STRATEGIC

COST
MANAGEMENT
A B R A H A M R A M O S, C P A
THE RELATIONSHIP
COST-VOLUME-
BETWEEN COSTS
VOLUME AND
PROFITS
PROFIT
ANALYSIS
INTRODUCTION
TO COST-VOLUME-PROFIT ANALYSIS

Cost-volume profit analysis is a tool than can be used for planning and decision-making. It is a systematic examination
of the relationships between costs, cost drivers/activity and profit.

The Cost-Volume-Profit Analysis (CVP Analysis) aims to answer the following questions:
1. How many units does the entity need to breakeven during the year?
2. How much will the net profit of the entity grow if additional units were to be produced?
3. What will be the new break even point when additional fixed costs are introduced?

It is very important to be able to determine the cost behavior in order to properly perform the CVP Analysis.
APPLICATION OF CVP ANALYSIS

The Application
of CVP

Types of
Type or product Marketing productive
Pricing policy
to produce or sell strategy facilities to
acquire
ELEMENTS OF CVP ANALYSIS

Elements of
CVP Analysis

Sales:
Variable cost Total Fixed
1. Selling price Sales Mix
2. Sales volume
per unit Costs
CLASSIFICATION OF COSTS UNDER CVP

All costs of the company, whether manufacturing, marketing and administrative expenses, are taken into account. For
CVP analysis, costs are classified only as either variable or fixed costs.

Variable costs are all costs that increase as more units are sold (DM, DL, VOH and variable selling and administrative).
Fixed costs are costs that remain the same in total regardless of the number of units produced or sold.

CVP analysis uses the contribution margin format:

Sales xx
Less:Variable costs (xx)
Contribution Margin xx
Less: Fixed costs (xx)
Income before tax xx
THE INHERENT
ASSUMPTIONS OF CVP ANALYSIS

The assumptions involving CVP analysis:

1. All costs are either variable or fixed
2. Cost and revenue relationships are predictable and linear over a relevant range of activity and a specified period
of time.
3. The selling prices and costs are assumed to be known.
4. Selling prices per unit and market conditions remain unchanged.
5. Production equal sales (i.e. there is no change in inventory).
6. If the company sell multiple product, sales mix is known and constant.
7. Technology, as well as productive efficiency, is constant.
8. The time value of money is ignored.
THE BREAK-EVEN ANALYSIS

CVP analysis may be used to determine the number of units or sales volume to break-even. Break-even point (BEP) is
when total costs is equal to total revenue, thus there is neither profit nor loss. The BEP is where all fixed costs are
covered and any additional units add only variable costs. Thus, contribution margin above BEP will result to profit.
There are two ways to obtain the BEP.

1. Formula method = Operating income = Sales revenue – Variable costs – Fixed costs
2. Graphical method = Plot the sales/costs at the y-axis and the volume/units at the x-axis. The point where the
total revenue line meets the total cost line is the break-even point.
FORMULA METHOD

The general formula for the break-even point in units is

1. Operating Income = Sales revenue – Variable Expenses – Fixed Costs
2. 0 = (Selling price x number of units) – (Variable cost per unit x number of units) – Total fixed costs
3. Fixed Costs = (Selling price – Variable cost per unit) number of units
4. Number of UnitsBEP = _____ Total Fixed Costs
(Selling Price – Variable Cost per unit)
FORMULA METHOD

The general formula for the break-even point in sales is

1. Operating Income = Sales revenue – Variable Expenses – Fixed Costs
2. 0 = Sales – (Variable Cost Ratio x Sales) – Total fixed costs
3. Fixed Costs = Sales(1 – Variable Cost Ratio)
4. SalesBEP = _____ Total Fixed Costs
(Contribution Margin Ratio)
GRAPHICAL METHOD

1. Break-even chart
GRAPHICAL METHOD

2. Profit-volume graph
SAMPLE COMPUTATION - BEP
SAMPLE COMPUTATION

1. BEP in units
Total fixed costs = 800,000 + 400,000 = 1,200,000
Selling price = 400
Variable costs = 220 (variable product costs) + 20 (400 x 5%; variable selling) = 240

BEPunits = 1,200,000 / (400 – 240) = 7,500 units

SAMPLE COMPUTATION

2. BEP in sales revenue

Total fixed costs = 800,000 + 400,000 = 1,200,000
Selling price = 400
Variable costs = 220 (variable product costs) + 20 (400 x 5%; variable selling) = 240
Contribution margin ratio = CM/unit / Sales = 160/400 = 40%

BEPsales = 1,200,000 / 40% = 3,000,000

PROOF

The Contribution Margin Statement:

Sales (400 x 7,500) 3,000,000

Less:Variable costs (240 x 7,500) 1,800,000
Contribution margin 1,200,000
Less: Fixed costs 1,200,000
Operating Income –

The break-even point is the point where there is no income nor loss. Fixed costs equals the contribution margin.
TARGET PROFIT

1. Before tax target profit

Total Fixed Costs + Target profit
 Number of units required = (Selling Price – Variable Cost per unit)
 Sales volume required = Total Fixed Costs + Target profit
(Contribution Margin Ratio)

2. After-tax target profit Target After-Tax Profit

Total Fixed Costs + (1 – Tax Rate)
 Number of units required = (Selling Price – Variable Cost per unit)
Target After-Tax Profit
Total Fixed Costs+ (1 – Tax Rate)
 Sales volume required = (Contribution Margin Ratio)
SAMPLE COMPUTATION – TARGET PROFIT

Further assume that Blazin-boards wants to earn $240,000 operating income.

SAMPLE COMPUTATION

1. Required number of units

Total fixed costs = 800,000 + 400,000 = 1,200,000
Selling price = 400
Variable costs = 220 (variable product costs) + 20 (400 x 5%; variable selling) = 240
Target profit = 240,000 (before-tax)

BEPunits = 1,200,000 +240,000 / (400 – 240) = 9,000 units

SAMPLE COMPUTATION

2. Required sales revenue

Total fixed costs = 800,000 + 400,000 = 1,200,000
Selling price = 400
Variable costs = 220 (variable product costs) + 20 (400 x 5%; variable selling) = 240
Contribution margin ratio = CM/unit / Sales = 160/400 = 40%
Target profit = 240,000 (before-tax)

BEPsales = 1,200,000 + 240,000 / 40% = 3,600,000

PROOF

The Contribution Margin Statement:

Sales (400 x 9,000) 3,600,000

Less:Variable costs (240 x 9,000) 2,160,000
Contribution margin 1,440,000
Less: Fixed costs 1,200,000
Operating Income 240,000

Producing goods beyond the break-even point results to profit for the firm.
SAMPLE COMPUTATION – AFTER TAX

Further assume that Blazin-boards wants to earn $140,000 net income. Tax-rate is 30%
SAMPLE COMPUTATION

1. Required number of units

Total fixed costs = 800,000 + 400,000 = 1,200,000
Selling price = 400
Variable costs = 220 (variable product costs) + 20 (400 x 5%; variable selling) = 240
Target profit = 140,000 (After-tax)
Tax rate = 30%

Requiredunits = 1,200,000 + [140,000/0.7] / (400 – 240) = 8,750 units

SAMPLE COMPUTATION

2. Required sales revenue

Total fixed costs = 800,000 + 400,000 = 1,200,000
Selling price = 400
Variable costs = 220 (variable product costs) + 20 (400 x 5%; variable selling) = 240
Contribution margin ratio = CM/unit / Sales = 160/400 = 40%
Target profit = 140,000 (After-tax)
Tax rate = 30%

Requiredsales = 1,200,000 + [140,000/0.7] / 40% = 3,500,000

PROOF

The Contribution Margin Statement:

Sales (400 x 8,750) 3,500,000

Less:Variable costs (240 x 8,750) 2,100,000
Contribution margin 1,400,000
Less: Fixed costs 1,200,000
Operating Income 200,000
Less: Tax (200,000 x 30%) 60,000
Net Income 140,000
MULTI-PRODUCT SETTING

Here we introduce sales mix in the CVP analysis. An organization selling multiple products has their own relative
proportion of each type of product sold. This is known as the sales mix. The weighted average contribution
margin will be introduced to the equation. This is the average of the several products’ unit contribution margin, weighted
by the relative sales proportion of each product. Refer to the sample below:

Cheesecakes and Cookies are being sold in a 9:1 ratio. Selling price are P500 and P100, respectively. While variable
cost per unit are P240 and P36, respectively.

WA. Contribution margin per unit = (90% x 260) + (10% x 64) = P240.4
WA. Contribution margin percentage = (90% x 52%) + (10% x 64%) = 53.2%
MULTI-PRODUCT SETTING

An important question is can we just compute the unit contribution margin for each product instead of getting the
weighted average contribution margin? This is possible if there were no common fixed costs which are allocated to
each product line. Thus, we may instead view the break-even point equation as a single product after factoring in the
sales mix. Total fixed costs included common and direct.

_____ Total Fixed Costs

1. BEPunits =
(Weighted Ave. CM/unit)

2. BEPSales = _____ Total Fixed Costs

(Weighted Ave. CM%)

3. Composite BEP = BEPunits / Sales Mix

SAMPLE COMPUTATION – MULTIPRODUCT
SAMPLE COMPUTATION

1. BEP in units
Total fixed costs = 800,000 + 550,000 = 1,350,000
Sales mix = 4:1
Selling price = 400 (Regular); 600 (Deluxe)
Unit variable costs = 240 (Regular); 300 (Deluxe)
WA. CM/unit = (4/5x 160) + (1/5 x 300) = 188

BEP in units = 1,350,000 / 188 = 7,181

Number of packages/Composite BEP = 7,181 / 5 = 1,436
SAMPLE COMPUTATION

2. BEP in sales
Total fixed costs = 800,000 + 550,000 = 1,350,000
Sales mix = 4:1
Selling price = 400 (Regular); 600 (Deluxe)
Unit variable costs = 240 (Regular); 300 (Deluxe)
WA. CM% = (4/5x 40%) + (1/5 x 50%) = 42%

BEP in sales = 1,350,000 / 42% = 3,214,286

RISK AND UNCERTAINTY –
MARGIN OF SAFETY & OPERATING LEVERAGE

An important assumption of the CVP analysis is that both sales and costs are known with certainty. But in actual
scenarios, this is rarely the case. Risk and uncertainty are a part of the business decision and must be considered.

The margin of safety is the difference between the current or budgeted sales revenue less its break-even sales
revenue. The safety margin gives management a feel for how close projected operations are to the organization’s
break-even point.

The operating leverage is concerned with the usage of fixed costs in an organization. Firms may decrease variable
costs per unit, causing contribution margin per unit to increase. The effect changes in sales on profitability increases.
The greater the fixed cost proportion, as compared to variable costs, will benefit the firm with greater increases in
profits as sales increases. Unfortunately, when sales decrease the organization will also suffer greater losses.
RISK AND UNCERTAINTY –
MARGIN OF SAFETY & OPERATING LEVERAGE

1. MOSsales = Current/Budgeted Sales – Break-even point in sales

2. MOSunits = Current/Budgeted Sales in units – Break-even point in units
3. MOS% = Margin of Safety or 1
Current/Budgeted Sales DOL

4. Degree of operating leverage = % Profit = % Sales x DOL or Contribution Margin

EBIT
SAMPLE COMPUTATION – MARGIN OF SAFETY
SAMPLE COMPUTATION

1. MOS in units
Total fixed costs = 800,000 + 400,000 = 1,200,000
Selling price = 400
Variable costs = 220 (variable product costs) + 20 (400 x 5%; variable selling) = 240
BEPunits = 1,200,000 / (400 – 240) = 7,500 units
Planned sales in units = 10,000

Margin of safety = 10,000 – 7,500 = 2,500 units

SAMPLE COMPUTATION

2. MOS in sales
Total fixed costs = 800,000 + 400,000 = 1,200,000
Selling price = 400
Variable costs = 220 (variable product costs) + 20 (400 x 5%; variable selling) = 240
BEPsales = 1,200,000 / (40%) = 3,000,000
Planned sales = 10,000 x 400 = 4,000,000

Margin of safety = 4,000,000 – 3,000,000 = 1,000,000

SAMPLE COMPUTATION – OPERATING LEVERAGE

What would happen to profit if sales increase by 40%?

SAMPLE COMPUTATION

1. Degree of operating leverage 2. Degree of operating leverage

Automated System Manual System
Contribution margin = 500,000 Contribution margin = 200,000
Operating income = 125,000 Operating income = 100,00

DOL = 500,000 / 125,000 = 4x DOL = 200,000 / 100,000 = 2x

SAMPLE COMPUTATION

3. Degree of operating leverage 4. Degree of operating leverage

Increase in sales = 40% Increase in sales = 40%
DOL = 4x DOL = 2x

Change in Profit = 40% x 4 = 160% increase Change in Profit = 40% x 2 = 80% increase
Increase in profit = 125,000 x 1.6 = 200,000 Increase in profit = 100,000 x 0.8 = 80,000
New profit after increase in sales = 325,000 New profit after increase in sales = 180,000
COST-VOLUME-PROFIT
ANALYSIS THE END