed (salaries and other) 48, 000 49, 800
Net operating loss: P (19, 000)

All variable expenses in the company vary in terms of unit sold, except for sales commissions
which are based on peso sales. Variable manufacturing overhead is P 0.30 per unit. There was no
beginning or ending inventories. Cleene Corporation’s plant has a capacity of 75, 000 units per
year.

The company has been at a loss for several years. Management is studying several possible
courses of action to determine what should be done to make next year profitable.

Requirements:

1. The president is considering two proposals prepared by his staff:


a. For next year, the vice president would like to reduce the unit selling price by 20%.
She is certain that this would fill the plant to capacity.

b. For next year, the sales manager would like to reduce the unit selling price by 20%,
increase the sales commission to 9% of sales, and increase advertising by P 100, 000.
Based on marketing studies, he is confident this would increase unit sales by one-third.
Compute the amounts of income, one under the vice president’s proposal and the other
one under the sales manager’s proposal.

2. Refer to the original data. The president believes it would be a mistake to change the unit
selling price. Instead, he wants to use less costly raw materials, thereby reducing unit costs by P
0.70. How many units would have to be sold next year to earn a target profit of P 30, 200?

3. Refer to the original data. Cleene Corporation’s board of directors believes that the company’s
problem lies in inadequate promotion. By how much can advertising be increased and still allow
the company to earn a target profit of 4.5% on sale of 60, 000 units?
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4. Refer to the original data. The company has been approached by an overseas distributor who
wants to purchase 9, 5000 units on a special price basis. There would be no sales commission on
these units. However, shipping costs would be increased by 50% and variable administrative cost
would be reduced by 25%. In addition, a P 5, 700 special insurance fees would have to be paid
by Cleene Corporation to protect the goods in transit. What unit price would have to be quoted
on the 9, 500 units to allow the company to earn a profit of P 14, 250 on total operations?
Regular business would not be affected by this special order.

Problem 8. Snake Company has fixed expenses of P 60, 000, a contribution margin ratio of 40%
and a margin of safety ratio of 25% for a quarter’s operations.

Required: Compute the company’s profit for the quarter.

Problem 9. The accountant of Cyrus Company is trying to prepare comparative income


statements for the first two months of the year 2015. However, he obtained only the following
information:

January February
Sales P 500, 000
Variable cost ratio 60% 64%
Margin of safety ratio 30% 24%

Changes in the given ratio are due to the decrease in sales and fixed costs.

Requirements: Compute for the following:

1. Decrease in sales.
2. Decrease in fixed costs.
3. Breakeven point for February.

Problem 10. Orange na Bago Company’s break-even sales would increase from P 240, 000 to P
320, 000 if fixed costs would go up by P 32, 000.

Requirements: Assuming no change in the selling price and variable costs per unit, compute:

1. the company’s variable cost ratio.


2. the company’s fixed cost before and after the increase of P 32, 000.

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