Chapter 3 - Cost-Volume-Profit (CVP) Analysis

CHAPTER 3
COST-VOLUME-PROFIT (CVP) ANALYSIS
Learning Objectives

This chapter presents the concepts necessary to understand the relationship

among volume, cost and profit.
After studying this chapter, readers must be able to comprehend, demonstrate
and discuss the following:
11, The concept of CVP analysis and its purpose(s).
12. The CVP income statement (Contribution margin format).
13: The concept of breakeven point and how it is being computed.
14. Basic assumptions in profit planning.
15. Sensitivity analysis and how it affects the CVP analysis.
16. Degree of operating leverage and margin of safety.
17. The point of indifference.
18. Application of CVP analysis for entities producing and selling multiple
products.

TOPIC OUTLINE
As an overview of this chapter, please refer to the concept map below.
CVP Definition and Purpose

Basic Assumptions

4 Single Product
Breakeven Point
Multiple Products

- Single Product
| Profit Planning Hy
Lf Multiple Products
[OST-VOLUME-PROFIT -{ Sensitivity Analyis|
(CVP) ANALYSIS
Operating Leverage

in units

| Margin of Safety in peso amount |

in percentage

in units
Point of
Indifference
in peso amount

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 Chapter 3 — Cost-Volume-Profit (CVP) Analysis

BASIC CONCEPTS
WHAT IS COST-VOLUME-PROFIT (CVP) ANALYSIS?
CVP Analysis is the systematic study or examination of the relationship AMOn,
cost, volume (cost driver) and profit. Basically, CVP Analysis focuses on hoy,
changes in cost driver impact variable costs and fixed costs and how changes o
these costs affect profit.

On a business perspective, CVP Analysis carefully examines the three of the

essential cornerstones of business - cost, volume and profit. It is used for planning
purposes as it maximizes profitability by analysing the relationship of the three
elements. The profit of the firm is dependent on its total sales and total costs. It ig
because of the positive difference between gross revenue (sales), and the tota|
cost is profit. Thus, CVP Analysis assumes that there is a direct relationship
between the cost of production, volume of output, and profit earned (i.e. these
factors or elements are interdependent).

PURPOSE AND APPLICATIONS OF CVP ANALYSIS

CVP Analysis is generally used in planning and decision making in relation to the
relationship mentioned above. Specifically, it is used in making decisions on
choosing the:

(a) Type of product to produce and sell

CVP Analysis provides information in determining the optimal level and mix
of output to be produced with available resources.

Cost-volume-profit analysis is used to measure the economics characteristics

of manufacturing a proposed product. Based on accounting data, the cost-
volume-profit analysis is used to determine the sales quantity needed to
break even (to be discussed later on this chapter) as well as the sales quantity
required to earn a desired profit margin. Manager then compares a product's
expected sales with the sales quantities required to break-even and earns a
target profit margin to determine whether the product should be produced.

This is also being addressed if an entity has multiple products to produce or

sell. (Concepts of multiple products is to be discussed later)

(b) Pricing policy and strategy to follow

Pricing is one of the most important aspects of any business; with right
pricing, sales and profit flow. Pricing is considered as a complex aspect
because it can make or break any business.

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Chapter 3 - Cost-Volume-Profit (CVP) Analysis

CVP Analysis is one of the best tools for setting prices and formulating pricing
policy and strategy as it provides management necessary cost data which
eventually affects the selling prices of the products. In using CVP Analysis in
this area, it is necessary to examine the cost of products produced and the
planned profit before making the pricing decision.

(c) Marketing strategy to be used

A marketing strategy refers to a business's overall game plan for reaching
prospective consumers and turning them into customers of their products or
services.

Any marketing strategy carries cost with it (either variable or fixed cost).
Thus, any marketing strategy to follow affects the sales volume of an entity as
well as its profits.

(d) Type of productive facilities to acquire

Production facility means any building or equipment used for the purpose of
producing or manufacturing goods to be sold by an entity. The type of
production facility to be used also carries costs. The bigger and more
advanced a production facility is, the higher the cost it carries.

CVP analysis provides information to be used in determining the optimal

production facility of an entity in accordance with its production
requirements or needs.

BASIC OR INHERENT ASSUMPTIONS OF CVP ANALYSIS

The following are the several assumptions that commonly underlie CVP analysis:

(1) All costs are categorized as variable or fixed.

This means that under CVP Analysis, costs are classified according to their
behavior or response on changes in activity level. In addition, mixed costs are
required to be segregated into its variable and fixed components to properly
apply the concepts of CVP.

(2) COST AND REVENUE relationships are PREDICTABLE and LINEAR over a
relevant range of activity.
CVP Analysis also uses the linearity assumption. As a recap, linearity
assumption assumes that there is a strict linear relationship between the cost
and cost driver within relevant range. In other words, costs are shown
graphically as straight lines.

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Chapter 3 — Cost-Volume-Profit (CVP) Analysis

Under CVP Analysis, this assumption applies not only to cost but also ¢,
revenue. In other words, CVP assumes that revenue can also be graphed jp
straight lines since it has a direct relationship with the cost driver which jg
sales volume (e.g. if there are no units of product sold, then there is no
revenue to be recognized; the higher the number of units sold, the higher the
revenue to be recognized in the income statement).

fore This assumption precludes the concept of volume or sales discounts

n either purchased materials or units of finished goods sold.

To further understand the linearity assumption in CVP Analysis, please see

the CVP Chart and the Profit Chart in the following exhibits:

Exhibit 3.1 - The Cost-Volume-Profit (CVP) Chart

CVP CHART
Pesos (P)

Breakeven Point Revenug Line

Total Cost Line

au ase
Variable Cost
Area

Fixed Cost
Area
Units Sold

The cost-volume-profit graph is useful in highlighting the cost-volume-profit

relationship over wide range of activity.

KEY POINTS ON CVP CHART:

¥ The CVP chart shows the linearity of total cost and revenue over relevant
range of activity. Both lines slope upward to the right in a straight diagonal
line. The starting point of the total cost line is the y-intercept (the point in y-
axis), represented by the total fixed costs. Remember that total cost or total
mixed costs have a fixed and variable costs components. This is the reason
why the total cost line has fixed and variable cost areas. On the other hand,
the starting point of the total revenue line is the origin (point 0,0 in algebra)
since as explained before, total revenue has a direct relationship with the
sales volume; meaning, if there are no units of product sold, then there is no
revenue to be recognized.

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v¥ The intersection point of the total revenue line and total cost line is known as
the BREAKEVEN POINT. At breakeven point, the total cost and total revenue
are equal and therefore there is no profit or loss. Since the CVP Chart is
helpful in identifying breakeven point graphically, it is also called the
BREAKEVEN CHART. (To further understand breakeven point, please see its
discussion on the succeeding pages)
¥ The anticipated profit or loss at any given level sales is measured by the
vertical distance between the total revenue and the total expenses line. The
area below the intersection point or the breakeven point represents the “loss
area” while the area above the intersection point or the breakeven point
represents the “profit area”. This is consistent with the concept that if an
entity is operating above breakeven point, then it is earning profits. If an
entity is operating below breakeven point, then it is incurring losses.

Some managers prefer an alternative format to the CVP Chart known as the Profit-
Volume Chart. Please see the next exhibit for further understanding:

Exhibit 3.2 - The Profit-Volume Chart

PROFIT-VOLUME GRAPH
P
R
O Breakeven Point
i Profit Line
a ee
T

0 (Zero) Sales in Pesos

L
0
SS Total Fixed Cost

Units Sold

The profit-volume chart expresses the relationships between profit and volume.
Its usefulness is to show a direct relationship between profit and the volume of
sales, the reason why it is sometimes preferred by some managers.

KEY POINTS ON PROFIT-VOLUME CHART:

¥ In this graph, sales volume is depicted on the horizontal line and profit or loss
on the vertical line. The total revenues or sales is plotted that way to show its
direct relationship with units sold (i.e. the higher the sales volume, the higher
the amount of sales. The profit line is plotted by the determined profit or loss,
(i.e. difference between sales and total cost) at each volume.

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Chapter 3 - Cost-Volume-Profit (CVP) Analysis

¥ The breakeven point is the point where the profits line intersects tp,
horizontal line, the point where there is no profit or loss.
¥ Another noticeable thing on this graph is the point of total fixed costs. Baseq
on the graph, it is the point where the profit line starts and where the unit,
sold is zero or none. Remember that only total variable cost has a direc,
relationship with the cost driver. For total fixed cost, its behavior is constan,
regardless of changes in cost driver. Simply stated, if there are no unit sales
generally total fixed costs are the same. In addition, if there are no unit sales
the company is at a loss equal to the amount of total fixed costs, the reason
why it is the starting point of the profit line and placed at the loss area of the
graph.

The main disadvantage of this graph is the fact that it does not show clearly how
cost are affected by changes on the levels of sales (which is addressed by the CVp |
Chart).

(3) Total variable costs change directly with cost driver, but variable cost per
unit is constant over a relevant range of activity.

(4) Total fixed costs are constant but fixed cost per unit changes inversely
with cost driver over a relevant range of activity.
[For assumptions 3 & 4] This implies that understanding of the concepts of
cost behavior is a must in order to understand CVP Analysis since behavior of
cost is included as part of its inherent or basic assumptions. (Please refer to |
Chapter2 - Cost Behavior and Cost Classification to recall on these concepts.) |

(5) Selling prices do not change as sales volume changes.

In other words, selling price is assumed to be constant under CVP Analysis.
This means that changes in total revenue or sales is attributable to changes in
sales volume or units sold rather than changes in selling price. REVENUES
change PROPORTIONATELY with SALES VOLUME, their relationship to each
other is direct.

(6) Inventory levels are constant.

Hence, there is no change in inventory balance during the year since it is |
assumed under CVP Analysis that PRODUCTION EQUALS SALES (e.g. |
everything produced is sold).

(7) Technology as well as productive efficiency is CONSTANT.

Productive efficiency means that, given the available inputs and technology,
it’s impossible to produce more of one good without decreasing the quantity
of another good that’s produced. This, along with technology does not change |
under CVP Analysis.

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In addition, the concept of learning curve is not used under CVP Analysis as it
will violate the assumption that variable cost per unit is constant. The
learning curve is a visual representation of how long it takes to acquire new
skills or knowledge. Through learning curve, direct labor hours in producing
inventories decrease as the employee learns the task more. Hence, direct
labor cost per unit (which is a variable cost), decreases in effect.

(8) For multiple products, SALES MIX is CONSTANT.

Sales mix is the relative composition of products that compose a company’s
total sales in units or in peso amount. Under CVP Analysis, if a company sells
more than one product, they are sold in the same mix. (The importance of
sales mix will be determined during the discussion of “multiple products” on this
chapter.)

(9) Time value of money is ignored.

Thus, the process of discounting amounts is not applicable under CVP
Analysis.

SOLUTION GUIDE IN ANSWERING CVP ANALYSIS

QUESTIONS
(CVP INCOME STATEMENT)
The CVP Income Statement A.K.A. Contribution Margin Income Statement is a
format that facilities CVP Analysis since costs are classified as to behavior. The
format is shown on the exhibit below:

lexhibit 3.3 - The CVP Income Statement (Contribution Margin Income Statement)

. PERUNIT PERTOTAL PERCENTAGE

Quantity’ Sold Sales xX XX 100%
} Variable Cost (x) (x) (xx)
Contribution Margin XX XX xX
Fixed Cost (x) (xx)
Income Before Tax XX XX
Tax Expense (xx)
Net Income xx

The above template shall be used to understand the relationship of every income
statement line items. The line items are divided into three columns; the per unit,
per total and percentage columns.

Think of the template as a jigsaw puzzle wherein every movement will result to an
amount and even if another way is used in solving it, the result is the same.

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For instance, if the given amounts are sales per unit, contribution margin per Unit
quantity sold and total contribution margin, variable cost can be computed pp,
unit as the difference of sales per unit and contribution margin per unit.

Alternatively, variable cost per unit can be also be computed by computing firg
the total variable cost then dividing it with quantity sold. This is done by
computing first the total sales (quantity sold x sales per unit) and deducting fron,
it the total contribution margin, which is equal to total variable cost. Subsequently
divide it by the quantity sold, that’s variable cost per unit. It is a must to know
the rules on how to work-back! ©

KEY
REMINDERS
FROM THE TEMPLATE:
(1) SALES PER UNIT is referred to as the SELLING PRICE. SALES IN UNITS is
referred to as SALES VOLUME or QUANTITY SOLD.

(2) QUANTITY SOLD extends only up to CONTRIBUTION MARGIN since based on

the inherent assumptions, volume or quantity affects directly variable costs
as well as revenue. Thus, contribution margin which is the difference of sales
and variable cost is directly related to quantity sold.

In other words, the per total amounts of sales, variable cost and contribution
margin can be computed by multiplying their per unit amounts to quantity
sold.

NOTE: Contribution margin indicates how a particular product contributes to the

overall profit of the company.(the incremental profit for each unit sold since total
fixed cost is constant regardless of sales volume) It represents the remaining
amount of revenue available to cover fixed expenses.

(3) Per unit column is up to contribution margin only since these amounts are
directly related to sales volume or quantity sold.

(4) The percentage column is up to operating income only since tax expense is a
percentage based on operating income and not sales. Thus, on all percentages
presented on the income statement, the base is sales (the 100%). If the
exercise or problem gave an income percentage which is after-tax, we need to
work it back and convert it into a before-tax percentage.

For example, the problem gave a 14% after-tax income percentage and the
tax rate is 30%. To convert such into a before-tax amount, divide 14% by
70% (100% - 30%). Therefore, the before-tax income percentage is 20%.

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Chapter 3 - Cost-Volume-Profit (CVP) Analysis

(5) If in case the problem gave another scenario but using the same given
information of the problem, be minded to carry-over only the amounts which
are considered as CONSTANT. They are as follows (the amounts in BOLD):
¥ All per unit amounts (unless otherwise stated by the problem) are
constant by nature. According to basic assumptions of CVP, selling price
and variable cost per unit are constant (see discussion on inherent
assumption). This makes contribution margin per unit also constant
since it is simply the difference of the two amounts.
¥ On per total column, only the total fixed cost (Again, unless otherwise
stated by the problem) is considered to be constant according to the
basic assumptions of CVP.
¥ On the percentage column, the variable cost ratio and contribution
margin ratio are the only ones constant provided that all per unit
amounts are constant. Thus, if any one of them changes, then the
percentages cannot be carried-over anymore and are not constant.

In order to understand the CVP income statement, as well as the relationship of

each items, look at the following illustrations:

Illustration 1 - CVP Income Statement& Relationship of Items

PAQUITO CORP. earned P400,000 selling 100,000 units at P16 per unit. Its fixed
costs are P800,000.

REQUIREMENTS:
(a) What is total contribution margin?
(b) What is the variable cost per unit?
(c) What would income be if sales increased by 10,000 units?

Solution (Illustration 1):

Requirement (a):
The first thing to do in answering CVP questions is to plot the given information of
the problem in the CVP income statement. From there, work out the requirements
by applying the relationship of the items in the income statement.

PERUNIT PERTOTAL
xx
100,000 units Sales 16

Variable Cost (xx) (xx)

Contribution Margin XX xx
Fixed Cost f (800,000)
Income Before Tax WorKback | 409,900
Based on the above diagram, the percentage column is not included since there
were no percentages given by the problem. Also, it is assumed that P400,000 is an
income before tax since there were no tax rates provided by the problem.
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 Chapter 3 - Cost-Volume-Profit (CVP) Analysis

Hence, if it is work-backed, total contribution margin is P1,200,000 (P400,00)

+ P800,000).
Requirement (b):
After solving the first requirement, the CVP income statement will now look like
this:

PERUNIT PERTOTAL
100,000 units Sales 16 ne

} Variable Cost (xx) (xx)

Contribution Margin XX 1,200,000
Fixed Cost SQUEEZE (800,000)
Income Before Tax 400,000

It is clear based on the discussion that quantity sold extends up to contribution

margin. Thus, to compute contribution margin per unit, simply divide the total
contribution margin by the number of units sold. From there, compute variable
cost per unit as the difference of selling price and unit contribution margin (UCM).

Per unit
Sales P16
Variable Cost (SQUEEZE) (4)
Contribution Margin (P1,200,000 = 100,000 units) P12

Alternative Solution:
Variable cost per unit can also be computed by squeezing the total variable cost as
the difference of total sales and total contribution margin. With that, the income
statement will now look as follows:

100,000 units PERUNIT PERTOTAL

Sales fas) 1,600,
fe
] Variable Cost
Contribution Margin =
XX “2000
on ,000
Fixed Cost SQUEEZE
Income Before Tax “40000.
000
The total amount of sales can be calculated by multiplying the quantity sold by the |
selling price: (100,000 units x P16)= P1,600,000. The squeezed amount of total |
variable cost is P400,000. Remember that quantity sold extends up to contribution
margin.

Variable cost per unit is now computed as P400,000 + 100,000 units equals P4 |
per unit.
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See, as what have been discussed on the previous pages, different approaches will
lead to the same answer as long as the amounts move in the income statement in
accordance with CVP’s basic assumptions.

Requirement (c):
Always remember that UCM represents the incremental profit for each unit sold
since total fixed cost is constant regardless of sales volume
Therefore, as a general rule:

Change in Operating Income = Change in Total Contribution Margin

Hence, the increase in operating income is P120,000 (10,000 units x P12 UCM).
Proof
In order to prove the answer, a new CVP income statement should be created with
110,000 units as the new quantity sold. Remember that it is necessary to carry
over the constant amounts only. In line with this, the CVP income statement will
now look as follows:

110,000 units PERUNIT PER TOTAL

Sales 16 xx
| Variable Cost (4) (xx)
Contribution Margin 12 XxX
Fixed Cost (800,000)
Income Before Tax XX

Only the above items are considered constant and together with the new quantity
sold, they complete the income statement.

Total contribution margin (110,000 units x P12) P1,320,000

Total fixed cost (800.000)
Income before tax P520,000
Less: Original income before tax (see original information) (400,000)
Increase in income before tax P120,000

As a short-cut, the starting point of the income statement is the total contribution
margin which is computed by multiplying the new quantity sold by the unit
contribution margin.

NOTE: The rule “change in operating income = change in contribution margin” is

applicable only if the change pertains to sales volume. When the cost structure or
selling price changes, the rule is inapplicable.

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Chapter 3 — Cost-Volume-Profit (CVP) Analysis

Illustration 2 - CVP Income Statement & Relationship of Items

ADEL COMPANY has return on sales of 20%, income of P50,000, selling price 0
P10, and a contribution margin of 40%,

REQUIREMENTS: |
(a) Whatare sales in total peso amount? |
(b) What is the total fixed cost?
(c) Whatare sales in units (quantity sold)?
(d) What is the variable cost per unit? |

Solution (Illustration 2):

Requirement (a):
Return on sales pertains to the percentage of income before tax on sales or the
income percentage. Just like on the previous illustration, the first step is to plot the
given information on the CVP income statement:
|

; PERUNIT PERTOTAL PERCENTAGE

RUBS Sales 10 xx 100%
| Variable Cost (xx) (xx) (xx)
Contribution Margin XX XX 40%
Fixed Cost (xx) (xx)
Income Before Tax 50,000 + 20%
Again, the portion of tax expense wasn’t included since the problem did not state
any tax rate.

Remember that on all percentages, the base is sales. Therefore total contribution
margin is 40% of total sales; income before tax is 20% of total sales. Following |
that concept, if the income before tax of P50,000 will be divided by 20%, the
amount of total sales which is P250,000 can be computed.

Requirement (b):
After answering requirement (a), the CVP income statement will now look like
this: |

PERUNIT PERTOTAL PERCENTAGE

xx units
Sales 10 250,000 100% |
| Variable Cost (xx) (xx) (xx) |
Contribution Margin XX XX 40% |
Fixed Cost (xx) (xx) |
Income Before Tax 50,000 20% |

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Based on the income statement, total fixed cost can be computed in two (2) ways:
Y First, compute the total contribution margin which is 40% of total sales of
P250,000. Afterwards, squeeze total fixed cost as the difference of total
contribution margin and income before tax:
Total contribution margin (P250,000 x 40%) P100,000
Total fixed cost (SQUEEZE) (50,000)
Income before tax P50,000

Y Alternatively total fixed costs can be computed by squeezing the total fixed
cost percentage. It is computed as the difference between the CMR and return
on sales.
Contribution margin ratio 40%
Total fixed cost percentage (SQUEEZE) (20%)
Return on sales (income percentage) 20%
Total fixed cost (P250,000 x 20%) P50,000

Requirement (c):
After answering the first 2 requirements, the look of the CVP income statement is
now as follows:
PERUNIT PERTOTAL PERCENTAGE
BEANS! Buloe 10 250,000 100%
} Variable Cost (xx) (x) (xx)
Contribution Margin xX 100,000 40%
Fixed Cost (50,000) (20%)
Income Before Tax 50,000 20%
Obviously, quantity sold can be computed by dividing P250,000 by the selling
price of P10. Hence the number of units sold is 25,000 units.

In addition, contribution margin per unit (UCM) can now be computed as: (Total
CM + quantity sold) or (P100,000 + 25,000 units = P4 UCM).

Requirement (d):
After the previous requirements got completed, the current look of the CVP
income statement is:
PERUNIT PERTOTAL PERCENTAGE
Aa DOO UNS ste 10 250,000 100%
Variable Cost (xx) (xx) (xx)
Contribution Margin 4 100,000 40%
Fixed Cost (50.000) (20%)
Income Before Tax 50,000 20%

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Variable cost per unit can be computed in three (3) ways based on the aboy,
income statement:
v First (the simplest approach), squeeze variable cost per unit as the differeng,
of selling price and unit contribution margin:
Selling price P10
Variable cost per unit (6)
Unit contribution margin P4

¥ Second, squeeze the total variable cost as the difference of total sales ang
total contribution margin. From there, divide total variable cost by the
quantity sold to compute variable cost per unit.
Sales P250,000
Variable cost (SQUEEZE) (150,000)
Contribution margin P100,000

Variable cost per unit (P150,000 + 25,000 units) P6 per unit

Y Lastly (the longest approach), squeeze the variable cost percentage then
multiply it to the total amount of sales to compute total variable cost. From
there, divide total variable cost by the quantity sold to compute variable cost
per unit.
Variable cost percentage or ratio (100% - 40%) 60%
Total variable cost (P250,000 x 60%) 150,000
Variable cost per unit (P150,000 + 25,000 units) P6perunit

BREAKEVEN POINT
The break-even point (BEP) or break-even level represents the sales amount—in
either unit (quantity) or revenue (sales) terms—that is required to cover total
costs, consisting of both fixed and variable costs to the company. Total profit at the
break-even point is zero.

Simply stated, breakeven point is the level of sales volume level where total
revenues equals total costs, thus profit is zero. At breakeven point, contribution
margin is equal to total fixed costs and therefore, income before tax is zero.

Breakeven point is useful in determining how much is needed to sell to cover costs
or make a profit. And, thus, help the company set budgets, control costs, and
decide a pricing strategy.

In an economical perspective, breakeven point is a rough indicator of the earnings

impact of a marketing activity since it represents the minimum output that must
be exceeded for a business to earn profit.

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Break-even analysis can also help businesses see where they could re-structure or
cut costs for optimum results. This may help the business to become more
effective and achieve higher returns.

HOW TO COMPUTE BREAKEVEN POINT?

BREAKEVEN POINT in UNITS = FC / UCM
BREAKEVEN POINT in PESOS = FC / CMR

Where:
e FC is total fixed costs
e UCMis unit contribution margin
e CMRis contribution margin ratio or percentage.
NOTE: Breakeven point in peso amount is also known as BREAKEVEN SALES.

The above formula can actually be derived by using the CVP income statement.
Please refer to the diagram below:

— XX xx <— 100%
(xx) (xx) (xx)
Contribution Margin XX +, 100,000 + xx |
Fixed Cost WORKBACK ]aon.000) (xx)
Income Before Tax 0 xx

Based on the above income statement, it is assumed that the total fixed cost is
P100,000. Always remember that at breakeven point, total profit is zero. Hence,
total fixed cost is equal to total contribution margin.

In effect, to compute the quantity sold to have a zero profit, just divide total
contribution margin by UCM. That quantity is actually known as the breakeven
point in units. So it is clear that the formula of breakeven point was actually
derived from the CVP income statement. The formula used total fixed cost as its
numerator since total fixed costs and total contribution margin are equal at
breakeven point.

Again, use the CVP income statement to compute the required peso sales to earn
zero profit. It is done by dividing total contribution margin by CMR. The required
amount of sales is actually the breakeven sales. In the formula, it used total fixed
cost as the numerator since it is equal to total contribution margin at breakeven
point.

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Chapter 3 — Cost-Volume-Profit (CVP) Analysis

Illustration 3 - Breakeven Point

In the month of September, IMELDA CORP. sold 1,000 units of product. Tp,
average sales price was P60. During the month, fixed costs were P14,400 an,
variable costs were 60% of sales.
REQUIREMENTS:
(a) Determine the contribution margin in total peso arsOu per unit, and as,
ratio.
(b) Compute the monthly break-even point in peso sales and in units.
Solution (Illustration 3):
Requirement (a):
Based on the given information, since the variable cost percentage is 60%, the
contribution margin ratio is automatically 40%.
Thus, the unit contribution margin is P24 (P60 selling price x 40% CMR).
The total contribution margin of selling 1,000 units is P24,000 (1,000 units x 24
UCM)
NOTE: Just plot the above information on the CVP template and the above answers
can be derived.
Requirement (b):
Breakeven point in units: Total fixed costs + UCM
Breakeven point in units: (P14,400 + P24) = 600 units
Breakeven sales: Total fixed costs + CMR
Breakeven sales: (P14,400 + 40%) = P36,000
Alternative, breakeven sales can also be computed by multiplying the breakeven
point in units by the selling price. This is computed as follows:
Breakeven sales: (600 units x P60) = P36,000
Since the company sold 1,000 units during the month, then it is operating above
breakeven point and therefore, earning profit. To prove that, the income before
tax of the company during the month of September is computed as follows:
Sales (1,000 units x P60) P60,000
Variable cost [1,000 units x (P60 x 60%)] (36,000)
Contribution margin 24,000
Fixed cost (14.400)
Income before tax P9,600
NOTE: If the problem is asking for the annual breakeven point, whether in units or
in total sales, just multiply the answer above by twelve (12) since the above
answers are all monthly amounts.

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Illustration 4 - Breakeven Point (No UCM or CMR given)

BUNJOY CORP. is a manufacturer of school bags. During its first year of operations,
it earned P300,000 on sales of P2,000,000. During the subsequent period, it
earned P660,000 on sales of P2,800,000.
REQUIREMENTS:
(a) Determine the total annual fixed costs of the company.
(b) Determine the annual breakeven sales.
Solution (Illustration 4):
Requirement (a):
Based on the given information, two levels of sales were given. Even though there
is a change in the amount of sales (resulting to a change in the amount of income),
it can still be assumed that selling price, variable cost and UCM are constant.
Hence the CMR is also constant.
In this type of situation, the following special formula for CMR or UCM, which
were derived from high-low method, can be used:

CMR = Change in income before tax + Change in sales

UCM = Change in income before tax + Change in quantity
OTE: The above formula can only be used if the change in sales and operating
ncome is due to change in quantity or sales volume. This formula is inapplicable
or situations where there is a change in selling price or cost structure.

If the above formula is applied:

CMR: [(P660,000 - P300,000) + (P2,800,000 - P2,000,000) = 45%
To compute total fixed cost, squeeze it as the difference between total
contribution margin and income before tax. Please see the following solution:

@ 2M sales @ 2.8M sales

Total CM (P2M x 45%) P900,000 (P2.8Mx45%) P1,260,000
Total fixed cost (SQUEEZE) (600,000) (600,000)
Income before tax P300,000 P660,000
Observe that the total fixed cost is the same on the two sales levels since total
fixed cost is constant regardless of the changes in activity levels (basic assumption
in CVP analysis).
Requirement (b):
Breakeven sales: Total fixed costs + CMR
Breakeven sales: (P600,000 + 45%) = P1,3333,333
Since the two sales levels were above breakeven point, they both earned profits
amounting to P300,000 and P600,000, respectively.

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PROFIT PLANNING
Profit planning is the set of actions taken to achieve a targeted profit leva,
Basically, it aims to set a profit objective for a budgeting period.
The frequently asked questions regarding this topic are:
(1) Whatare the required unit sales to meet the desired or target profit?
(2) What are the required peso sales to meet the desired or target profit?
NOTE: The desired profit could be before-tax or after-tax profit.
In answering profit planning questions, simply workback and squeeze amounts jp
the CVP income statement. Just remember to carry-over amounts which are
considered or identified as constant.
Illustration 5 - Breakeven Point, Profit Planning & Other CVP Concerns
KM CORP. produces and sells a single product. The product's variable cost per unit
is P12 while the corporation’s total fixed costs is P120,000 per month. The
company expected to sell 30,000 units per month and planned its monthly results
as follows:
Sales P600,000
Variable cost (360,000)
Contribution margin 240,000
Fixed cost (120,000)
Income before tax 120,000
Tax (30%) (36.000)
Net income P84,000
REQUIREMENTS: Based on the preceding information, answer the following
questions independently:
(a) What selling price did the company establish? What is the contribution
margin per unit?
(b) What is the break-even point in units and in total peso sales?
(c) If the company wants a P160,000 before-tax profit, how many units must it
sell? What are the required sales to earn that target profit?
(d) If the company wants a P105,000 after-tax profit, how many units must it
sell? What are the required sales to earn that target profit?
(e) Ifthe company wants a 10% before-tax return on sales, what level of sales, in
pesos, does it need? How many units must it sell to earn the target profit
percentage?
(f) If the company wants a 10.50% after-tax return on sales, what level of sales,
in pesos, does it need? How many units must it sell to earn the target profit
percentage?
(g) If the company wants an after-tax profit of P126,000 on its expected sales
volume of 30,000 units, what price must it charge?
(h) If the company wants a before-tax return on sales of 25% on its expected
sales volume of 30,000 units, what price must it charge?
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Solution (Illustration 5):

Requirement (a):
The first thing necessary to do is to plot the given information in the CVP income
statement. Then fill in the blank items in order to complete the income statement.
The CVP income statement looks like as follows:
‘ PERUNIT PERTOTAL PERCENTAGE
SOSCOUMNS citi 20 600,000 100%
] Variable Cost (12) (360,000) (60%)
Contribution Margin 8 240,000 40%
Fixed Cost (120,000) (20%)
Income Before Tax 120,000 20%
Tax Expense (36,000)
Net Income 84,000
To compute the selling price, simply divide the total sales of P600,000 by the
quantity sold of 30,000 units. The established selling price is P20 per unit.

Afterwards, UCM is computed by deducting variable cost per unit of P12 from the
selling price of P20 per unit. The unit contribution margin is P8 per unit.

Requirement (b):
Breakeven point in units: Total fixed costs + UCM
Breakeven point in units: (P120,000 + P8) = 15,000 units

Breakeven sales: Total fixed costs + CMR

Breakeven sales: (P120,000 + 40%) = P300,000 or
Breakeven sales: (15,000 units x P20) = P300,000

Requirement (c):
Requirements (c) to (f) are profit planning questions. In answering these types of
questions, the first step is to plot the constant amounts, along with the desired or
target profit in the CVP income statement. From there, work-back and squeeze
amounts to compute the requirement(s) of the questions.

For requirement (c), the CVP income statement with plotted constant amounts
and target profit looks as follows:

PERUNIT PERTOTAL PERCENTAGE

xx units
Sales 20 XX 100%
Variable Cost (12) (xx) (60%)
Contribution Margin 8 XX 40%
Fixed Cost (420,000) (xx)
RKBACK
Income Before Tax wo 160,000 XX

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Based on the preceding income statement, the total contribution margin at :

desired profit before tax of P160,000 is P280,000. (P160,000 + P120,000).

From there, compute the required number of units and required amount of sale,
to meet the target profit before-tax of P160,000.
Required number of units: (P280,000 + P8) = 35,000 units
Required sales amount: (P280,000 + 40%) = P700,000 or
Required sales amount: (35,000 units x P20) = P700,000

Requirement (d):
Same procedures shall be applied on this requirement. The only difference of this,
requirement from the previous requirement is the fact that the given profit is,
after-tax. With such, it is necessary to convert the after-tax profit into before-tay
profit. |

To do that, simply divide the after-tax profit of P105,000 by 70% (100% - tax rate
of 30%). Thus, the before tax profit is P150,000. Please see the CVP income
statement below:
PERUNIT PERTOTAL PERCENTAGE
TEM gales 20 xx 100%
| Variable Cost (12) (xx) (60%)
Contribution Margin 8 xx 40%
Fixed Cost (120,000) (xx)
Income Before Tax worKBAcK | 150,000 XX
Tax Expense (xx)
Net Income 105,000

Based on the above income statement and after the before-tax profit of P150,000
was computed, compute now the total contribution margin which is P270,000,
(P150,000 + P120,000). |

From there, compute the required number of units and required amount of sales|
to meet the target profit after-tax of P105,000.

Required number of units: (P270,000 + P8) = 33,750 units

Required sales amount: (P270,000 + 40%) = P675,000 or
Required sales amount: (33,750 units x P20) = P675,000
Requirement (e):
This requirement is still a profit planning question but the target profit is nor
stated in an amount but rather stated in a percentage. To visualize the strategy i!
answering this question, the first thing that is required to do is plot the constan!
amounts together with the target profit percentage. Please see the CVP incomé
statement below: |
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PERUNIT PERTOTAL PERCENTAGE

XUN soles 20 x <— 100%
I Variable Cost (12) (xx) (60%)
Contribution Margin 8 xx 40%
Fixed Cost | (120,000) + {xx)] squeeze
Income Before Tax XX 10%

Since the total fixed cost is already given based on ‘the above CVP income
statement, it is necessary to squeeze its percentage. It is done by deducting the
profit percentage of 10% from the CMR of 40%. Hence the fixed cost percentage is
30%.

Afterwards, compute the required sales by dividing P120,000 by the fixed cost
percentage of 30%. Thus, the required sales to achieve the target profit of 10% is
(P120,000 + 30%) P400,000.

Thereafter, the required number of units to achieve a 10% profit-before tax

percentage is computed by dividing the computed sales of P400,000 by the selling
price of P20 per unit. Hence, the required number of units is (P400,000 + P20),
20,000 units.

Requirement (f):
The same procedures from the previous requirement shall be applied to
requirement (f), except that it is required to convert first the after-tax income
percentage into a before-tax percentage.

To do that, simply divide the after-tax profit percentage of 10.50% by 70% (100%
- tax rate of 30%). Thus, the before tax profit is 15%. Please see the below CVP
income statement:

xx units
PERUNIT PERTOTAL PERCENTAGE
Sales 20 x < 100%
| Variable Cost (12) (x) (60%)
Contribution Margin 8 XX 40%
Fixed Cost | (120,000) + (xx) ] squeeze
Income Before Tax XX 15%

Now, compute the required sales by dividing P120,000 by the fixed cost
percentage of 25% (40% - 15%). Thus, the required sales to achieve the target
profit of 15% is (P120,000 + 25%) P480,000.

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Thereafter, the required number of units to achieve a 15% profit-before t,

percentage is computed by dividing the computed sales of P480,000 by the selling
price of P20 per unit. Hence, the required number of units is (P480,000 + P20)
24,000 units.

Requirement (q):
To answer this requirement, the strategy again is to plot the target profit along
with the constant amounts in the CVP income statement.

In addition, it is a must to convert the after-tax income of P126,000 to before-ta,

income. The before tax income is P180,000 (P126,000 + 70%). Please see the Cyp
income statement below:

PERUNIT PERTOTAL PERCENTAGE

ane ? xx 100%
Variable Cost (12) (360,000) (xx)
Contribution Margin XX XX xX
Fixed Cost WORKBACK | (120,000) (xx)
Income Before Tax 180,000 xx

Observe that UCM is not constant anymore since the problem is asking a new
selling price, meaning, the selling price is not constant. Also, since there is a
change in selling price, the variable cost ratio and contribution margin ratio are
not constant.

The total variable cost, by nature, is not constant but on this problem it was
carried over since both the quantity and variable cost per unit are constant.

To compute the selling price per unit to achieve a target profit before tax of
P180,000, workback the total contribution by adding the target income before-tax
and the total fixed cost, which is equal to P300,000 (P180,000 + P120,000). Then
workback the amount of sales by adding the computed contribution margin and
the total variable cost, which is equal to P660,000 (P300,000 + P360,000).

From there, divide the computed total sales of P660,000 by the sales volume of
30,000 units to compute the target selling price of P22 per unit (P660,000 +
30,000 units).

Requirement (h):
Just like from the previous requirement, plot the target profit percentage of 25%
along with the constant amounts in the CVP income statement in order to answet
requirement (h). The CVP income statement looks like as follows:

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30,000 units PERUNIT PERTOTAL PERCENTAGE

, Sales ? XX 100%
\ Variable Cost (12) (260.000 bs
Contribution Margin xX
Fixed Cost eeannii est
Income Before Tax xx 25%

Since the requirement is asking for a new selling price, the UCM, variable cost rate
and CMR are considered to be NOT CONSTANT.

The strategy for this requirement is actually quite different from what was done
on the previous requirements. As can be seen, total variable cost was carried over
since both the quantity and variable cost per unit are constant. In addition, total
fixed cost is also available. The CVP income statement can be transformed into this
format:
Amount Percentage
Sales ? 100%
Variable Cost (360,000) L— 759
Fixed Cost (120,000) Pe
Income Before-tax XX 25%

Based on the above information, it can be technically stated that the combined
amount of variable cost and fixed is 75% of total sales. In conclusion, to compute
the required amount of sales to earn a 25% profit percentage, divide the sum of
total variable cost and fixed cost by 75% (100% - 25%).

Required Sales: [(P360,000 + P120,000) + 75%] = P640,000. Afterwards, divide

the computed sales amount by the sales volume of 30,000 units. The required
selling price is P21.33 (P640,000 + 30,000 units).

Illustration 6 - Breakeven Point & Profit Planning (with Step Cost)

CARLA CORP. is a new business planning to earn a spot and to be known in the
industry of manufacturing baking supplies.

The company plans to launch a new product to be sold in the market for a price of
P20.00 per unit. Fixed costs to manufacture this product is estimated at P400,000
for less than 40,000 units and P560,000 for 40,000 or more units.

At both levels, contribution margin is constant at 40%.

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REQUIREMENTS:
(a) Whatis the company’s breakeven point in units and breakeven sales?
(b) If the company plans to earn a net income of P140,000, how many units j,
required to be sold in order to reach the target net income? What would bh,
the amount of the sales pesos to realize the target net income?
(c) Assuming that CMR will increase to 50% for units in excess of 40,000 units
what is breakeven point in units and total peso amount?
(d) Assuming that CMR will increase to 50% for units in excess of 40,000 units
and the company plans to earn a net income of P80,000, how many units js
required to be sold in order to reach the target net income? What would be
the amount of the sales pesos to realize the target net income?

Solution (Illustration 6):

Requirement (a):
In solving CVP problems with step-fixed cost, segregate the manufacturing
operations of the company into two levels; the first level being the production of
40,000 units or less and the next level is the production of more than 40,000 units,
In both levels, the unit contribution margin and the contribution margin ratio are
constant. Unit contribution margin is P8 per unit (P20 x 40%). |

On this problem, it is as if, you need to choose between two levels of fixed costs; |
either P400,000 or P560,000. But, actually that is not the case. |
|
If you will use the total fixed cost of P400,000, you'll realize that the level of
production is not enough to meet the breakeven point. The breakeven point of |
using P400,000 is 50,000 units (P400,000 + P8 UCM), but P400,000 is applicable |
only up to 40,000 units of production (the first level). This means that the |
company cannot reach breakeven point despite the production level at a
maximum of 40,000 units.

In this case, to reach breakeven point, use the total fixed cost of P560,000. Since |
CMR and UCM are constant at both levels of production, simply compute |
breakeven point as: |
Breakeven point in units: Total fixed costs + UCM
Breakeven point in units: (P560,000 + P8) = 70,000 units

Breakeven sales: Total fixed costs + CMR

Breakeven sales: (P560,000 + 40%) = P1,400,000 or
Breakeven sales: (70,000 units x P20) = P1,400,000

Requirement (b): |
Just like on the previous requirement, the total fixed cost of P560,000 will be used |
to determine the number of units and amount of sales required to reach the target
net income of P140,000.
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The next step is to workback total contribution margin by adding the target net
income and total fixed cost. (Total contribution margin = target profit + total fixed
costs) (Please see illustration 5 to understand the strategy)

Total contribution margin P700,000

Total fixed cost WORKBACK (560,000)
Income before tax P140,000

From there, divide the computed total contribution margin by UCM (P8 per unit)
and CMR (40%) in order to compute the required number of units and required
peso sales, respectively.

Required number of units: (P700,000 + P8) = 87,500 units

Required amount of sales: (P700,000 + 40%) = P1,750,000

Requirement (c):
The main difference of requirements (c) and (d) from the previous requirements
is that the CMR and UCM are not constant anymore.

When an entity produces 40,000 units or less, the CMR is 40% while the UCM is P8
per unit (P20 x 40%). On the other hand, when an entity produces more than
40,000 units, the CMR goes up to 50% with a corresponding UCM of P10 per unit
(P20 x 50%).

In this case, there will be a slight change on the strategy and the solution. Still, the
total fixed cost of P560,000 will be used for the solution. The breakeven point is
computed as follows:

40,000 units and below Above 40,000 units

Selling price P20 P20
UCM P8 P10
CMR 40% 50%
Total fixed cost P320,000 P240,000
Breakeven point (units) 40,000 units 24,000 units

Based on the above solution, the breakeven point for the first level (40,000 units
and below) is the maximum number of units that the entity can produce on that
level because if the company will use the total fixed cost of P400,000, it cannot
reach breakeven point. Therefore, it is clear that the company needs to produce
more and proceed to the next level (above 40,000 units) to reach breakeven point.

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The amount of total fixed costs assigned to 40,000 units and below is P320,009_
This amount was squeezed from the formula of breakeven point. It is computeg
as:
Total fixed cost = Breakeven point x UCM
Total fixed cost: (40,000 units x P8) = P320,000

The remaining fixed costs shall be allocated to the next level which is P240,00
(P560,000 - P320,000). The breakeven point in units for the next level jg
computed as:
Breakeven point in units: Total fixed costs + UCM
Breakeven point in units: (P240,000 + P10) = 24,000 units

In conclusion, the total breakeven point in units is 64,000 units (40,000 units +
24,000 units).

To compute the breakeven sales, simply multiply the breakeven units by the|
product’s selling price: (64,000 units x P20) = P1,280,000 |
|

Requirement (d): |
For requirement (d), the answer for the breakeven point in units for the first level
is still 40,000 units. The reason behind this is that, regardless of the situation, it
will not reach breakeven point until it passed the first level. |

In addition, all profits to be earned by the entity are attributable to the production |
of the next level (above 40,000 units) because the objective of the first level is to)
produce maximum number of units and proceed to the next level where the entity,
has the chance to breakeven and earn profits.

The required number of units to earn the profit of P80,000 is computed as follows:
|
40,000 units and below Above 40,000 units |
Selling price P20 P20
UCM P8 P10
CMR 40% 50%
Total fixed cost P320,000 P240,000 |
Operating income - 80,000
Required number of units 40,000 units 32,000 units

As explained previously, the required number of units to be produced at the first

level should be at its maximum level which is 40,000 units. The excess of the fixed!
cost and required operating income is attributable to the next level.

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The number of units in excess of 40,000 units which is required to earn income of
P80,000 is computed as:

Required number of units: [(Operating income + Total fixed costs) + UCM]

Required number of units: [(P80,000 + P240,000) + P10) = 32,000 units

In conclusion, the total required number of units to earn the P80,000 target
profit is 72,000 units (40,000 units + 32,000 units).

To compute the required sales to earn the P80,000 target profit, simply multiply
the computed number of units by the product’s selling price: (72,000 units x P20)
= P1,440,000.

SENSITIVITY ANALYSIS
Sensitivity analysis, A.K.A. “What-if Analysis” or Simulation Analysis, involves
predicting the outcomes of a situation after considering the effects of the changes
in the variables affecting the outcome of the said situation.

A business environment can change quickly, so a business should understand how

sensitive its sales, costs, and income are to changes. Thus, sensitivity analysis
shows how the CVP model will change with changes in any of its variables (e.g,
changes in fixed costs, variable costs, sales price, or sales mix). The focus is
typically on how changes in variables will alter or affect profit.

Sensitivity analysis may alter the underlying assumptions of CVP since the
amounts which are usually considered as constant may not be constant under
sensitivity analysis.

To answer sensitivity analysis questions, the strategy is:

e First, fill in the CVP income statement with amounts considered to be
constant. Unless otherwise stated by the problem, follow the basic
assumptions to determine which of the items are considered constant.

e Then, fill in the CVP income statement with new estimate of amounts such as
new variable cost per unit, new quantity or sales volume and etc. From there,
workback and squeeze amounts in order to compute the requirement of the
problem.

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Illustration 7 - Breakeven Point & Sensitivity Analysis .

MIRAK CORP. developed the following information for its newly launcheg |
product: |
Per unit Total |
Sales P180 P1,800,000
Variable cost _108 (1,080,000)
Contribution margin P72 720,000 |
Fixed costs (540,000)
Net income 180,000

The company plans to sell 10,000 units of this product for the upcoming year.

REQUIREMENTS: Answer the following questions independently:

(a) How many units must be sold to break even for the upcoming year? |
(b) Management plans to spend an additional P144,000 on an advertising
program, how many additional units must the company sell to earn the same
net income it is now making?
(c) Using the original data in the problem, compute the new break-even point in
units if the unit sales price has increased by 20%, unit variable cost has
increased by 10%, and total fixed costs has decreased by P54,000.
(d) Refer to the original data; compute for the new planned net income assuming
management wants to increase both selling price by P10 per unit and
variable costs by P7 per unit by using a higher quality material in the
production of its products. The higher-priced product would cause demand to
drop by approximately 10%.
(e) Use the original data in the problem, the marketing manager would like to cut
the selling price by P20 and increase the advertising budget by P65,000 per
month. The marketing manager predicts that these two changes would
increase monthly sales by 500 units. What should be the overall effect on the
company's monthly net operating income of this change?

Solution (Illustration 7):

Requirement (a):
Breakeven point in units: Total fixed costs + UCM
Breakeven point in units: (P540,000 + P72) = 7,500 units

Requirement (b):
Take note that the question is asking for the incremental unit sales which is
required to maintain the same net income of P180,000. The increase in
advertising cost will result to an increase in total fixed cost.

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In order to answer this requirement, plot first the constant amounts and the new
amounts as given by the problem, then compute the new unit sales by working
back and squeezing amounts in the CVP income statement. Please see the
following CVP income statement:

PERUNIT
PER TOTAL
Punts ‘sales 180 xX
| Variable Cost (108) (xx)
Contribution Margin 72 xX
Fixed Cost WORKBACK (684,000)

Income Before Tax 180,000

Observe that the inputted total fixed cost in the income statement is its new
amount of P684,000 (P540,000 + P144,000). In addition, per unit amounts are all
constant since there is no indication on the problem that there was a change on
them. The original net income was carried over since the problem stated that the
entity plans to maintain it despite the increase in advertising costs. The total
contribution margin is computed as P180,000 + P684,000, equals P864,000. The
new sales in units is computed by dividing the computed total contribution
margin by UCM which is 12,000 units (P864,000 = P72).

New sales in units (using the new information) 12,000 units

Original planned sales in units 0 ni
Increase in sales in units 2,000 units

Requirement (c):
The formula to compute breakeven point in units is:
Breakeven point in units: Total fixed costs + UCM
But using the new total fixed cost and new UCM under this requirement.

New selling price (P180 x 120%) P216.00

New variable cost per unit (P108 x 110%) (118.80)
New unit contribution margin P97.20
New total fixed costs (P540,000 - P54,000) P486,000

Breakeven point in units: (P486,000 + P97.20) = 5,000 units

Requirement (d):
The requirement is asking for the new planned operating income using the new
information given by this requirement. To compute it, squeeze and workback
amounts in the CVP income statement as follows:

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9,000 units
Sales 190 XX
| Variable Cost 115 (xx)
Contribution Margin 75 XX
Fixed Cost (540,000)
Income Before Tax ?

Based on the given information, the new sales quantity is (90% x 10,000 units)
9,000 units. On the other hand, the new selling price is (P180 + P10) and the ney
variable cost per unit is (P108 + P7). Total fixed cost is unaffected. The ney
planned net income is computed as:

Total contribution margin (9,000 units x P75) P675,000

Total fixed cost (540,000)
New planned net income P135,000

Requirement (e):
The requirement is asking for the increase or decrease in planned net income asa.
result of new information introduced by the requirement. Please see the following,
CVP income statement: |
. PERUNIT PERTOTAL
10,500 units Sales 160 xx
) Variable Cost (108) (xx)
Contribution Margin 52 XX
Fixed Cost (605,000)
Income Before Tax ?

Observe that the new sales in units are 10,500 units since the requirement stated
that the action expects to result to an increase in sales in units by 500 units. In
addition, the new selling price is P160 due to the decrease in the original selling
price by P20. The variable cost per unit is constant while total fixed costs increase
by P65,000 attributable to the increase in advertising costs. The new planned net
income is computed as:

Total contribution margin (10,500 units x P52) P546,000

Total fixed cost (605,000)
New planned net loss (P59,000)
Original planned net income (180,000)
Decrease in net income P239,000

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OPERATING LEVERAGE
The degree of operating leverage shows the extent to which a company uses fixed
costs in its cost structure. In other words, calculating operating leverage helps a
company measure what percentage of its total costs are constituted by fixed and
variable costs. This enables management to determine how effectively the
company is using fixed costs in generating profits.

A company with high degree of operating leverage indicates that the proportion of
fixed to variable costs is relatively high. Consequently, a business shall maintain a
high amount of sales in order to cover their fixed costs.

It can be computed as:

DOL = Contribution Margin (CM) + Operating Income (OI)
This formula can be used if only one activity level was given in the problem.
Otherwise, consider using the next formula to be discussed.

The degree of operating leverage (DOL) is also a measure used to evaluate how a
company's operating income changes after a percentage change in its sales. In
other words, operating leverage measures the sensitivity of a company’s operating
income to its sales. This financial metric shows how a change in the company’s
sales will affect its operating income.

DOL can also be computed as:

DOL = % Change in operating income + % Change in sales
This formula can be used if there are two activity levels given by the problem since
the amount and percentage change in income and sales can be computed.

To summarize the concept of operating leverage:

Areas of Comparison High DOL Low DOL
A large proportion of | A large proportion of
Cost Structure the company’s costs | the company’s costs
are fixed costs. are variable costs.
An entity earns a
small profit on each
An entity earns a
incremental sale,
Effect of Incremental Sale large profit on each
since large amount of
incremental sale
sales will go to
variable costs
Income will be more Income will be less
Sensitivity of Income sensitive to changes | sensitive to changes
in sales volume. in sales volume.
Income penoration The entity will earna The entity earns
é major profit on all profits at low sales
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sales after it has paid | levels, but it does not

for its fixed costs. earn substantial
amount of profits if it
can generate
additional sales.

OTE: Degree of operating leverage is constant as long as there is no change jp

elling price, total fixed costs and variable cost per unit.

MARGIN OF SAFETY
Margin of safety (MOS) is the amount of peso sales or the number of units by
which actual or budgeted sales may be decreased without resulting into a loss,
Margin of safety represent the maximum amount in peso sales or in unit sales that
it can decrease but without resulting to a loss.

Simply stated, margin of safety is the reduction in sales that can occur before the
breakeven point of a business is reached because if an entity is operating below
breakeven point, it will incur operating losses.

In effect, margin of safety is computed as:

Margin of safety (units) = Actual or Planned Units - Breakeven Point in Units |
Margin of safety (peso amount) = Actual or Planned Sales - Breakeven Sales

Hence, if an entity has breakeven sales of P100,000 and margin of safety is

P200,000, then the planned or actual sales is P300,000.

Alternatively, the margin of safety in units and peso amount can be computed
through the computation of margin of safety ratio or percentage. The formula is:
MOS (in percentage) = Operating Income (01) + Contribution Margin (CM)

Afterwards, multiple the MOS ratio to the actual or planned sales in units and peso
amount to calculate the MOS in units and peso amount, respectively.

Illustration 8 - Operating Leverage & Margin of Safety

JANEYAH CORP. developed the following information for the product it sells:
Sales price P100 per unit
Variable cost of goods sold P46 per unit
Fixed cost of goods sold P400,000
Variable selling expense 10% of sales price
Variable administrative expense P4 per unit
Fixed selling expense P200,000
Fixed administrative expense P150,000
For the current year ended, JANEYAH CORP. produced and sold 50,000 units of
product.
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REQUIREMENTS:
(a) Prepare a CVP income statement for the current year.
(b) What was the company's break-even point in units and breakeven sales in
current year?
(c) What was the company's margin of safety in units and peso amount in the
current year?
(d) What is the degree of operating leverage?
(e) If the company can increase sales in units by 30 percent, what percentage
increase will it experience in income?

Solution (Illustration 8):

Requirement (a):
Before preparing the CVP income statement, figure out and compute first the
necessary amounts to complete the income statement and they are as follows:

Variable cost per unit:

Variable cost of goods sold P46 per unit
Variable selling expense (10% x P100) 10 per unit
Variable administrative expense 4 per unit
Total P60 per unit

Total fixed costs:

Fixed cost of goods sold P400,000
Fixed selling expense 200,000
Fixed administrative expense 150,000
Total P750,000

Remember that under the CVP income statement, costs are classified according to
behavior. This means that the variable cost to be presented in the income
statement includes variable product and period costs. This goes as well for fixed
cost.

With that, the CVP income statement is presented as follows:

PERUNIT PERTOTAL
50/000 units: ies 100 5,000,000
} Variable Cost (60) (3,000,000)
Contribution Margin 40 2,000,000
Fixed Cost (750,000)
Income Before Tax 1,250,000

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Requirement (b):
Breakeven point in units: Total fixed costs + UCM
Breakeven point in units: (P750,000 + P40) = 18,750 units

Breakeven sales: Total fixed costs + CMR

Breakeven sales: (P750,000 + 40%) = P1,875,000 or
Breakeven sales: (18,750 units x P100) = P1,875,000

Requirement (c):
Since the breakeven point in units and breakeven sales were already computed
compute margin of safety in units and in peso amount.
Margin of safety in units = Actual units sold - breakeven point in units
Margin of safety in units = (50,000 units - 18,750 units) = 31,250 units

Margin of safety in total amount = Actual sales - breakeven sales

Margin of safety in total amount = (P5,000,000 - P1,875,000) = P3,125,000

Alternative Solution:
Alternatively, the margin of safety in units and total peso amount can be computed
by computing first the margin of safety ratio or percentage.

MOS (in percentage) = Operating Income (OJ) + Contribution Margin (CM)

MOS (in percentage): (P1,250,000 + P2,000,000) = 62.50%

Afterwards, multiply the MOS ratio to the actual sales in units and peso amount to
calculate the MOS in units and peso amount, respectively.

MOS in units: (50,000 units x 62.50%) = 31,250 units

MOS in total peso amount: (P5,000,000 x 62.50%) = P3,125,000

NOTE: There is an alternative solution in computing MOS percentage. Since the

breakeven sales or breakeven point in units was already computed, simply divide
it by the actual unit sales or actual sales to compute breakeven point percentage.

Using the breakeven sales, the breakeven point percentage is: (P1,875,000 +
P5,000,000) = 37.50%. Automatically, the margin of safety percentage is 62.50%,
the same amount that was computed a while ago. © Always remember that
breakeven point and margin of safety are opposite amounts.

Requirement (d):
DOL = Contribution Margin (CM) + Operating Income (01)
DOL: (P2,000,000 + P1,250,000) = 1.60

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Requirement (e):
Remember that DOL is constant provided there is no change in selling price or
cost structure. On this requirement, even though there is an increase in sales, it
can be safely assumed that this is due to change in quantity sold. The formula of
DOL can be used for this problem is:
DOL = % Change in operating income + % Change in sales

Since the DOL has been computed and the problem gave the percentage change in
sales, the percentage change in operating income can now be computed by
working back the above formula:
% Change in operating income = DOL x % Change in sales
% Change in operating income: (1.60 x 30%) = 48%

In order to prove the 48% change in operating income, prepare a new CVP income
statement with the 30% increase in sales (with the assumption that the change is
due to change in sales in units).
Total contribution margin (50,000 units x 130% x P40) P2,600,000
Total fixed costs (750,000)
Income before tax / net income P1,850,000
Original net income (1.250.000)
Increase in net income P600,000
Percentage increase in net income (P600,000 + P1,250,000) 48%

Illustration 9 - Comprehensive
JHEMA CORP. had a 25 percent margin of safety. Its after-tax return on sales is 6
percent, and tax rate of 40 percent. Its total fixed costs amount to P320,000.

REQUIREMENT: How much sales did JHEMA make for the year?

Solution (Illustration 9):

The first thing that is needed to accomplish is to convert the after-tax income
percentage of 6% to its before-tax percentage. That is done by dividing 6% by the
after-tax rate of 60% (100% - 40% tax rate). Hence, the before-tax income
percentage is 10%.

As previously discussed, the formula for margin of safety percentage is:

MOS (in percentage) = Operating Income (01) + Contribution Margin (CM)

Since the problem gave the MOS percentage and the operating income percentage
was derived, the CMR or CM percentage can now be computed by modifying the
above formula into:
CM Percentage = Operating Income Percentage + MOS percentage

Hence, the CMR is 40% (6% + 25%).

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Afterwards, compute the amount of sales by squeezing the total fixed cog
percentage as follows:
Per Total Percentage
Sales XX 100%
Variable Cost (xx) (xx)
Contribution Margin XX 40%
Total Fixed Cost (320,000) SQUEEZE (30%)
Operating Income XX 10%

Then divide the total fixed cost of P320,000 by 30% to compute the amount of
sales which is P1,066,667 (P320,000 + 30%).

Illustration 10 - Comprehensive
BUDOY CORP. has a degree of operating leverage of 2.5. It’s sales for the upcoming
year is estimated at P400,000. There is no proposed change in the cost structure
of the entity and selling price of its product.

REQUIREMENT: What are BUDOY’s breakeven sales?

Solution (Illustration 10):

Remember that the formula to compute operating leverage is CM + OI. Therefore,
it can be safely assumed that total contribution margin is equal to 2.5 while
operating income is equal to 1.

In line with these, the margin of safety percentage can now be computed using the
formula OI + CM which is equal to 40% (1 + 2.5).

Since the margin of safety percentage is 40%, it is safe to conclude that the
breakeven percentage is 60%. (Remember that the two concepts are interrelated on
that sense)

The estimated sales for the upcoming year was given at P400,000. Thus, the
breakeven sales is 60% of P400,000 or P240,000.

Illustration 11 - Comprehensive
The following information relates to CHECHA CORP.
Sales at the break-even point P312,500
Total fixed expenses 250,000
Net operating income 150,000

REQUIREMENT: What is CHECHA’s margin of safety?

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Solution (Illustration 11):

e + CM)
To compute MOS percentage, the formula is: (MOS percentag = OI

Thus, by adding net income to total fixed costs, the total contribution margin can
now be computed which is as follows:
Total contribution margin (WORKBACK) P400,000
Total fixed costs (250,000)
Net income P150,000

Hence, the MOS percentage is 37.50% (P150,000 + P400,000); which makes

breakeven sales percentage at 62.50%.

In addition, CMR can be calculated by modifying the formula of breakeven point,

which is as follows:
Breakeven Sales = Total Fixed Costs + CMR, then
CMR = Total Fixed Costs + Breakeven Sales

Contribution margin ration (CMR) is 80% (P250,000 + P312,500). By doing this,

the total amount of sales can now be computed which will lead subsequently in
computing the margin of safety. Sales can be computed by dividing the computed
total contribution margin of P400,000 by the CMR of 80%, which amounts to
P500,000.

Therefore, margin of safety is 37.50% of the total sales of P500,000, which is

P187,500.

For checking purposes, if you multiply P500,000 by the breakeven sales

percentage of 62.50%, it will result to the same amount of breakeven sales of
P312,500 (P500,000 x 62.50%).

Alternatively, you can compute margin of safety as: (P312,500 + 62.50% x

37.50%) = P187,500.

POINT OF INDIFFERENCE
Point of Indifference (POI) or Indifference Point, is the point where two
alternatives, either of them to be chosen, will produce the same profit.

This point is called cost indifference point since:

Profit of alternative A = Profit of alternative B

Point of indifference is useful in analyzing many types of alternative choice

decisions such as choosing between alternative production methods, marketing
plan or quality control programs.

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It is computed as follows:
Point of Indifference (units) = Change in Total FC + Change in UCM
Point of Indifference (total amount) = Change in Total FC + Change in CMR

Illustration 12 - Point of Indifference

IVY CORP. sells one of its products known as “sleep-well pillow” for P50. Variable
cost per unit is P24, and monthly fixed costs is P52,000.

The company has an alternative to produce and sells this product. This involves
reducing variable cost per unit to P20 but increase monthly fixed costs by
P20,000.

REQUIREMENTS:
(a) Determine the monthly break-even points under the two available
alternatives.
(b) Determine the indifference point of the two alternatives.

Solution (Illustration 12):

Requirement (a):
In order to facilitate the computation of breakeven point, present the necessary
information as follows:
Alternative 1 Alternative 2
Selling price P50 P50
Variable cost per unit (24) (20)
Unit contribution margin P26 P30
Contribution margin ratio 52% 60%
Total fixed costs P52,000 P72,000

Based on the above information, compute the breakeven point for each alternative
as follows:
Alternative 1: (P52,000 + P26) = 2,000 units or (P52,000 + 52%) = P100,000;
Alternative 2: (P72,000 + P30) = 2,400 units or (P72,000 = 60%) = P120,000

WARNING: Please be mindful in the use of “increase or decrease by” and “increase
or decrease to”. In the illustration, it used increase by which represents the
amount of increase in total fixed costs.

Requirement (b):
To compute point of indifference, the formula is:
Point of Indifference (units) = Change in Total FC + Change in UCM
Point of Indifference (total amount) = Change in Total FC + Change in CMR

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Point of indifference (units): (P20,000 + P4) = 5,000 units

Point of Indifference (total amount): (P20,000 + 8%) = P250,000 or
Point of Indifference (total amount): (5,000 units x P50) = P250,000

In order to prove that the computed point of indifference is correct, construct a

CVP income statement for the two alternatives:

Alternative 1 Alternative 2
Sales (5,000 units x P50) P250,000 P250,000
Variable cost (5,000 unitsx P24) (120,000) (5,000 unitsx P20) (100,000)
Contribution Margin P130,000 P150,000
Fixed cost (52,000) (72.000)
Net income 78,000 78,000

Remember that indifference point is the point where the two alternative will
generate the same amount of net income.

MULTIPLE PRODUCTS
Same concepts shall be used in applying the concepts of CVP for an entity that
produces and sells more than one type of products. Remember that in reality,
many businesses offer more than one type of product in order to diversify their
product lines.

These individual products have different selling prices, variable costs per units,
contribution margins and contribution margin ratios but the firm’s total fixed
costs are generally the same regardless of the mix of the products sold. In line with
these, the CVP income statement of a company having multiple products would
look like this:

exhibit 3.4 - The CVP Income Statement (Multiple Products)

PRODUCT 1 PRODUCT2
TOTAL
as UNIT TOTAL x UNIT TOTAL %
Sales KX xx 100% = Sales XX “Xx 100% xx

| Variable Cost (xx) (aa) (xx) Variable Cost ix) = kd tax ix)
Contribution Margin xx Xx xx Contribution Margin = xx XX xx xx

Fixed Cost (xx)

income Before Tax xx

Tax Expense (xx)

Net Income xx

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Based on exhibit 3.4, sales, variable cost and contribution margin (whether pe,
unit, per total or percentage), are specifically identifiable for each type of product
On the other hand, total fixed costs cannot be specifically identified to any product
since by nature, it is constant regardless of the product mix.

As mentioned before, same CVP concepts shall be applied in this topic but there
are two (2) rules that are significant to remember when it comes to CVP analysis
of multiple products.

RULE 1: The Averaging Rule

When using information from sales until contribution margin, the amount should
be weighted averaged (e.g. selling price, variable cost per unit, UCM, variable cost
ratio and CMR).

For instance, everyone knows that the formula of breakeven point in units is Fixed
Cost + UCM. For breakeven point in units of multiple products, the formula will be
modified as follows:
Total BEP (units) = Total Fixed Cost + Weighted Average UCM (WAUCM)

Accordingly, the formula of total breakeven sales of multiple products is:

Total BES = Total Fixed Cost + Weighted Average CMR (WACMR)

To compute weighted average amounts, use the concept of sales mix. Sales mix is
the relative composition or combination of products that compose a company’s
total sales.

Sales mix is expressed IN UNITS OR IN PESO SALES.

Illustration 13 - Computation of Sales Mix

MJ CORP. has three products, PRODUCT A, PRODUCT B and PRODUCT C. Recent
information regarding these products was gathered and they are as follows:

Units sold Selling Price

Product A 20,000 P20
Product B 30,000 P30
Product C 50,000 P14

For the upcoming year, the sales mix is considered to be the same as last year.

REQUIREMENT: Compute sales mix in units and sales mix in peso sales.

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Solution (Illustration 13):

In computing sales mix in units, the basis is the number of units sold per product:

Units sold Sales Mix (units)

Product A 20,000 20%
Product B 30,000 30%
Product C 50,000 50%
Total 100,000 100%

In computing sales mix in peso sales, the basis is the total amount of sales for each
product:

Amount of Sales Sales Mix (Peso Sales)

Product A (20,000 units x P20) P400,000 20%
Product B (30,000 units x P30) 900,000 45%
Product C (50,000 units x P14) 700,000 35%
Total P2,000,000 100%

Based on the above computations, sales mix in units is generally not the same as
the sales mix in pesos sales. If the problem is silent in terms of sales mix, safely
assume that the sales mix given is expressed in units.

Sales mix in units and in peso sales are used differently depending on the given
information and requirement of the problem. To understand this, please see the
next rule in applying CVP analysis for multiple products.

RULE 2: The Compatibility Rule

Under this rule, amounts used should be compatible, everything should be
compatible. This is best explained when using sales mix.

Sales mix is used in the following:

(1) In computing weighted average amounts (please see Rule 1)
The sales mix to be used in computing average amounts should be compatible
with the amount it is being multiplied to. For instance, in computing weighted
average UCM, the UCM of each product should be multiplied by their
respective sales mix in UNITS. The amounts are compatible since they are
both expressed in units. Weighted average UCM cannot be computed if sales
mix in peso amount will be used; they are incompatible.

If the goal is to compute weighted average CMR, it is necessary to multiply the

CMR of each product by their respective sales mix in peso amount. The
amounts are compatible since they are both expressed in peso sales.

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—
OTE: Weighted average CMR can still be computed even if the given is sales mix in
nits by using the following special formula:
WACMR = WAUCM + WASP
Where:
ACMR = Weighted average CMR
AUCM = Weighted average UCM
ASP = Weighted average selling price (This is computed by multiplying the
elling price of each product by their respective sales mix in units; the amounts
re compatible)
——)

(2) Sales mix is used in allocating amounts to products. For instance, the total
breakeven point in units has been already computed which is to be allocated
to the products in order to compute per product’s breakeven point. This is to
be allocated through the use of sales mix, provided sales mix expressed in
UNITS since it is necessary to follow the compatibility rule.

On the other hand, if to be allocated is the computed total breakeven sales to

the products, sales mix in pesos shall be used. The amounts are compatible
since both of them are expressed in peso sales.

In conclusion, in computing weighted average amounts and in allocating

amounts into the products, everything should be compatible.

Illustration 14 - CVP Analysis of Multiple Products

ELSON CORP. produces and sells two kinds of calculators: manual and scientific.
The information in relation to these products is provided below:
Manual Scientific
Selling price P20 P50
Variable cost per unit (12) (26)
Unit contribution margin P8 P24
CMR 40% 48%
No. of units sold 30,000 20,000

Total fixed costs amounted to P259,200

REQUIREMENTS:
(a) What is the break-even point in total units? What is the breakeven point in
units of each product?
(b) What is the break-even point in total sales? What are the breakeven sales of
each product?

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Solution (Illustration 14):

Requirement (a):
WAUCM shall be computed first in order to compute the total breakeven point in
units.

To do this, compute and use sales mix in units. When it has been computed, the
sales mix in units is 60% for manual (30,000 units + 50,000 units) and 40% for
scientific (20,000 units + 50,000 units). (Note: The denominator of 50,000 units is
actually the sum of the units sold for manual and scientific)

Then, WAUCM is computed by multiplying the UCM of each product by their

respective sales mix in units. It is computed as follows:
WAUCM: (P8 x 60%) + (P24 x 40%) = P14.40 per unit

Therefore, total breakeven point in units is:

Total BEP (units) = Total Fixed Cost + Weighted Average UCM (WAUCM)
Total BEP (units): (P259,200 + P14.40) = 18,000 units.

To allocate the computed total breakeven point in units to manual and scientific,
use the sales mix in units. Hence, the breakeven point of manual and scientific is
computed as:
Manual Calculator: (18,000 units x 60%) = 10,800 units
Scientific Calculator: (18,000 units x 40%) = 7,200 units

Requirement (b):
WACMR shall be computed first in order to compute the total breakeven sales.
This is done by first computing the sales mix in peso sales.
Sales Sales Mix
Manual (30,000 units x P20) P600,000 37.50%
Scientific (20,000 units x P50) 1,000,000 62.50%
Total P1,600,000 100.00%

Afterwards, calculate WACMR by multiplying the CMR of each product by their

respective sales mix in pesos:
WACMR: (40% x 37.50%) + (48% x 62.50%) = 45%

Therefore, total breakeven sales are computed as:

Total BES = Total Fixed Cost + Weighted Average CMR (WACMR)
Total BES: (P259,200 + 45%) = P576,000

To allocate the computed total breakeven sales to manual and scientific, use the
sales mix in peso sales. Hence, the breakeven sales of manual and scientific are
computed as:
Manual Calculator: (P576,000 x 37.50%) = P216,000
Scientific Calculator: (P576,000 x 62.50%)= P360,000
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Alternative solution:
Since the breakeven point in units of both manual and scientific on requiremey,
(a) has already been computed, simply multiply them to the product's respecting
selling price to compute the product's breakeven sales.

The breakeven sales of each product are computed as:

Manual Calculator: (10,800 units x P20) = P216,000
Scientific Calculator: (7,200 units x P50) = P360,000

Furthermore, WACMR can also be computed by using the special formula:

WACMR = WAUCM + WASP

Weighted average selling price is computed by multiplying each product’s selling

price by their respective sales mix in UNITS.
WASP: (P20 x 60%) + (P50 x 40%) = P32

WACMR: (P14.40 = P32) = 45%

Total BES = Total Fixed Cost + Weighted Average CMR (WACMR)
Total BES: (P259,200 + 45%) = P576,000

Observe that in answering the two requirements, the averaging rule and
compatibility rule have been properly used. These rules shall be observed
diligently in CVP Analysis for multiple products.
Illustration 15 - CVP Analysis of Multiple Products
IAN CORP. is engaged in the manufacturing of bed mattresses. It sells two types of
mattress, the regular and premium. IAN CORP. sells the regular and premium
mattresses in the ratio of 1:2.
Selling prices for regular and premium mattress are, respectively, P300 and P900;
respective variable costs are P180 and P540. The company's fixed costs are
P1,400,000 per year. The entity is subject to a 30% tax rate.
REQUIREMENTS:
(a) What is the breakeven point in units of regular and premium mattresses?
What are the total breakeven sales?
(b) What is the number of units of regular and premium mattresses required for
the company to earn P350,000 income before taxes?
(c) What is the number of units of regular and premium mattresses required for
the company to earn P392,000 income after taxes?
(d) What is the number of units of regular and premium mattresses required for
the company to earn before-tax return on sales of 10%,
(e) What is the number of units of regular and premium mattresses required for
the company to earn after-tax return on sales of 8.40%.

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Solution (Illustration 15):

Requirement (a):
Based on the given information, the sales ratio of 1:2 is the basis of computing
sales mix in units. Hence, the sales mix in units for regular mattress and
premium mattress is 33.33% (1/3) and 66.67% (2/3), respectively.

In addition, before answering the requirements, compute first the necessary

information needed for CVP analysis and they are as follows:
REGULAR PREMIUM
Selling Price P300 P900
Variable Cost Per Unit (180) (540)
Unit Contribution Margin 120 360
CMR 40% 40%

To compute total breakeven point in units, the formula is:

Total BEP (units) = Total Fixed Cost + Weighted Average UCM (WAUCM)

In computing weighted average UCM, multiply the UCM of each product by their
respective sales mix in units.
WAUCM: (P120 x 33.33%) + (P360 x 66.67%) = P280 per unit.

Thus, total breakeven point in units is:

Total BEP (units): (P1,400,000 + P280) = 5,000 units

To allocate the total breakeven point in units of 5,000 units, sales mix in units shall
be used. The breakeven point in units of each product is:
REGULAR: (5,000 units x 33.33%) = 1,667 units
PREMIUM: (5,000 units x 66.67%) = 3,333 units

The formula to compute total breakeven sales is:

Total BES = Total Fixed Cost + Weighted Average CMR (WACMR)

Take note, WACMR cannot be computed by multiplying the products CMR by their
respective sales mix since the sales mix is expressed in units; making the two
items incompatible. Therefore, use the special formula in computing WACMR,
which is:
WACMR = WAUCM + WASP

WAUCM is already computed at P280 per unit. To compute WASP, simply multiply
the product’s selling price by its corresponding sales mix in units since the two
amounts are both expressed in units; making them compatible.
WASP: (P300 x 33.33%) + (P900 x 66.67%) = P700 per unit.

Hence, WACMR is 40% (P280 + P700). The total breakeven sales are computed as:
Total BES: (P1,400,000 + 40%) = P3,500,000.
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Requirement (b):
To answer this type of question regarding multiple products, always remembe, |
that the same concepts from CVP analysis of single product are being used here »,__
multiple products. Hence, the first thing to do is to visualize the problem, as if itis
a single product question (so use the CVP income statement).

From there, formulate a strategy to squeeze or work back the required amount(s),
provided that the averaging rule and compatibility rule have been properly
applied.

Just like on this requirement, it is asking for the required number of units
necessary for the company to earn profit before tax of P350,000. If it is a single
product question, the CVP income statement would look like as follows:

PERUNIT PERTOTAL
ans Sales (xx) XX
} Variable Cost (xx) (xx)
Contribution Margin xx 1,750,000
Fixed Cost WORKBACK i (1,400,000)
Income Before Tax 350,000

Based on the income statement, the strategy is to workback total contribution |

margin which is P1,750,000. Subsequently, to compute the required sales in units,
divide P1,750,000 by UCM but since this is CVP analysis of multiple products, use
WAUCM rather than simply UCM.

Thus, the required total number of units necessary for an entity to earn P350,000
before-tax income is 6,250 units (P1,750,000 + P280).

To allocate 6,250 units to regular and premium mattresses, sales mix in units will
be used.
REGULAR: (6,250 units x 33.33%) = 2,083 units
PREMIUM: (6,250 units x 66.67%) = 4,167 units

Requirement (c):
Just like on requirement (b), same procedures shall be applied on requirement (c)
except that it is necessary to convert first the after-tax income of P392,000 to its
before-tax amount. It can be done by simply dividing P392,000 by the after-tax
rate of 70%. Thus, the target before-tax income is P560,000 (P392,000 + 70%).
If it is a single product question, the CVP income statement would look like as
follows:

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2 uni PERUNIT PERTOTAL

units
Sales (xx) XX
{ Variable Cost (xx) (xx)
Contribution Margin XX 1,960,000
Fixed Cost WORKBACK | (1,400,000)
Income Before Tax 560,000

Again, our strategy is to workback total contribution margin which is P1,960,000.

Subsequently, to compute the required sales in units, we will divide P1,960,000 by
WAUCM.

Thus, the required total number of units necessary for an entity to earn P560,000
before-tax income is 7,000 units (P1,960,000 + P280).

To allocate 7,000 units to regular and premium mattress, again use sales mix in
units.
REGULAR: (7,000 units x 33.33%) = 2,333 units
PREMIUM: (7,000 units x 66.67%) = 4,667 units

Requirement (d):
To answer this type of CVP question on multiple product, assume again that this is
a single product question to formulate the strategy. The CVP income statement
would look like this:

2 | PERUNIT PERTOTAL PERCENTAGE

TOONS es [oy + x $7 100%
| Variable Cost (xx) (xx) (xx)
Contribution Margin XX XxX 40% 14
Fixed Cost | (1,400,000) + (xx) | SQUEEZE
Income Before Tax XX 10%

Based on the income statement, the strategy is to squeeze the fixed cost
percentage as the difference of CMR and income percentage of 10%. But since this
is CVP analysis of multiple products, use WACMR rather than CMR. WACMR, as
computed previously, is 40%. Then, the fixed cost percentage if it was squeezed, it
is 30% (40% - 10%).

From there, compute the total required sales which is P4,666,667 (P1,400,000 +
30%) but the requirement is to compute the required number of units necessary
for the entity to earn an income percentage of 10% and not the required amount
of sales.

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Hence, to compute the required number of units, divide the computed requireg
amount of sales of P4,666,667 by the WASP (not selling price since this is CVp
analysis of multiple products).

The required number of units is 6,667 units (P4,666,667 + 700).

To allocate 6,667 units to regular and premium mattresses, use sales mix in units,
REGULAR: (6,667 units x 33.33%) = 2,222 units
PREMIUM: (6,667 units x 66.67%) = 4,444 units

Requirement (e):
Same strategy on requirement (d) shall be applied on requirement (e) except that
it is necessary to convert first the after-tax income percentage of 8.40% to its
before-tax amount. It can be done by simply dividing 8.40% by the after-tax rate of
70%. Thus, the target before-tax income percentage is 12% (8.40% + 70%).

Afterwards, the CVP income statement would be as follows:

sarnlte =. 2 PERUNIT PERTOTAL PERCENTAGE
: ~ Sales [ = xx [<7 100%
Variable Cost (xx) (xx) (xx)
Contribution Margin XX XX 40% 11
Fixed Cost |(1,400,000)
+ (xx) | sQUEEZE
Income Before Tax xX 12%

Since same strategy shall be applied, the squeezed fixed cost percentage is 28%
(40% - 12%). From there, compute the total required sales which is P5,000,000
(P1,400,000 + 28%)

Since the requirement is to compute the required number of units necessary for
the entity to earn an income before-tax percentage of 12%, divide again the
computed required amount of sales of P5,000,000 by the WASP of P700. The
required number of units is 7,143 units (P5,000,000 + 700).

To allocate 7,143 units to regular and premium mattresses, use sales mix in units.
REGULAR: (7,143 units x 33.33%) = 2,381 units
PREMIUM: (7,143 units x 66.67%) = 4,762 units

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APPENDIX 3A: COMPOSITE BREAKEVEN POINT

Composite breakeven point is a concept applicable for entities producing and
selling more than one product (multiple products).

In multi-product CVP analysis, it is viewed that composite unit is not sold to

customers but is a concept used to calculate a combined contribution margin,
which leads to the computation of breakeven point.

To understand composite unit, imagine you are holding a basket of fruits which
contains proportion of individual fruits such as oranges, apples and bananas. The
fruit basket contains 3 oranges, 2 apples and 5 bananas. If we purchased these
items individually to make the fruit basket, each one would have a separate price,
distinct variable cost and a different contribution margin. This is how a composite
unit works in CVP analysis. Calculate the contribution margins of all of the
component parts of the composite unit and then use the total to calculate the
break-even point.

Composite breakeven point is computed as:

Composite breakeven point (units) = Total Fixed Cost + Composite UCM

Composite UCM is computed just like the computation of WAUCM except that the
UCM of each product is being multiplied to the composite unit not the sales mix
percentage.

Use the previously mentioned example on the fruit basket, if the UCM of orange,
apple and banana is P5, P10 and P5, respectively, composite UCM is computed as:
(PS x 3 units) + (P10 x 2 units) + (P5 x 5 units) = 60. Observe that instead of a
percentage, UCM was multiplied by the composite unit.

NOTE: Upon computation of the composite breakeven point, simply multiply it to

he composite unit to compute the breakeven point in units of each product.

Remember that composite breakeven point is the same across the products of the
entity. The main reason breakeven point in units changes is because composite
unit changes.

Illustration 16 - CVP Analysis of Multiple Products

IAN COMPANY produces and sells two types of products, Product MAN and
Product NYAK. IAN sells these products at the rate of 2 units of MAN and 3 units of
NYAK with a contribution margin per unit of P4 and P2, respectively.

IAN COMPANY has a total fixed cost of P420,000. The selling price of MAN is P10
while NYAK is P8.

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REQUIREMENTS:
(a) Compute the composite breakeven point.
(b) Compute the breakeven point in units and in total peso sales for each
product.

Solution (Illustration 16):

Requirement (a):
Composite breakeven point is computed as:
Composite breakeven point (units) = Total Fixed Cost + Composite UCM

Composite UCM is computed by multiplying the UCM of each product by their

respective composite units. The composite units for products MAN and NYAK are
2 and 3, respectively.

Thus, composite UCM is:

Composite UCM: (P4 x 2) + (P2 x 3) = P14 per unit

Composite breakeven point is:

Composite breakeven point: (P420,000 + P14) = 30,000 units

Requirement (b):
To compute breakeven point in units of each product, simply multiply the
composite breakeven point by the composite unit of each product. Afterwards,
multiply the computed breakeven point in units of each product by their
respective selling price in order to compute the product’s breakeven sales.

Please see the following supporting solution:

Product MAN Product NYAK
Composite BEP 30,000 units 30,000 units
Composite units / mix x2 x3
Breakeven point (units) 60,000 units 90,000 units
Selling price x P10 xP8
Breakeven sales P600,000 P720,000

To prove that the above answers are correct, compute the breakeven point in
units and breakeven sales of each product by using sales mix percentage, WAUCM
and WACMR.

Since the composite units of the two products are 2 for MAN and 3 for NYAK,
hence, sales mix percentage is 40% for MAN (2/5) and 60% for NYAK (3/5).

WAUCM is computed by multiplying the UCM of each product by their respectivé

sales mix percentage:
WAUCM: (P4 x 40%) + (P2 x 60%) = P2.80 per unit
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Total breakeven point in units is computed as:

Total BEP (units): (P420,000 + P2.80) = 150,000 units

To allocate the total breakeven point in units of 150,000 units, sales mix in units
shall be used. The breakeven point in units of each product is:
MAN: (150,000 units x 40%) = 60,000 units
NYAK: (150,000 units x 60%) = 90,000 units

In order to compute breakeven sales of each product, simply multiply their

respective breakeven point in units by their respective selling price. Their
breakeven sales are computed as:
MAN: (60,000 units x P10) = P600,000
NYAK: (90,000 units x P8) = P720,000

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