6-1

Cost-Volume-Profit
Relationships

Chapter Five
6-2

Learning Objective 1

Explain how changes in

activity affect
contribution margin
and net operating
income.
6-3

Basics of Cost-Volume-Profit Analysis

Contribution Margin (CM) is the amount

remaining from sales revenue after variable
expenses have been deducted.
6-4

Basics of Cost-Volume-Profit Analysis

CM is used first to cover fixed

expenses. Any remaining CM
contributes to net operating income.
6-5

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.
 6-6

The Contribution Approach

Each month, Racing must generate at least $80,000 in total

CM to break even.
6-7

The Contribution Approach

If Racing sells 400 units in a month, it will be

operating at the break-even point.
6-8

The Contribution Approach

If Racing sells one more bike (401 bikes), net

operating income will increase by $200.
 6-9

The Contribution Approach

We do not need to prepare an income statement to

estimate profits at a particular sales volume. Simply
multiply the number of units sold above break-even by the
contribution margin per unit.

If Racing sells
430 bikes, its
net income will
be $6,000.
6-10

Learning Objective 2

Prepare and interpret a

cost-volume-profit
(CVP) graph.
6-11

CVP Relationships in Graphic Form

The relationship among revenue, cost, profit and

volume can be expressed graphically by
preparing a CVP graph. Racing developed
contribution margin income statements at 300,
400, and 500 units sold. We will use this
information to prepare the CVP graph.
6-12

CVP Graph
Dollars

In
In aa CVP
CVP graph,
graph, unit
unit volume
volume isis
usually
usually represented
represented on
on the
the
horizontal
horizontal (X)
(X) axis
axis and
and dollars
dollars on
on
the
the vertical
vertical (Y)
(Y) axis
axis..

Units
6-13

CVP Graph
Dollars

Fixed Expenses

Units
6-14

CVP Graph
Dollars

Total Expenses
Fixed Expenses

Units
6-15

CVP Graph

Total Sales
Dollars

Total Expenses
Fixed Expenses

Units
6-16

CVP Graph

Break-even
Break-even point
point
(400
(400 units
units or
or $200,000
$200,000 in
in sales)
sales)
re a
fit A
P ro
Dollars

re a
s A
L o s

Units
6-17

Learning Objective 3

Use the contribution

margin ratio (CM ratio)
to compute changes in
contribution margin
and net operating
income resulting from
changes in sales
volume.
6-18

Contribution Margin Ratio

The contribution margin ratio is:

Total CM
CM Ratio =
Total sales
For Racing Bicycle Company the ratio is:
$80,000
= 40%
$200,000
Each $1.00 increase in sales results in a
total contribution margin increase of 40¢.
6-19

Contribution Margin Ratio

Or, in terms of units, the contribution margin ratio

is:
Unit CM
CM Ratio =
Unit selling price
For Racing Bicycle Company the ratio is:

$200 = 40%
$500
6-20

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 operating
operating income
income $$ -- $$ 20,000
20,000

A $50,000 increase in sales revenue

results in a $20,000 increase in CM.
($50,000 × 40% = $20,000)
6-21

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 CM Ratio for Coffee Klatch?

a. 1.319
b. 0.758
c. 0.242
d. 4.139
6-22

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 CM Ratio for Coffee Klatch?’
Unit contribution margin
a. 1.319
CM Ratio =
Unit selling price
b. 0.758 ($1.49-$0.36)/
c. 0.242 =
$1.49
d. 4.139
$1.13/
= = 0.758
$1.49
6-23

Learning Objective 4

Show the effects on

contribution margin of
changes in variable
costs, fixed costs,
selling price, and
volume.
 Changes in Fixed Costs and Sales
6-24

Volume

What is the profit impact if Racing can increase unit

sales from 500 to 540 by increasing the monthly
advertising budget by $10,000?
 Changes in Fixed Costs and Sales
6-25

Volume
$80,000 + $10,000 advertising = $90,000

Sales increased by $20,000, but net operating

income decreased by $2,000.
 Changes in Fixed Costs and Sales
6-26

Volume

The Shortcut Solution

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

Increase in advertising expenses 10,000
Decrease in net operating income $ (2,000)
 Change in Variable Costs and Sales
6-27

Volume

What is the profit impact if Racing can use higher quality

raw materials, thus increasing variable costs per unit by
$10, to generate an increase in unit sales from 500 to 580?
Change in Variable Costs and Sales
6-28

Volume
580 units × $310 variable cost/unit = $179,800

Sales increase by $40,000, and net operating income

increases by $10,200.
 Change in Fixed Cost, Sales Price and
6-29

Volume

What is the profit impact if Racing (1) cuts its selling

price $20 per unit, (2) increases its advertising budget
by $15,000 per month, and (3) increases sales from 500
to 650 units per month?
Change in Fixed Cost, Sales Price and
6-30

Volume

Sales increase by $62,000, fixed costs increase by

$15,000, and net operating income increases by $2,000.
 6-31
Change in Variable Cost, Fixed Cost and Sales
Volume

What is the profit impact if Racing (1) pays a $15 sales

commission per bike sold instead of paying salespersons
flat salaries that currently total $6,000 per month, and
(2) increases unit sales from 500 to 575 bikes?
6-32
Change in Variable Cost, Fixed Cost and Sales
Volume

Sales increase by $37,500, variable costs increase

by $31,125, but fixed expenses decrease by
$6,000.
 6-33

Change in Regular Sales Price

If Racing has an opportunity to sell 150 bikes to a wholesaler

without disturbing sales to other customers or fixed expenses,
what price would it quote to the wholesaler if it wants to
increase monthly profits by $3,000?
6-34

Change in Regular Sales Price

$$ 3,000
3,000 ÷÷ 150
150 bikes
bikes == $$ 20
20 per
per bike
bike
Variable
Variable cost
cost per
per bike
bike == 300
300 per
per bike
bike
Selling
Selling price
price required
required == $$ 320
320 per
per bike
bike

150
150 bikes
bikes ×× $320
$320 per
per bike
bike == $$ 48,000
48,000
Total
Total variable
variable costs
costs == 45,000
45,000
Increase
Increase in
in net
net income
income == $$ 3,000
3,000
6-35

Learning Objective 5

Compute the break-

even point in unit
sales and sales
dollars.
6-36

Break-Even Analysis

Break-even analysis can be approached in two ways:

1. Equation method
2. Contribution margin method (Formula Method)
6-37

Equation Method

Profits = (Sales – Variable expenses) – Fixed expenses

OR

Sales = Variable expenses + Fixed expenses + Profits

At the break-even point

profits equal zero
6-38

Break-Even Analysis

Here is the information from Racing Bicycle Company:

Total
Total Per
PerUnit
Unit Percent
Percent
Sales
Sales(500
(500bikes)
bikes) $$250,000
250,000 $$ 500
500 100%
100%
Less:
Less:variable
variable expenses
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
Netoperating
operatingincome
income $$ 20,000
20,000
6-39

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 selling price
$300 = Unit variable expense
$80,000 = Total fixed expense
6-40

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 = $80,000 ÷ $200 per bike
Q = 400 bikes
6-41

Equation Method


The equation can be modified to calculate 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 % of sales
$80,000 = Total fixed expenses
6-42

Equation Method


The equation can be modified to calculate the
break-even point in sales dollars.

Sales = Variable expenses + Fixed expenses + Profits

X = 0.60X + $80,000 + $0
0.40 X = $80,000
X = $80,000 ÷ 0.40
X = $200,000
6-43

Contribution Margin Method

The contribution margin method has two key equations.

Break-even point Fixed expenses

=
in units sold CM per unit

Break-even point in Fixed expenses

total sales dollars =
CM ratio
6-44

Contribution Margin Method

Let’s use the contribution margin method to calculate the

break-even point in total sales dollars at Racing.

Break-even point in Fixed expenses

total sales dollars =
CM ratio

$80,000
= $200,000 break-even sales
40%
6-45

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. 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
6-46

Quick Check 

Coffee Klatch is an espresso stand in a downtown

office building. The average selling price
Fixed of a cup of
expenses
Break-even
coffee is $1.49 and = variable
the average expense
CM per Unit
per cup is $0.36. The average fixed expense per
$1,300
month is $1,300. 2,100 cups are sold each month on
=
$1.49/cup
average. What is the break-even - $0.36/cup
sales in units?
$1,300
a. 872 cups =
$1.13/cup
b. 3,611 cups
c. 1,200 cups = 1,150 cups
d. 1,150 cups
6-47

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
6-48

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 Break-even Fixed expenses/

b. $1,715 =
sales CM Ratio
c. $1,788 $1,300/
=
d. $3,129 0.758
= $1,715
6-49

Learning Objective 6

Determine the level of

sales needed to
achieve a desired
target profit.
6-50

Target Profit Analysis

The equation and contribution margin methods can be used

to determine the sales volume needed to achieve a target
profit.

Suppose Racing Bicycle Company wants to know how many

bikes must be sold to earn a profit of $100,000.
6-51

The CVP Equation Method

Sales = Variable expenses + Fixed expenses + Profits

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

$200Q = $180,000

Q = 900 bikes
6-52

The Contribution Margin Approach

The contribution margin method can be used to

determine that 900 bikes must be sold to earn the
target profit of $100,000.

Unit sales to attain Fixed expenses + Target profit

=
the target profit CM per unit

$80,000 + $100,000
= 900 bikes
$200/bike
6-53

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
6-54

Quick Check 
Unit sales
Fixed expenses + Target profit
to attain =
Unit CM
target profit
Coffee Klatch is an espresso stand
$1,300 in a downtown
+ $2,500
=
office building. The average selling price of a cup of
$1.49 - $0.36
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$3,800
=
$1,300. How many cups of coffee would have to be
$1.13
sold to attain target profits of $2,500 per month?
= 3,363 cups
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups
6-55

Learning Objective 7

Compute the margin of

safety and explain its
significance.
6-56

The Margin of Safety

The margin of safety is the excess of budgeted (or

actual) sales over the break-even volume of sales.

Margin of safety = Total sales - Break-even sales

Let’s look at Racing Bicycle Company and determine the

margin of safety.
 6-57

The Margin of Safety

If we assume that Racing Bicycle Company 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
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 operating
operating income
income $$ -- $$ 20,000
20,000
6-58

The Margin of Safety

The margin of safety can be expressed as 20% 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 operating
operating income
income $$ -- $$ 20,000
20,000
6-59

The Margin of Safety

The margin of safety can be expressed in terms of the

number of units sold. The margin of safety at Racing is
$50,000, and each bike sells for $500.

Margin of $50,000/
Safety in units = $500 = 100 bikes
6-60

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
6-61

Quick Check 

Margin of safety = Total sales – Break-even sales

Coffee Klatch is an espresso stand
= 2,100 cupsin –a 1,150
downtown
cups
office building. The average selling price of a cup of
= 950 cups
coffee is $1.49 and the average variable expense per
or expense per month is
cup is $0.36. The average fixed
$1,300. 2,100 cups
Margin are sold each
of safety 950month
cups/ on average.
What is the percentage = 2,100 cups = 45%
margin of safety?

a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
6-62

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.
6-63

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
will be higher in good years
compared to companies A disadvantage of a high fixed
with lower proportion of cost structure is that income
fixed costs. will be lower in bad years
compared to companies
with lower proportion of
fixed costs.
6-64

Learning Objective 8

Compute the degree of

operating leverage at a
particular level of sales
and explain how it can
be used to predict
changes in net
operating income.
6-65

Operating Leverage

A measure of how sensitive net operating income is to

percentage changes in sales.

Degree of Contribution margin

operating leverage = Net operating income
6-66

Operating Leverage

At Racing, the degree of operating leverage is 5.

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
$20,000 = 5
6-67

Operating Leverage

With an operating leverage of 5, if Racing increases its sales

by 10%, net operating income would increase by 50%.

Percent increase in sales 10%

Degree of operating leverage × 5
Percent increase in profits 50%

Here’s the verification!

6-68

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.
6-69

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
6-70

Quick Check 

Actual sales
2,100 cups
Coffee Klatch is an espresso
Sales
stand in a downtown $ 3,129
office building. The average selling price of a cup of
Less: Variable
coffee is $1.49 and the average expenses
variable expense per 756
cup is $0.36. The averageContribution margin
fixed expense per month 2,373
is
Less:each
$1,300. 2,100 cups are sold Fixed expenses
month on average.1,300
What is the operating leverage?
Net operating income $ 1,073

a. 2.21
b. 0.45
c. 0.34 Operating Contribution margin/
d. 2.92 leverage = Net operating income
$2,373/
= $1,073 = 2.21
6-71

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, the average fixed expense per month
is $1,300 and an average of 2,100 cups are sold
each month.

If sales increase by 20%, by how much should net

operating income increase?

a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%
6-72

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, the average fixed expense per month
is $1,300 and an average of 2,100 cups are sold
each month.
If sales increase by 20%, by how much should net
operating income increase?

a. 30.0% Percent increase in sales 20.0%

b. 20.0% × Degree of operating leverage 2.21
c. 22.1% Percent increase in profit 44.20%
d. 44.2%
6-73

Verify Increase in Profit

Actual Increased
sales sales
2,100 cups 2,520 cups
Sales $ 3,129 $ 3,755
Less: Variable expenses 756 907
Contribution margin 2,373 2,848
Less: Fixed expenses 1,300 1,300
Net operating income $ 1,073 $ 1,548
% change in sales 20.0%
% change in net operating income 44.2%
6-74

Structuring Sales Commissions

Companies generally compensate salespeople by paying

them either a commission based on sales or a salary plus a
sales commission. Commissions based on sales dollars can
lead to lower profits in a company.

Let’s look at an example.

6-75

Structuring Sales Commissions

Pipeline Unlimited produces two types of surfboards, the

XR7 and the Turbo. The XR7 sells for $100 and generates a
contribution margin per unit of $25. The Turbo sells for
$150 and earns a contribution margin per unit of $18.

The sales force at Pipeline Unlimited is compensated based

on sales commissions.
6-76

Structuring Sales Commissions

If you were on the sales force at Pipeline, you would push

hard to sell the Turbo even though the XR7 earns a higher
contribution margin per unit.

To eliminate this type of conflict, commissions can be

based on contribution margin rather than on selling price
alone.
6-77

Learning Objective 9

Compute the break-

even point for a
multiproduct company
and explain the effects
of shifts in the sales
mix on contribution
margin and the break-
even point.
6-78

The Concept of Sales Mix

• Sales mix is the relative proportion in which a

company’s products are sold.
• Different products have different selling prices, cost
structures, and contribution margins.

Let’s assume Racing Bicycle Company sells bikes and

carts and that the sales mix between the two
products remains the same.
6-79

Multi-product break-even analysis

Racing Bicycle Co. provides the following information:

$265,000
= 48.2% (rounded)
$550,000
6-80

Multi-product break-even analysis

Break-even Fixed expenses
sales = CM Ratio
$170,000
=
48.2%
= $352,697
6-81

Key Assumptions of CVP Analysis

 Selling price is constant.

 Costs are linear.
 In multiproduct companies, the sales mix is constant.
 In manufacturing companies, inventories do not change
(units produced = units sold).
6-82

End of Chapter 5