Equation Method

Profits = Sales – (Variable expenses + Fixed expenses)

OR

Sales = Variable expenses + Fixed expenses + Profits

At the break-even point

profits equal zero.

Irwin/McGraw-Hill 1 © The McGraw-Hill Companies, Inc., 2002

 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
500 100%
100%
Less:
Less:variable
variableexpenses
expenses 150,000
150,000 300
300 60%
60%
Contribution
Contributionmargin
margin $$100,000
100,000 $$ 200
200 40%
40%
Less:
Less:fixed
fixedexpenses
expenses 80,000
80,000
Net
Netincome
income $$ 20,000
20,000

Irwin/McGraw-Hill 2 © The McGraw-Hill Companies, Inc., 2002

 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

Irwin/McGraw-Hill 3 © The McGraw-Hill Companies, Inc., 2002

 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

Irwin/McGraw-Hill 4 © The McGraw-Hill Companies, Inc., 2002

 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

Irwin/McGraw-Hill 5 © The McGraw-Hill Companies, Inc., 2002

 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

Irwin/McGraw-Hill 6 © The McGraw-Hill Companies, Inc., 2002

 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

Irwin/McGraw-Hill 7 © The McGraw-Hill Companies, Inc., 2002

 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. 2,100 cups
are sold each month on average. What is the
break-even sales in units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups
Irwin/McGraw-Hill 8 © The McGraw-Hill Companies, Inc., 2002
 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. 2,100 cups
are sold each month on average. What is the
break-even sales in dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129
Irwin/McGraw-Hill 10 © The McGraw-Hill Companies, Inc., 2002
 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 Wind 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

Irwin/McGraw-Hill 12 © The McGraw-Hill Companies, Inc., 2002

 CVP Graph
400,000

350,000

300,000

250,000 Total Expenses

Dollars

200,000

150,000 Fixed expenses

100,000

50,000

-
100

200

300

400

500

600

700

800
-

Units

Irwin/McGraw-Hill 13 © The McGraw-Hill Companies, Inc., 2002

 CVP Graph
400,000

350,000

300,000
Total Sales
250,000
Dollars

200,000

150,000

100,000

50,000

-
100

200

300

400

500

600

700

800
-

Units

Irwin/McGraw-Hill 14 © The McGraw-Hill Companies, Inc., 2002

 CVP Graph
400,000

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

200,000
Break-even point
150,000

100,000
r ea
A
50,000 o ss
L
-
100

200

300

400

500

600

700

800
-

Units

Irwin/McGraw-Hill 15 © The McGraw-Hill Companies, Inc., 2002

 Target Profit Analysis

Suppose Wind 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.

Irwin/McGraw-Hill 16 © The McGraw-Hill Companies, Inc., 2002

 The CVP Equation
Sales = Variable expenses + Fixed expenses + Profits

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

$200Q = $180,000

Q = 900 bikes

Irwin/McGraw-Hill 17 © The McGraw-Hill Companies, Inc., 2002

 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

Irwin/McGraw-Hill 18 © The McGraw-Hill Companies, Inc., 2002

 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. 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
Irwin/McGraw-Hill 19 © The McGraw-Hill Companies, Inc., 2002
 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.

Irwin/McGraw-Hill 21 © The McGraw-Hill Companies, Inc., 2002

 The Margin of Safety

Wind 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
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

Irwin/McGraw-Hill 22 © The McGraw-Hill Companies, Inc., 2002

 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

Irwin/McGraw-Hill 23 © The McGraw-Hill Companies, Inc., 2002

 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. 2,100 cups
are sold each month on average. What is the
margin of safety?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
Irwin/McGraw-Hill 24 © The McGraw-Hill Companies, Inc., 2002
 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

Irwin/McGraw-Hill 26 © The McGraw-Hill Companies, Inc., 2002

 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

Irwin/McGraw-Hill 27 © The McGraw-Hill Companies, Inc., 2002

 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!

Irwin/McGraw-Hill 28 © The McGraw-Hill Companies, Inc., 2002

 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.
Irwin/McGraw-Hill 29 © The McGraw-Hill Companies, Inc., 2002
 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. 2,100 cups
are sold each month on average. What is the
operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92
Irwin/McGraw-Hill 30 © The McGraw-Hill Companies, Inc., 2002
 Quick Check 
At Coffee Klatch the average selling price of a
cup of coffee is $1.49, the average variable
expense per cup is $0.36, and the average fixed
expense per month is $1,300. 2,100 cups are sold
each month on average.
If sales increase by 20%, by how much should
net income increase?
a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%
Irwin/McGraw-Hill 32 © The McGraw-Hill Companies, Inc., 2002
 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.

Irwin/McGraw-Hill 35 © The McGraw-Hill Companies, Inc., 2002

 Multi-product break-even analysis
Wind Bicycle Co. provides the following
information:
Bikes Carts Total
Sales $ 250,000 100% $ 300,000 100% $ 550,000 100.0%
Var. exp. 150,000 60% 135,000 45% 285,000 51.8%
Contrib. margin $ 100,000 40% $ 165,000 55% 265,000 48.2%
Fixed exp. 170,000
Net income $ 95,000

Sales mix $ 250,000 45% $ 300,000 55% $ 550,000 100.0%

$265,000
= 48.2% (rounded)
$550,00

Irwin/McGraw-Hill 36 © The McGraw-Hill Companies, Inc., 2002

 Multi-product break-even analysis
F
Breakeven sales =
CM Ratio
$170,000
= = $352,697
0.482
Bikes Carts Total
Sales $ 158,714 100% $ 193,983 100% $ 352,697 100.0%
Var. exp. 95,228 60% 87,293 45% 182,521 51.8%
Contrib. margin $ 63,485 40% $ 106,691 55% 170,176 48.2%
Fixed exp. 170,000
Net income $ 176
Rounding error

Sales mix $ 158,714 45% $ 193,983 55% $ 352,697 100.0%

Irwin/McGraw-Hill 37 © The McGraw-Hill Companies, Inc., 2002

 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).

Irwin/McGraw-Hill 38 © The McGraw-Hill Companies, Inc., 2002