Profit planning and cost-volume-profit analysis PDF

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CHAPTER 5Profit Planning and Cost-Volume-Profit AnalysisIntroductionManagers are constantly faced with decisions about selling prices, variable costs and fixed costs. To be able to choose from among the alternative actions, it is necessary to have a good estimate of the probable costs that would res...

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CHAPTER 5 Profit Planning and Cost-Volume-Profit Analysis Introduction Managers are constantly faced with decisions about selling prices, variable costs and fixed costs. To be able to choose from among the alternative actions, it is necessary to have a good estimate of the probable costs that would result from each choice. Furthermore, management needs to know the costs that are likely to be incurred under normal operating conditions and how they might vary if conditions change. At the end of the chapter, the student should be able to: ● ● ● ● ● ● ● ● ● ● ● ●

Identify the different margins in the variable costing income statement. Enumerate the underlying assumptions in the cost-volume-profit relationships. Explain the concept of relevant range in profit planning. Discuss the importance of contribution margin. Compute the contribution margin in at least four different ways. Explain the relationship of volume, sales price, and costs to profit. Compute the breakeven point and sales with profit Calculate the margin of safety and explain its relation to profit. Apply sensitivity analysis to variable costing profit or loss statements. Apply the CVP analysis in a multi-product sales situation. Determine and explain the operating leverage. Relate the importance of indifference to profit planning.

Profit Planning Profit planning is the process of anticipating profit under varying conditions and analyzing the effects of variables affecting it. It directly relates to the normal operating activities and is short-term in nature. Variable costing and profit planning The Variable Costing system is preferred as a managerial tool in profit planning. Variable costing is straight forward, stresses the importance of quantity and price to sales and profit, and follows the foundation of economic principles. In this model, costs are classified as fixed and variable. Total fixed costs are related to normal capacity and are independent from the changes in the level of sales volume. Variable costs change directly in relation to the change in volume of sales. Variable costing system (also known as the marginal costing system or contribution margin approach) determines profit as follows (values are assumed).

Sales Variable costs Fixed costs Profit

Quantity 10,000 10,000

Price P200 120

Amount P 2,000,000 (1,200,000) (500,000) P 300,000

Contribution margin Sales and variable costs directly relate with sales volume. The difference in sales and variable costs is originally called as profit/volume, but is now popularly referred to as the contribution margin. This amount is used to absorb fixed costs. The difference between contribution margin and fixed costs is profit. The format to determine profit using the variable costing system is as follows: Table 2.1. The contribution margin format Condensed Format Sales Less: Variable costs and expenses

Expanded Format Px x -----x x -----Px ===

Sales Less: Variable cost of goods sold

Px x -----Contribution margin Manufacturing Margin x Less: Fixed costs and expenses Less: Var marketing and admin exp x -----Profit Contribution margin x Less: Fixed costs and expenses x Profit Px === For purposes of profit analysis and control, managers give emphasis to the contribution margin. To avoid operating loss, contribution margin should be at least equal to fixed costs. Any amount of contribution margin in excess of fixed costs is profit. A peso increase in contribution margin is a peso increase operating profit. In this learning module, we will use the term “costs” to include all the costs of production, marketing, distribution, and general expenses. And we will use the condensed format for purposes of introductory learning. Assumptions in profit planning and CVP analysis Management has to control costs. The process of understanding the relationships of costs, sales price, and sales volume, and sales mix to profit in order to identify the level of optimal operating performance in achieving the overall goal of an enterprise is profit planning. The variables of profit are the unit sales, unit variable costs, total fixed costs, sales volume (or volume), and the sales mix. Sales mix happens when a business sells two or more products. The assumptions to these variables as they relate to units sold, are as follows:

Table 2.2. Profit Planning Assumptions Basic Assumptions

Sensitivity Assumptions

Sales volume

Changes

Changes

Unit sales price

Constant

Changes

Unit variable costs

Constant

Changes

Total fixed costs

Constant

Changes

Sale mix

Constant

Changes

Basic Assumptions The s  ales price is considered constant for planning purposes . It is influenced by competition, variability in supply and demand, laws, technology, distribution channels, emerging practices, production input prices, taxes subsidies, seasonality, and other determinants. However, once set by the marketing and planning department, the sales price is considered constant, hence, considered outside the controllable domain of the expense management. The most the management accountant can do is to influence the setting of the sales price. The v  ariable costs rate is considered constant for planning purposes . It is affected by a change in the prices of suppliers, labor, rentals, telecommunications, fuel, warehousing, distribution, taxes and licenses, agency costs, and such other determinants. The t otal fixed costs and expenses are also considered constant for planning purposes. The basic CVP analysis is based on the following assumptions: Table 2.3. CVP Analysis Basic Assumptions Areas

Basic Assumptions

Cost classification

Segregated as to fixed and variable costs

Linearity and behavior

The behavior of sales and costs is linear within the relevant range. Total fixed costs remain constant, but unit fixed cost inversely changes in relation to volume (i.e., unit fixed costs decreases as production increases). Total variable costs change, but unit variable cost is constant Unit sales price is constant

Product

There is only one product or, in case of multi-product operations, the sales mix is constant.

Work-in-process inventory

There is no work-in-process inventory.

Production equals sales

There is no change in the finished goods inventory, that means, production equals sales.

Cost-volume-profit analysis also assumes that labor productivity, production technology, and market conditions will not change. Or if they change, their impact shall be covered in the sensitivity analysis. Also, it is assumed that there is no inflation, or if it can be forecasted, it is already included in the CVP analysis data. CVP sensitivity assumptions The assumptions that sales price, unit variable costs, and total fixed costs are constant are used to establish the “standard costs”. Thes costs serve as the “ballpark figures” or initial points of understanding the results of business operations. The assumptions used in the basic CVP Analysis are stiff, unreal and are not reflective of the practical business conditions. In the real world, changes abound and their impacts are sometimes profound. Sales prices change. Unit variable costs and total fixed costs also change. Sales mix changes as well. The process of considering the impact and the results to profit of the changes in its variables is called CVP Sensitivity Analysis. Levels of profit planning The four (4) levels of learning in profit planning are as follows: 1. Basic cost-volume-profit analysis 2. Cost-volume-profit sensitivity analysis 3. Multi-product cost-volume-profit analysis 4. Degree of operating leverage The basic CVP analysis operates within the context of the basic assumptions used in the profit planning and controlling system. Sensitivity CVP analysis incorporates possibilities of changes in the assumptions underlying profit planning. Multi-product CVP analysis considers the occurrence of two or more products produced and distributed by an enterprise as it impacts portfolio profit. Operating leverage unfolds the secret of managing change in profit. The Basic of CVP Analysis The basic CVP analysis covers the study on contribution margin, breakeven point, margin of safety, profit setting, sales mix analysis, and degree of operating analysis. The contribution margin is the heart of variable costing analysis (i.e., marginal analysis, profitability analysis, differential costing analysis). Its relevance is based on the premise that “an increase in contribution margin means an increase in profit”. To illustrate a “walk-through” of the techniques applied in the CVP analysis, let us consider the following illustrative problem.

Sample Problem 2.1 - The contribution Margin, Breakeven Point, and Margin of Safety Pilot Company establishes the following information for its profit planning activities: Unit sales price P 200 Total fixed costs P400,000 Unit variable costs 120 Unit sold 8,000 units Determine the following for Pilot Company’s profit planning analysis: 1. Unit contribution margin, contribution margin rate, and variable cost rate. 2. Breakeven point in units and in pesos. 3. Margin of safety in units and in pesos, and the margin of safety rate. Solution/Discussions: 1. Unit contribution margin (UCM), contribution margin rate (CMR), and variable cost rate (UCV) If : And : Then :

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CM = Sales - Variable costs UCM = USP - UCV The unit contribution margin is P80, ie, P200 - P120. The contribution margin rate is 40%, ie, P80 / P200 The variable cost rate is 60%, ie, P120 / P200 The basic interrelationships

Let’s use this problem to discover the intriguing relationships of contribution margin, fixed costs, and profit. Using the variable costing income statement, we will have the following tabular information: Units Sales 8,000 Less: Variable costs 8,000 Contribution Margin 8,000 Less Fixed costs Profit

Unit Prices P 200  120 20

Amount P 1,600,000  960,000 640,000  400,000  P 240,000

Percentage 100 Sales rate 60 VC rate 40 CM rate

Note that net sales is the base, ie, total sales is 100%, unit sales price is also 100%. ●

Now, focus on the power of the contribution margin. Inasmuch as the total fixed costs is constant, then, an increase in the contribution margin is automatically an increase in profit. This gives us an understanding of the first approach to control profit: that is, manage the contribution margin to control profit !

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Further, you should have noticed that contributed margin may be computed is at least four (4) important ways, as follows:

1. 2. 3. 4.

CM CM CM CM

= = = =

Sales - Variable Costs Fixed costs + Profit Units sold x UCM Sales x CMR

Likewise, you should have observed the following important relationships: Profit Variable Cost rate CM Rate

= = = = = =

CM- Fixed costs Variable cost/ Sales unit variable cost/ Unit sales price Contribution margin/ Sales Unit CM / Unit sales price 100% - VCRation

2. Breakeven point in units and in pesos ●

Breakeven point (BEP) is where total sales equal total costs. At this point of sales level, there is no profit or loss. Also, at breakeven point, contribution margin equals total fixed costs.

●

The breakeven point in units is 5,000. The breakeven point in pesos is P1,000,000.

●

The breakeven point formulas are as follows:

BEP (units)

=

TFC / UCM

From this, we could say: FC UCM

= =

BEPU x UCM FC / BEPU

To derive the BEP formula, we have” Total sales = Total costs Total sales = Fixed costs + Variable costs QS (USP) = FC + QS (UVC) QS (USP) - QS (UVC) = FC QS (USP - UVC) = FC

and, BEP (pesos) =

FC/ CMR

QS = FC/USP - UVC QS = FC/UCM

Applying the formulas in our illustrative problem, we have: BEP (units) = P 400,000 / P 80 = 5,000 units BEP (pesos) = P 400,000 / 40% = P 1,000,000

To prove, Sales (5,000 units x P 200) P 1,000,000 Less: Variable costs (5,000 x P 120) 600,000 Contribution margin 400,000 Less: Fixed costs 400,000 Profit (loss) P 0

And, also: CM (5,000 units x P 80) Less: Fixed costs Profit (loss)

P 400,000 P 400,000 P 0

At BEP, total contribution margin equals total fixed costs. 3. Margin of safety in units and in pesos, and the margin of safety rate. ● Margin of safety is the difference between budgeted sales and breakeven sales. It is the maximum amount of reduction in sales before loss happens. ● The margin of safety in units is 3,000, the margin in safety pesos is P 600,000, and the margin of safety rate is 37.5%. ● The margin of safety expressions and computations are tabulated below: Units

Amount

Rate

Budgeted sales (8,000 units x P 200)

8,000

P 1,600,000

100.00% Budgeted Sales Rate

Less: Breakeven sales

5,000

1,000,000

62.50% Breakeven Sales Rate

Margin of safety

3,000

P 600,000

37.50% Margin of Safety Rate

Margin of safety ratio (MSR) is margin of safety over budgeted sales. The MSR may be determined based in units or in pesos. ●

The presence of a margin of safety indicates profit. Since margin of safety is the amount of sales in excess of breakeven point, it means that in every peso of margin of safety there is a profit. And profit is the incremental contribution margin after the breakeven point b  ecause all fixed costs have already been covered by the contribution margin by then. Managing the margin of safety is the second approach in controlling economic profit.

●

From this understanding, we can say that: Profit = Margin of Safety x CMRate

It also means that:

Applying it, we have:

NPRatio = MSR x CMR

Profit = P 600,000 x 40% Profit = P 240,000

Therefore: MSR = NPR / CMR CMR = NPR/ MSR

Now, refer to preceding discussion Sample Problem 2.1, solution/ discussions no. 1, we can find the profit amount to P 240,000.

Sales with Profit Business organizations should operate with profit. Otherwise, they are not in business. The question is: how much sales should a business generate to achieve a target profit? This query necessitates the business to establish a profit. Profit may be expressed in various ways as exemplified in the next sample problem. Sample Problem 2.2 - Estimating Sales with Profit Mayaman Company determines its sales price and costs structure as follows: Unit sales price P 400 Unit variable costs 240 Total fixed costs 800,000 Tax rate 40% How much is the required sales, units and amount, if the profit is targeted as follows: 1. 2. 3. 4.

Profit before tax of P 400,000. Profit after tax of P 480,000. Profit before tax is 20% of sales. Profit before tax is P 25 per unit.

5. After-tax profit is 20% of sales. 6. Pre-tax profit is 20% of CMR. 7. Post-tax profit is 20% of CMR.

Solutions/ Discussions ●

The profit is expressed in many ways - profit before tax, profit after tax, profit percentage, or profit rate per unit. The formula and applications for each of the expressions of profit are presented below:

Expression of profit

Formulas

1. Profit Sales (units) before tax

=

(FC + PBT) UCM

Sales (pesos) =

(FC + PBT) CMR

Applications Sales (units)

= =

=

(FC + PBT) UCM

Sales (pesos) =

(FC + PBT) CMR

2. Profit after Sales (units) tax

(800,000 + 400,000) 40% = P 3,000,000

Sales (pesos) =

Sales (units)

= =

PBT = [PAT / (1- Tax Rate)]

(800,000 + 400,000) P 160 7,500 units

(800,000 + 800,000) P 160 10,000 units

(800,000 + 800,000) 40% = P 4,000,000

Sales (pesos) =

3. Profit % Sales (pesos) = FC/ (CMR - PRBT) before tax Sales (units)

=

FC/ (UCM - UPM)

Sales (pesos) = P 800,000/(40%- 20%) = P 4,000,000 Sales (units)

= P 800,000 / P 80 = 10,000 units

UPM = P 400 x 20% = P 80 4. Profit per Sales (units) unit before tax

=

FC/ (UCM - UPM)

5. After-tax Sales (pesos) = FC/ (CMR - PRBT) profit as a % of sales PRBT = [PRAT / (1-Tax Rate)]

Sales (units)

= P 800,000/(P 160-P 25) = 5,926 units

P800,000 (40% - 33.33333%) = P 12,000,000

Sales (pesos) =

PRBT = 20%/60% = 33.3333% 6. Pre-tax Sales (pesos) profit as a % of CMR

= FC/(CMR- PRBT)

Sales (pesos) = P 800,000/ 40%(1-20%)) = P 2,500,000

7. Post-tax Sales (pesos) profit as a % of CMR

= FC/(CMR- PRBT)

Sales (pesos) = P 800,000 [40%{1-(20%/60%)] = P 3,000,000

CMR FC PBT PAT PR

= Contribution Margin Ratio = Fixed Costs = Profit Before Tax = Profit After Tax = Profit Rate

PRBT UCM UPM PPAT ATR

= Profit Rate Before Tax = Unit Contribution Margin = Unit Profit Margin = Profit Percentage After Tax = 1 - Tax Rate

●

Profit is added to the fixed costs in the numerator. Unit profit margin is deducted from the unit contribution margin in the denominator. Contribution margin rate is deducted from the contribution margin rate in the denominator.

●

The profit to be added or deducted is the profit before tax (PBT). If the post-tax profit is given, then, the PBT is (PAT - 1- Tax Rate).

●

If the profit given is a percentage based on sales, it is deducted from the CMR in the denominator. Sales with profit in pesos equals fixed costs divided by the fixed cost rate (i.e., CMR - Profit Rate). Sales with profit in units equals fixed costs divided by the fixed costs rate per unit (i.e., unit contribution margin less unit profit margin).

●

Always remember the mathematical RULE, “any number divided by its corresponding percentage is equal to 100% of that number.” In the profit/ loss statement relationships, sales are always equal to 100%. So, if we divide fixed costs by its percentage, we get its 100% base which is the sales value.

●

The formulas used in this illustration are derived as follows: IF

THEN

CM = FC + Profit

QS(UCM) = FC + Profit QS = (FC + Profit) / UCM

CM = FC + Profit

S(CMR) = FC + Profit S = (FC + Profit) / CMR

CM = FC + Profit

QS(UCM) = FC + QS(UPM) QS = FC / (UCM-UPM)

CM = FC + Profit

S(CMR) = FC + S(PR) S = FC/ (CMR-PR)

Multi-Product CVP Analysis In many instances, businesses produce and sell more than one product, hence, the multi-product sales situation. If there are two or more products to be considered, the composite breakeven point (CBET) is determined to establish the overall breakeven point situation of the enterprise. The basic breakeven point formula (i.e., FxC/UCM) is to be used. Except that in the multi-product sales, the denominator is the average unit contribution margin (average UCM) and the average contribution margin rate (Average CMR). Average UCM is the sum of individual product UCM times their sales mix ratio based on units. Average CMR is the sum of individual product CMR times their sales mix ratio based on amount...