MODULE 2
Mabuhay and welcome to Module 2: Cost-volume-profit (CVP) analysis.
Under this module, we will be learning about the relationship between cost, volume, and profit and analyze how the relationship is useful in decision
making.
But before we start, let us read about the ILOs.
Intended Learning Outcomes (ILOs):
At the end of the topic, the students are expected to be able to
1. Articulate the relationship between cost, volume, and profit;
2. Determine the break-even point with one product;
3. Determine the targeted sales and targeted profit;
4. Determine the margin of safety and degree of operating leverage;
5. Determine the break-even point with multiple products.
2.1 Cost, volume and profit relationship
Let us start the topic by highlighting the behavior of cost under normal capacity. As we recall from the last topic that cost can be classified according
to its behavior, namely:
1. Total Variable cost varies directly proportional to the activity level.
2. Total Fixed cost is constant regardless of activity level
3. Fixed cost per unit varies inversely proportional to the activity level
4. Variable cost per unit is constant regardless of activity level
As we move forward, we will understand that the above cost concept is useful in analyzing the relationship of cost with regards to the company's
sales volume and the company's profit.
But to fully utilize these cost concepts, we will be using variable costing rather than absorption costing, because for the main reason, the former is
focused on the behavior of cost.
2.2 Break-even point (single product)
Break-even is the point where total sales equal to total costs.
The Keynotes in computing the break-even point:
1. The net operating income (disregarding tax) is ZERO and would mean Total Sales = Total Cost.
2. Total cost would include both variable cost (constant per unit) and fixed cost (constant in total amount) which is linear.
3. Since NOI is zero, then FC = CM
4. CM per unit is therefore also constant
5. Any other variables such as sales price are constant
6. If multiple products, the sales mix is constant.
7. Units sold = Units produced.
2.2.1 Variable costing for CVP analysis
Let us apply the concept by solving the illustrative problem.
Mimi Company data:
Selling price per unit P50
Units produced 1,000
Units sold 1,500
Variable costs per unit:
Direct materials P12
Direct labor 20
Variable manufacturing overhead 1
Variable selling and admin 2
Fixed costs:
Fixed manufacturing overhead P3,000
Fixed selling and administrative 3,000
Given the above data, let us construct the Income statement under Variable costing:
In the above data, Mimi sold 1,500 units and the corresponding net operating income is P16,500.
Imagine, if you are the management accountant and the management, would like to know how much the company would sell to have a zero net
operating income. In that case, we call it the break-even point. We discuss it on the next page.
2.2.2 Break-even point using CM per unit
Interpretation: To break-even, Mimi Company should sell 400 units.
The break-even point is 4,000 units and the break-even sales amount is P20,000.
Things to remember:
1. Since NOI is zero, then, FC should be equal to CM.
2. As we all know, total fixed cost is constant regardless of the activity level. Hence, CM is also P6,000.
3. VC is constant and the selling price in CVP analysis is also constant, therefore CM per unit should also be constant.
4. The only thing that can change is the units sold and the total sales amount, total variable cost, and total CM.
5. Formula: BE in units = FC / CM per unit
2.2.3 Target net operating income
Note: To earn a net operating income of P906,000, Mimi should sell 60,800 units and sales revenue of P3,040,000.
60,800 target sales units are computed by adding the P906,000 target NOI and P6,000 fixed cost to arrive at the P912,000 contribution margin. The
CM is then divided into CM per unit if P15.
2.2.4 Target net income
Note: For Mimi to earn a P840,000 net income, the company should sell 80,400 units and have a P4,020,000 sales revenue.
The target sales in units of 80,400 are computed by dividing by P840,000 target NI to 70%, to arrive at P1,200,00 NOI. The NOI is then added to FC
to arrive at CM of P1,206,000. The P1,206,000 is then divided into P15 CM margin ratio.
Since corporate tax expense is generally 30% in the Philippines, the target NI is deducted by a 30% income tax expense. This would mean that the
target net income is 70% of the Net operating income.
2.2.5 Break-even point using CM ratio
Key considerations:
1. If CM per unit is not available, we use the CM ratio to compute for the break-even amount.
2. The CM ratio is computed using vertical analysis percentage. The total contribution margin divided by total sales equals to CM ratio.
3. If we use the CM ratio, we can only compute for the break-even amount.
4. If we use CM per unit, the first thing we can compute is the break-even sales in units.
5. TFC is still constant and is equals to TCM, so we will be using it as the starting point.
Let us apply the key considerations by solving the illustrative problem.
Note: P100,000 break-even sales are computed by dividing the P40,000 fixed cost to the 40% CM ratio.
The 40% CM ration is computed by dividing the P80,000 CM to 200,000 sales.
2.3 Margin of safety and Degree of operating leverage
The margin of safety (MOS) is the excess of the actual sales to break-even sales.
The margin of safety indicates the amount by which a company's sales could decrease before the company will have no profit.
Formula: Actual sales - BE sales = MOS
Degree of operating leverage (DOL) is the degree at any level of sales, how the percentage change in sales volume affects profit.
Formula: CM / NOI = DOL
Using the data of Mimi Company, we compute for the MOS and DOL:
Interpretation: The change in sales volume will have 1.36 times the effect on profit.
2.4 Break-even point (multiple products)
Key concepts:
1. Since it is multiple products, the assumption is that the sales mix is constant.
2. We use the total CM ratio as a basis to compute the company's break-even sales and not the individual product's CM ratio.
3. To distribute the break-even sales per product, we prorate the total break-even sales based on the actual sales amount.
4. We use the actual CM ratio per product to distribute the CM per product line.
5. Formula: TFC / TCM ratio = BE sales amount
Let us apply the key concepts by solving the illustrative problem:
Note: The P120,000 break-even sales are computed by dividing 40% company's CM ratio by the P120,000 total fixed cost.
The computation of the P180,000 break-even sales is: (360,000/600,000)*300,000.
2.5 Summary
1. Break-even is the point where total sales equal to total costs. The formula is FC / CM per unit = BE units.
2. Disregarding tax, targeted unit sales is computed as (TNOI + Fixed cost) / CM per unit = Targeted unit sold.
3. Disregarding tax, the target unit sales is computed as (TNOI + Fixed cost) / CM per unit = Targeted unit sold.
4. The target unit sales (including tax) is computed as (TNOI/.70) + (Fixed cost) / CM per unit = Targeted unit sold.
5. The margin of safety is computed as Actual sales less break-even sales.
6. The degree of operating leverage (DOOL) is computed as CM /NOI.
