Chapter 6

Cost-Volume-Profit
Relationships
Basics of Cost-Volume-Profit Analysis

Contribution Margin (CM) is the amount

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

CM is used first to cover fixed

expenses. Any remaining CM
contributes to net operating income.
 Learning Objective
LO1

To explain how changes in

activity affect contribution
margin and net operating
income.
 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.
 The Contribution Approach
Each month, Racing must generate at least
$80,000 in total CM to break even.
 The Contribution Approach
If Racing sells 400 units in a month, it will
be operating at the break-even point.
 The Contribution Approach
If Racing sells one more bike (401 bikes), net
operating income will increase by $200.
 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.
 Learning Objective
LO2

To prepare and interpret a

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

400,000

350,000

300,000

250,000

200,000
In a CVP graph, unit volume is
150,000 usually represented on the
100,000
horizontal (X) axis and dollars on
50,000 the vertical (Y) axis.
-
- 100 200 300 400 500 600 700 800

Units
 CVP Graph
450,000

400,000

350,000

300,000

250,000

200,000

150,000 Fixed Expenses

100,000

50,000

-
- 100 200 300 400 500 600 700 800

Units
 CVP Graph
450,000

400,000

350,000

300,000

250,000
Total Expenses
200,000

150,000 Fixed Expenses

100,000

50,000

-
- 100 200 300 400 500 600 700 800

Units
 CVP Graph
450,000

400,000

350,000
Total Sales
300,000

250,000
Total Expenses
200,000

150,000 Fixed Expenses

100,000

50,000

-
- 100 200 300 400 500 600 700 800

Units
 CVP Graph
450,000

400,000
Break-even point
(400 units or $200,000 in sales)
350,000

300,000

250,000

200,000

150,000

100,000

50,000

-
- 100 200 300 400 500 600 700 800

Units
 Learning Objective
LO3

To use the contribution

margin ratio (CM ratio) to
compute changes in
contribution margin and net
operating income resulting
from changes in sales
volume.
 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¢.
 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
 Contribution Margin Ratio

400 Bikes 500 Bikes

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

A $50,000 increase in sales revenue

results in a $20,000 increase in CM.
($50,000 × 40% = $20,000)
 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. On average, 2,100
cups are sold each month. What is the CM Ratio
for Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139
 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. On average, 2,100
cups are sold each month. 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
 Learning Objective
LO4

To show the effects on

contribution margin of
changes in variable costs,
fixed costs, selling price, and
volume.
Changes in Fixed Costs and Sales 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 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 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 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 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
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 unit sales from
500 to 650 units per month?
 Change in Fixed Cost, Sales Price and
Volume

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

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

Increase in CM (75 units X $85) $ 6,375

Reduced fixed costs 6,000
Increase in net operating income $ 12,375

Sales increase by $37,500, variable costs increase by

$31,125, but fixed expenses decrease by $6,000.
 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?
 Change in Regular Sales Price

$ 3,000 ÷ 150 bikes = $ 20 per bike

Variable cost per bike = 300 per bike
Selling price required = $ 320 per bike

150 bikes × $320 per bike = $ 48,000

Total variable costs = 45,000
Increase in net income = $ 3,000
 Learning Objective
LO5

To compute the breakeven

point in unit sales and dollar
sales.
 Break-Even Analysis

Break-even analysis can be

approached in two ways:
1. Equation method
2. 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
 Break-Even Analysis

Here is the information from Racing Bicycle

Company:

Total Per Unit Percent

Sales (500 bikes) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Net operating income $ 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 selling price
$300 = Unit variable expense
$80,000 = Total fixed expense
 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
 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
 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
0.40X = $80,000
X = $80,000 ÷ 0.40
X = $200,000
 Contribution Margin Method

The contribution margin method has

two key equations.
Break-even point Fixed expenses
=
in units sold Unit contribution margin

Break-even point in Fixed expenses

total sales dollars = CM ratio
 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%
 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. On average 2,100
cups are sold each month. What is the break-even
sales in units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups
 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
Fixed expenses
expense per cupBreak-even =
is $0.36. The average fixed
Unit CM
expense per month is $1,300. On average 2,100
$1,300
=
cups are sold each month. What is- $0.36/cup
the break-even
$1.49/cup
sales in units?
$1,300
a. 872 cups =
$1.13/cup
b. 3,611 cups
= 1,150 cups
c. 1,200 cups
d. 1,150 cups
 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. On average 2,100
cups are sold each month. What is the break-even
sales in dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129
 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. On average 2,100
cups are sold each month. What is the break-even
sales in dollars?
a. $1,300 Break-even Fixed expenses
=
b. $1,715 sales CM Ratio
$1,300
c. $1,788 =
0.758
d. $3,129
= $1,715
 Learning Objective
LO6

To determine the level of

sales needed to achieve a
desired target profit.
 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.
 The CVP Equation Method
Sales = Variable expenses + Fixed expenses + Profits

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

$200Q = $180,000

Q = 900 bikes
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 Unit contribution margin

$80,000 + $100,000
= 900 bikes
$200/bike
 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
 UnitQuick
sales Check 
Fixed expenses + Target profit
to attain =
Coffee Klatch is an espresso standUnit
in CM
a downtown
target profit
office building. The average
$1,300selling price of a cup
+ $2,500
of coffee is $1.49 and = the average variable
$1.49 - $0.36
expense per cup is $0.36. The average fixed
$3,800 How many cups of
expense per month =is $1,300.
$1.13
coffee would have to be sold to attain target profits
= 3,363 cups
of $2,500 per month?
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups
 Learning Objective
LO7

To compute the margin of

safety and explain its
significance.
 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.
 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
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
 The Margin of Safety

The 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
 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
= = 100 bikes
Safety in units $500
 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. On average 2,100 cups are sold each
month. What is the margin of safety?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
 Quick Check 
Coffee Klatch is an espresso stand in a
downtown
Margin office building.
of safety = Total The
salesaverage selling
– Break-even sales
= 2,100
price of a cup of coffee cups –and
is $1.49 1,150 cups
the
= 950 cups
average variable expense per cup is $0.36.
The average fixed expense or per month is
$1,300. of safety2,100950
On average
Margin cups
cups are sold each
percentage = 2,100 cups = 45%
month. What is the margin of safety?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
 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.
 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.
 Learning Objective
LO8

To 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.
 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
 Operating Leverage
At Racing, the degree of operating leverage is 5.
Actual sales
500 Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income $ 20,000

$100,000 = 5
$20,000
 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!

 Operating Leverage
Actual sales Increased
(500) sales (550)
Sales $ 250,000 $ 275,000
Less variable expenses 150,000 165,000
Contribution margin 100,000 110,000
Less fixed expenses 80,000 80,000
Net operating income $ 20,000 $ 30,000

10% increase in sales from

$250,000 to $275,000 . . .
. . . results in a 50% increase in
income from $20,000 to $30,000.
 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. On average 2,100 cups are sold each
month on. What is the operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92
 Quick Check 
Actual sales
Coffee Klatch is an espresso stand in a 2,100 cups
downtown office building.
Sales The average selling $ 3,129
price of a cup of coffee is $1.49
Less: and
Variable the
expenses 756
average variable expense per cup
Contribution is $0.36. 2,373
margin
The average fixed expense perexpenses
Less: Fixed month is 1,300
$1,300. On average2,100Net operating
cups areincome $
sold each 1,073
month. What is the operating leverage?
a. 2.21
Operating Contribution margin
b. 0.45 leverage = Net operating income
c. 0.34
$2,373
d. 2.92 = $1,073 = 2.21
 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. On average 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%
 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. On average 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
Percent increase in profit 44.20%
c. 22.1%
d. 44.2%
 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%
 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.

 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.
 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.
 Learning Objective
LO9

To 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.
 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.
Multi-product break-even analysis
Racing Bicycle Co. provides the following
information:

$265,000
= 48.2% (rounded)
$550,000
 Multi-product break-even analysis
Break-even Fixed expenses
sales = CM Ratio
$170,000
=
48.2%
= $352,697
 Key Assumptions of CVP Analysis
 Selling price is constant.
 Costs are linear.
 In multi-product companies, the
sales mix is constant.
 In manufacturing companies,
inventories do not change (units
produced = units sold).
End of Chapter 6