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In using CVP analysis, management should understand that:

 A change in UVC changes the CM % and the BEP.
 A change in SP changes the CM ratio and the BEP.
 A change in FC changes the BEP but not the CM ratio.
 A combined change in fixed and variable costs in the same direction
causes an extremely sharp change in the BEP.
 A change in SM also changes the BEP of each product.

The mix of fixed & variable costs depends on the firm's choice of
technology. For example, if a firm decides to automate its plant & reduce
DL costs, then FC will be high & VC will decrease. So a firm with high FC
must produce & sell more to breakeven than a firm with low FC. The lower
the FC are for a firm, the lower the breakeven quantity is.

For some firms, losses are normal during parts of the year, but others
experience losses even without the pronounced seasonality. When should
businesses continue to operate despite having the losses currently? For as
long as they generate a positive CM, then they should continue to operate
because their losses would be greater if they stopped operating.

MARGINAL INCOME is the increase in income or decrease in loss arising

from additional units produced and sold.

The UCM is a measure of the increase in profit for a unit increase in sales.
The CM ratio can be used to predict the change in TCM that would result
from a given change in peso sales:

Change in peso sales x CM% = Change in CM

Relationship between CM and Net Income:

 The CM must first cover the FC. If it doesn't, then there is a LOSS.
 BEP is reached when the TCM = FC
 Once the BEP is reached, net income will increase by the amount of
the UCM for each additional unit sold.

Generally, a company should concentrate its sales efforts on the products

that have the highest CM ratio. A peso of sales will have the greatest
impact on net income if it comes from the product which has the highest
CM ratio.

Case A: The company's projected profit for the coming year is as follows:
Total Per Unit
Sales P 200,000 P 20
Less: Variable Costs 120,000 12
Contribution Margin P 80,000 P 8
Less: Fixed Costs 64,000 =====
OP P 16,000
=========
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Compute the additional profit that the company would earn if sales were P25,000
more than expected.

Case B: A company had a loss of P3 per unit when sales were 40,000 units.
when sales were 50,000 units, the company had a loss of P1.60 per
unit. Determine the BEP in units.
Analysis:
@ 40,000 u, OL is (P120,000);
@ 50,000 u, OL is (P 80,000); hence the differential loss is P40,000.
Therefore @ 60,000 u, the OL is (P40,000);
@ 70,000 u, the bottomline is zero so 70,000 u is the BEP.

OR

40 X – Y = - 120 40(4) – Y = -120

50 X – Y = - 80 160 - Y = -120
- Y = -120 - 40X - Y = -160 -120
Y = 40 X +120 Y = 280
50 X – (40X+120) = - 80
50 X – 40X-120 = -80 280,000 / 4 = 70,000 u
10X = 40 =======
X = 40/10
X =4

The margin of safety (MOS) is a cushion against sales decreases. The greater
the margin, the greater is the security. The MOS ratio is a useful measure for
comparing the risk of 2 alternative products or for assessing the risk in any given
product. The product with a relatively low MOS ratio is more risky and usually
requires more of management’s attention. Managers who face a low MOS may
wish to consider actions to increase sales or decrease costs. These will increase
the MOS and lower the risk of having losses.

A cost structure refers to the company’s relative composition of its VC and FC

which strongly influences the degree to which its profit respond to changes in SV.
A tool that managers use to choose between alternative cost structures is the
INDIFFERENCE POINT, the volume at which total costs, and hence profits are
the same under both cost structures. If the company operated at IP, the
alternative used would not matter because resulting profit would be the same. To
compute IP, set up an equation where each side represents the total cost of each
alternative.

At a volume below the IP, the alternative with the lower FC gives higher profits;
At a volume above the IP, the alternative with the higher FC is more profitable.

Case C: Kinna Company has decided to introduce a new product. The new
product can be manufactured by either a capital-intensive method or a
labor-intensive method. The mfg. method will not affect the quality of
the product. The estimated unit mfg.costs by the two methods follow:
Capital Labor
Intensive Intensive
Materials.................... P 5.00 P5.60
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Direct Labor................. 6.00 7.20

Variable factory overhead 3.00 4.80

Directly traceable incremental fixed factory overhead is expected to be

P2,440,000 if the capital-intensive method is chosen and P1,320,000 if the labor-
intensive method is chosen. Kinna's market research department has
recommended an introductory unit sales price of P30. Regardless of the mfg.
method chosen, the incremental fixed marketing expenses are estimated to be
P500,000 per year plus a variable marketing expense of P2 for each unit sold.

Required: a) Calculate the estimated BEP for the new product in annual units of
sales, if Kinna Company uses the:
(1) capital-intensive manufacturing method.
(2) labor-intensive manufacturing method.
b) Determine the annual sales volume at which the choice between
the two manufacturing methods would not make a difference.
(ICMA adapted)

When a company is operating at a volume above the BEP, the MOS becomes an
important part of CVP analysis. Closely related to MOS is the company's degree
of operating leverage (DOL).

Typically, highly labor-intensive firms have high VC and low FC and thus, have
low OL. Conversely, firms that are highly capital intensive or automated have a
cost structure of a low VC and high FC, thus providing a high OL. As they
become more automated, companies will face this type of cost structure and
become more dependent on volume to add profits. Clearly, a firm with high FC is
riskier because profits are very strongly affected by the level of activity.

CVP analysis is particularly important in planning the use of new manufacturing

technologies that have the potential to change the relationship between fixed and
variable costs. Risk differs from uncertainty in that under risk the probability
distributions of the variables are known; under uncertainty, they are not known.
MOS and OL are considered measures of risk. There are events , unknown when
plans are made, that can lower sales below the original expected level. The
potential effect of the risk that sales will fall short of planned levels, as influenced
by the relative proportion of fixed to variable manufacturing costs can be
measured by operating leverage, which is the ratio of the CM to profit. In
financial terms, OL is concerned with the relative mix of FC and VC in an entity. It
is sometimes possible to trade off FC for VC. As VC decrease, the UCM
increases, making the contribution of each unit sold that much greater. In such a
case, fluctuations in sales have an increased effect on profitability. Thus, firms
that have realized lower VC by increasing the proportion of FC will benefit with
greater increases in profits as sales increase than will firms with a lower
proportion of FC. FC are being used as leverage to increase profits. A high OL
indicates a high risk in the sense that a given change in sales will have a
relatively greater impact on profits. When SV is strong, a high level of leverage is
desirable, but when sales begin to fall, a lower level of leverage is preferable.
Each firm chooses the level of OL that is consistent with its competitive strategy.
For example, a firm with a dominant position in its market might choose a high
level of leverage to exploit its advantage. In contrast, a weaker firm might choose
the less risky low-leverage strategy. The DOL measures how a percentage
change in sales from the current level will affect company profits. It indicates how
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sensitive the company is to changes in sales volume or in the firm's revenues.

Such calculation assumes that FC do not increase when sales increase. The
DOL decreases the farther a company moves from its BEP. Thus, when the MOS
is small, the DOL is large. In fact, at breakeven, the DOL is infinite because any
increase from zero is an infinite percentage change. As the company moves
away from breakeven sales, the MOS increases, but the DOL declines. The MOS
will always be the reciprocal of the operating leverage factor (OLF) or DOL. If a
company is fairly near its BEP, then even small increases in sales can yield large
increases in profits. This explains why management will often work very hard for
only a small increase in sales volume.

CVP Analysis for Multi-Product Firm

SALES MIX means the relative combination in which company's products are
sold. It can be measured in units sold or in proportion of peso sales. However, for
CVP analysis, we must use the SM expressed in units. Some products are sold
and used together so that the sales of the products are associated. For example,
some products are normally sold together, such as tables and chairs, cups and
saucers, wallpaper and paste. In other cases, though the products are not
always sold together, they are used together so that the sale of one product
influences the sale of the other product such as cameras and films, razors and
blades, golf clubs and golf balls. These are what we call COMPLEMENTARY
PRODUCTS. A shift in the SM from high-margin items to low-margin items can
cause total profits to decrease even though total sales may increase.

Case D: Alza Company is planning to produce and sell 100,000 units of Chip A
at P8 a unit and 200,000 units of Chip B at P6 a unit. Variable costs are
30% of sales for Chip A and 25% of sales for Chip B.

Required: If the total planned OP is P250,000, what must the total FC be?

Case E: C2 Co. manufactures two products, L and Q. L sells for P20 and Q for
P15. Variable costs per unit are P12 and P10 for L and Q, respectively.
Total FC is P372,000. The management of C2 has targeted profit for
the coming year at P93,000. Two units of L are expected to sell for
every three units of Q sold during the period.
Compute the:
1. breakeven sales in units and in pesos
2. level of sales in units and in pesos necessary to achieve their profit goal.
Capital-Intensive Labor-Intensive
Item (automated) Company Company

The CM ratio for a given product

will tend to be relatively.... High Low

Operating leverage will tend to be.... High Low

In periods of increasing sales,

net income will tend to increase.... Rapidly Slowly

In periods of decreasing sales,

net income will tend to decrease.... Rapidly Slowly

The volatility of net income

with changes in sales will tend to be... Greater Less

The break-even point will tend to be.... Higher Lower

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The MS at a given level of

sales will tend to be.... Lower Higher

The overall degree of risk associated with

Operating activities will tend to be … Greater Less