Topic: Break even Analysis

The ultimate goal of every businessman is maximization of profit, without necessarily disregarding the
firm's social responsibilities.

Computation of Profit:
Profit = Sales – Total Costs and Expenses

Using the conventional income statement format, profit may be calculated as follows:

Sales (Units sold x Selling price per units)

Less: Cost of goods sold
Gross Profit
Less: Operating expenses
Profit (Loss)

Profit planning: Profit does not just come. Its realization cannot be left to chance. Businessmen
cannot just stay in their office, wait for customers, then hope and pray that enough sales volume be
generated to yield the desired profit. Actually, profit can be planned. A certain amount of profit may
be set as the goal for a period, and strategies may be thought of to attain the goal set. It seems not too
difficult to do. We just have to consider the formula to compute the profit,

Profit = Sales – Total Costs and Expenses

and from there we can observe that increasing profit merely requires an increase in sales and/or a
decrease in costs and expenses.

Cost – Volume – Profit Analysis

One of the analytical tools that managers can use in profit planning is the CVP analysis, which is a
systematic examination of the relationships among costs, activity levels or volume and profit.

Cost Concept and Classification

Cost – it refers to the amount of resources given up in exchange for some goods or services.

Classification of costs:
a). Functional classification – such as manufacturing ( materials, labor and factory overhead),
selling and administrative.
b). Behavioral classification -

Cost behavior – refers to the way costs change with respect to a change in the activity level, such as
production or sales volume, labor or machine hours. There are costs which remain constant, some
change directly or proportionately with the change in activity level, and others change in different
patterns.

Classification of costs according to behavior:

a). Fixed costs
b). Variable costs
c). Mixed costs
 d). Semi variable costs
e). Semi fixed costs
a). Fixed costs are costs that do not change with changing levels of activity. They remain constant
regardless of the change in activity level. Examples: Monthly rental, property taxes, insurance,
depreciation and salaries of some personnel.

Fixed costs may be assigned to specific objectives such as a product, a department, an activity or a
business segment.

Production in units Total Fixed Cost Fixed Cost Per Unit

10,000 P25,000 P2.50
25,000 25,000 1.00
26,000 25,000 .96

It therefore be said that fixed costs possess the following characteristics:

Fixed Cost
Change in activity level Total Per activity level
(units, hours, etc.)
Increase Constant Decrease
Decrease Constant Increase

b). Variable costs – are costs that change directly and proportionately with the level of activity. In this
case, the total variable cost increases as the activity level increases, and the total variable cost decreases
as the activity level decreases but the variable cost per activity level remains constant. Examples:
direct materials, direct labor, factory supplies, sales commissions, office supplies and others.

Units of materials Materials cost per unit Total Materials Cost

800 P5.00 P4,000
1,000 5.00 5,000
1,500 5.00 7,500

Based on the tabulation, the characteristics of variable costs may be restated as follows:
Variable costs
Change in activity level Per activity level Total
(units, hours, etc)
Increase Constant Increase
Decrease Constant Decrease
Fixed cost is expressed in equation form as:

Fixed cost = a or y = a

In the case of variable cost, the general equation form is

y = bx
where:
y = the total variable cost
b = the variable cost per activity level
x = the activity level measured in terms of units, labor hours, etc.

Assuming, therefore, that the company's total costs consist only of variable and fixed costs, the same
may be expressed in equation form as follows:

y = a + bx
where
y = total cost
a = total fixed cost
b = variable cost per unit, hour, etc
x = number of units, hours, etc

c). Mixed costs – some costs cannot be described by a single cost behavior pattern. These are called
mixed costs, which possess both fixed and variable components.

If we shall compare the characteristics of our labor cost example of those of the purely variable and
fixed costs, we can come up with the following:

Total Cost Cost Per Unit

Variable cost Increases as volume increases Constant
Fixed cost Constant Increases as volume decreases
Decreases as volume increases
Labor Cost Example Increases as volume increases Increases as volume decreases
Decreases as volume increases

d). Semi variable costs – tend too either increase at an increasing rate or increase at a decreasing rate.
e). Semi fixed costs – they possess some characteristics of both variable and fixed costs

Cost Behavior Assumptions

a). Relevant range – refers to the band of activity within which the identified cost behavior patterns are
valid.
b). The Time Assumption states that the cost behavior patterns identified are true only over a specific
period of time. Beyond that, th cost may show a different behavior.

Segregation of fixed and variable elements of mixed costs

In making a cost analysis, it is best to identify specific cost items as either variable or fixed. To do
this, the best tool to use is experience. To isolate the fixed and variable components of mixed costs, the
following techniques may be used:
a). the high low method
b). the scatter graph method
c). the least squares method

High-Low Method:
A simple and widely used technique of segregating mixed costs components is the high low
method.

Example:
Month Cost Labor Hours Cost per Hour
January P4,400 1,200 hrs P3.67
February 4,700 1,350 hrs 3.48
March 4,200 1,100 hrs 3.82
April 3,800 900 hrs 4.22
May 4,000 1,000 hrs 4.00
June 4,800 1,400 hrs 3.43

Steps:

1). Choose the representative highest and lowest Cost Direct Labor Hours
activity levels (direct labor hours) with their Highest P4,800 1,400 hrs
corresponding costs Lowest 3,800 900 hrs
2). Get the differences (or changes) between the Cost Direct Labor Hours
highest and lowest cost and direct labor hours. Highest P4,800 1,400 hrs
These differences represent the change in cost Lowest 3,800 900 hrs
with the change in direct labor hours. Differences 1,000 500 hrs
3). Determine the rate of cost variability with
activity level b = Difference in cost
Difference in activity level

= P1,000
500 direct labor hrs

= P2.00 per direct labor hour

where b = variable rate per hour

4). Determine the total amount of fixed cost by Highest Lowest
subtracting the total variable cost from the total Total Cost (y) P4,800 P3,800
cost for any activity level. Less: Variable cost (bX) 2,800 1,800
Total Fixed Cost P2,000 P2,000

From our total cost equation,

y = a + bX

where y = Total (Mixed) Cost

a = Fixed cost
b = Variable rate per activity level
x = activity level,

fixed cost may be determined as:

a = y – bX

* P2,800 = 1,400 hrs x P2.00

**P1,800 = 900 hrs x P2.00

The Variable Costing Income Statement

Sales
Cost of Goods Sold ( Materials, Labor and Factory overhead)
Gross Profit
Operating expenses (Selling Expenses and Administrative Expenses)
Profit

Cost of goods sold

Cost Behavior
Materials Variable
Labor Variable
Factory overhead Variable
Fixed factory overhead

Operating expenses:
Selling expenses Variable Selling Expenses
Fixed Selling Expenses

Administrative Expenses Variable Administrative Expenses

Fixed Administrative Expenses
Finally, if we combine all the variable costs and expenses together, as well as all the fixed costs and
expenses, our income statement can be presented as follows:

Sales
Less: Variable costs and expenses (manufacturing, selling and administrative)
Fixed costs and expenses (manufacturing, selling and adminstrative)
Profit

when the variable costs and expenses are deducted from sales, the difference is called contribution
margin. Contribution margin is the excess of revenue over all the variable costs, and this is the amount
available for the recovery of fixed costs and generation of profit.

Therefore,

Sales
Less: Variable Costs
Contribution Margin
Less: Fixed Costs
Profit

Breakeven Analysis

Example: Fermay Company produces and sells rubber balls. The variable rate costs to produce and
sell one unit of rubber ball amount to P4.00, while the total fixed manufacturing, selling and
administrative costs per period are P12,000. The rubber balls are sold for P10.00 per unit. Determine
the breakeven sales in units and in pesos?

BEP = Fixed Cost ______________ P12,000 = 2,000 units

sales Contribution Margin Per Unit P6.00

BEP = Fixed Cost P12,000 = P20,000

Pesos Contribution Margin Ratio 60%

For profit planning purposes, sales with desired profit can be determined using the following formulas:

Sales in Units = Fixed Cost + Profit

Contribution Margin Per Unit

Sales in Pesos = Fixed Cost + Profit

Contribution Margin Ratio