Cost-Volume-Profit

Relationships
CHAPTER 6

Introduction to
Managerial Accounting
Ninth edition

Cover image credit: wavebreakmedia/Shutterstock

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 6-2

Cost-Volume-Profit Analysis: Key

Assumptions
To simplify CVP calculations, managers typically
adopt the following assumptions with respect to
these factors:
1. Selling price is constant. The price of a product or
service will not change as volume changes.
2. Costs are linear and can be accurately divided
into variable and fixed components. The variable
costs are constant per unit and the fixed costs are
constant in total over the entire relevant range.
3. In multiproduct companies, the mix of products
sold remains constant.

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 6-3

Learning Objective 1

Explain how changes in

sales volume affect
contribution margin and
net operating income.

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 6-4

Basics of Cost-Volume-Profit Analysis

–Part 1
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.
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 6-5

Basics of Cost-Volume-Profit Analysis

– Part 2
CM is used first to cover fixed expenses.
Any remaining CM contributes
to net operating income.
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

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 6-6

The Contribution Approach – Part 1

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

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 6-7

The Contribution Approach – Part 2

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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 6-8

The Contribution Approach – Part 3

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 $ -

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 6-9

The Contribution Approach – Part 4

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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 6-10

The Contribution Approach – Part 5

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 RBC sells 430 bikes, its

net operating income will be
$6,000
(30 units × $200 per unit).

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 6-11

CVP Relationships in Equation

Form
The contribution format income statement can
be expressed in the following equation:
Profit = (Sales – Variable expenses) – Fixed expenses
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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 6-12

CVP Relationships in Equation Form –

Example
This equation can be used to show the profit
RBC earns if it sells 401. Notice, the answer of
$200 mirrors our earlier solution.
Profit = (Sales – Variable expenses) – Fixed expenses

$80,000
401 units × $500

401 units × $300

Profit = ($200,500 – $120,300) – $80,000

$200 = ($200,500 – $120,300) – $80,000
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 6-13

CVP Relationships in Equation Form –

Detail Breakdown
When a company has only one product,
we can further refine this equation
as shown on this slide.
Profit = (Sales – Variable expenses) – Fixed expenses

Quantity sold (Q)

× Variable expenses per unit (V)
= Variable expenses (Q × V)

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

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 6-14

CVP Relationships in Equation Form –

Example Showing Detail
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

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

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

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 6-15

CVP Relationships in Equation Form –

Using Unit Contribution Margin
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

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 6-16

CVP Relationships in Equation Form –

Example Using Unit CM

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

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

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

Profit = $200 × 401 – $80,000
This equation
Profit = $80,200 – $80,000 can also be used
Profit = $200 to compute
RBC’s $200 profit
if it sells 401
bikes.

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 6-17

Learning Objective 2

Prepare and interpret a

cost-volume-profit (CVP)
graph and a profit graph.

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 6-18

CVP Relationships in Graphic Form

The relationships among revenue, cost, profit, and
volume can be expressed graphically by preparing a
CVP graph. Racing Bicycle developed contribution
margin income statements at 0, 200, 400, and 600
units sold. We will use this information to prepare the
CVP graph.
Units Sold
0 200 400 600
Sales $ - $ 100,000 $ 200,000 $ 300,000
Total variable expenses - 60,000 120,000 180,000
Contribution margin - 40,000 80,000 120,000
Fixed expenses 80,000 80,000 80,000 80,000
Net operating income (loss) $ (80,000) $ (40,000) $ - $ 40,000

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 6-19

Preparing the CVP Graph – Step 1

$350,000

$300,000

$250,000
Dollars

$200,000

$150,000

$100,000
In a CVP graph, unit volume is usually
$50,000
represented on the horizontal (X) axis and
dollars on the vertical (Y) axis.
$0
0 100 200 300 400 500 600

Units

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 6-20

Preparing the CVP Graph – Step 2

$350,000
Draw a line parallel to the
$300,000 volume axis to represent total
fixed expenses.
$250,000

$200,000
Dollars

Fixed expenses
$150,000

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units

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 6-21

Preparing the CVP Graph – Step 3

Choose some
$350,000
sales volume, say 400 units, and plot the point representing
total expenses (fixed and variable). Draw a line through the data point back
to where the fixed expenses line intersects the dollar axis.
$300,000

$250,000

$200,000
Dollars

Total expenses
Fixed expenses
$150,000

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units

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 6-22

Preparing the CVP Graph – Step 4

Choose some
$350,000 sales volume, say 400 units, and plot the point representing
total sales. Draw a line through the data point back to the point of origin.
$300,000

$250,000

$200,000
Dollars

Sales
Total expenses
$150,000 Fixed expenses

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units

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 6-23

Preparing the CVP Graph – Break-Even

Point
$350,000
Break-even point
$300,000
(400 units or $200,000 in sales) Profit Area

$250,000

$200,000
Dollars

Sales
Total expenses
$150,000 Fixed expenses

$100,000

$50,000

$0
0 100 200 300 400 500 600

Loss Area Units

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 6-24

Preparing the Profit Graph – Simple

Form
Profit = Unit CM × Q – Fixed Costs
$ 60,000

$ 40,000

$ 20,000
Profit

$0

-$20,000
An even simpler form
-$40,000 of the CVP graph is
-$60,000
called the profit graph.
0 100 200 300 400 500 600
Number of bicycles sold

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 6-25

Preparing the Profit Graph – Showing

Break-Even Point

$ 60,000
Break-even point, where
$ 40,000 profit is zero, is 400
units sold.
$ 20,000
Profit

$0

-$20,000

-$40,000

-$60,000

0 100 200 300 400 500 600

Number of bicycles sold

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 6-26

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.

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 6-27

Contribution Margin Ratio (CM Ratio)

and the Variable Expense Ratio – Step 1
The contribution margin as a percentage of sales is
referred to as the contribution margin ratio (CM ratio).
This ratio is computed as follows:

For RBC, the contribution margin ratio is calculated

as follows:
$80,000
CM Ratio = = 40%
$200,000

Each $1.00 increase in sales results in a

total contribution margin increase of 40¢.

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 6-28

Contribution Margin Ratio (CM Ratio)

and the Variable Expense Ratio – Step 2

The CM ratio can also be calculated by dividing

the contribution margin per unit by the selling
price per unit.
Contribution Margin Per Unit
CM Ratio =
Selling Price Per Unit

CM Ratio = $200 = 40%

$500

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 6-29

Contribution Margin Ratio (CM Ratio)

and the Variable Expense Ratio – Step 3
The variable expenses as a percentage of
sales is referred to as the variable expense
ratio. This ratio is computed as follows:

For RBC, the variable expense ratio is

calculated as follows:
$120,000
Variable Expense Ratio = = 60%
$200,000

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 6-30

Contribution Margin Ratio (CM Ratio)

and the Variable Expense Ratio – Step 4
Having defined the two terms, it bears
emphasizing that the contribution margin ratio
and the variable expense ratio can be
mathematically related to one another:

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 6-31

Applications of Contribution Ratio

If RBC increases sales from 400 to 500 bikes (or $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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 6-32

Concept Check 1
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. An average of 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
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 6-33

Concept Check 1a
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. An average of 2,100 cups
Unit are soldmargin
contribution
CM Ratio =
each month. What is the CM Ratio for Coffee
Unit selling price
Klatch? ($1.49 - $0.36)
A. 1.319 =
$1.49
B. 0.758
C. 0.242 $1.13
= = 0.758
D. 4.139 $1.49

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 6-34

Applications of Contribution Ratio –

Increase in Sales Volume
The relationship between profit and the CM ratio can be
expressed using the following equation:

Profit = (CM ratio × Sales) – Fixed expenses

If RBC increased its sales volume to 500 bikes, what would
management expect profit or net operating income to be?

Profit = (40% × $250,000) – $80,000

Profit = $100,000 – $80,000
Profit = $20,000

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 6-35

Learning Objective 4

Show the effects on net

operating income of
changes in variable costs,
fixed costs, selling price,
and sales volume.

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 6-36

Additional Applications of CVP Concepts

– Example 1
Example 1:
Change in Fixed Cost and Sales Volume

What is the profit impact if RBC can

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

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 6-37

Additional Applications of CVP Concepts

– Solution to Example 1
Example 1: Change in Fixed Cost 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.
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 6-38

Additional Applications of CVP Concepts – A

Shortcut

Example 1: Change in Fixed Cost 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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 6-39

Additional Applications of CVP

Concepts – Example 2
Example 2:
Change in Variable Costs and Sales Volume

What is the profit impact if RBC 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?

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 6-40

Additional Applications of CVP Concepts –

Solution to Example 2
Example 2: 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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 6-41

Additional Applications of CVP

Concepts – Example 3
Example 3:
Change in Fixed Cost, Selling Price,
and Sales 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?

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 6-42

Additional Applications of CVP Concepts –

Solution to Example 3
Example 3: Change in Fixed Cost, Selling Price, and Sales 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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 6-43

Additional Applications of CVP Concepts –

Example 4
Example 4:
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?

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 6-44

Additional Applications of CVP Concepts –

Solution to Example 4
Example 4: 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, and net operating income increases by $12,375.
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 6-45

Additional Applications of CVP Concepts –

Example 5
Example 5:
Change in Selling 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?

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 6-46

Additional Applications of CVP Concepts –

Solution to Example 5
Example 5: Change in Selling 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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 6-47

Learning Objective 5

Determine the
break-even point.

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 6-48

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 use 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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 6-49

Break-Even Analysis: Equation Method

Part 1
The equation method relies on the basic profit
equation introduced earlier in the chapter.
Because Racing Bicycle has only one product,
we’ll use the contribution margin form of this equation
to perform the break-even calculations.
We calculate break-even
by solving the equation below:

Profit = Unit CM × Q – Fixed expenses

$0 = $200 × Q – Fixed expenses

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 6-50

Break-Even Analysis: Equation Method

Part 2

In a single product situation,

the equation method for computing
the unit sales at break-even is:
Profit = Unit CM × Q – Fixed expenses
$0 = $200 × Q – Fixed expenses
$200 × Q = $0 + $80,000
Q = $80,000 ÷ $200
Q = 400 units

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 6-51

Break-Even Analysis: Formula

Method
The formula method is a shortcut version of the
equation method.
It centers on the idea discussed earlier in the
chapter that each unit sold provides a certain
amount of contribution margin that goes toward
covering fixed expenses.
Fixed expenses
Unit sales to break even =
Unit CM
$80,000
=
$200
= 400 Units

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 6-52

Break-Even Analysis: Dollar Sales

Suppose RBC wants to compute the sales
dollars required to break-even
(earn a target profit of $0).
Let’s use the equation method and the formula
methods to solve this problem.

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 6-53

Break-Even Analysis: Dollar Sales

Using Equation Method
The equation method is shown on this slide:

Profit = CM ratio × Sales – Fixed expenses

$ 0 = 40% × Sales – $80,000
40% × Sales = $80,000

Sales = $80,000 ÷ 40%

Sales = $200,000

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 6-54

Break-Even Analysis: Dollar Sales

Using CM Ratio
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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 6-55

Concept Check 2
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. An average of 2,100 cups are sold
each month. What is the break-even sales
dollars?
A. $1,300
B. $1,715
C. $1,788
D. $3,129

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 6-56

Concept Check 2a
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. An average of 2,100 cups are sold
each month. What is the break-even
Break-even sales
Fixed expenses
=
dollars? sales CM Ratio
A. $1,300
= $1,300
B. $1,715 0.758
C. $1,788 = $1,715
D. $3,129
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 6-57

Concept Check 3
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. An average of 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
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 6-58

Concept Check 3a
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 cupexpenses
Fixed is $0.36.
The average fixedBreak-even
expense=per month is
CM per Unit
$1,300. An average of 2,100 cups are sold
$1,300
each month. What is=the$1.49/cup
break-even sales in
- $0.36/cup
units?
A. 872 cups = $1,300
B. 3,611 cups $1.13/cup
C. 1,200 cups = 1,150 cups
D. 1,150 cups
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 6-59

Learning Objective 6

Determine the level of

sales needed to achieve
a desired target profit.

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 6-60

Target Profit Analysis

In target profit analysis, we estimate what
sales volume is needed to achieve a specific
target profit.
We can compute the number of units that must
be sold to attain a target profit using either:
◦ (1) Equation method, or
◦ (2) Formula method.

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 6-61

Target Profit Analysis – Equation

Method
Profit = Unit CM × Q – Fixed expenses

Our goal is to solve for the unknown “Q,”

which represents the quantity of units
that must be sold to attain the target profit.

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 6-62

Target Profit Analysis – Equation

Method Solution
Suppose RBC’s management wants to know how
many bikes must be sold to earn a target profit of
$100,000.

Profit = Unit CM × Q – Fixed expenses

$100,000 = $200 × Q – $80,000
$200 × Q = $100,000 + $80,000
Q = ($100,000 + $80,000) ÷ $200
Q = 900 units
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 6-63

Target Profit Analysis – Formula

Method

The formula method uses the following equation.

Unit sales to attain Target profit + Fixed expenses

=
the target profit CM per unit

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 6-64

Target Profit Analysis – Formula Method

Solution
Suppose RBC 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 units

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 6-65

Target Profit Analysis – Formula Method

Sales Dollars

We can also compute the target profit in

terms of sales dollars using either the
equation method or the formula method.

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 6-66

Target Profit Analysis – Equation

Method Sales Dollars Solution

Suppose RBC management wants to know the sales

volume that must be generated to earn a target
profit of $100,000.
Profit = CM ratio × Sales – Fixed expenses
$100,000 = 40% × Sales – $80,000
40% × Sales = $100,000 + $80,000
Sales = ($100,000 + $80,000) ÷ 40%
Sales = $450,000

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 6-67

Target Profit Analysis – Formula

Method Sales Dollars Solution

Dollar sales to attain Target profit + Fixed expenses

=
the target profit CM ratio

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

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 6-68

Concept Check 4
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. Use the formula method to determine
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
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 6-69

Concept Check 4a
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 averageUnitfixed expense per month is
sales
$1,300. Usetothe formulaTarget profit +to
method Fixed expenses
determine
attain =
Unit CM
how many cups of coffee
target profit would have to be
sold to attain target profits of $2,500
$2,500 + $1,300per
=
month? $1.49 - $0.36
A. 3,363 cups $3,800
=
B. 2,212 cups $1.13
C. 1,150 cups = 3,363 cups
D. 4,200 cups
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 6-70

Concept Check 5
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. Use the formula method to determine
the sales dollars that must be generated to
attain target profits of $2,500 per month.
A. $2,550
B. $5,013
C. $8,458
D. $10,555

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 6-71

Concept Check 5a
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
Salesexpense
$ per month is
Target profit + Fixed expenses
$1,300. Use theto attain = method to
formula determine
CM ratio
the sales dollars
targetthat
profitmust be generated to
attain target profits of $2,500 per month.
$2,500 + $1,300
=
A. $2,550 ($1.49 – 0.36) ÷ $1.49
B. $5,013 $3,800
=
C. $8,458 0.758
D. $10,555 = $5,013
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 6-72

Learning Objective 7

Compute the margin of

safety and explain its
significance.

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 6-73

The Margin of Safety in Dollars

The margin of safety is the excess of
budgeted or actual sales dollars over the
break-even volume of sales dollars. It is the
amount by which sales can drop before
losses are incurred. The higher the margin of
safety, the lower the risk of not breaking even
and incurring a loss.

Margin of safety in dollars = Total sales - Break-even sales

Let’s look at RBC and

determine the margin of safety.
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 6-74

The Margin of Safety in Dollars –

Example
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

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 6-75

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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 6-76

The Margin of Safety in Units

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

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 6-77

Concept Check 6
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. An average of 2,100 cups are sold
each month. What is the margin of safety
expressed in cups?
A. 3,250 cups
B. 950 cups
C. 1,150 cups
D. 2,100 cups
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 6-78

Concept Check 6a
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.
TheMargin
average fixed=expense
of safety Total salesper month is sales
– Break-even
$1,300. An average of 2,100
= 2,100 cups cups are
– 1,150 sold
cups
each month. What= is the
950 margin of safety
cups
expressed in cups?
A. 3,250 cups
B. 950 cups
C. 1,150 cups
D. 2,100 cups
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 6-79

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.

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 6-80

Cost Structure and Profit Stability –

High and Low Fixed Cost Structures
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 Companies with
structure is that income will be higher
in good years compared to companies
low fixed cost
with lower proportion of fixed costs. structures enjoy
greater stability
A disadvantage of a high fixed cost
in income across
structure is that income will be
lower in bad years compared to good and bad
companies with lower proportion of years.
fixed costs.
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 6-81

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.

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 6-82

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.

Degree of Contribution margin

operating leverage = Net operating income

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 6-83

Operating Leverage – Example

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
$100,000
Operating = =5
$20,000
Leverage
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 6-84

Operating Leverage – Changes in Profit

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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 6-85

Operating Leverage – Proof of Changes

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.

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 6-86

Concept Check 7
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. An average of 2,100 cups are sold
each month. What is the operating leverage?
A. 2.21
B. 0.45
C. 0.34
D. 2.92

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 6-87

Concept Check 7a
Actual sales
Coffee Klatch is an espresso stand in a 2,100 cups
downtown office building.
Sales The average$selling3,129
price of a cup of coffee is $1.49
Less: Variable and the
expenses 756
average variable expense
Contributionper cup is $0.36.
margin 2,373
The average fixedLess:
expense per month is 1,300
Fixed expenses
$1,300. An average Net of
operating
2,100 income $
cups are sold 1,073
each 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

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 6-88

Concept Check 8
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%

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 6-89

Concept Check 8a
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%
Percent increase in sales 20.0%
C. 22.1%
D. 44.2% × Degree of operating leverage 2.21
Percent increase in profit 44.20%

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 6-90

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%

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 6-91

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.

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 6-92

Structuring Sales Commissions –

Example
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.

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 6-93

Structuring Sales Commissions –

Solution
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.

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 6-94

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.

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 6-95

The Definition 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 RBC sells bikes and carts

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

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 6-96

Sales Mix and Break-Even Analysis –

Part 1
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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 6-97

Sales Mix and Break-Even Analysis – Part

2
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 63,486 40% 106,690 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%

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 6-98

End of Chapter 6

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