Cost-volume-profit (CVP) relationships and analysis

Cost-volume-profit (CVP) analysis is one the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions between the following five elements:

1. Prices of products
2. Voume or level of activity
3. Per unit variable cost
4. Total fixed cost
5. Mix of products sold

Contribution margin per unit is the excess of unit selling price over unit variable costs and the amount each unit sold contributes toward

1. Covering fixed costs and
2. Providing operating profits

Formula:              CM per unit = Unit selling price – unit variable costs

Contribution margin ratio is the percentage of contribution margin to total sales. This ratio is computed as follows:

                               CM ratio = Contribution Margin / Sales

The CM ratio is very useful in that it shows how the contribution margin will be affected by a given peso change in total sales. For instance, if a company’s CM ratio is 35%, it means that for each peso increase in sales, total contribution margin will increase by P0.35. Net income likewise will increase by P0.35 assuming that there are no changes in fixed costs. 

Break-even point (unit) = Total Fixed Costs / Contribution Margin per unit

Break-even point (pesos) = Total Fixed Costs

                                                1 – Variable Costs or CM %

                                                               Sales

Break-even sales for multi-products firm (combined units) = Total Fixed Costs / Weighted Average Contribution Margin per unit 

Weighted Contribution Margin per unit = Unit CM x No. of units / mix + Unit CM x No. of units / mix / Total number of units per Sales Mix 

Break-even sales for multi-products firm (combined pesos) = Total Fixed Costs / Weighted CM ratio 

Weighted CM ratio = Total Weighted CM (P) / Total Weighted Sales (P) 

Target sales volume to earn a desired amount of profit.

This is the amount of sales needed to earn a desired amount of profit.

The equation that may be used to compute for this follows:

Sales (units) = Total Fixed Cost + Desired Profit / Contribution Margin per unit 

Sales (pesos) = Total Fixed Cost + Desired Profit / Contribution Margin Ratio

 Margin of Safety (MS) 

This is the excess of actual or budgeted sales over break-even sales and indicates the amount by which sales could decrease before losses are incurred.

Margin of Safety Ratio 

Once the margin of safety is determined, the MS ratio may be computed as follows:

MS ratio = Margin of Safety (P) / Actual or Budgeted Sales 

How is operating leverage computed? What is its significance? 

The potential effect of the risk that sales will fall short of planned levels, as influenced by the relative proportion of fixed to variable manufacturing costs, can be measured by operating leverage. Operating leverage is the ratio of the contribution margin to profit. Assume the following data :

                                                                                2011                   2012                    Change

Sales                                                                      P180,000             P195,000       P15,000

Variable costs                                                         84,000                91,000             7,000

Contribution margin                                           96,000             104,000              8,000

Fixed costs                                                                60,000               60,000                      0

Profit                                                                          36,000               44,000              8,000

Operating leverage = Contribution margin / Profit

                                                P96,000/P36,000 = 2.667 

Operating leverage of 2.667 means that since  sales increased 8.33 percent (P15,000 / P180,000) from 2011 to 2012, profits should increase by 22.22 percent (2.667 x 8.33%). A quick calculation demonstrates that profit has increased by 22.22 percent (P8,000/P36,000).

A higher value for operating leverage indicates a higher risk in the sense that a given change in sales will have a relatively greater impact on profits. When sales volume is strong, it is desirable to have a high level of leverage, but when sales begin to fall, a lower level of leverage is preferable. Each firm chooses the level of operating leverage that is consistent with its competitive strategy. For example, a firm with dominant position in its market might choose a high level of leverage to exploit its advantage. In contrast, a weaker firm might choose the less risky low-leverage strategy.

Moreover, the CVP analysis can be done through the Income Statement approach to  avoid memorizing of formulas.