Saint Mary’s University

School of Accountancy & Business

Accountancy Department
COST-VOLUME PROFIT ANALYSIS

LECTURE OUTLINE
A. Cost Behavior Analysis.
1. Cost behavior analysis is the study of how specific costs respond to changes in the level
of business activity.
2. The activity index identifies the activity that causes changes in the
behavior of costs. Changes in activity levels make it possible to classify the behavior
of costs into three categories: variable, fixed, or mixed.
3. Variable costs are costs that vary in total directly and proportionately with changes in
the activity level. A variable cost remains the same per unit at every level of activity.
4. Fixed costs are costs that remain the same in total regardless of changes in the activity
level.
a. Because total fixed costs remain constant as activity changes, it follows that fixed
costs per unit vary inversely with activity.
b. Examples of fixed costs include property taxes, insurance, rent,
supervisory salaries, and depreciation on buildings and equipment.
B. Relevant Range.
1. The relevant range is the range of activity in which a company expects to operate during
a year. It is important in CVP analysis because the
behavior of costs is linear (straight-line) throughout the relevant range. Although the
straight-line relationship may not be completely realistic, the linear assumption
produces useful data for CVP analysis as long as the level of activity remains within
the relevant range.
C. Mixed Costs.
1. Mixed costs are costs that contain both a variable element and a fixed element.
Sometimes called semivariable costs, mixed costs increase in total but not
proportionately with changes in the activity level.
a. For purposes of CVP analysis, mixed costs must be classified into their fixed and
variable elements. One method that management may use is the high-low
method.
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School of Accountancy & Business
Accountancy Department
b. The high-low method uses the total costs incurred at the high and low levels of
activity. The difference in costs between the high and low levels represents
variable costs, since only the variable cost element can change as activity levels
change. Fixed costs are
determined by subtracting the total variable cost at either the high or low activity
level from the total cost at that activity level.
D. Cost-Volume-Profit Analysis.
1. Cost-Volume-Profit (CVP) analysis is the study of the effects of changes in costs and
volume on a company’s profits. CVP analysis is important in profit planning. It is also
useful in setting selling prices, determining product mix, and maximizing use of
production facilities.
2. CVP analysis considers the interrelationships among the following components:
a. Volume or level of activity.
b. Unit selling prices.
c. Variable cost per unit.
d. Total fixed costs.
e. Sales mix.
3. The following assumptions underlie each CVP analysis:
a. The behavior of both costs and revenues is linear throughout the relevant range
of the activity index.
b. All costs can be classified as either variable or fixed with reasonable accuracy.
c. Changes in activity are the only factors that affect costs.
d. All units produced are sold.
e. When more than one type of product is sold, the sales mix will
remain constant (the percentage that each product represents of total sales will
stay the same).
E. CVP Income Statement.
1. The CVP income statement classifies costs as variable or fixed and computes a
contribution margin.
2. Contribution margin is the amount of revenue remaining after deducting variable costs.
It can be stated as a total amount, a per unit amount or as a ratio.
a. Total Contribution Margin = Total Sales – Total Variable Costs.
b. Contribution Margin per Unit = Unit Selling Price – Unit Variable Costs.
c. Contribution Margin Ratio = Contribution Margin per Unit  Unit Selling Price.
 Saint Mary’s University
School of Accountancy & Business
Accountancy Department
3. Both a total and a per unit amount are often shown on a CVP income statement to
facilitate CVP analysis.
4. Expressing contribution margin as a ratio (percentage) is very helpful in determining
the effect of changes in sales on net income. Managers can easily determine increases
in net income from any change in sales.

F. Break-even Analysis.
1. At the break-even point, the company will realize no income and will suffer no loss.
2. Knowledge of the break-even point is useful to management when it
decides whether to introduce new product lines, change sales prices on established
products, and enter new markets.
3. The break-even point can be:
a. Computed from a mathematical equation:
Break-even Point in Units = Fixed Costs divided by (Unit Selling Price – Unit
Variable Costs).

Break-even point in pesos can be computed by multiplying the units sold at the
break-even point by the selling price per unit.

b. Computed by using contribution margin:

Break-even Point in Units = Total Fixed Costs  Contribution Margin per
Unit.
Break-even Point in Pesos = Fixed Costs  Contribution Margin Ratio.

c. Found from a CVP graph at the intersection of the total-cost line and the total-
revenue line.
 Saint Mary’s University
School of Accountancy & Business
Accountancy Department
Dollars (000)
Sales Line

900
Total Cost Line
800

700

600
Break-even Point
Variable Costs
500

400

300

200 Fixed Cost Line

100 Fixed Costs

0 200 400 600 800 1000 1200 1400 1600 1800
Units of Sales
G. Target Net Income.
1. The income objective for individual product lines is called target net
income. To meet target net income, required sales must be determined.
a. Mathematical equation: Required Sales = Variable Costs + Fixed Costs + Target
Net Income. Required sales may be expressed in either sales units or sales pesos.
b. Contribution margin technique: Fixed Costs + Target Net Income  Contribution
Margin Ratio = Required Sales.
c. Graphic presentation: In the profit area of the CVP graph, the distance between
the sales line and the total cost line at any point equals net income. Required
sales are found by analyzing the differences between the two lines until the
desired net income is found.

2. CVP analysis can help management respond to changes in business conditions.

H. Margin of Safety.
1. Margin of safety is the difference between actual or expected sales and sales at the
break-even point. The margin of safety may be expressed in pesos or as a ratio.
a. Margin of Safety in Pesos = Actual (Expected) Sales – Break-even Sales.
b. Margin of Safety Ratio = Margin of Safety in Pesos  Actual
(Expected) Sales.
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School of Accountancy & Business
Accountancy Department

I. Indifference Point = the level of volume at which two alternatives being analyzed
would yield equal amount of total costs or profits

Alternative A Alternative B
(Unit CM x Q) – Fixed Costs = (Unit CM x Q) – Fixed Costs
Fixed Costs + (Unit VC x Q) = Fixed Costs + (Unit VC x Q)

Note: Q – number of units (indifference point)

J. Sales Mix = the relative combination of quantities of sales of various products that make
up the total sales of a company

Weighted Average Unit CM =

Product A = Unit CM x Sales Mix Ratio xx
Product B = Unit CM x Sales Mix Ratio xx
Weighted Average unit contribution margin xx

Weighted Average Contribution Margin Ratio = Weighted Average Unit CM

Weighted Average Selling Price

Product A Unit Selling Price x Sales Mix Ratio xx

B Unit Selling Price x Sales Mix Ratio xx
Weighted Average Selling Price xx

Composite BEP units = Fixed Costs ÷ Weighted average CM per unit

Allocation of BEP in units among products

Product A = Composite BEP x Sales Mix Ratio
Product B = Composite BEP x Sales Mix Ratio

BEP pesos = Fixed Costs ÷ Weighted average CM ratio

Sample Problem:

X Company sells two products A and B. the following data are available.
Product A Product B
Selling Price P 50.00 P 60
Variable Cost 30.00 45
Contribution Margin 20.00 15

Sales Mix 2 3
Fixed Costs P 126,650
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School of Accountancy & Business
Accountancy Department

1. Determine the sales mix ratio

Product A 2/5
Product B 3/5

2. Compute the Weighted Average Contribution Margin per unit and Weighted Average
Contribution Margin Ratio

Weighted Average Unit Contribution Margin(WAUCM) =

WAUCM = Contribution Margin/unit x Sales Mix Ratio
Product A 20 x 2/5 = 8
Product B 15 x 3/5 = 9
WAUCM 17

Weighted Average Unit Selling Price(WAUSP) Selling Price x Sales Mix Ratio
Product A 50 x 2/5 = 20
Product B 60 x 3/5 = 36
WAUSP 56

Weighted Average Contribution Margin Ratio (WACMR) = Weighted Average Unit CM

Weighted Average Unit SP

WACMR = 17/56 = 30.35714% (round to 5 decimal places)

3. Compute Composite Break-even Point

Composite BEP = Fixes Costs = P 126,650 = 7,450

WAUCM 17

Allocation of Composite BEP to products

Product A = 7,450 x 2/5 = 2,980
Product B = 7,450 x 3/5 = 4,470

Proof:
Product A Product B Total
Sales P149,000 P 268,200 P 417,200
Variable Costs 89,400 201,150 290,550
Contribution 59,600 67,050 126,650
Fixed costs 126,650
Net Income P 0

4. Computation of Break-even Point in Pesos = Fixed costs

 Saint Mary’s University
School of Accountancy & Business
Accountancy Department
WACMR

BEP = P 126,650/.3035714 = P 417,200

K. Degree of Operating Leverage (DOL) = measures how a percentage change in sales from
the current level will affect profits. It indicates how sensitive the company is to sales
volume increases and decreases. It is also known as operating leverage factor.

DOL = Contribution Margin ÷ Profit before tax

Δ % Sales x DOL = Δ % Profit before tax

References:
Lanen, W.N. (2017). Fundamentals of cost accounting. (5e). New York, N.Y.: Mc Graw-Hill Education
Blocher, E.J., Stout, D.E., Juras, P. E. Cost management. New York, N.Y.: Mc Graw-Hill Education
Vanderbeck,E.J. & Mitchell M.R. (2017). Principles of cost accounting. 17th edition. Australia: Cengage
 Saint Mary’s University
School of Accountancy & Business
Accountancy Department
Exercise

Silver Star Inc. manufactures decorative iron railings. In preparing for next year's operations,
management has developed the following estimates:
TOTAL
Sales (20,000 units) P 1,000,000
Direct Materials 200,000
Direct labor (variable) 50,000
Factory Overhead
Variable 70,000
Fixed 80,000
Selling and Administrative Expenses
Variable 100,000
Fixed 30,000

Required:

Compute the following items:

a. Unit contribution margin.
b. Contribution margin rate
c. Break-even in peso sales.
d. If the company wants to earn profit before tax of P 564,050, what is the targeted sales in units and
pesos?
e. If the company wants to earn profit after tax of P 658,560, what is the targeted sales in units and
pesos? (Tax rate is 40%)
f. Margin of safety in pesos and percentage.
g. Degree of operating leverage.
h. If the sales volume increases by 20% with no change in total fixed expenses, what will be the
change in net operating income?
i. If the per unit variable production costs increase by 15%, and if fixed selling administrative
expenses increase by 12%, what will be the new break-even point in peso sales and units.