AE 232 Management Science CVP Analysis

UNIT 3: Linear Equations applied: Models of cost, revenue and profit

 A line as drawn in a graph is normally expressed as: Y = a + bx
where: Y = Y axis : dependent variable a = y intercept : constant
x = X axis : independent variable b = slope of the line

 the most commonly used linear equations in the field of business management involve the revenue, cost, and profit of the entity.

A. REVENUE (SALES) Line (Function) = a mathematical expression of how sales (revenues) changes with activity level. Underlying
this function is the belief that activity level (units sold) explains the total sales (revenues) and the relationship is linear within the
relevant range.
Y = a + bx NOTE:
Total revenue (R) = 0 + Total sales b = sales price per unit (SPU)
Total revenue (R) = SPU x Q x = activity level (units sold) = Q

B. COST Line (Function): a mathematical expression of how a cost changes with activity level. Underlying cost functions is the
belief that activity level explains the total costs and that the relationship is linear within the relevant range.
Y = a + bx NOTE:
Total Costs (TC) = Fixed Costs + Total variable cost b = variable cost per unit (VCU)
Total Costs (TC) = Fixed Costs + VCU x Q x = activity level (units sold or produced) = Q

RELEVANT RANGE - the range of activity within which the behavior of variable and fixed costs are valid. Any level of activity
outside this range may show different cost behavior pattern.
 For the entire range of possible activity, changes in efficiency are likely to result in a curvilinear function.

C. PROFIT Line (Function) = a mathematical expression of how profit changes with activity level.
Profit = R - TC
Profit = (SPU x Q) - (VCU x Q) + FC)
Profit = (SPU - VCU) (Q) - FC
Profit = Contribution Margin FC

COST VOLUME PROFIT (CVP) ANALYSIS – the systematic examination of the relationships among costs, cost driver (activity
level – volume) and profit. It is used to measure the functional relationship between the major factors affecting profits and to
determine the profit structure of an entity.
 the ELEMENTS of CVP Analysis, usually referred to as profit factors are the Sales price, Total Fixed costs, Variable cost/unit,
Activity level and Sales mix (in case of multiple products)

APPLICATIONS of CVP Analysis –used for planning and decision making like in the following areas:
1. Optimization of the use of scarce resources – what type of product to produce and sell
2. Marketing strategy to apply (Examples: pricing, promotion and distribution)
3. Type of productive facilities to acquire
4. Non routine decisions (Examples: special orders, sell or process further, add or delete a product line)

SIMPLIFYING ASSUMPTIONS of CVP Analysis

1. All costs are classifiable as either fixed costs or variable costs.
a. FIXED costs – cost that remain constant (in total) regardless of change in volume of activity. (Examples: depreciation of facilities,
rent, taxes, insurance, monthly salaries)
Example: If monthly rent for a factory is P150,000, the costs to be incurred at different levels of production are as follows:
Total RENT Costs Units produced RENT per unit
P150,000 10,000 P15.00
P150,000 15,000 P10.00
P150,000 20,000 P 7.50
P150,000 25,000 P 6.00
NOTE that total rent cost is constant at P150,000 per month regardless of units produced. However, the rent cost per unit
changes inversely in proportion to units produced. The more units produced, the lesser the rent cost per unit to be incurred.
AE 232 Management Science CVP Analysis

b. VARIABLE costs – cost that change (in total) directly in proportion to changes in volume of activity. (Examples: direct materials,
direct labor, variable factory overhead, supplies)
Example: To produce 1 unit of product, 2 hours needs to be spent by a direct laborer who is paid P50 per hour. The direct
labor costs to be incurred at different levels of production are as follows:
Direct Labor
per unit Units produced Total Direct Labor Cost
P100.00 10,000 P1,000,000
P100.00 15,000 P1,500,000
P100.00 20,000 P2,000,000
P100.00 25,000 P2,500,000
NOTE that direct labor cost is constant per unit at P100 but total direct labor costs changes directly in proportion to units
produced. The more units produced, the greater the total direct labor costs to be incurred.
 The above assumption is most reasonable when analyzing the profitability of a specific event or the profitability of an
organization that produces a single product or service on a continuous basis.

NOTE: In case of MIXED costs (contains fixed and variable costs), a cost segregation technique must be applied to determine how
much of the mixed costs is fixed and how much is variable.

2. LINEARITY and RELEVANT RANGE Assumptions – costs and revenue relationships are predictable and linear over a relevant range
of activity and a specified period of time.

3. Sales price per unit of product and market conditions remain unchanged.
 This implies a purely competitive market for final products or services. In some economic models in which demand
responds to price changes, the revenue function is curvilinear. In these situations, the linear approximation is accurate only
within a limited range of activity.

4. Inventory level remains constant. (Units produced = units sold). Any change in inventory level is insignificant.
5. If the company sells multiple products, sales mix is constant.
6. Technology and production efficiency is constant.
7. Time value of money is ignored.

CVP MODELS – for CVP analysis, the EQUATION Method, Contribution Margin Method or Graphical Method is normally used.
I. EQUATION Method : Sales – Total Costs = Profit
A. Functional Income Statement (I/S) : Sales – Cost of Sales – Selling and Administrative expenses = Profit
B. MARGINAL (Variable) I/S : Sales – Variable Costs – Fixed Costs = Profit

II. Contribution Margin Method

CONTRIBUTION MARGIN (marginal income; marginal profit) refers to the amount generated from sales which will be used to
recover fixed costs and then to provide profits to owners.
To address the needs of management for better planning and controlling of activities, the income statement provided to them is
prepared according to the behavior of expense (costs) incurred in the different functions of management. Such report called
Marginal Income statement (Contribution Margin I/S or Variable I/S), as well as the major terms and concepts relevant for planning
operations, are presented below:
MARGINAL Income Statement Total Per Unit Rate** Term
Sales (S) P xx P xx 100% Sales ratio (SR)
Variable Costs (VC) (xx) (xx) x% VC ratio (VCR)
Contribution Margin (CM) P xx P xx (100 – x) % CM ratio (CMR)
Fixed Costs (FC) (xx)
Operating income (OI) Pxx
**Note: Ratio is based on sales. If based on cost, VC is 100%.
From the Equation method using the Marginal I/S: Sales – Variable Costs – Fixed Costs = Profit
Contribution Margin Method will be : (Sales – Variable Costs) - Fixed Costs = Profit
: Contribution Margin - Fixed Costs = Profit
AE 232 Management Science CVP Analysis
III. Graphic Approach
Under this approach, the cost lines (variable costs, fixed costs and total costs) and the revenue line are drawn in the graph.
Y axis represents total costs and total sales (revenues) while the X axis represents the activity level in units sold. The point
where the total costs line and total sales line intersects is called break-even point or break – even sales. Above this profit,
profit will be generated. Below this point, loss will be incurred.

ILLUSTRATIVE PROBLEM 1
ABC Retail Corporation obtained the following revenue and cost data:
2018 2019
Sales Revenue P325,000 P335,000
Cost of sales 175,500 180,900
Operating expenses 99,500 100,100

Selling price per unit is constantly at P50 per unit. Revenue and costs are dependent on units sold.
REQUIRED:
1. REVENUE line (equation and graph) 3. Profit line (equation and graph) 5. Profit (loss) if 6,000 units is sold.
2. COSTS Lines (equation and graph) 4. Sales (in units and pesos) to break even

SUGGESTED ANSWERS
1. Total revenue (R) = bx Therefore: 2018 2019
Total revenue (R) = SPU x Q Total revenue (R) P325,000 P335,000
Total revenue (R) = P50Q Sales Price per unit (SPU) P50 P50
Units sold (Q) 6,500 6,700

Two points make a line. A point consists of Y and X components. Thus, choose any 2 levels of activity (x):
Units sold (x) Total sales (Y) Point (x; Y)
0 P0 (0 ; P0)
6,000 P300,000 (6,000; P300,000)

Revenue Line
400000
Total Revenue

300000
200000
100000
0
0 1000 2000 3000 4000 5000 6000
Quantity Sold

2. Total Costs (TC) = Fixed Costs + Total variable cost

Total Costs (TC) = P80,000 + P30Q

in this case, a simple segregation technique (high – low method) will be applied to determine fixed costs and variable costs.
Since total fixed costs does not change with activity level, the Change on total costs must be the change in total variable costs.
Difference in TC = Difference in Total VC ( P281,000 - P275,000) P6,000
Difference in activity level (x) = (6,700 – 6,500) 200
Variable Cost per unit (b) P30
Fixed costs can be solved using the TC equation for any activity level.
2019 2018
Total Costs P281,000 P275,000
Total VC (P30 (x 6,700; x 6,500) (201,000) (195,000)
Fixed Costs (FC) P80,000 P80,000

Therefore: Total Costs = P80,000 + P30Q

AE 232 Management Science CVP Analysis

Two points make a line. A point consists of Y and X components. Thus, choose any 2 levels of activity (x):
Total Variable
Units sold (x) Costs (Y) Point (x; Y) Fixed Costs Point (x; Y) Total Costs (TC) Point (x; Y)
0 P0 (0 ; P0) P80,000 (0 ; P80,000) P80,000 (0 ; P80,000)
6,000 P180,000 (6,000; P180,000) P80,000 (6,000; P80,000) P260,000 (6,000; P260,000)

Variable Cost Line Fixed Cost Line

200000 100000
Total Variable Cost

Total Fixed Cost

150000 80000
60000
100000
40000
50000 20000
0 0
0 1000 2000 3000 4000 5000 6000 0 2000 4000 6000
Quantity Sold Quantity Sold

CVP Graph Profit Line

450000 60000
400000
40000
Amount in pesos

350000
300000 20000
250000
Profits in Peso

200000 0
150000 0 2000 4000 6000
-20000
100000
50000 -40000
0 -60000
0 2000 4000 6000 80
-80000
Units sold
-100000
Revenue Units Sold
Total Cost

3. Profit = R - TC
Profit = P50Q - (P30Q + P80,000)
Profit = (P50Q – P30Q) - P80,000

Two points make a line. A point consists of Y and X components. Thus, choose any 2 levels of activity (x):
Units sold (x) Total Sales Total Costs (TC) Total Profit Point (x; Y)
0 P0 P80,000 (P80,000) (0 ; (P80,000)
6,000 P300,000 P260,000 P40,000 (6,000; P40,000)

4. BREAK EVEN POINT (BEP) refers to the level of sales (in pesos or in units) where total revenue equals total costs, that
is, there is neither profit nor loss.
A. EQUATION Method : Sales – Total Costs = Profit Therefore:
P50Q – (P30Q + P80,000) = P0 BEP (Q) = 4,000 units
P20Q = P80,000 BEP (₱) = P200,000 (4,000 x P50)
Q = P80,000/P20 = 4,000 units
AE 232 Management Science CVP Analysis
B. CONTRIBUTION MARGIN Method: Contribution Margin - Fixed Costs = Profit Therefore:
(P50Q – P30Q) - P80,000 = P0 BEP (Q) = 4,000 units
P20Q = P80,000 BEP (₱) = P200,000 (4,000 x P50)
Q = P80,000/P20 = 4,000 units

C. GRAPHICAL Method – looking at the CVP Graph, the revenue line and total costs line intersects at (4,000; P200,000).
- looking at the PROFIT Line graph, profit is P0 at point (4,000; P200,000).

5. PROFIT PLANNING – projecting the profit (loss) to be incurred if only a certain sales level is attained.
 IF only 6,000 units (Q) is sold, the profit (loss) will be as follows:

A. EQUATION Method: Sales – Total Costs = Profit

P50Q – (P30Q + P80,000) = Profit
(P50 x 6,000) – [ (P30 x 6,000) + P80,000] = Profit
P40,000 = Profit

B. CONTRIBUTION MARGIN Method: Contribution Margin - Fixed Costs = Profit

(P50Q – P30Q) - P80,000 = Profit
P20 x 6,000 - P80,000 = Profit
P40,000 = Profit

C. GRAPHICAL Method – looking at the CVP Graph, at 6,000 units (x-axis) the Y axis for revenue line is at P300,000 and for
total costs line is at P260,000. Thus, resulting to profit of P40,000.
- looking at the PROFIT Line graph, at 6,000 units (x-axis) profit is P40,000 (Y axis).

ILLUSTRATIVE PROBLEM 2: SINGLE Product - COMPREHENSIVE

The following budgeted income statement was prepared by KTA Corporation for 2020:
Sales (P1,000/unit) P10,000,000
Cost of goods sold:
Prime Cost P 2,900,000
Variable factory overhead 800,000
Fixed factory overhead 600,000 4,300,000
Gross margin P5,700,000
Selling expenses
Variable P 600,000
Fixed 1,000,000
Administrative expenses:
Variable 500,000
Fixed 1,000,000 3,100,000
Net operating income P 2,600,000

REQUIRED: Compute the following

1. Contribution Margin a. Pesos b. per unit c. ratio
2. Break Even sales a. Pesos b. units c. Ratio
3. How much is the operating income when only 5,001 units are sold?
4. Margin of Safety a. Pesos b. units c. Ratio
5. What is the required sales in units and in pesos to earn operating income of P1,500,200?
6. What is the required sales in units and in pesos to earn net income of P1,679,860? (Tax rate is 30%)
7. What is the required sales in units and in pesos to earn profit of P270 per unit?
8. What is the required sales in units and in pesos to earn profit of 32% of sales?
9. What would be the break-even sales (in units and in pesos) if fixed factory overhead increases by P101,400?
10. Degree of Operating leverage
11. What would be the net operating income if sales increase by 25%?
AE 232 Management Science CVP Analysis

SUGGESTED ANSWERS
INITIALLY, we can squeeze the following data based on what is given on the problem.
Variable Fixed
Prime costs (DM & DL) P2,900,000 -
Overhead 800,000 600,000
Selling expense 600,000 1,000,000
Administrative expense 500,000 1,000,000
Total Costs P4,800,000 P2,600,000
Units sold (P10M/P1,000) 10,000 10,000
Cost/unit P480 P260

In this case, only the CONTRIBUTION MARGIN Method will be used for illustration purposes;
Contribution Margin - Fixed Costs = Profit Contribution Margin - Fixed Costs = Profit
(SPU – VCU) x Q - FC =P (SR – VCR) x S (₱) - FC =P
(CMU x Q) - FC =P (CMR x S (₱) - FC =P

 Transferring the FC to the right side of the equation, the work of CM will be emphasized for planning purposes as follows:
OBJECTIVE Required Sales in UNITS Required Sales in PESOS
1. To break even (BEP) FC
. . FC . .

CMU CMR

2. To earn desired Profit (OI) FC + DP FC + DP

(DP = desired profit) CMU CMR

3. To earn desired Profit after FC + ( NP / (1-Tax rate)

. FC + ( NP / (1-Tax rate)
.

tax (net profit = NP) CMU CMR

4. To earn desired profit ratio . FC . . FC .

(Profit as % of sales ) CMU – PU CMR – PR

PU = profit per unit PR = profit ratio

Therefore, the SUGGESTED ANSWERS will be as follows:

Requirement #1 Pesos Per unit Ratio
Sales P10,000,000 P1,000 100%
Variable Costs (VC) (4,800,000) (480) (48%)
Contribution Margin (CM) P5,200,000 P520 52%

Requirement #2 Pesos Units Alternative:

Fixed Costs (FC) P2,600,000 P2,600,000 BES -units 5,000
÷ CMR; CMU 52% P520 SP/u P1,000
Break Even Sales (BES) P5,000,000 5,000 BES - pesos P5,000,000

 Above the BES, profit will start to be generated. Also, since FC is constant and is already recovered at BES, the only relevant
costs above the BES is the variable costs. Thus, above the BES:
PROFIT = Incremental Sales – incremental Variable costs = incremental Contribution Margin

Requirement #3 Alternative:
CMU P520 CM (P520 x 5,001) P2,600,520
÷ Units in excess of BES units (5,001 – 5,000) 1 FC (2,600,000)
Incremental CM = Operating income (OI) P520 OI P520
AE 232 Management Science CVP Analysis
MARGIN OF SAFETY (MOS) is the level of sales (in pesos or in units) by which actual or budgeted sales may be decreased
without resulting into a loss.
Pesos Units Rate** Term
Sales (S) P xx xx 100% Sales ratio (SR)
Break Even Sales (BES) (xx) (xx) x% BES ratio (BESR)
Margin of Safety (MOS) P xx xx (100 – x) % MS ratio (MSR)

Requirement #4 Pesos Units Ratio

Sales P10,000,000 10,000 100%
BES (5,000,000) (5,000) (50%)
Margin of Safety (MOS) P5,000,000 5,000 50%

 IF profit starts above the BES, the OI of P2.6M of KTA Corporation for 2020 can also be computed using MOS as follows:
Pesos Units
Margin of Safety (MOS) = Excess over BES P5,000,000 5,000
CMR; CMU 52% P520
Incremental CM = Operating income (OI) P2,600,000 P2,600,000

PROFIT PLANNING is the process of determining the level of sales (in pesos or in units) required in order to earn the desired level
of profit (before or after tax).

Requirement #5 Units Pesos Alternative:

FC P2,600,000 P2,600,000
Desire OI 1,500,200 1,500,200
Total CM P4,100,200 P4,100,200 Sales -units 7,885
÷ CMU; CMR P520 52% SPU P1,000
Required Sales 7,885 P7,885,000 Sales - pesos P7,885,000

Requirement #6 Units Pesos Alternative:

FC P2,600,000 P2,600,000
Desire OI (NI/70%) 2,399,800 2,399,800
Total CM P4,999,800 P4,999,800 Sales -units 9,615
÷ CMU; CMR P520 52% SPU P1,000
Required Sales 9,615 P9,615,000 Sales - pesos P9,615,000

Requirement #7 Units Pesos PROOF

Fixed Costs (FC) P2,600,000 CM (P520 x 10,400) P5,408,000
÷ CMU – PU (P520 – P270) P250 FC (2,600,000)
Required Sales 10,400 x SPU P10,400,000 OI P2,808,000 /10,400 P270

Requirement #8 Pesos Units PROOF

Fixed Costs (FC) P2,600,000 CM (P13M x 52%) P6,760,000
÷ CMR – PR (52% – 32%) 20% FC (2,600,000)
Required Sales P13,000,000 /SPU 13,000 OI P4,160,000 /P13M 32%

SENSITIVITY ANALYSIS is the process of determining the change (effect) on profit caused by changes in any or any combination
of the profit factors (5 elements) of CVP analysis.

Requirement #9 Units Pesos Alternative:

FC new P2,701,400 P2,701,400 BES -units 5,195
÷ CMU; CMR P520 52% SPU P1,000
BES 5,195 P5,195,000 BES - pesos P5,195,000
AE 232 Management Science CVP Analysis
OPERATING LEVERAGE – measures the extent of change in operating income (OI) resulting from change in sales. In essence, it
is also a tool for sensitivity analysis, but the stimulus is only change in sales.
 The higher the fixed costs in a firm’s cost structure, the higher will be the CM and the higher will be the degree of operating
leverage (DOL) or operating leverage factor (OLF).

DOL (OLF) = Total CM = % change in profit before tax

.

OI % change in sales

Requirement #10
CM P5,200,000
÷ OI (2,600,000)
Degree of Operating Leverage 2x

 Applying the concepts, the operating income if sales increase by 25%, can be computed as follows:

Requirement #11
Using CM I/S Using DOL
CM-new (P5.2M x 125%) P6,500,000 DOL 2 OI - old P2,600,000
FC (2,600,000) % increase in sales 25% OI – new (%) 150%
OI - new P3,900,000 % increase in OI 50% OI - new P3,900,000