Cost-Volume-Profit Relationships: Key Assumptions of CVP Analysis

5-1
Cost-Volume-Profit Relationships
Chapter 5
Lecture 3
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
5-2
Key Assumptions of CVP Analysis

1. Selling price is constant.
2. Costs are linear and can be accurately
divided into variable (constant per unit) and
fixed (constant in total) elements.
3. In multiproduct companies, the sales mix is
constant.
4. In manufacturing companies, inventories do
not change (units produced = units sold).
5-2
5-3
Basics of Cost-Volume-Profit Analysis

The contribution income statement is helpful to managers
in judging the impact on profits of changes in selling price,
cost, or volume. The emphasis is on cost behavior.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Sales (500 bicycles) $ 250,000
Less: Variable expenses 150,000
Contribution margin 100,000
Less: Fixed expenses 80,000
Net operating income $ 20,000
Contribution Margin (CM) is the amount remaining from

sales revenue after variable expenses have been deducted.
5-4
Basics of Cost-Volume-Profit Analysis

CM is used first to cover fixed expenses.
Any remaining CM contributes to net operating income.
Sales (500 bicycles) $ 250,000
Less: Variable expenses 150,000
Contribution margin 100,000
5-3
5-5
Practical aspects to cover today

1. Calculate the sales/unit (S), variable cost/unit (VC) and
the unit contribution margin.
2. Prepare a contribution format income statement if the
company sold 400 units.
3. Use the equation method to calculate the profits if the
4. Prepare a CVP graph and a profit graph.
5. Determine the break-even point in units and in sales dollars
using the equation method.
6. Determine the number of units sold to achieve a desired
profit using the equation method.
7. Calculate the margin of safety in dollars, percentage and
units.
5-6
The Contribution Approach

Sales, variable expenses, and contribution margin
can also be expressed on a per unit basis. If Racing
sells an additional bicycle, $200 additional CM will
be generated to cover fixed expenses and profit.
Total Per Unit
Sales (500 bicycles) $ 250,000 $ 500
Less: Variable expenses 150,000 300
Contribution margin 100,000 $ 200
5-4
5-7

Each month, RBC must generate at least
$80,000 in total contribution margin to break-even
(which is the level of sales at which profit is zero).

Total Per Unit
Sales (500 bicycles) $ 250,000 $ 500
5-8

1. Calculate the sales/unit (S), variable cost/unit (VC) and the
unit contribution margin.
units.
5-5
5-9

If RBC sells 400 units in a month, it will be
operating at the break-even point.
Total Per Unit
Sales (400 bicycles) $ 200,000 $ 500
Net operating income $ -
5-10
Note
• What is a contribution margin?
• Is the amount remaining from sales revenue
after variable expenses have been deducted.
CM is used first to cover fixed expenses. Any
remaining CM contributes to net operating
income.
• What is the breakeven point?
• Is the level of sales at which profit is zero.
Hence, it is when total revenues equal total
expenses (variable and fixed).
5-6
5-11

If RBC sells one more bike (401 bikes), net
operating income will increase by $200.
Total Per Unit
Sales (401 bicycles) $ 200,500 $ 500
Net operating income $ 200
5-12

units.
5-7
5-13
CVP Relationships in Equation Form
When a company has only one product we can further

refine this equation as shown on this slide.
Profit = (Sales – Variable expenses) – Fixed expenses
Quantity sold (Q) Quantity sold (Q)

× Selling price per unit (P) × Variable expenses per unit (V)
= Sales (Q × P) = Variable expenses (Q × V)
Profit = (P × Q – V × Q) – Fixed expenses
5-14
This equation can be used to show the profit RBC

earns if it sells 401. Notice, the answer of $200 mirrors
our earlier solution.
Profit = (Sales – Variable expenses) – Fixed expenses
$80,000
401 units × $500
401 units × $300
$200 = ($200,500 – $120,300)

Profit – $80,000
Variable expenses) – Fixed
Fixed expenses
5-8
5-15

It is often useful to express the simple profit equation in
terms of the unit contribution margin (Unit CM) as follows:
Unit CM = Selling price per unit – Variable expenses per unit
Unit CM = P – V
Profit = (P – V) × Q – Fixed expenses
Profit = Unit CM × Q – Fixed expenses
5-16

Profit = (P – V) × Q – Fixed expenses
Profit = ($500 – $300) × 401 – $80,000

Profit = $200 × 401 – $80,000
This equation
Profit = $80,200 – $80,000 can also be
Profit = $200 used to compute
RBC’s $200 profit
if it sells 401
bikes.
5-9
5-17

units.
5-18
CVP Relationships in Graphic Form

The relationships among revenue, cost, profit, and volume
can be expressed graphically by preparing a CVP graph.
Racing Bicycle developed contribution margin income
statements at 0, 200, 400, and 600 units sold. We will
use this information to prepare the CVP graph.
Units Sold
0 200 400 600
Sales $ - $ 100,000 $ 200,000 $ 300,000
Total variable expenses - 60,000 120,000 180,000
Contribution margin - 40,000 80,000 120,000
Fixed expenses 80,000 80,000 80,000 80,000
Net operating income (loss) $ (80,000) $ (40,000) $ - $ 40,000
5-10
5-19
Preparing the CVP Graph

$350,000
$300,000
$250,000
$200,000
$150,000
$100,000
In a CVP graph, unit volume is usually
$50,000
represented on the horizontal (X) axis
and dollars on the vertical (Y) axis.
$0
0 100 200 300 400 500 600
Units
5-20

$350,000

Draw a line parallel to the volume axis
$300,000
to represent total fixed expenses.
$250,000
$200,000
Fixed expenses
$150,000
$100,000
$50,000
$0
0 100 200 300 400 500 600
Units
5-11
5-21

$350,000 
Choose some sales volume, say 400 units, and plot the point representing
total expenses
$300,000
(fixed and variable). Draw a line through the data point
back to where the fixed expenses line intersects the dollar axis.
$250,000
$200,000
Total expenses
Fixed expenses
$150,000
$100,000
$50,000
$0
0 100 200 300 400 500 600
Units
5-22

$350,000 
Choose some sales volume, say 400 units, and plot the point representing
total sales.
$300,000
Draw a line through the data point back to the point of origin.
$250,000
$200,000
Sales
Total expenses
$150,000 Fixed expenses
$100,000
$50,000
$0
0 100 200 300 400 500 600
Units
5-12
5-23

$350,000 Break-even point
(400 units or $200,000 in sales) Profit Area
$300,000
$250,000
$200,000
Sales
Total expenses
$150,000 Fixed expenses
$100,000
$50,000
$0
0 100 200 300 400 500 600
Loss Area
Units
5-24

Profit = Unit CM × Q – Fixed Costs
$ 60,000
$ 40,000
$ 20,000
Profit
$0
-$20,000 An even simpler form of

the CVP graph is called
-$40,000
the profit graph.
-$60,000
0 100 200 300 400 500 600

Number of bicycles sold
5-13
5-25
$ 60,000 Break-even point, where

profit is zero, is 400
$ 40,000
units sold.
$ 20,000
Profit
$0
-$20,000
-$40,000
-$60,000
0 100 200 300 400 500 600

Number of bicycles sold
5-26

5. Determine the break-even point in units and in sales
dollars using the equation method.
units.
5-14
5-27
Break-even Analysis
The equation and formula methods can be used to
determine the unit sales and dollar sales needed to
achieve a target profit of zero. Let’s use the RBC
information to complete the break-even analysis.
Total Per Unit CM Ratio
Sales (500 bicycles) $ 250,000 $ 500 100%
Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 $ 200 40%
5-28
Break-even in Unit Sales:

Equation Method
Profits = Unit CM × Q – Fixed expenses
Suppose RBC wants to know how many
bikes must be sold to break-even
(earn a target profit of $0).
$0 = $200 × Q + $80,000
Profits are zero at the break-even point.

5-15
5-29
Break-even in Unit Sales:

Equation Method
Profits = Unit CM × Q – Fixed expenses
$0 = $200 × Q + $80,000
$200 × Q = $80,000
Q = 400 bikes
5-30
Break-even in Dollar Sales:

Equation Method
Suppose Racing Bicycle wants to compute
the sales dollars required to break-even (earn
a target profit of $0). Let’s use the equation
method to solve this problem.
Profit = CM ratio × Sales – Fixed expenses
Solve for the unknown “Sales.”

5-16
5-31
Break-even in Dollar Sales:

Equation Method
$ 0 = 40% × Sales – $80,000
40% × Sales = $80,000
Sales = $80,000 ÷ 40%
Sales = $200,000
5-32
Quick Check 
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. An average of 2,100 cups are sold each
month. What is the break-even sales dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129
5-17
5-33
Quick Check 
coffee is $1.49 and the average variable expense
per cup is $0.36. The average fixed expense per
month is $1,300. An average of 2,100 cups are sold
each month. What is the break-even sales dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129
5-34
Quick Check 
month. What is the break-even sales in units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups
5-18
5-35
Quick Check 
month. What is the break-even sales in units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups
5-36

6. Determine the number of units sold to achieve a
desired profit using the equation method.
units.
5-19
5-37
Target Profit Analysis

We can compute the number of units
that must be sold to attain a target
profit using either:
(1) Equation method, or
(2) Formula method (next lecture).
5-38
Equation Method
Our goal is to solve for the unknown “Q” which

represents the quantity of units that must be sold
to attain the target profit.
5-20
5-39

Suppose RBC’s management wants to know
how many bikes must be sold to earn a target
profit of $100,000.

$100,000 = $200 × Q – $80,000
$200 × Q = $100,000 – $80,000
Q = ($100,000 + $80,000) ÷ $200
Q = 900
5-40

We can also compute the target profit in terms of
sales dollars using either the equation method or
the formula method.
Equation OR Formula
Method Method
5-21
5-41
Equation Method
Our goal is to solve for the unknown “Sales,”
which represents the dollar amount of sales
that must be sold to attain the target profit.
Suppose RBC management wants to know the
sales volume that must be generated to earn a
target profit of $100,000.
$100,000 = 40% × Sales – $80,000
40% × Sales = $100,000 + $80,000
Sales = ($100,000 + $80,000) ÷ 40%
Sales = $450,000
5-42
Quick Check 
month is $1,300. Use the equation method to
determine how many cups of coffee would have to
be sold to attain target profits of $2,500 per month.
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups
5-22
5-43
Quick Check 
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is
$0.36. The average fixed expense per month is $1,300.
Use the formula method to determine how many cups of
coffee would have to be sold to attain target profits of
$2,500 per month.
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups
5-44
Quick Check 
month is $1,300. Use the equation method to
determine the sales dollars that must be generated
to attain target profits of $2,500 per month.
a. $2,550
b. $5,013
c. $8,458
d. $10,555
5-23
5-45
Quick Check 
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is
$0.36. The average fixed expense per month is $1,300.
Use the formula method to determine the sales dollars
that must be generated to attain target profits of $2,500
per month.
a. $2,550
b. $5,013
c. $8,458
d. $10,555
5-46

7. Calculate the margin of safety in dollars, percentage
and units.
5-24
5-47
The Margin of Safety in Dollars

The margin of safety in dollars is the excess
of budgeted (or actual) sales over the
break-even volume of sales.
Margin of safety in dollars = Total sales - Break-even sales
Let’s look at Racing Bicycle Company and

determine the margin of safety.
5-48
The Margin of Safety in Dollars

If we assume that RBC has actual sales of
$250,000, given that we have already
determined the break-even sales to be
$200,000, the margin of safety is $50,000 as
shown.
Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 20,000
5-25
5-49
The Margin of Safety Percentage

RBC’s margin of safety can be expressed
as 20% of sales.
($50,000 ÷ $250,000)
Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 20,000
5-50
The Margin of Safety

The margin of safety can be expressed in terms of
the number of units sold. The margin of safety at
RBC is $50,000, and each bike sells for $500;
hence, RBC’s margin of safety is 100 bikes.
Margin of $50,000
= = 100 bikes
Safety in units $500
5-26
5-51
Quick Check 
Coffee Klatch is an espresso stand in a
downtown office building. The average selling
price of a cup of coffee is $1.49 and the average
variable expense per cup is $0.36. The average
fixed expense per month is $1,300. An average
of 2,100 cups are sold each month. What is the
margin of safety expressed in cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
5-52
Quick Check 
month. What is the margin of safety expressed in
cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
5-27
5-53
Cost Structure and Profit Stability
Cost structure refers to the relative proportion

of fixed and variable costs in an organization.
Managers often have some latitude in
determining their organization’s cost structure.
5-54
Cost Structure and Profit Stability

There are advantages and disadvantages to high fixed cost
(or low variable cost) and low fixed cost (or high variable
cost) structures.
An advantage of a high fixed
cost structure is that income A disadvantage of a high fixed
will be higher in good years cost structure is that income
compared to companies will be lower in bad years
with lower proportion of compared to companies
fixed costs. with lower proportion of
fixed costs.
Companies with low fixed cost structures enjoy greater
stability in income across good and bad years.
5-28
5-55
End of Lecture

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5-1

Key Assumptions of CVP Analysis

Basics of Cost-Volume-Profit Analysis

Contribution Margin (CM) is the amount remaining from

Basics of Cost-Volume-Profit Analysis

Practical aspects to cover today

The Contribution Approach

The Contribution Approach

Racing Bicycle Company

Practical aspects to cover today

The Contribution Approach

The Contribution Approach

Practical aspects to cover today

CVP Relationships in Equation Form

When a company has only one product we can further

Profit = (Sales – Variable expenses) – Fixed expenses

Quantity sold (Q) Quantity sold (Q)

Profit = (P × Q – V × Q) – Fixed expenses

CVP Relationships in Equation Form

This equation can be used to show the profit RBC

$200 = ($200,500 – $120,300)

CVP Relationships in Equation Form

CVP Relationships in Equation Form

Profit = ($500 – $300) × 401 – $80,000

Practical aspects to cover today

CVP Relationships in Graphic Form

Preparing the CVP Graph

Preparing the CVP Graph

Preparing the CVP Graph

Preparing the CVP Graph

Preparing the CVP Graph

Preparing the CVP Graph

-$20,000 An even simpler form of

0 100 200 300 400 500 600

Preparing the CVP Graph

$ 60,000 Break-even point, where

0 100 200 300 400 500 600

Practical aspects to cover today

Break-even in Unit Sales:

Profits are zero at the break-even point.

Break-even in Unit Sales:

Break-even in Dollar Sales:

Profit = CM ratio × Sales – Fixed expenses

Solve for the unknown “Sales.”

Break-even in Dollar Sales:

40% × Sales = $80,000

Sales = $80,000 ÷ 40%

Practical aspects to cover today

Target Profit Analysis

Our goal is to solve for the unknown “Q” which

Target Profit Analysis

Profit = Unit CM × Q – Fixed expenses

Target Profit Analysis

Practical aspects to cover today

The Margin of Safety in Dollars

Let’s look at Racing Bicycle Company and

The Margin of Safety in Dollars

The Margin of Safety Percentage

The Margin of Safety