Managerial Accounting

Module 2: Cost-Volume-Profit Analysis

Module Learning Outcomes

Understand the Cost-Volume-Profit analysis

2.1: Create a Cost-Volume-Profit model

2.2: Use the contribution margin model for Cost-Volume-Profit anal
ysis
2.3: Distinguish between variable costing and full absorption costi
ng
Learning Outcomes: Cost-Volume-Cost Model

2.1: Create a Cost-Volume-Profit model

2.1.1: Understand the relationship between fixed, variable, mixed
and total costs
2.1.2: Calculate contribution margin and contribution margin ratio
Cost-Volume-Profit Model
 Understand the Relationship Between Fixed,
Variable, Mixed and Total Costs
Total costs can be classified as
variable, fixed, or mixed.
● A variable cost is an
expenditure directly correlated
with the sale or manufacture of
goods or services.
● Fixed costs remain the same in
terms of their total dollar
amount, regardless of the
number of units manufactured
or sold.
● Mixed costs have both a fixed
 Types of Cost Behavior Patterns
Recall the summary of our cost behavior
discussion from an earlier chapter.

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
 Examples of Variable Costs
1. Merchandising companies – cost of goods sold.
2. Manufacturing companies – direct materials,
direct labor, and variable overhead.
3. Merchandising and manufacturing companies –
commissions, shipping costs, and clerical costs
such as invoicing.
4. Service companies – supplies, travel, and
clerical.
 Types of Fixed Costs

Committed
Committed Discretionary
Discretionary
Long-term,
Long-term, cannot
cannot bebe May
May be
be altered
altered in
in the
the
significantly
significantly reduced
reduced short-term
short-term byby current
current
in
in the
the short
short term.
term. managerial
managerial decisions
decisions

Examples Examples
Examples
Depreciation on Advertising
Advertising and
and
Equipment and Research
Research and
and
Real Estate Taxes Development
Development
 Mixed Costs
The
The total
totalmixed
mixedcost
costline
line can
canbe
be expressed
expressed
as an equation: Y = a + bX
as an equation: Y = a + bX

Where:
Where: YY == the
the total
totalmixed
mixedcost
cost
aa == the
the total fixed cost(the
total fixed cost (the
Y vertical
vertical intercept ofthe
bb == the
intercept of the line)
line)
the variable cost per unitof
variable cost per unit of
Total Utility Cost

activity (the slope of the

activity (the slope of the line)line)

ost XX == the
the level
levelof ofactivity
activity
d c
m ixe
t al
To Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
Mixed Costs Example
If your fixed monthly utility fees is $40, your
variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours,
what is the amount of your utility bill?

Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
Analysis of Mixed Costs
Account Analysis and the Engineering Approach

Each
Each account
account isis classified
classified as
as either
either
variable
variable or
or fixed
fixed based
based on
on the
the analyst’s
analyst’s
knowledge
knowledge of of how
how the
the account
account behaves.
behaves.

Cost
Cost estimates
estimates are
are based
based on
on an
an
evaluation
evaluation of
of production
production methods,
methods, and
and
material,
material, labor
labor and
and overhead
overhead
requirements.
requirements.
The High-Low Method
Assume the following hours of maintenance
work and the total maintenance costs for six
months.
The High-Low Method
The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.

$2,400
= $8.00/hour
300
The High-Low Method

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($8/hour × 800 hours)
Total Fixed Cost = $9,800 – $6,400
Total Fixed Cost = $3,400
Quick Check 

Sales
Sales salaries
salaries and
and commissions
commissions are are $10,000
$10,000
when
when 80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000
when
when 120,000
120,000 units
units are
are sold.
sold. Using
Using the
the high-
high-
low
low method,
method, what
what is
is the
the variable
variable portion
portion of
of
sales
sales salaries
salaries and
and commission?
commission?
a.
a. $0.08
$0.08 per
per unit
unit
b.
b. $0.10
$0.10 per
per unit
unit
c.
c. $0.12
$0.12 per
per unit
unit
d.
d. $0.125
$0.125 per
per unit
unit
Quick Check 

Sales
Sales salaries
salaries and
and commissions
commissions are are $10,000
$10,000
when
when 80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000
when
when 120,000
120,000 units
units are
are sold.
sold. Using
Using the
the high-
high-
low
low method,
method, what
what is
is the
the variable
variable portion
portion of
of
sales
sales salaries
salaries and
and commission?
commission?
a.
a. $0.08
$0.08 per
per unit
unit Units Cost
b.
b. $0.10
$0.10 per unit High level
per unit 120,000 $ 14,000
Low level 80,000 10,000
c.
c. $0.12
$0.12 per
per unit
unit
Change 40,000 $ 4,000
d.
d. $0.125
$0.125 per
per unit
unit
$4,000 ÷ 40,000 units
= $0.10 per unit
Quick Check 

Sales
Sales salaries
salaries and
and commissions
commissions are are $10,000
$10,000
when
when 80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000
when
when 120,000
120,000 units
units are
are sold.
sold. Using
Using the
the high-
high-
low
low method,
method, what
what is
is the
the fixed
fixed portion
portion of
of sales
sales
salaries
salaries and
and commissions?
commissions?
a.
a. $ $ 2,000
2,000
b.
b. $ $ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000
Quick Check 

Sales
Sales salaries
salaries and
and commissions
commissions are are $10,000
$10,000
when
when 80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000
when
when 120,000
120,000 units
units are
are sold.
sold. Using
Using thethe high-
high-
low
low method,
method, what
what is
is the
the fixed
fixed portion
portion of of sales
sales
salaries
salaries and
and commissions?
commissions?
a.
a. $ $ 2,000
2,000 Total
Total cost
cost == Total
Total fixed
fixed cost
cost ++
b.
b. $ $ 4,000
4,000 Total
Total variable
variable cost
cost
c.
c. $10,000
$10,000 $14,000
$14,000 == Total
Total fixed
fixed cost
cost ++
($0.10
($0.10 ×× 120,000
120,000 units)
units)
d.
d. $12,000
$12,000
Total
Total fixed
fixed cost
cost == $14,000
$14,000 -- $12,000
$12,000
Total
Total fixed
fixed cost
cost == $2,000
$2,000
The Contribution Format
The
The contribution
contribution income
income statement
statement format
format is
is used
used
as
as an
an internal
internal planning
planning and
and decision
decision making
making tool.
tool.
Total Unit
Sales Revenue $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Net operating income $ 10,000

The
The contribution
contribution margin
margin format
format emphasizes
emphasizes cost
cost
behavior.
behavior. Contribution
Contribution margin
margin covers
covers fixed
fixed costs
costs
The Contribution Format
Comparison of the Contribution Income Statement
with the Traditional Income Statement

Traditional Approach Contribution Approach

(costs organized by function) (costs organized by behavior)

Sales $ 100,000 Sales $ 100,000

Less cost of goods sold 70,000 Less variable expenses 60,000
Gross margin $ 30,000 Contribution margin $ 40,000
Less operating expenses 20,000 Less fixed expenses 30,000
Net operating income $ 10,000 Net operating income $ 10,000

Used primarily for Used primarily by

external reporting. management.
Basics of Cost-Volume-Profit Analysis

Contribution
Contribution Margin
Margin (CM)
(CM) is
is the
the amount
amount
remaining
remaining from
from sales
sales revenue
revenue after
after variable
variable
expenses
expenses have
have been
been deducted.
deducted.
Basics of Cost-Volume-Profit Analysis

CM is used first to cover fixed

expenses. Any remaining CM
contributes to 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.
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
Income Income
Income
300
300 units
units 400
400 units
units 500
500 units
units
Sales
Sales $$ 150,000
150,000 $$ 200,000
200,000 $$250,000
250,000
Less:
Less: variable
variable expenses
expenses 90,000
90,000 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin $$ 60,000
60,000 $$ 80,000
80,000 $$100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000 80,000
80,000
Net
Net operating
operating income
income $$ (20,000)
(20,000) $$ -- $$ 20,000
20,000
CVP Graph
450,000

400,000

350,000

300,000
Dollars

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
Dollars

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
Dollars

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
Dollars

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
re a
f it A
Pro
300,000
Dollars

250,000

200,000

150,000

100,000 re a
s A
50,000 L o s
-
- 100 200 300 400 500 600 700 800

Units
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
ratioUnit
is: CM
CM Ratio =
Unit selling price

For Racing Bicycle Company the ratio is:

$200 = 40%
$500
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)
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
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
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
$80,000++ $10,000
$10,000advertising
advertising== $90,000
$90,000

Sales
Sales increased
increased by
by $20,000,
$20,000, but
but net
net operating
operating
income
income decreased
decreased byby $2,000.
$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
580units
units ×× $310
$310variable
variablecost/unit
cost/unit == $179,800
$179,800

Sales
Sales increase
increase by
by $40,000,
$40,000, and
and net
net operating
operating income
income
increases
increases by
by $10,200.
$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
Sales increase
increase by
by $62,000,
$62,000, fixed
fixed costs
costs increase
increase by
by
$15,000,
$15,000, and
and net
net operating
operating income
income increases
increases byby $2,000.
$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

Sales
Sales increase
increase by
by $37,500,
$37,500, variable
variable costs
costs increase
increase by
by
$31,125,
$31,125, but
but fixed
fixed expenses
expenses decrease
decrease by
by $6,000.
$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

$$ 3,000
3,000 ÷÷ 150
150 bikes
bikes == $$ 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
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
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
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. 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
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 theFixed
average variable
expenses
expense per cup isBreak-even
$0.36. The= average fixed
Unit CM
expense per month is $1,300. 2,100 cups are sold
$1,300
each month on average. = What is the break-even
$1.49/cup - $0.36/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. 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
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
=
0.758
d. $3,129
= $1,715
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
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? Unit sales
Fixed expenses + Target pro
a. 3,363 cups to attain =
Unit CM
b. 2,212 cups target profit
$1,300 + $2,500
c. 1,150 cups =
$1.49 - $0.36
d. 4,200 cups = $3,800
$1.13
= 3,363 cups
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
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
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
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. 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
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
Margin of safety = Total sales – Break-even sale
expense per month is $1,300. 2,100 cups are sold
= 2,100 cups – 1,150 cups
each month on average. What is the margin of
= 950 cups
safety?
or
a. 3,250 cups
Margin of safety 950 cups
b. 950 cups percentage
= 2,100 cups = 45%
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
with lower proportion of A disadvantage of a high fixed
fixed costs. cost structure is that income
will be lower in bad years
compared to companies
with lower proportion of
fixed costs.
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
Actual sales
sales
500
500 Bikes
Bikes
Sales
Sales $$ 250,000
250,000
Less:
Less: variable
variable expenses
expenses 150,000
150,000
Contribution
Contribution margin
margin 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000
Net
Net income
income $$ 20,000
20,000

$100,000 = 5
$20,000
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. 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
Quick Check 
Actual sales
Coffee Klatch is an espresso stand2,100 in acups
downtown office building.
Sales The average $ 3,129
selling price of a cupLess:
of coffee isexpenses
Variable $1.49 and 756
the average variableContribution
expense margin
per cup is 2,373
Less: Fixed expenses 1,300
$0.36. The average fixed expense per month
Net operating income $ 1,073
is $1,300. 2,100 cups are sold each month
on average. What is the operating leverage?
a. 2.21
Operating Contribution margin
b. 0.45 leverage = Net operating income
c. 0.34 $2,373
= $1,073 = 2.21
d. 2.92
Quick Check 
At Coffee Klatch the average selling price
of a cup of coffee is $1.49, the average variable
expense per cup is $0.36, and the average
fixed expense per month is $1,300. 2,100 cups
are sold each month on average.
If sales increase by 20%, by how much
should net 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. 2,100 cups are sold each month on
average.
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%
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.
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 2