LEARNING MATERIALS IN FM 113 (FINANCIAL CONTROLLERSHIP)

Lesson 1: Financial Controllership: An overview

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Learning Outcomes:
After this lesson, students should have:
1. explained financial controllership; and
2. distinguished controllership from treasurership.
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Key Concepts

Financial Controllership is a management function that supervises the accounting and

financial reporting
of an organization. It is responsible in the implementation and monitoring of internal controls.

What are Internal Controls?

Internal controls is a process, effected by an entity’s Board of Directors, management and other
personnel,
designed to provide reasonable assurance regarding the achievement of objectives in the
following categories:
 effectiveness and efficiency of operations;
 reliability of financial reporting; and
 compliance with rules and regulations.

Management must control identified risk to help the Company:

 achieve its performance and profitability targets;
 prevent loss of resources;
 ensure reliable financial reporting; and
 ensure compliance with rules and regulations, avoiding damage to its reputation and
other consequences.

In summary, internal controls can help the company get where it wants to go, and avoid pitfalls
and surprises along the way.

Control definition reflects certain fundamental concepts:

 Internal control is a process. It’s a means to an end, not an end in itself.
 Internal control is effected by people. It’s not merely policy manuals and forms, but
people at every level of an organization.
 Internal control can be expected to provide only reasonable assurance, not absolute
assurance, to an entity’s management and board.

Objectives of Internal Control

Internal controls are established to further strengthen:
 The reliability and integrity of information.
 Compliance with policies, plans, procedures, laws and regulations.
 The safeguarding of assets.
 The economical and efficient use of resources.
 The accomplishment of established objectives and goals for operations and programs.

CONTROLLERSHIP VS. TREASURERSHIP

The controllership functions are accounting functions while the treasurership functions are finance
Function.
Lesson 2: Cost Terminology and Concepts

COST TERMINOLOGY AND CONCEPTS

Cost Behavior and Classification
Management accounting gathers information according to the purpose for which it is going to be used. The
same basic information originating in the organization’s transactions is summarized in different ways for
different uses. The data collection needs to be flexible enough to provide the possibility of combining
information in different ways.
Cost is defined as a foregoing or a sacrifice measured in monetary terms, incurred or potentially to be
incurred to achieve an objective. Sacrifice or foregoing means current or future decreases in cash or other
resources. There are two kinds of cost, namely:
1. Unexpired cost – this is a kind of cost which is considered as an assets.
2. Expired cost – this is a kind of cost which represents expense or loss.
As differentiated from cost, expense is a kind of expired cost wherein benefit is received. Loss on the other
hand, is a kind of cost where no benefit is received.

Classification of Cost
It is important to realize that there are different cost concepts for different purposes and no single concept
is relevant to all situations. Cost may be classified by the following manner.
A. Tendency to vary with volume of activity
Costs may be classified based on their behavior in relation to a change in activity level in the short-
term within the relevant change. In the long-term, all costs are variable because management must
make a decision to incur those costs. For example, the decision to build a new factory causes a new
“fixed” cost to be incurred. Short-term fixed and variable costs are used to plan budgets and analyze
variances.
1. Variable costs – Total variable costs vary directly with the level of production because they are
constant for each unit. For example, if each unit needs two direct labor hours to produce, making
two units will require four hours and three units will require a total of six hours, etc.
2. Fixed costs – These costs remain fixed in total over the relevant range for a specific period of
time. They will, therefore, vary per unit when divided by the number of units produced and applied
to a cost object. If total fixed costs are P100, 000 and 100 units are to be produced, fixed costs per
unit would be P1, 000. However, if P1, 000 units were produced, fixed costs would be P100 per unit.
3. Semi-variable costs – Costs that increases as volume increases but not in direct proportion to the
activity level. It contains both fixed and variable cost elements. Electricity and water expenses are
examples of semi-variable costs.

B. Natural classification
1. Manufacturing cost or production cost – This includes costs used in production such as direct
materials, direct labor and factory overhead.
2. Commercial or operating expenses – are of two kinds:
a. Marketing or selling expenses – Also known as distribution expenses. These covers the
expenses incurred in making sales and delivery of products sold.
b. Administrative of general expenses – These include expenses incurred in direction, control
and administration of the business.

C. Applicability to Accounting Period

1. Capital expenditures – are those that benefit the current as well as the future periods and are
classified as assets. A major overhaul of equipment is considered a capital expenditure.
 2. Revenue expenditures – are intended to benefit only the current period and is classified as an
expense. Minor repairs are considered revenue are considered revenue expenditures and are
expensed outright when incurred.

D. Costs for Planning and Control

1. Budgeted costs – These are predetermined costs that may be incurred in undertaking a plan or
activity. In preparing budgets, standard costs play a vital role in the determination of estimated
costs. Oftentimes after the plan or activity is undertaken, the actual costs incurred and the
budgeted costs are compared. The difference between the actual costs and the budgeted costs,
also known as the variance, are analyzed and studied for control purposes.
2. Standard costs – are carefully (or scientifically) predetermined costs established by management
to be used in preparing budgets for comparison with actual costs. In most cases, standard costs are
considered as what the management thinks a cost should be.

E. In Relation to the Product

1. Direct materials – These costs relate to the materials that become part of the finished product,
including packaging, and which can be feasibly and cost effectively traced to the product on a per
unit basis. The following are generally included as direct materials costs: invoice price less
discounts (whether taken or not); sales taxes; customs duties; delivery costs paid to vendors; cost
of delivery containers, net of deposit refunds.

2. Direct labor – These costs relate to the work that is performed directly on the product and which
can be cost effectively traced and attached to the product on a per unit basis. The following are
generally included as elements of direct labor cost: basic compensation, cost of living allowances.

3. Overhead – This is also called manufacturing overhead, factory overhead, or burden. It includes all
costs other than direct labor and direct materials that are part of making the product but which are
not directly traceable to a specific product. Cost accumulated in the overhead account may be
either indirect variable costs, such as indirect materials, or indirect fixed costs, such as depreciation
on factory plant and equipment.
a. Indirect materials – These include materials that are used in the manufacturing process which
either do not become part of the product (such as solvents and cleaning fluids), or do become a
part of the product but which are not cost effectively traceable to the product (such as paints,
varnishes, nails, screws, etc). These costs become part of factory overhead and are attached to
the product or cost object through the overhead application process.
b. Indirect labor – This is factory labor that cannot be cost effectively traced to the product.
Examples include janitors, plant security personnel, materials handling operators, and
inspection workers. These costs are a component of manufacturing overhead. Technically,
indirect labor does not include manufacturing supervisors’ or managers’ salaries. Such items
are more properly treated as a separate element of manufacturing overhead.

F. In Relation to the Department

1. Direct costs – These are the costs that are identifiable with the department. These are also
costs that a particular department solely incurs. The salary of a sales manager is a direct cost to
the sales department of a company.
2. Indirect costs – are the costs that cannot be easily identified with a department because this
type of cost is not solely incurred by a particular department. Indirect costs are usually shared
by two or more departments that are benefited. Example, the electricity expense of the whole
building that houses more than one department should be allocated to the departments
concerned. Some costs are considered direct to a particular department and at the same time
indirect to other departments. Example, the salary of a maintenance personnel is considered a
direct cost to the maintenance department but assuming that the maintenance personnel
maintains cleanliness of the sales department, his salary may be considered as an indirect cost
to the sales department.
G. For Analytical Processes
1. Relevant costs – In order for costs to be important in making a decision, they must differ among
the alternatives under consideration. Such costs exist in the future and their incurrence is
dependent on the choice made. Another term for this is incremental or marginal costs. Example,
given two alternatives:
a. To go home by riding in a taxi where the fare is P70.
b. To go home by riding in a jeep, the fare is P10.
The fare in going home by either riding in a taxi cab or a jeepney is the relevant cost in this
decision situation.
2. Irrelevant costs – Costs which exist no matter which alternative is selected are irrelevant to the
decision process. A sunk cost is an example of this.

H. For Decision Making

 1. Differential cost – Refers to the difference in cost between two alternatives. There are two kinds
of differential costs, namely:
a. Incremental differential cost – This happens when the decision results to increased cost.
From the example given above, should the decision make ride in a taxi, the incremental
differential cost is P60.
b. Decremental differential cost – This happens when the decision results to decreased cost. If
the decision maker in the situation above chooses to ride on a jeepney, the decremental
differential cost is P60.

2. Avoidable cost – This is sometimes called escapable cost. It is the cost that can be eliminated by
virtue of an alternative. It represents the cost savings arising from a decision to discontinue an
undertaking.

3. Out of pocket cost – The future outlay of financial resources as a consequence of a decision.
Example, the decision to buy snack after the class involves an out of pocket cost.

4. Imputed cost – A form of cost that does not involve actual outlay of cash but is considered as a
relevant cost for decision making. Imputed cost is only a hypothetical cost representing the usage
of a particular resource. Example, interest expense. The importance of the equivalent interest for a
borrowed capital that could have been invested somewhere else constitutes an imputed cost.

5. Opportunity costs – These are the benefits sacrificed by selecting one alternative over another
where the alternatives are mutually exclusive. Typically it is the revenue or profit associated with
the next best alternative. Opportunity costs are not transactional and do not normally represent
cash received or paid. They are used for decision-making purposes only. Example, given two
alternatives:
a. Work in the Philippines, with a salary of P15, 000 monthly
b. Work abroad with a salary of P75, 000 monthly.
If the decision is to work in the Philippines, the opportunity cost is P75, 000 monthly, while if the
decision is to work abroad, the opportunity cost is P15, 000 monthly. It should be understood that
decision making using financial data does not take into consideration qualitative information, it only
considers quantitative data.
6. Sunk cost – This is the cost that is already incurred and is therefore irrelevant for decision making.
Expenditures in the past are the result of foregone decisions where the chances of recovery are
almost zero.

I. Degree of Controllability
1. Controllable cost – a cost is considered controllable at a particular level of management if the
level has the power to authorize the cost.
2. Non-controllable cost – a cost is non-controllable when the level of management does not have
the power to authorize the expenditure.

J. Quality Costs – Experts have estimated the cost of quality for businesses is in the range of 10 to 30
percent of sales. Definitions of cost of quality vary, but one simple and effective definition is that of the
president of KODAK, who, in a recent annual report, said “It’s basically the sum of all costs that would
disappear if we did everything right the first time.” We can analyze and categorize quality costs in
several ways. The most common is a four-way classification:
1. Prevention cost – Incurred to avoid defects, which are units that do not meet specifications.
Examples: design costs, costs of improving production process and methods, costs of upgrading
worker skills and instilling in them the importance of quality, higher wages paid to workers who
produce higher quality work, preventive maintenance

2. Appraisal costs – Incurred to monitor and find defective units before they leave the plant.
Examples: inspections cost for materials, semi-finished units, and finished units, costs of automated
monitoring of processes and products, such as lasers that scan products for defects, cost of
maintaining a laboratory to test for conformance to specifications.

3. Internal failure costs – Incurred when a unit is found to be defective before it leaves the plant.
Examples: lost contribution margin on lost output, cost to repair or rework defective units, cost to
produce defective units that must be scrapped, cost of downtime on machinery while rework is
done, cost to readjust malfunctioning machinery

4. External failure costs – Incurred when customers find defective units. Examples: cost to repair or
replace returned units, cost or processing customer complaints, cost to send service people to
customer’s premises, ill-will of customers who might not buy from you again, and might inform
others of problems with your products.
TRADITIONAL MANUFACTURING INVENTORIES

Raw Materials inventory – This includes anything tangible that becomes part of the product or its
packaging. Materials are held in this account until they are requisitioned by the production department. In
a Just-in-Time (JIT) production system, raw materials are not stored in inventory. They are delivered
directly to the factory floor by the vendor “just as” they are needed in the production process. However,
small, modest materials inventory balances may be maintained to avoid stock-out risk.

Beginning raw materials inventory

+ purchases of new materials (both direct and indirect)
- ending raw materials inventory
= raw materials used

Work-In-Process (WIP) Inventory – Once production is begun, costs are accumulated in the work-in-
process account until the product is finished and transferred to the finished goods inventory. Note that the
cost flow through WIP is a summary of the cost of goods manufactured for the period. A WIP account is not
used in a JIT production system.
Beginning WIP
+ raw materials used (from # A above)
+ direct labor used
+ overhead
- ending WIP
= cost of goods manufactured

Finished Goods Inventory – This account shows the balance of finished product on hand ready to be
sold. Both the beginning and ending balances of this account are used to compute the cost of goods sold
on the income statement for the period.
Beginning finished goods
+ cost of goods manufactured (from #B above)
- ending finished goods
= cost of goods sold
ESTIMATING AND CONTROLLING COSTS
In business enterprise there are many different costs such as materials, wages, insurance, and taxes, and
each has its own peculiar characteristics. Even within a company, a particular type of cost will behave
differently depending upon the way a particular service or material is used by a division or a department. A
knowledge of how costs are affected by operations is essential in the budgeting process and the control of
costs.

Techniques of Cost Estimation

Cost studies are made continuously in as much as cost behavior may change over time as conditions
change. Management is constantly examining cost behavior in an effort to prepare better budgets through
more accurate cost prediction. The costs of projects or departments may be estimated or predicted by a
combination of two approaches:
1. engineering estimates of materials and work requirements
2. an examination of past cost behavior
Engineers who are familiar with the technical requirements will estimate the quantities of materials that
are needed for production and the labor or machine hours required for various operations. prices and rates
are applied to the physical measurements to obtain cost estimates. In the preparation of budgets, the
effect of changes in critical factors such as materials prices, labor rates, or machine hours of operation
must be considered in the prediction process and controlled to the extent possible in actual operations.

Past cost behavior is also studied as a guide in predicting costs. The future is seldom a duplication of the
past, yet a study of past cost behavior can be effectively utilized in the overall problem of cost allocation.

It may appear that costs that have already been incurred can be determined precisely. This is not always
true. For example, the cost of repairs may have been P600 at a time when a department operated at 300
hours and may have been P700 in another period of similar length. The rate of cost variability per hour
may not be determinable at a precise amount. As a general rule, the problem is estimating cost behavior,
which is, determining the average rate of cost variability.

Cost Segregation
Costs are segregated for the purpose of determining the rate of past cost variability. After the variable cost
is determined, the estimated fixed cost can be established. The methods employed are:
1. High-Low Point Method – In the high-low point method, the observed costs for various hours of
activity are listed in order from the highest number of hours in the range to the lowest. The difference
in hours between the highest level of activity and the lowest is divided into the difference in cost for
 the corresponding hours to arrive at a rate of variable cost per hour. For example, repair cost for
various hours of operation have been incurred in the past as follows:
Hours of Activity Repair Cost
80, 000 P 246, 000.00
70, 000 216, 000.00
60, 000 186, 000.00
50, 000 156, 000.00
40, 000 126, 000.00
30, 000 96, 000.00

The difference in hours is 50, 000 (80, 000-30,000), and the difference in cost is P150, 000
(P246, 000 – P96, 000). The variable repair cost is computed below:
Difference in cost = P150, 000 = P3. 00 variable cost per
Difference in 50, 000 hour
hours
the fixed cost can be estimated at any level (assuming a uniform rate of variability) by subtracting the
variable cost portion from the total cost. At 80, 000 hours, for example, the total cost is P246, 000; and
the total variable cost is P240, 000 (80, 000 hours x P3.00 variable cost per hour). Hence, the fixed cost
is P6, 000 (P246, 000 – P240, 000). In this example, it was assumed that a constant rate of variability
existed over the entire range. For every increase of 10, 000 hours, there was a P30, 000 increase in
cost. In some cases, however, the rate of variability may change, and this possibility must be
considered in cost analysis.
2. Least Squares Method
When cost characteristics are such that they do not always vary at a constant rate for each hour of
activity, the most frequently used alternative to the high-low point is the line of regression method
wherein an average rate of variability is computed. The costs for the various numbers of hours may be
plotted on a graph, an by visual inspection a line of average that represents the costs for the various
hours can be fitted to the data. The line of average for costs that are influenced by a factor such as
hours of activity is called the line of regression. The variable cost per hour is indicated by the slope of
the line, and the fixed cost is measured where the line begins at zero hours of activity.
When a cost has been classified as semi-variable, or when the analysts has no clear idea about the
behavior of a cost item, it is helpful to use the visual fit method (otherwise known as scattergraph
method) to plot recent observations of the cost at various activity levels. The resulting scatter diagram
helps analyst to visualize the relationship between cost and the level of activity (or cost driver).

Lesson 3: Cost Volume Profit Analysis

INTRODUCTION:
CVP analysis looks at the effect of sales volume variations on costs and operating profit. The analysis is
based on the classification of expenses as variable (expenses that vary in direct proportion to sales
volume) or fixed (expenses that remain unchanged over the long term, irrespective of the sales volume).
Accordingly, operating income is defined as follows:

Operating Income = Sales – Variable Costs – Fixed Costs

A CVP analysis is used to determine the sales volume required to achieve a specified profit level.
Therefore, the analysis reveals the break-even point where the sales volume yields a net operating
income of zero and the sales cutoff amount that generates the first dollar of profit.
Cost-volume profit analysis is an essential tool used to guide managerial, financial and investment
decisions.

COST-VOLUME PROFIT ANALYSIS

Contribution Margin and Contribution Margin Percentage
The first step required to perform a CVP analysis is to display the revenue and expense line items in a
Contribution Margin Income Statement and compute the Contribution Margin Ratio.

A simplified Contribution Margin Income Statement classifies the line items and ratios as follows:
Contribution Margin Income Statement
Table 1:
Statement Contribution Margin Income

Statement Item Amoun

t Percent
Income of

Sales P100 100%

Variable Costs (60) (60%)
Contribution
Margin P40 40%*

Fixed Costs (30) (30%)

 Operating Income P10 10%

Table 1: Contribution Margin Income Statement. The table shows the percent of income for sales,
contribution margin, and operating income are observed as totals, after variable and fixed cost deductions.

* Contribution Margin Percentage

The method relies on the following assumptions:
 Sales price per unit is constant (i.e. each unit is sold at the same price);
 Variable costs per unit are constant (i.e. each unit costs the same amount);
 Total fixed costs are constant (i.e. costs such as rent, property taxes or insurance do not vary with
sales over the long term);
 Everything produced is sold;
 Costs are only affected because activity changes.
The equation: Operating Income = Sales – Variable Costs – Fixed Costs

Sales = units sold X price per unit

Variable Costs = units sold X cost per unit
The first equation above can be expanded to highlight the components of each line item:
Operating Income = (units sold X price per unit) – (units sold X cost per unit) – Fixed Cost

The contribution margin is defined as Sales – Variable Costs. Therefore,

Contribution Margin (Peso) = (units sold X price per unit) – (units sold X cost per unit)
And the Contribution Margin Percentage (CM%) is computed as follows:
CM% = Contribution Margin (Peso) / Sales (Peso)

Accordingly, the following is another way to express the relationship between contribution margin, CM
percentage, and sales:
Contribution Margin (peso) = Sales (peso) X Contribution Margin %
The contribution margin percentage indicates the portion each peso of sales generates to pay for fixed
expenses (in our example, each peso of sales generates P.40 that is available to cover the fixed costs).
As variable costs change in direct proportion (i.e. in %) of revenue, the contribution margin also changes
in direct proportion to revenues, However, the contribution margin percentage remains the same.
Example:

Revenues P 100 ( 20 units) x P5)

Variable costs (60) 60% (20 units x 60%)
Contribution Margin P 40 40%

If revenues double:
Revenues P 200 (40 units X P5)
Fixed Costs (120) 60% (40 units X 60%)
Contribution Margin P 120 40%
f income ($100) minus $60 from variable costs equals $tio00 and deducting fixed costs of $120, that
regin.re
BREAK-EVEN POINT
The break-even point is reached when total costs and total revenues are equal, generating no gain or loss
(Operating Income of ₱0). Business operators use the calculation to determine how many product units
they need to sell at a given price point to break-even or to produce the first peso of profit.
Break-even analysis is also used in cost/profit analyses to verify how much incremental sales (or revenue)
is needed to justify new investments. The break-even sales can be computed using the three methods:
Illustrative Problem
Assume that Pacman Inc. manufactures and sells boxing gloves. The selling price for a pair of boxing
gloves is set at P2, 500. The leather material used for a pair of gloves costs P500, labor costs is P400,
indirect materials and indirect labor costs P300, other variable manufacturing costs per pair or gloves
amounts to P200, variable selling and administrative expenses per pair of gloves amounts to P100, fixed
manufacturing costs amount to P500, 000 and fixed selling and administrative costs total to P300, 000.
Compute for the break-even point in units and in pesos.

A. EQUATION METHOD
The variable costing income statement above can be expressed in equation form as follows:
Sales – Variable Costs – Fixed Costs = Profit
If the costs are transposed to the other side and since there is zero profit at break-even, the next equation
will be:
Sales = Variable Costs + Fixed Costs
Note that:
Sales = Selling price per unit (SPU) x No. of units (Q)
Variable Costs = Variable cost per unit x No. of units (Q)

To compute the break-even point:

(a) P2, 500Q = (P500+P400+P300+P200+P100) Q+(P500, 000+P300, 000)
(b) P2, 500Q – P1, 500Q = P800, 000
 (c) P1, 000Q = P800, 000
(d) Q = P800, 000/P1,000
(e) Q = 800 units
To break-even, the company needs to sell 800 pairs of boxing gloves. The 800 pairs of gloves or break-
even point in units is then multiplied by the selling price per pair of P2, 500 to compute for the break-
even point in pesos, P2, 000, 000

B. CONTRIBUTION MARGIN METHOD

Under this method, a formula is used in computing for break-even point. Consider equation letter (d):
Q = P800, 000/P1, 000
Recall that Q = number of units to break-even;
P800, 000 = total fixed costs;
P1, 000 = contribution margin/unit (selling price – variable costs)

Thus, we can derive the formula for break-even point as:

Break-even Point (Units) = Total Fixed Costs / Contribution Margin per Unit
Since contribution margin should be enough to cover total fixed costs, it is used as a divisor to
determine the number of units needed to be sold to break-even. The break-even point in pesos can be
computed by using contribution margin ratio which is contribution margin, presented as a percentage
of sales.
Break-even point (Pesos) = Total Fixed Costs / Contribution Margin
Ratio

Using the illustrative problem:

1. Compute for the contribution margin per unit (CMU) and contribution margin ratio (CMR):
Selling Price P 2, 500
Less: Variable costs
Direct materials P 500
Direct labor 400
Variable FOH 500
Manufacturing Margin per unit P 1, 400
Less: Variable selling and admin. expense 1, 100
Contribution Margin per unit P1, 000
Divide by: selling Price 2, 500
Contribution Margin Ratio 40%

2. Compute the total fixed costs

Fixed manufacturing costs P 500, 000
Fixed selling and 300, 000
administrative
Total fixed costs P 800, 000

3. Use formula to compute for BEP (units) and BEP (pesos)

BEP (units) = Total fixed costs / Contribution Margin per unit
= P800, 000 / P1, 000
= 800
BEP (pesos) = Total fixed costs / Contribution Margin Ratio
= P800, 000 / 40%
= P 2, 000, 000

PROOF OF BEP:
BEP in units 800
Multiply by: SP 2, 500.00
BEP in Pesos 2, 000, 000.00
Less: VC 1, 200, 000.00
CM 800, 000.00
Less: FC 800, 000.00
Profit / (Loss) - 0 -

At 800 units sold, the resulting contribution margin is just enough to cover fixed costs therefore
resulting to no profit and no loss or in other words, a break-even result of operations.

C. The following graph illustrates the break-even point based on the number of covers sold in a
restaurant
Figure 1: Break-even point based on the number of covers sold in a restaurant

Long description:
A line graph with covers sold on the x axis. the x axis starts at 0, and has increment markers in intervals of
50, increasing to a maximum of 400. There is a label for loss indicated from the start of the x axis ( 0 ) to
the fifth interval marker ( 250 ). There is a label for profit indicated on the x axis starting after the 250
marker. The Y axis is labeled for revenues, also starting at 0, incrementing by one thousand dollars every
marker, to a maximum of six thousand dollars. There are four lines graphed. One of which is a line
representing total sales, which increases at linear rate, starting point (0 , $0), and ending point (400,
$6000). Another line represents the total costs, which also increases at a linear rate. Its starting point is
(0 , $2500), and its ending point is (400, $5000). The total sales and total costs lines that are graphed,
intersect at the point (250, $4000) which is labeled as the break even point. the intersection of these two
lines emphasize (as the x axis profit label does, which was mentioned earlier in this description) that profit
occurs after 250 covers are sold. A fixed cost line is represented in this graph as well. Starting point ( 0 ,
$2500), and ending point (400, $2500). Showing that fixed costs are static and not dependent on covers
sold. The last line represents variable costs, starting point ( 0, $0) and ending point (400, $2500). Notice
the ending point of the total costs line equals the fixed cost and variable cost totals.
End long description.
 The Sales line starts at the origin (0 revenue for 0 covers) and grows in direct proportion to the number
of covers sold;
 Variable costs grow in direct proportion to Sales but at a slower rate. The line starts at the origin since
no variable cost arises if no sale occurs;
 The Fixed Costs line remains flat (unchanged irrespective of the number of covers sold). The operation
incurs Fixed Costs such as rent whether the operation operates (is open for business) or not;
 Total Cost grows at the same rate as Variable Costs. The Total Cost minimum is represented by the
Fixed Costs line;
 The Break-Even point occurs where the Total Sales line crosses the Total Costs line. In this illustration,
the operation starts being profitable when selling exceeds 250 covers.
PROFIT PLANNING
Managers can use the CVP relationships and formulas in determining the number of units to sell to realize
a target profit. Target profit is normally set by the owners (stockholders) of the business through the board
of directors. Using the BEP formula, the desired sales (in pesos and units) are computed as follows:
Desired sales (units) = Fixed Costs + Target Profits / Contribution Margin per
Unit
Desired sales (pesos) = Fixed Costs + Target Profits / Contribution Margin per
Unit

Desired Profit Is Before Tax

using the information in the illustrative problem except that the shareholders want a P350, 000 profit.
Compute for the desired sales and the number of units needed to be sold by the company.
Desired Sales
Units Pesos
Fixed Costs 800, 000.00 800, 000.00
Add: Target Profits 350, 000.00 350, 000.00
Total Contribution Margin 1, 150, 000.00 1, 150, 000.00
Divide By: CMU; CMR 1, 000.00 40%
Desired Sales (units; 1, 150.00 2, 875, 000.00
pesos)

Desired Profit Is After Tax

If the after tax profit is desired, the following formulas should be used:
Desired sales = Fixed Costs + ( Target Profits / 1 – Tax Rate) / Contribution Margin per
Unit
Desired sales = Fixed Costs + (Target Profits / 1 – Tax Rate) / Contribution Margin per Unit
If the desired profit of P350, 000 is income after corporate tax of 30%, then desired sales is computed as
follows:
Desired sales
Units Pesos
Desired Profit After Tax 350, 000.00 350, 000.00
 Divide by : 100% - 30% 70% 70%
Desired Profit Before Tax 500, 000.00 500, 000.00
Add: Fixed Costs 800, 000.00 800, 000.00
Total Contribution Margin 1, 300, 000.00 1, 300, 000.00
Divide by : CMU; CMR 1, 000.00 40%
Desired sales (units; 1, 300.00 3, 250, 000.00
pesos)

Desired Profit Is a Percentage of Sales

To compute for the desired sales in units, if the desired profit is stated as a percentage of sales, the fixed
cost is divided over the difference of the contribution margin per unit and profit per unit. The profit per unit
is computed by multiplying the desired profit ratio by the selling price per unit. For the desired sales in
pesos, the contribution margin ratio and the profit ratio are used. Consider the following:
Desired sales (units) = Fixed Costs / (Contribution Margin per unit – Profit per
unit)
Desired sales (pesos) = Fixed Costs / (Contribution Margin Ratio – Profit Ratio)
Using the same information except that the company plans for a 15% profit, then desired sales is
computed as follows:
Desired Sales
Units Sales
Fixed Costs 800, 000.00 800, 000.00
Divide by : CMU-PU; CMR-PR 625.00 25%
Desired sales (units; pesos) 1, 280.00 3, 200, 000.00

SUPPORTING COMPUTATIONS:
Pesos Ratio
CMU 1, 000.00 40%
Less: Profit / Unit (2, 500* .15) 375.00 15%
CM net of profit 625.00 25%

In understanding the relationships of cost, volume, and profit, a company is able to plan its profits with
related volume of sales. Desired sales are naturally expected to be higher than the break-even point in
order to earn profit. Every unit sold after the break-even units would result to a profit amounting to the
contribution margin per unit. This is because all of the fixed costs were already covered in the break-even
volume so the units in excess of the break-even point will only cover the related variable costs, thus, profit
is earned at the rate of the contribution margin per unit. Using the example of desired profit of P350, 000,
each unit sold in excess of the BEP units will earn P1, 000 of profit for the company as shown in the
following computation.
Units in desired sales 1, 150.00
Less: Units in BEP 800.00
Units in excess of BEP 350.00
Multiply by: CMU 1, 000.00
Profit 350, 000.00

MARGIN OF SAFETY
The margin of safety is the excess of budgeted (or actual) sales over the brea k-even sales. It is the amount
by which sales can decrease before losses are incurred. The higher the margin of safety, the lower the risk
of not incurring a loss. The margin of safety can be expressed in units, in peso sales or as a ratio called the
margin of safety ratio. Managers give importance on the margin of safety because it is a useful reminder
that if sales dropped by this amount, the company may start incurring losses. Considering the previous
example, the computation for margin of safety is as follows:
Units Pesos Percentages
Desired sales 1, 150 2, 875, 000.00 100%
Less : Break-even sales 800 2, 000, 000.00 69.57%
Margin of safety 350 875, 000.00 30.43%
For Pacman Inc., sales can be reduced by at most 350 units or P875, 000 without resulting into loss. This
means that they have a buffer of 350 units before they incur losses.
The margin of safety is also directly related to profits. Profit ratio (PR) is the product of contribution margin
ratio (CMR) and margin of safety ratio (MOSR). Thus using the formula PR= CMR x MOSR. Using this
formula, net income can be computed by multiplying the sales by the profit ratio.
Margin of Safety Ratio 30.43% Sales 2, 875, 000.00
Multiply by : CMR 40% Multiply by : Profit 12.17%
Ratio
Profit Ratio 12.17% Net Income 350, 000.00

SENSITIVITY ANALYSIS
Profit is affected by five factors: (1) selling price per unit; (2) variable cost per unit; (3) volume or number
of units; (4) fixed cost; (5) sales mix. These are often called profit factors because changes in any of these
factors result in a change in profit. It is therefore imperative for managers to understand the effect of
changes in these different factors to the profit of the organization. A change in any of the factors is
acceptable or favorable if it will result to an increase in profit and a decrease in break-even point.
To illustrate the effect of changes in the different factors on profit and break-even point, consider the
following:
Selling price per unit 100. 00
Variable cost per unit 75.00
Total fixed costs 100, 000.00

BEP Units Pesos

Total Fixed Costs 100, 000.00 100, 000.00
Divide by : CMU; CMR 25.00 25%
BEP 4, 000 400, 000.00

Change in Selling Price per Unit

An increase in selling price per unit will increase the contribution margin and vice versa. An increase in the
contribution margin will result to a lower break-even point which is generally better for a company. In the
given data, assume that the selling price will be increased to P125 per unit while all other data remain
same.
NEW BEP
Units Pesos
Total Fixed Cost 100, 000.00 100, 000.00
Divide by : CMU; CMR 50.00 40%
BEP 2, 000 250, 000.00
When selling price is increased to P125, the CM increases to P50 per unit, which also results to a higher
CMR of 40%. The higher CMU and CMR then results to a lower break-even point. From the original BEP of
P400, 000, the new BEP is only P250, 000. This means that it will easier and faster for the company to earn
profit.

Change in Variable Costs

An increase in variable costs will decrease contribution margin per unit and also decrease the contribution
margin ratio, and vice versa. In the given data, assume that variable cost per unit increases by P5, while
all other data remain the same. The new BEP is compared to the original BEP as follows:
NEW BEP
Units Pesos
Total Fixed Cost 100, 000.00 100, 000.00
Divide by : CMU; CMR 20.00 20%
BEP 5, 000 500, 000.00
The resulting BEP is higher because of the decrease in contribution margin. Since the new contribution
margin per unit is lower, it will be harder for the company to earn profit.

Change in Volume
An increase in volume will not have an effect on the contribution margin nor in the break-even point but
will increase profit because of the contribution margin of additional units sold. In the given data, assume
that the original volume is 4, 500 units while the new volume is 5, 000 units. In as much as contribution
margin will be the same at P25, then break-even point will also be the same at pegged 4, 000 and P400,
000 in units and pesos respectively. However, the increase of 100 units from the original volume of 5, 000
will result to an increase in profit of P12, 500.
@ 4, 500 @ 5, 000
Selling price 100. 00 100.00
Multiply by : No. of units 4, 500 5, 000
Sales 450, 000.00 500, 000.00
Less : Variable Costs 337, 500.00 375, 000.00
Contribution Margin 112, 500.00 125, 000.00
Less : Fixed Costs 100, 000.00 100, 000.00
Profit 12, 500.00 25, 000.00

Change in Fixed Costs

A change in fixed costs will bring about a change in break-even point. An increase in fixed costs will
increase the break-even point and vice versa. Assume that the fixed cost in the given data is P80, 000.
NEW BEP
Units Pesos
Total Fixed Cost 80, 000.00 80, 000.00
Divide by : CMU; CMR 25.00 25%
BEP 3, 200 320, 000.00