Cost Volume Profit Analysis (with leverage)

COST-VOLUME PROFIT ANALYSIS - a systematic examination of the relationships among costs,

cost driver or activity level (or volume) and profit. It is a profit planning tool that deals with
profit’s relationship with costs and sales volume.
The CVP analysis is a powerful tool in determining the effect of changes on operating income
with the following assumptions:
1. No change in selling price regardless of the changes in sales volume.
2. Linear relationship between costs (variable and fixed costs) and level of activity within the
relevant range.
3. No change in sales mix for companies with more than one product.
4. Units produced is equal to units sold.
CONTRIBUTION MARGIN (CM) - is a measure of company’s ability to cover variable costs with
revenues. It is also known as marginal income, profit contribution, contribution to fixed cost or
incremental contribution.
Comprehensive Problem I
ABC Company provided the following information:

Sales (100,000 units) P1010,000,000 10M

Cost of Sales 67,000,000 6M

Gross Profit 43,000,000 4M
Selling and General Expenses 32,500,000 3.5M
EBIT 500,000
Interest Expense 100,000
EBT / NIBT 400,000
Tax (30%) 120,000
NIAT 280,000
NIAT – Preference Shares (dividends) 70,000
NIAT – Ordinary Shares 210,000
Outstanding Ordinary Shares 10,000 shares
Earnings Per Share (EPS) P21.00 / share21.00

Management Accounting (introduction) Prepare an income statement using the contribution

margin format assuming that fixed manufacturing costs amounted to P2,000,000 while the fixed
selling and general expenses amounted to P1,500,000.
Cost Volume Profit Analysis (Break-even Analysis)
Key Concept/s:
The break-even point (BEP) represents the point where total revenue will equal total costs or
simply the level of sales at which profit is zero. The break-even point is useful in determining the
appropriate level of activity to achieve the objectives of a company.
The concept of breakeven suggests that a company must sell beyond a certain sales level (break-
even point) to generate a profit. Once the break-even point has been reached, net operating
income will increase by the amount of unit contribution margin for each additional unit sold. On
the other hand, selling below the break-even point will result in a loss.

(1) How much is the break-even point/break even sales (in pesos and in units)?
Cost Volume Profit Analysis (Target Income)
Key Concept/s:
Target profit analysis is used to determine the level of sales, in units or in amounts, to achieve
the desired profit by the company.
(2) How much is the required sales (in pesos and in units) if the company wants to earn an
operating income before tax of 800,000?
(3) How much is the required sales (in pesos and in units) if the company wants to earn a 10%
operating profit margin?
(4) How much is the required sales (in pesos and in units) if the company wants to earn an
after-tax profit of P315,000?

Cost Volume Profit Analysis (Change in Factors – application for decision making)
Key Concept/s:
Changes in factors that will increase operating income will most likely be considered for
decision making.
(5) If the company reduces it selling price by 10% and increases its sales volume by 20%, how
much will be the expected change in operating profit?
(6) If the company proposed to increase its advertising expenses (fixed) by P500,000 which is
expected to result in a 10% increase in sales, would you approve the proposal? Why?
Cost Volume Profit Analysis (Margin of Safety)
Key Concept/s:
Margin of safety (MOS) is the excess of actual/budgeted sales over the break-even sales. It
represents the maximum decline in sales that the entity can afford before it incurs an operating
loss.
(7) How much is the present margin of safety in pesos?
(8) What is the company’s margin of safety ratio?
(9) If sales were anticipated to decrease by P2M, how much is the expected operating income?
(10) If sales were anticipated to decrease by 10%, how much is the expected operating
income?

Cost Volume Profit Analysis (Degree of Operating Leverage)

Key Concept/s:
The degree of operating leverage (DOL) is a measure of sensitivity of the net operating income
towards changes in sales volume. It acts as a multiplier, at a given level of sales, to determine
the effect on operating income of a percentage change in sales volume. Operating leverage
measures the degree to which a fi rm builds fixed costs into its operations. If fixed costs are high
a significant decrease in sales can be devastating. Therefore, all other things being equal, the
greater a firm’s fixed costs the greater its business risk.

(11) What is the company’s degree of operating leverage?

(12) If sales increase by 30%, how much will be the expected % increase in operating income
and the expected operating income?
(13) If sales decrease by 10%, how much will be the expected % increase in operating income
and the expected operating income?
Financial Management (Degree of Financial Leverage - review)
Key Concept/s:
The degree of financial leverage (DFL) measures the extent to which the firm uses debt
financing. While the use of debt can produce high returns to stockholders, it also increases their
risk. Since debt generally is a less costly form of financing, a firm will generally attempt to use as
much debt for financing as possible. However, as more and more debt is issued, the firm
becomes more leveraged and the risk of its debt increases, causing the interest rate on
additional debt to rise. Therefore, the optimal capital structure for a fi rm involves a mixture of
debt and equity.

(14) What is the company’s degree of financial leverage?

(15) If the operating income increases by 20%, how much will be the expected EPS?
(16) If the operating income decreases by 15%, how much will be the expected EPS?

Management Accounting and Financial Management (Degree of Total Leverage - review)

Key Concept/s:
The degree of total leverage (DFL) measures the combined effects of both operating and
financial leverage.

(17) What is the company’s degree of total leverage?

(18) If sales increase by 25%, how much will be the expected operating income and the
expected earnings per share?
(19) If sales decrease 20%, how much will be the expected operating income and the
expected earnings per share?
Comprehensive Problem II (Sales Mix)
Key Concept/s:
Sales mix analysis is used to determine the overall contribution margin and break-even point
from the mixture or combination of the products sold.

ABC Company has the following information:

A B
Units 6,000 4,000
SP per unit 80 120
VC per unit 32 36
Total Fixed Cost = P390,000

(1) Determine the sales mix ratio in terms of units.

(2) Determine the break even point in units (total and per product)
(3) Determine the sales mix ration in terms of peso sales.
(4) Determine the break-even point in pesos (total and per product)