Cost-Volume-Profit

Relationships
 LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Explain how changes in activity affect
contribution margin and net operating income.
2. Prepare and interpret a cost-volume-profit
(CVP) graph.
3. Use the contribution margin (CM) ratio to
compute changes in contribution margin and
net operating income resulting from changes
in sales volume.
4. Show the effects on contribution margin of
changes in variable costs, fixed costs, selling
price, and volume.
5. Compute the break-even point.
 LEARNING OBJECTIVES
After studying this chapter, you should be able to:
6. Determine the level of sales needed to achieve a
desired target profit.
7. Use the margin of safety and explain its significance.
8. Compute the degree of operating leverage at a
particular level of sales and explain how the degree of
operating leverage can be used to predict changes to
net operating income.
9. Compute the break-even point for a multiple-product
company and explain the effects of shifts in the sales
mix on contribution margin and the break-even point.
10. Understand cost-volume-profit with uncertainty.
 The Basics of Cost-Volume-
Profit (CVP) Analysis
Bengal Motors Ltd.
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bikes) 250,000 500
Less: variable expenses 150,000 300
Contribution margin 100,000 200
Less: fixedMargin
Contribution expenses 80,000
(CM) is the amount remaining
Net income
from sales revenue after variable 20,000
expenses have been
deducted.
The Basics of Cost-Volume-
Profit (CVP) Analysis
Bengal Motors Ltd
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bikes) 250,000 500
Less: variable expenses 150,000 300
Contribution margin 100,000 200
Less: fixed expenses 80,000
Net income 20,000

CM is used to cover fixed expenses.

The Basics of Cost-Volume-
Profit (CVP) Analysis
Bengal Motors Ltd
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bikes) 250,000 500
Less: variable expenses 150,000 300
Contribution margin 100,000 200
Less: fixed expenses 80,000
Net income 20,000
After covering fixed costs, any remaining CM
contributes to income.
 The Contribution Approach
For each additional unit Wind sells, 200
more in contribution margin will help to
cover fixed expenses and profit.
 The Contribution Approach
Each month Wind must generate at least
80,000 in total CM to break even.
 The Contribution Approach
If Wind sells 400 units in a month, it will be
operating at the break-even point.
 The Contribution Approach
If Wind sells one additional unit (401 bikes), net
income will increase by 200.
Bengal Motors Ltd
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (401 bikes) 200,500 500
Less: variable expenses 120,300 300
Contribution margin 80,200 200
Less: fixed expenses 80,000
Net income 200
 The Contribution Approach
The break-even point can be defined either as:
• The point where total sales revenue equals total
expenses (variable and fixed).
• The point where total contribution margin equals
total fixed expenses.
 CVP Relationships in Graphic Form
Viewing CVP relationships in a graph gives managers a
perspective that can be obtained in no other way.
Consider the following information for Bengla Co.:

Income
Income Income
Income Income
Income
300
300 units
units 400
400 units
units 500
500 units
units
Sales
Sales 150,000
150,000 200,000
200,000 250,000
250,000
Less:
Less: variable
variable expenses
expenses 90,000
90,000 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin 60,000
60,000 80,000
80,000 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000 80,000
80,000
Net
Net income
income (loss)
(loss) (20,000)
(20,000) -- 20,000
20,000
 CVP Graph
450,000

400,000

350,000

300,000
Total Expenses
Dollars

250,000

200,000
Fixed expenses
150,000

100,000

50,000

-
- 100 200 300 400 500 600 700 800
Units
 CVP Graph
450,000

400,000

350,000

300,000 Total Sales

Dollars

250,000

200,000

150,000

100,000

50,000

-
- 100 200 300 400 500 600 700 800
Units
 CVP Graph
450,000

400,000

rea
350,000
it A
o f
300,000 Pr
250,000
Dollars

200,000

150,000
Break-even point
100,000

50,000
rea
A
s- s
-
L o 100 200 300 400 500 600 700 800

Units
Contribution Margin Ratio
The contribution margin ratio is:
Contribution margin
CM Ratio =
Sales

For Bengal Co. the ratio is:

200
= 40%
500
 Contribution Margin Ratio
At Bengal, each 1.00 increase in sales
revenue results in a total contribution
margin increase of 40.

If sales increase by Tk. 50,000, what will be

the increase in total contribution margin?
 Contribution Margin Ratio
400
400 Bikes
Bikes 500
500 Bikes
Bikes
Sales
Sales 200,000
200,000 250,000
250,000
Less:
Less: variable
variable expenses
expenses 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin 80,000
80,000 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000
Net
Net income
income -- 20,000
20,000

A Tk. 50,000 increase in sales revenue

 Contribution Margin Ratio
400
400 Bikes
Bikes 500
500 Bikes
Bikes
Sales
Sales 200,000
200,000 250,000
250,000
Less:
Less: variable
variable expenses
expenses 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin 80,000
80,000 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000
Net
Net income
income -- 20,000
20,000

A Tk.50,000 increase in sales revenue

results in a 20,000 increase in CM
or (50,000 × 40% = 20,000)
Changes in Fixed Costs and Sales
Volume
Bengal is currently selling 500 bikes per
month. The company’s sales manager
believes that an increase of 10,000 in the
monthly advertising budget would increase
bike sales to 540 units.

 Should we authorize the requested increase

in the advertising budget?
Changes in Fixed Costs and Sales
Volume
80,000
80,000++ 10,000
10,000advertising
advertising ==90,000
90,000
Current Projected
Sales (500 Sales (540
bikes) bikes)
Sales 250,000 270,000
Less: variable expenses 150,000 162,000
Contribution margin 100,000 108,000
Less: fixed expenses 80,000 90,000
Net income 20,000 18,000

Sales
Salesincreased
increasedby
by20,000,
20,000, but
butnetnet
income
incomedecreased
decreasedby
by2,000
2,000..
Changes in Fixed Costs and Sales
Volume
The Shortcut Solution

Increase in CM (40 units X 200) 8,000

Increase in advertising expenses 10,000
Decrease in net income (2,000)
 APPLICATIONS OF CVP
Consider the following basic data:
Per unit Percent
Sales Price 250 100
Less: Variable cost 150 60
Contribution margin 100 40
Fixed costs total 35,000
 Change in Fixed Cost and Sales
•
Volume
Current sales are 100,000. Sales manager
feels 10,000 increase in sales budget will
provide 30,000 increase in sales. Should the
budget be changed?
YES
Incremental CM approach:
TK.30,000 x 40% CM ratio 12,000
Additional advertising expense 10,000
Increase in net income 2,000
 Change in Variable Cost and Sales
Volume
• Management is considering increasing
quality of speakers at an additional cost of
Tk. 10 per speaker and plan to sell 80 more
units. Should management increase quality?
Expected total CM YES
= (480 speakers x 90) 43,200
Present total CM
= (400 speakers x 100) 40,000
Increase in total contribution margin 3,200
(and net income)
 Change in Fixed Cost, Sales Price
and Sales Volume
• Management advises that if selling price
dropped 20 per speaker and advertising
increased by 15,000/month, sales would
increase 50%. Good idea?
NO
Expected total CM
= (400 x 150% x 80) 48,000
Present total CM (400 x 100) 40,000
Incremental CM 8,000
Additional advertising cost 15,000
Reduction in net income (7,000)
 Changes in Variable Cost, Fixed
Cost, and Sales Volume

• A plan to switch salespeople from flat salary

(6,000 per month) to a sales commission of 15
per speaker could increase sales by 15%.
YES
Good idea?
Expected total CM (400x115%x85) 39,100
Current total CM (400 x 100) 40,000
Decrease in total CM (900)
Salaries avoided if commission paid 6,000
Increase in net income 5,100
 Change in Regular Sales Price
• A wholesaler is willing to buy 150 speakers if
we will give him a discount off our price. The
sale will not disturb regular sales and will not
change fixed costs. We want to make 3,000
on this sale. What price should we quote?
Variable cost per speaker 150
Desired profit on order (3,000/150) 20
Quoted price per speaker 170
 Break-Even Analysis
Break-even analysis can be approached in
two ways:
 Equation method
 Contribution margin method.
 Equation Method
Profits = Sales – (Variable expenses + Fixed expenses)

OR

Sales = Variable expenses + Fixed expenses + Profits

At the break-even point

profits equal zero.
 Equation Method
Here is the information from Wind Bicycle Co.:

Total
Total Per
PerUnit
Unit Percent
Percent
Sales
Sales(500
(500bikes)
bikes) 250,000
250,000 500
500 11
Less:
Less:variable
variable expenses
expenses 150,000
150,000 300
300 11
Contribution
Contributionmargin
margin 100,000
100,000 200
200 00
Less:
Less:fixed
fixedexpenses
expenses 80,000
80,000
Net
Netincome
income 20,000
20,000
 Equation Method

We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits

500Q = 300Q + 80,000 + 0

Where:
Q = Number of bikes sold
500 = Unit sales price
300 = Unit variable expenses
80,000 = Total fixed expenses
 Equation Method

We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits

500Q = 300Q + 80,000 + 0

200Q = 80,000

Q = 400 bikes
 Equation Method

We can also use the following equation to
compute the break-even point in sales dollars.
Sales = Variable expenses + Fixed expenses + Profits

X = 0.60X + 80,000 + 0
Where:
X = Total sales dollars
0.60 = Variable expenses as a
percentage of sales
80,000 = Total fixed expenses
 Equation Method

We can also use the following equation to
compute the break-even point in sales dollars.
Sales = Variable expenses + Fixed expenses + Profits

X = 0.60X + 80,000 + 0

0.40X = 80,000

X = 200,000
 Contribution Margin Method
The contribution margin method is a
variation of the equation method.

Break-even point Fixed expenses

=
in units sold Unit contribution margin

Break-even point in Fixed expenses

total sales dollars = CM ratio
 Target Profit Analysis
Suppose Bengal Co. wants to know how
many bikes must be sold to earn a profit
of 100,000.

We can use our CVP formula to determine

the sales volume needed to achieve a
target net profit figure.
 The CVP Equation
Sales = Variable expenses + Fixed expenses + Profits

500Q = 300Q + 80,000 + 100,000

200Q = 180,000

Q = 900 bikes
The Contribution Margin Approach
We can determine the number of bikes that
must be sold to earn a profit of 100,000
using the contribution margin approach.

Units sold to attain Fixed expenses + Target profit

=
the target profit Unit contribution margin

80,000 + 100,000
= 900 bikes
200
 The Margin of Safety
Excess of budgeted (or actual) sales over
the break-even volume of sales. The
amount by which sales can drop before
losses begin to be incurred.
Margin of safety = Total sales - Break-even sales

Let’s calculate the margin of safety for Wind.

 The Margin of Safety
Bengal has a break-even point of 200,000. If
actual sales are 250,000, the margin of safety
is 50,000 or 100 bikes.
Break-even
Break-even Actual
Actual
sales
sales sales
sales 500500
400
400 units
units units
units
Sales
Sales 200,000
200,000 250,000
250,000
Less:
Less: variable
variable expenses
expenses 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin 80,000
80,000 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000
Net
Net income
income -- 20,000
20,000
 The Margin of Safety
The margin of safety can be expressed as 20
percent of sales.
(50,000 ÷ 250,000)
Break-even
Break-even
sales
sales Actual
Actual sales
sales
400
400 units
units 500
500 units
units
Sales
Sales 200,000
200,000 250,000
250,000
Less:
Less: variable
variable expenses
expenses 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin 80,000
80,000 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000
Net
Net income
income -- 20,000
20,000
 Operating Leverage
• A measure of how sensitive net income is to
percentage changes in sales.
• With high leverage, a small percentage
increase in sales can produce a much larger
percentage increase in net income.
Degree of Contribution margin
operating leverage = Net income
Operating Leverage
Actual
Actual sales
sales
500
500 Bikes
Bikes
Sales
Sales 250,000
250,000
Less:
Less: variable
variable expenses
expenses 150,000
150,000
Contribution
Contribution margin
margin 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000
Net
Net income
income 20,000
20,000

100,000 = 5
20,000
 Operating Leverage
With a measure of operating leverage of 5, if
Wind increases its sales by 10%, net
income would increase by 50%.
Percent increase in sales 10%
Degree of operating leverage × 5
Percent increase in profits 50%

Here’s the proof!

 Operating Leverage

10% increase in sales from 250,000 to 275,000 . . .

. . . results in a 50% increase in

income from 20,000 to 30,000.
 The Concept of Sales Mix
• Sales mix is the relative proportions in
which a company’s products are sold.
• Different products have different selling
prices, cost structures, and contribution
margins.

Let’s assume Wind sells bikes and carts and

see how we deal with break-even analysis.
 The Concept of Sales Mix
Bengal Motors Ltd. provides us with the
following information:
Bikes Carts Total
Sales 250,000 1 300,000 1 550,000 1
Var. exp. 150,000 1 135,000 0 285,000 1
Contrib. margin 100,000 0 165,000 1 265,000 0
Fixed exp. 170,000
265,000
Net income = 48% (rounded) 95,000
550,000

Break-even point in sales dollars:

170,000 = 354,167 (rounded)
0.48
Assumptions of CVP Analysis
 Selling price is constant throughout
the entire relevant range.
 Costs are linear throughout the
entire relevant range.
 In multi-product companies, the
sales mix is constant.
 In manufacturing companies,
inventories do not change (units
produced = units sold).
Cost-Volume-Profit
with Uncertainty
 CVP with Uncertainty
• Use a decision tree to simplify
calculations
• The decision tree is used to calculate
profits under various alternatives
• A second decision tree can be used to
calculate the probabilities of the various
scenarios to further determine a
reasonable estimate of profit
• A computer can be used to save time
We made
it!