12/31/2024

Session 3
Cost-Volume-Profit analysis

Learning Objectives
1. Understand the basics of CVP analysis
2. Determine the break-even point, the
amount of sales required for a target profit,
the margin of safety, and the degree of
operating leverage.
3. Understand the underlying assumptions and
limitations of the CVP analysis tool.

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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.

Basics of Cost-Volume-Profit Analysis

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

CM is used first to cover fixed expenses. Any remaining CM

contributes to net operating income.

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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.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bicycles) $ 250,000 $ 500
Less: Variable expenses 150,000 300
Contribution margin 100,000 $ 200
Less: Fixed expenses 80,000
Net operating income $ 20,000

The Contribution Approach

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).
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bicycles) $ 250,000 $ 500
Less: Variable expenses 150,000 300
Contribution margin 100,000 $ 200
Less: Fixed expenses 80,000
Net operating income $ 20,000

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The Contribution Approach

If RBC sells 400 units in a month, it will be
operating at the break-even point.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (400 bicycles) $ 200,000 $ 500
Less: Variable expenses 120,000 300
Contribution margin 80,000 $ 200
Less: Fixed expenses 80,000
Net operating income $ -

The Contribution Approach

If RBC sells one more bike (401 bikes), net
operating income will increase by $200.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (401 bicycles) $ 200,500 $ 500
Less: Variable expenses 120,300 300
Contribution margin 80,200 $ 200
Less: Fixed expenses 80,000
Net operating income $ 200

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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
operating income
will be $6,000.

CVP Relationships in Equation Form

This equation can also be used to show the $200 profit RBC
earns if it sells 401 bikes.

Profit = (Sales – Variable expenses) – Fixed expenses

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

$200
Profit ($500××401
= =($500 $300 ××401)
401 –– $300 401)––$80,000
$80,000

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CVP Relationships in Equation Form

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

Contribution Margin Ratio (CM Ratio)

The CM ratio is calculated by dividing the total contribution
margin by total sales.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
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%
Less: Fixed expenses 80,000
Net operating income $ 20,000

$100,000 ÷ $250,000 = 40%

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Contribution Margin Ratio (CM Ratio)

The contribution margin ratio at Racing Bicycle is:

CM per unit $200

CM Ratio = = = 40%
SP per unit $500

The CM ratio can also be calculated by dividing

the contribution margin per unit by the selling
price per unit.

Contribution Margin Ratio (CM Ratio)

If Racing Bicycle increases sales by $50,000, contribution
margin will increase by $20,000 ($50,000 × 40%).
Here is the proof:
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

A $50,000 increase in sales revenue results in a $20,000

increase in CM. ($50,000 × 40% = $20,000)

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The Variable Expense Ratio

The variable expense ratio is the ratio of variable expenses to sales.
It can be computed by dividing the total variable expenses by the
total sales, or in a single product analysis, it can be computed by
dividing the variable expenses per unit by the unit selling price.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
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%
Less: Fixed expenses 80,000
Net operating income $ 20,000

Changes in Fixed Costs and Sales Volume

What is the profit impact if Racing Bicycle

can increase unit sales from 500 to 540
by increasing the monthly advertising
budget by $10,000?

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Changes in Fixed Costs and Sales Volume

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

500 units 540 units

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 operating income $ 20,000 $ 18,000

Sales increased by $20,000, but net operating

income decreased by $2,000.

Changes in Fixed Costs and Sales Volume

A shortcut solution using incremental

analysis

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

Increase in advertising expenses 10,000
Decrease in net operating income $ (2,000)

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Change in Variable Costs and Sales Volume

What is the profit impact if Racing Bicycle 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

500 units 580 units

Sales $ 250,000 $ 290,000
Less: Variable expenses 150,000 179,800
Contribution margin 100,000 110,200
Less: Fixed expenses 80,000 80,000
Net operating income $ 20,000 $ 30,200

Sales increase by $40,000, and net operating

income increases by $10,200.

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Change in Fixed Cost, Sales Price

and Volume

What is the profit impact if RBC: (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 Volume

650 units × $480 = $312,000

500 units 650 units

Sales $ 250,000 $ 312,000
Less: Variable expenses 150,000 195,000
Contribution margin 100,000 117,000
Less: Fixed expenses 80,000 95,000
Net operating income $ 20,000 $ 22,000

Sales increase by $62,000, fixed costs increase by $15,000, and

net operating income increases by $2,000.

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Change in Variable Cost, Fixed Cost

and Sales Volume

What is the profit impact if RBC: (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
575 units × $315 = $181,125
500 units 575 units
Sales $ 250,000 $ 287,500
Less: Variable expenses 150,000 181,125
Contribution margin 100,000 106,375
Less: Fixed expenses 80,000 74,000
Net operating income $ 20,000 $ 32,375

Sales increase by $37,500, fixed expenses decrease by $6,000.

Net operating income increases by $12,375.

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Change in Regular Sales Price

If RBC 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 operating income = $ 3,000

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Target Profit Analysis

Suppose Racing Bicycle management

wants to know how many bikes must be
sold to earn a target profit of $100,000.

Target Profit Analysis in Terms of Unit Sales

Suppose Racing Bicycle Company wants to know
how many bikes must be sold to earn a profit
of $100,000.
Unit sales to attain Target profit + Fixed expenses
=
the target profit CM per unit

$100,000 + $80,000
Unit sales =
$200
Unit sales = 900

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Target Profit Analysis in Terms of Dollar Sales

We can calculate the dollar sales needed to attain a
target profit (net operating profit) of $100,000 at
Racing Bicycle.
Dollar sales to attain Target profit + Fixed expenses
=
the target profit CM ratio

$100,000 + $80,000
Dollar sales =
40%
Dollar sales = $450,000

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 us the RBC information to
complete the break-even analysis.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
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%
Less: Fixed expenses 80,000
Net operating income $ 20,000

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Break-even in Unit Sales

Let’s apply this formula to determine the break-

even point.

Unit sales to Fixed expenses

=
break even CM per unit

$80,000
Unit sales =
$200
Unit sales = 400

Break-even in Dollar Sales:

Formula Method
Now, let’s use the formula method to calculate the
dollar sales at the break-even point.

Dollar sales to Fixed expenses

=
break even CM ratio

$80,000
Dollar sales =
40%
Dollar sales = $200,000

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Preparing the CVP Graph

$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

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.

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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

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

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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

Operating Leverage
Operating leverage is a measure of how sensitive net
operating income is to percentage changes in sales. It is a
measure, at any given level of sales, of how a percentage
change in sales volume will affect profits.
Contributi on Margin
DOL= Degree of Operating Leverage =
Net Operating Income * *

** Profit Before Tax is a commonly used alternative to Net Operating

Income in the degree of operating leverage calculation

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Operating Leverage
To illustrate, let’s revisit the contribution income
statement for RBC.
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

Degree of
Operating $100,000
= $20,000 = 5
Leverage

Operating Leverage
With an operating leverage of 5, if RBC 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!

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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.

What does higher value of Operating Leverage

mean?

– High Operating Leverage ratio

• signals the existence of high fixed costs.
• increases risk of making loss in adverse market conditions.
• increases opportunity to make profit when higher demand
exists.
• has lower margin of safety percentage (MoS%)

1
DOL
MoS%

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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.
• When a company sells more than one product,
break-even analysis becomes more complex as the
following example illustrates.

Let’s assume Racing Bicycle Company sells bikes and

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

Multi-Product Breakeven Analysis

(The BE% Method)
RBC’s Bikes and Carts sales and profit data are as follows:
Bicycle Carts Total
Sales $ 250,000 $ 300,000 $ 550,000
Variable expenses 150,000 135,000 285,000
Contribution margin 100,000 165,000 265,000
Fixed expenses 170,000
Net operating income $ 95,000

Sales $ 250,000 $300,000

x Contributi on Margin 1
DOL = =
BE% = 64.15% Net Operating Income MoS%
Net Operating Income
 MoS% =
Breakeven sales $160,375 $192,450 Contributi on Margin
95,000
Total breakeven sales = $352,825  MoS% = = 35 .85 %
265 ,000
 MoS% = 1 − BE%
 BE% = 1 − MoS% = 1 − 35 .85 = 64 .15 %

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Multi-Product Breakeven Analysis

(The BE% Method)
Bicycle Carts Total

Sales 160,375 100% 192,450 100% 352,825 100.0%

Variable expenses 96,225 60% 86,603 45% 182,828 51.8%

Contribution margin 64,150 40% 105,847 55% 169,997 48.2%

Fixed expenses 170,000

Net operating income Rounding error (3)

Multi-Product Breakeven Analysis

(The CM Ratio Method)
Bikes comprise 45% of RBC’s total sales revenue and the
carts comprise the remaining 55%. RBC provides the
following information:
Bicycle Carts Total
Sales $ 250,000 100% $ 300,000 100% $ 550,000 100.0%
Variable expenses 150,000 60% 135,000 45% 285,000 51.8%
Contribution margin 100,000 40.0% 165,000 55% 265,000 48.2%
Fixed expenses 170,000
Net operating income $ 95,000

Sales mix $ 250,000 45% $ 300,000 55% $ 550,000 100%

$265,000 = 48.2% (rounded)

$550,000

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Multi-Product Breakeven Analysis

(The CM Ratio Method)
Dollar sales to Fixed expenses
=
break even CM ratio

Dollar sales to $170,000

= = $352,697
break even 48.2%

Bicycle Carts Total

Sales $ 158,714 100% $ 193,983 100% $ 352,697 100.0%
Variable expenses 95,228 60% 87,293 45% 182,521 51.8%
Contribution margin 63,485 40% 106,691 55% 170,176 48.2%
Fixed expenses 170,000
Net operating income Rounding error $ 176

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

Key Assumptions of CVP Analysis

 Selling price is constant.
 Costs are linear and can be accurately divided into
variable (constant per unit) and fixed (constant in
total) elements.
 In multiproduct companies, the sales mix is
constant.
 In manufacturing companies, inventories do not
change (units produced = units sold).

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