Chapter 7 Cost-Volume-Profit Analysis

Chapter 7
Cost-Volume-
Profit Analysis: A
Managerial
Planning Tool
© 2019 Cengage. All rights reserved.

Learning Objectives
1. Determine the break-even point in number of units and

in total sales amount
2. Determine the number of units that must be sold, and
the amount of revenue required, to earn a targeted
profit
3. Prepare a cost-volume-profit graph, and explain its
meaning
4. Apply cost-volume-profit analysis in a multiple-product
setting
5. Explain the impact of risk, uncertainty, and changing
variables on cost-volume-profit analysis

Break-Even Point in Units and in Sales
Amount (1 of 4)
• Cost-volume-profit (CVP) analysis estimates how
changes in the following three factors affect a
company’s profit
– Costs (both variable and fixed)
– Sales volume
– Price
• Companies use CVP analysis to help them reach
important benchmarks, such as breakeven point

Amounts (2 of 4)
• The break-even point is the point where total revenue
equals total cost (i.e., the point of zero profit)
• The level of sales at which contribution margin just
covers fixed costs and consequently, net income is
equal to zero
• Since new companies experience losses (negative
operating income) initially, they view their first break-
even period as a significant milestone

Amount (3 of 4)
• CVP analysis can address many other issues:
1. The number of units that must be sold to break even
2. The impact of a given reduction in fixed costs on the
break-even point
3. The impact of an increase in price on profit

Amount (4 of 4)
• The basis of CVP analysis:
1. The contribution margin income statement
2. Calculating the break-even point in units
3. Calculating the contribution margin ratio and the
variable cost ratio
4. Calculating the break-even point in sales amounts

Using Operating Income in Cost-Volume-
Profit Analysis (1 of 6)
• In CVP analysis, the terms “cost” and “expense” are
often used interchangeably. This is because the
conceptual foundation of CVP analysis is the
economics of break-even analysis in the short run
• It is assumed that all units produced are sold.
Therefore, all product and period costs do end up as
expenses on the income statement
Operating Income = Total Revenue – Total Expense

• For the income statement, expenses are classified
according to function; that is, the manufacturing (or
service provision) function, the selling function, and the
administrative function
• For CVP analysis, however, it is much more useful to
organize costs into fixed and variable components

• Variable costs are all costs that increase as more units
are sold, including:
– direct materials
– direct labor
– variable overhead
– variable selling expenses
• Fixed costs include:
– fixed overhead
– fixed selling and administrative expenses

• The income statement format that is based on the
separation of costs into fixed and variable components
is called the contribution margin income statement

Using Operating Income in Cost-
Volume-Profit Analysis (5 of 6)

Using Operating Income in Cost-
Volume-Profit Analysis (6 of 6)
Contribution margin is the difference between sales
and variable expense. It is the amount of sales
revenue left over after all the variable expenses are
covered that can be used to contribute to fixed
expense and operating income
Sales $ XXX
Total variable cost (XXX)
Total contribution margin $ XXX
Total fixed cost (XXX)
Operating income $ XXX

Here’s How It’s Used: IN YOUR
LIFE (1 of 4)
Carson just graduated from State U with a major in
accounting. He needs a reliable car for work and is
considering a fairly basic sedan, like a Toyota Camry.
Carson likes the idea of a hybrid vehicle and its benefits
for the environment. He wonders if the extra cost is worth
it in terms of gasoline cost saved. Carson looked at the
difference in price between the basic Camry and the
hybrid and found that it was close to $3,500. He thinks
he’ll drive approximately 12,000 miles per year and that
gasoline will average $2.50 per gallon—Carson’s an
optimist!

LIFE (2 of 4)
With those numbers and the mileage advantage of the
hybrid over a regular gasoline engine, Carson found that
he will save $300 a year in fuel costs and that it will take
over 11.5 years to break even. If gas prices average $3.50
per gallon, it will take about 8.3 years to break even. Is it
worth it? Carson has some hard thinking to do. He’ll think
about his financial situation as well as his belief in the
environmental benefits of the hybrid. He’ll also examine
his assumptions about future gas prices. Clearly, the
higher the price of gas, the lower the break-even point.

Example 7.1: How to Prepare a
Contribution Margin Income Statement
(1 of 4)
Whittier Company plans to sell 1,000 mowers at $400
each in the coming year. Product costs include:
Direct materials per mower $ 180

Direct labor per mower 100
Variable factory overhead per 25
mower
Total fixed factory overhead 15,000
Variable selling expense is a commission of $20 per

mower; fixed selling and administrative expense totals
$30,000.
Example 7.1: How to Prepare a Contribution
Margin Income Statement (2 of 4)
Required:
1. Calculate the total variable expense per unit.
2. Calculate the total fixed expense for the year.
3. Calculate the unit contribution margin.
4. Prepare a contribution margin income statement for
Whittier for the coming year.

Example 7.1: How to Prepare a Contribution
Margin Income Statement (3 of 4)
Solution:
1. Total variable expense per unit:
Total Variable Expense per Unit = Direct Materials + Direct
Labor + Variable Overhead + Variable Selling Expense
= $180 + $100 + $25 + $20
= $325
2. Total Fixed Expense = Fixed Factory Overhead +
Fixed Selling and Administrative Expense
= $15,000 + $30,000 = $45,000

Example 7.1: How to Prepare a
Contribution Margin Income Statement
(4 of 4)
3. Unit Contribution Margin = Price – Unit Variable Cost
= $400 – $325 = $75

Break-Even Point in Units (1 of 2)
• If the contribution margin income statement is recast as
an equation, it becomes more useful for solving CVP
problems
• Basic CVP Equations:
Operating Income = Sales – Total Variable Expenses – Total
Fixed Expenses
Operating Income = (Price × Number of Units Sold) –
(Variable Cost per Unit × Number of Units Sold) – Total
Fixed Cost
• The break-even point tells managers how many units must
be sold to cover all costs. Once more than the break-even
units are sold, the company begins to earn a profit

Example 7.2: How to Calculate the Break-
Even Point in Units (1 of 3)
Refer to the Whittier Company information in Example 7.1.
Recall that mowers sell for $400 each, and variable cost
per mower is $325. Total fixed cost equals $45,000.
Required:
1. Calculate the number of mowers that Whittier must sell
to break even, using the operating income equation.
2. Calculate the number of mowers that Whittier must sell
to break even, using the contribution margin equation.
3. Check your answer by preparing a contribution margin
income statement based on the break-even point.

Even Point in Units (2 of 3)
Solution:
1. Operating Income = (Price × Units) – (Variable Cost ×
Units) – Total Fixed Cost
0 = ($400 × Units) – ($325 × Units) – $45,000
Units = $45,000/($400 – $325)
= 600
2. Break-Even Number of Mowers = Total Fixed Cost/Unit
Contribution Margin
= $45,000/$75 = 600
3. Contribution margin income statement based on 600
mowers.

Example 7.2: How to Calculate the
Sales ($400 × 600 mowers) $240,000

Total variable expense ($325 × 600) 195,000
Total contribution margin $ 45,000

Total fixed expense 45,000
Operating income $0
Indeed, selling 600 units does yield a zero profit.

• Break-even units are equal to the fixed cost divided by

the contribution margin per unit
Total Fixed Cost

Break  Even Units 
Unit Contribution Margin

Break-Even Point in Sales Dollars
• Managers using CVP analysis may use sales revenue

as the measure of sales activity instead of units sold. A
units sold measure can be converted to a sales
revenue measure by multiplying the unit selling price
by the units sold:
Sales Revenue = Price × Units Sold
For example, the break-even point for Whittier is 600
mulching mowers; the selling cost is $400 per mower.
Breakeven in Sales $’s = 600 x $400 = $240,000

Variable Cost Ratio and Contribution
Margin Ratio (1 of 2)
Any answer expressed in units sold can be easily
converted to one expressed in sales revenues
• Variable Cost Ratio
– Price – Variable cost per unit = $10 - $6 = $4
– Variable Cost × Units Sold = $6 × 10 units = $60
VariableCost per Unit $6

  60%
Price $10

Variable Cost Ratio and Contribution
Margin Ratio (2 of 2)
Contribution Margin Ratio
Total Contribution Margin $40

  40%
Total Sales $100
Alternatively :
Contribution Margin per Unit $4
  40%
Price $10

Example 7.3: How to Calculate the Variable Cost
Ratio and the Contribution Margin Ratio (1 of 3)
each in the coming year. Variable cost per unit is $325.
Total fixed cost is $45,000.
Required:
1. Calculate the variable cost ratio.
2. Calculate the contribution margin ratio using unit figures.
3. Prepare a contribution margin income statement based on
the budgeted figures for next year. In a column next to the
income statement, show the percentages based on sales
for sales, total variable expense, and total contribution
margin.

Solution :
Variable Cost per Unit
1.Variable Cost Ratio 
Price
$325
  0.8125, or 81.25%
$400
2. Contribution Margin per Unit = Price – Variable Cost

per Unit = $400 – $325 = $75
Contribution Margin per Unit
Contribution Margin Ratio 
Price
$75
  0.8175, or 81.75%
$400

3. Contribution margin income statement based on

budgeted figures:
Percent of
Sales
Sales ($400 × 1,000 mowers) $400,000 100.00
Total variable expense (0.8125 × 325,000 81.25
$400,000)
Total contribution margin $ 75,000 18.75
Operating income $ 30,000

Fixed Cost’s Relationship, Variable Cost
Ratio, Contribution Margin Ratio (1 of 2)
• How do fixed costs relate to the variable cost ratio and
contribution margin ratio?
• Since the total contribution margin is the revenue
remaining after total variable costs are covered, it must
be the revenue available to cover fixed costs and
contribute to profit
• How does the relationship of fixed cost to contribution
margin affect operating income?

Fixed Cost’s Relationship, Variable Cost
Ratio, Contribution Margin Ratio (2 of 2)
• There are three possibilities:
– Fixed cost equals contribution margin; operating income
is zero; the company breaks even
– Fixed cost is less than contribution margin; operating
income is greater than zero; the company makes a profit
– Fixed cost is greater than contribution margin; operating
income is less than zero; the company makes a loss

Calculating Break-Even Point in Sales
Amount
• The break-even point in sales dollars makes it easy for
managers to see instantly how close they are to
breaking even using only sales revenue data
• Since sales are typically recorded immediately, the
manager does not have to wait to have an income
statement prepared in order to see how close the
company is to breaking even
• The equation to figure the break-even sales dollars is:
Total Fixed Expenses

Break  Even Sales 

Even Point in Sales Amount (1 of 5)
each in the coming year. Total variable expense per unit is
$325. Total fixed expense is $45,000.
Required:
1. Calculate the contribution margin ratio.
2. Calculate the sales revenue that Whittier must make to
break even by using the breakeven point in sales
equation.
income statement based on the break-even point in
sales amount.
Solution:
1. Contribution Margin per Unit = Price – Variable Cost per
Unit
= $400 – $325 = $75

Contribution Margin Ratio 
Price
$75
  0.1875, or 18.75%
$400

[Hint: The contribution margin ratio comes out cleanly to
four decimal places. Don’t round it, and your break-even
point in sales amount will yield an operating income of $0
(rather than being a few dollars off due to rounding).]
Notice that the variable cost ratio equals 0.8125, or the
difference between 1.0000 and the contribution margin
ratio.

2. Calculate the break-even point in sales amount:
Total Fixed Cost $45,000

Break - Even Sales Dollars    $240,000
Contribution Margin Ratio 0.1875

sales of $240,000:

Sales $240,000
Total variable expense 195,000
(0.8125 × $240,000)
Operating income $0
Indeed, sales equal to $240,000 does yield a zero profit.

Here’s How It’s Used: SUSTAINABILITY (1 of 5)
Many cities and counties encourage residents to recycle

waste materials, including glass, paper, cardboard, cans,
and plastic. Traditionally, cities had residents set out two
blue recycling bins each week to be collected in special
trash pickups. This is dual-stream recycling, in which
paper and cardboard are separated from glass, cans, and
plastics. The separation makes it easier for the recycling
plant to use the higher value paper and cardboard with
less chance of contamination (which occurs when
residents toss trash, such as banana peels, in the
recycling bin).

Cities had actually been making money from the sale of

paper and cardboard to recycling centers. In a true win-
win, the recycling led not only to dollar payments but also
to less trash in local landfills and fewer trees needed for
paper manufacturing.
Recently, many cities, such as the District of Columbia,
have gone to single-stream recycling in which all
recyclable wastes are put into one bin. The advantage is
that it is easier for residents to set out the one bin and
avoid the sorting chore.

The downside is that many residents also add non

acceptable waste to the bins—essentially using them as
trash cans. This contamination makes the resulting waste
less valuable. Coupled with the falling market price for
plastic and aluminum, this has led to less profitability—or
even losses on recycling. For example, Fairfax County in
Virginia made $16 per ton of recyclables in 2011, but paid
about $38 per ton in 2015. The increased cost of waste
disposal has led county officials to reconsider the single-
stream recycling process.

That reconsideration surely uses the concepts of variable

cost of collection and disposal along with the falling price
of the recycled material. Cities can then compare the
break-even point for the single-stream versus the dual-
stream process.
Sensitivity analysis is used as cities consider the volatile
price for the various recyclables. The price paid for paper
depends crucially on the amount of contaminant included.

Cities that have gone to single-stream recycling have

much more contaminant and many have found that no one
will purchase the paper; it must be buried in landfills or
cities must pay to have it carted away.
The concepts of variable cost, price, and fixed cost help
cities determine to what extent recycling is profitable or
not, and whether or not the community can afford the
extra costs.

Units And Sales Amount Needed to Achieve
a Target Income (1 of 2)
• By looking at the number of units or sales dollars
needed to earn a target operating income, managers
turn their focus away from a point of zero profit and
can aim toward making a particular positive profit
• Managers can easily compare, at any point in time, the
actual sales revenue made with the sales revenue
needed to earn a particular profit objective

Units And Sales Amount Needed to Achieve
a Target Income (2 of 2)
• The break-even point is useful information and an
important benchmark for relatively young companies,
most companies would like to earn operating income
greater than $0
• CVP allows us to do this by adding the target income
amount to the fixed cost
• First, let’s look in terms of units that must be sold
Total Fixed Cost  Target Income

Number of Units to Earn Target Income 

Example 7.5: How to Calculate the Number of Units to
Be Sold to Earn a Target Operating Income (1 of 3)
Whittier Company sells mowers at $400 each. Variable

cost per unit is $325, and total fixed cost is $45,000.
Required:
1. Calculate the number of units that Whittier must sell to
earn operating income of $37,500.
income statement based on the number of units
calculated.

Example 7.5: How to Calculate the Number
of Units to Be Sold to Earn a Target
Operating Income (2 of 3)
Target Income  Total Fixed Cost

1.Number of Units 
Unit Contribution Margin
$37,500  $45,000
  1,100
$75

sales of 1,100 units:

Example 7.5: How to Calculate the Number
of Units to Be Sold to Earn a Target
Operating Income (3 of 3)
Sales ($400 × 1,100) $440,000

Total variable expense 357,500
($325 × 1,100)
Indeed, selling 1,100 units does yield operating

income of $37,500.

Units to Be Sold to Achieve a Target
Income (1 of 2)
• How much sales revenue must Whittier generate to
earn an operating income of $37,500?
• This question is similar to the one we asked earlier in
terms of units but phrases the question directly in
terms of sales revenue

Units to Be Sold to Achieve a Target
Income (2 of 2)
• To answer the question, add the targeted operating
income of $37,500 to the $45,000 of fixed cost and
divide by the contribution margin ratio. This equation
is:
Total Fixed Cost  Target Income

Sales Dollars to Earn Target Income 

Example 7.6: How to Calculate Sales Needed to
Earn a Target Operating Income (1 of 3)
Whittier Company sells mowers at $400 each. Variable
cost per unit is $325, and total fixed cost is $45,000.
Required:
1. Calculate the contribution margin ratio.
2. Calculate the sales that Whittier must make to earn an
operating income of $37,500.
income statement based on the sales dollars
calculated.

Example 7.6: How to Calculate Sales Needed to
Earn a Target Operating Income (2 of 3)
Solution :
$400  $325
1. Contribution Margin Ratio   0.1875
$400
Target Income  Total Fixed Cost
2.Sales Dollars 
$37,500  $45,000
  $440,000
0.1875

Example 7.6: How to Calculate Sales
Needed to Earn a Target Operating Income
(3 of 3)

sales revenue of $440,000:
Sales $440,000
Total variable expense (0.8125 × $440,000) 357,500
Indeed, sales revenue of $440,000 does yield operating

income of $37,500.

Impact of Change in Revenue on
Change in Profit
• Assuming that fixed costs remain unchanged, the
contribution margin ratio can be used to find the profit
impact of a change in sales revenue
• To obtain the total change in profits from a change in
revenues, multiply the contribution margin ratio times
the change in sales:
Change in Profits = Contribution Margin Ratio × Change in
Sales

Graphs of cost-Volume-Profit
Relationships
• Graphing sales revenue and total costs against units
sold helps managers clearly see the difference
between variable cost and revenue
• It may also help them understand quickly what impact
an increase or decrease in sales will have on the
break-even point

The Cost-Volume-Profit Graph (1 of 3)
• The cost-volume-profit graph depicts the relationships

among cost, volume, and profits (operating income) by
plotting the total revenue line and the total cost line on
a graph
• To obtain the more detailed relationships, it is
necessary to graph two separate lines—the total
revenue line and the total cost line

• These two lines are represented by the following two

equations:
Revenue = Price × Units
Total Cost = (Unit Variable Cost × Units) + Fixed Cost


CVP Analysis Assumptions
Major assumptions of CVP analysis include:

1. Linear revenue and cost functions remain constant
over the relevant range
2. Selling prices and costs are known with certainty
3. All units produced are sold; there are no finished
goods inventories
4. Sales mix is known with certainty for multiple-product
break-even settings

Here’s How It’s Used: AT BOYNE
RESORTS (1 of 3)
You are the chief accountant for Boyne Resorts winter
sports. Early in the year, you had budgeted sales prices
(lift tickets, restaurant prices), costs, and expected
quantity to be sold. However, once the season starts, you
will know from week to week more about the actual
weather conditions.
How can you use this information about current weather
conditions to better predict budgets for Boyne?

RESORTS (2 of 3)
You can recast the budgeted statements according to how
the weather will affect skiing. If the snow is good, some
costs will go down. For example, you will lower the
predicted cost of running the snow-making machines.
However, good weather and more skiers will require
additional seasonal hiring as more direct labor will be
needed to run the lifts, operate ski equipment rental
shops, restaurants, and so on. You can put together
contribution margin income statements under various
scenarios, increasing volume with good ski weather,
decreasing it with poor weather.

RESORTS (3 of 3)
Having the ability to recast budgets will help managers
respond quickly to the changing conditions and be able to
raise or lower some prices as needed.

Multiple-Product Analysis (1 of 2)
• Cost-volume-profit analysis is simple in a single-

product setting. However, most firms produce and sell
a number of products or services
• When managers calculate the break-even point for
individual products, they can see the contribution each
makes to profit and can tell at any point in time how
close a product is to breaking even
• How do we adapt the formulas used in a single-
product setting to a multiple-product setting?

Multiple-Product Analysis (2 of 2)
• One important distinction is to separate direct fixed

expenses from common fixed expenses
– Direct fixed expenses are those fixed costs that can be
traced to each segment and would be avoided if the
segment did not exist
– Common fixed expenses are the fixed costs that are
not traceable to the segments and would remain even if
one of the segments was eliminated

Break-Even Calculations for Multiple
Products
• When more than one product is produced and sold,
managers must estimate the sales mix and calculate a
package contribution margin
• Sales mix is the relative combination of products
being sold by a firm
Total Fixed Costs

Break - Even Packages 
Package Contribution Margin

Example 7.7: How to Calculate the Break-Even
Units for a Multiple-Product Firm (1 of 5)
Recall that Whittier sells two products: mulching mowers
priced at $400 and riding mowers priced at $800. The
variable cost per unit is $325 per mulching mower and
$600 per riding mower. Total fixed cost is $96,250.
Whittier’s expected sales mix is three mulching mowers to
two riding mowers.

Required:
1. Form a package of mulching and riding mowers based
on the sales mix and calculate the package
contribution margin.
2. Calculate the break-even point in units for mulching
mowers and for riding mowers.
3. Check your answers by preparing a contribution
margin income statement.

Break-Even Units for a Multiple-
Product Firm (3 of 5)
The three mulching mowers in the package yield $225 (3 × $75) in

The two riding mowers in the package yield $400 (2 × $200) in
Thus, a package of five mowers (three mulching and two riding) has a
total contribution margin of $625.

Total Fixed Costs

2.Break - Even Packages 
Package Contribution Margin
$96,250

$625
 154 Packages
Mulching Mower Break-Even Units = 154 × 3 = 462

Riding Mower Break-Even Units = 154 × 2 = 308

Break-Even Units for a Multiple-
Product Firm (5 of 5)

Sales Dollars for a Multiple-Product Firm (1 of 4)
Recall that Whittier Company sells two products that are
expected to produce total revenue next year of $1,120,000
and total variable cost of $870,000. Total fixed cost is
expected to equal $96,250.
Required:
1. Calculate the break-even point in sales dollars for
Whittier.
income statement.

Solution :
$250,000
1.Contribution Margin Ratio 
$1,120,000
 0.2232
Fixed Cost
Break - Even Sales 
$96,250

0.2322
 $431,228
[Note: Total break-even sales differ slightly between Examples

7.7 and 7.8 ($431,200 vs. $431,228) due to the rounding of the
contribution margin ratio to only four decimal places (0.2232).]

Even Sales Dollars for a Multiple-Product
Firm (3 of 4)
2. Income statement—break-even solution:
Sales $431,228
Total variable cost (0.7768 334,978
× $431,228)
contribution margin $ 96,250
Total fixed cost 96,250
Operating income $0

The break-even point in sales dollars implicitly uses the
assumed sales mix but avoids the requirement of building
a package contribution margin. No knowledge of individual
product data is needed. The computational effort is similar
to that used in the single-product setting. Unlike the break-
even point in units, the answer to CVP questions using
sales dollars is still expressed in a single summary
measure. The sales revenue approach, however, does,
sacrifice information concerning individual product
performance.

Here’s How It’s Used: BY A NEW
BUSINESS (1 of 5)
You are an accountant in private practice. A friend of
yours, Linda, recently started a novelty greeting card
business. Linda designs greeting cards that allow the
sender to write in his or her own message. She uses
heavy card stock, cut to size, and decorates the front of
each card with bits of fabric, lace, and ribbon in seasonal
motifs (e.g., a heart for Valentine’s Day, a pine tree for
Christmas). Linda hired several friends to make the cards,
according to Linda’s instructions, on a piece-work basis.
(In piece work, the worker is paid on the basis of number
of units produced.)

BUSINESS (2 of 5)
The workers could make the cards at their homes,
meaning that no factory facilities were involved. Linda
designs the cards and travels around her four-state region
to sell the completed cards on consignment. For the few
months the company has been in existence, the cards
have been selling well, but Linda is operating at a loss.
What types of information do you need to find the break-
even point? How can the business owner use this
information to make decisions?

BUSINESS (3 of 5)
In order to determine the break-even point, you need to
determine the prices and variable costs for the cards.
Since creating a multiple-product break-even analysis
could be complex, it may be easier to determine the
average price and the average variable cost for the cards,
then find the total fixed cost, and tell Linda how many
cards she would need to sell to break even.

BUSINESS (4 of 5)
Suppose that the break-even number of cards is 250 per
month, and that the average contribution margin per card
is $0.80. Then, as soon as Linda sells the 250th card, she
knows she is in the black. From then on, every card sold
adds $0.80 to her profit. This was very important
information for Linda— whose business losses are coming
right out of her family’s checking account. Not only does
Linda have a sales goal for each month, but she also
knows at any point in time how much income she has
made.

BUSINESS (5 of 5)
Owners of small businesses find break-even analysis and
concepts to be very helpful. A knowledge of contribution
margin helps owners exercise control by knowing how
they are doing at any point in time.

Cost-Volume-Profit Analysis and Risk and
Uncertainty
• Managers must be aware of many factors in our
dynamic world. CVP analysis is a tool that managers
use to handle risk and uncertainty
Changes in prices?
Risks?
Fixed costs?
Variable costs?
Uncertainty?

Introducing Risk and Uncertainty
• An important assumption of CVP analysis is that prices
and costs are known with certainty
• However, risk and uncertainty are a part of business
decision making and must be dealt with

Methods to Deal with Uncertainty and Risk
1. Management must realize the uncertain nature of

future prices, costs, and quantities
2. Management must assume a “break-even band” rather
than a breakeven point
3. Managers should use sensitivity or “what-if” analysis

Margin of Safety (1 of 4)
• The margin of safety is the units sold or the revenue

earned above the break-even volume
• For example, if the break-even volume for a company
is 200 units and the company is currently selling 500
units, the margin of safety in units is:
Margin of Safety= Sales – Break-Even Units
= 500 – 200 = 30

• If the break-even volume for a company is $200,000

and the current revenues are $500,000, the margin of
safety in sales revenue is:
Revenues – Margin of Safety = $500,000 – $200,000 =
$300,000
• In addition, the margin of safety can be expressed as a
percentage of total sales dollars 60%:
Margin of Safety $300,000


Revenues $500,000

• Two concepts useful to management are margin of
safety and operating leverage
• Both of these concepts may be considered measures
of risk
• Each requires knowledge of fixed and variable costs

• The degree of operating leverage (DOL) can be

measured for a given level of sales by taking the ratio
of contribution margin to operating income, as follows:
Total Contribution Margin

Degree of Operating Leverage 
Operating Income

Example 7.9: How to Calculate the Margin
of Safety (1 of 2)
Recall that Whittier plans to sell 1,000 mowers at $400
each in the coming year. Whittier has unit variable cost of
$325 and total fixed cost of $45,000. Break-even units
were previously calculated as 600.
Required:
1. Calculate the margin of safety for Whittier in terms of
the number of units.
2. Calculate the margin of safety for Whittier in terms of
sales revenue.

Example 7.9: How to Calculate the Margin
of Safety (2 of 2)
Solution:
1. Margin of Safety in Units = 1,000 – 600 = 400
2. Margin of Safety in Sales Revenue = $400(1,000) –
$400(600) = $160,000

Operating Leverage
• Operating leverage is the use of fixed costs to extract

higher percentage changes in profits as sales activity
changes
• It is the measure of the proportion of fixed costs in a
company’s cost structure
• It is used as an indicator of how sensitive profit
changes in sales volume

Degree of Operating Leverage (1 of 2)
Recall that Whittier plans to sell 1,000 mowers at $400
each in the coming year. Whittier has unit variable cost per
unit of $325 and total fixed cost of $45,000. Operating
income at that level of sales was previously computed as
$30,000.
Required:
Calculate the degree of operating leverage for Whittier.

Degree of Operating Leverage (2 of 2)
Solution :
Total Contribution Margin
Degree of Operating Leverage 
Operating Income

$400  $325 1,000 units 
$30,000
 2.5

Summary of Operating Leverage
Operating Leverage: Operating Leverage:

HIGH LOW
% profit Large Small
increase with
sales increase
% loss increase Large Small
with sales
decrease

Example 7.11: How to Calculate the Impact of Increased
Sales on Operating Income Using the Degree of Operating
Leverage (1 of 2)
Recall that Whittier had expected to sell 1,000 mowers
and earn operating income equal to $30,000 next year.
Whittier’s degree of operating leverage is equal to 2.5.
The company plans to increase sales by 20% next year.
Required:
1. Calculate the percent change in operating income
expected by Whittier for next year using the degree of
operating leverage.
2. Calculate the operating income expected by Whittier
next year using the percent change in operating
income calculated in Requirement 1.

Example 7.11: How to Calculate the Impact of Increased
Sales on Operating Income Using the Degree of Operating
Leverage (2 of 2)
Solution:
1. Percent Change in Operating Income = DOL ×
Percent Change in Sales
= 2.5 × 20% = 50%
2. Expected Operating Income = $30,000 + (0.5 ×
$30,000) = $45,000

Differences between a Manual and an
Automated System
Manual System Automated System
Price Same Same
Variable cost Relatively higher Relatively lower
Fixed cost Relatively lower Relatively higher
Contribution margin Relatively lower Relatively higher
Break-even point Relatively lower Relatively higher
Margin of safety Relatively higher Relatively lower
Degree of operating leverage Relatively lower Relatively higher
Down-side risk Relatively lower Relatively higher
Up-side potential Relatively lower Relatively higher

Sensitivity Analysis and Cost-Volume-Profit
(1 of 2)
• As the text presented, the widespread use of personal
computers and spreadsheets has placed sensitivity
analysis within reach of most managers
• Sensitivity analysis is a “what-if” technique that
examines the impact of changes in underlying
assumptions on an answer
• It is relatively simple to input data on prices, variable
costs, fixed costs, and sales mix and to set up
formulas to calculate break-even points and expected
profits

Sensitivity Analysis and Cost-Volume-Profit
(2 of 2)
• The data can be varied as desired to see how changes
impact the expected profit
• This comparison will allow the manager to make
informed decisions about whether to migrate
operations from a manual system to a more automated
one

LIFE (3 of 4)
You may face decisions that use sensitivity analysis in
deciding which product or service to use. For example,
Lacy Daniels just graduated with a degree in accounting
and now works for a national accounting firm as an entry-
level auditor. Lacy travels frequently for her work but
wants to stay in shape and exercise while she’s in her
home town. A local gym offers a rate of $12 for a day visit
or $90 for a month membership. Which should Lacy
choose? The answer depends on Lacy’s expected use of
the gym.

LIFE (4 of 4)
If she thinks she can only go four times a month, the day
visit rate is clearly better since it will cost $48 for a month
($12 × 4 visits) rather than $90. However, if Lacy thinks
she can go an average of about 10 times a month, then
the monthly membership is better since it is less than
$120 ($12 × 10 visits). The break-even point between the
two rates is 7.5 ($90/$12), meaning that at fewer than
eight times a month, the day rate is the better choice.

Chapter 7 Cost-Volume-Profit Analysis

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Chapter 7 Cost-Volume-Profit Analysis

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Chapter 7

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1. Determine the break-even point in number of units and

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Total fixed cost (XXX)

Operating income $ XXX

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Direct materials per mower $ 180

Variable selling expense is a commission of $20 per

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Sales ($400 × 600 mowers) $240,000

Total contribution margin $ 45,000

Indeed, selling 600 units does yield a zero profit.

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• Break-even units are equal to the fixed cost divided by

Total Fixed Cost

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• Managers using CVP analysis may use sales revenue

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VariableCost per Unit $6

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Contribution Margin Ratio

Total Contribution Margin $40

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2. Contribution Margin per Unit = Price – Variable Cost

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3. Contribution margin income statement based on

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Total Fixed Expenses

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Contribution Margin per Unit

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2. Calculate the break-even point in sales amount:

Total Fixed Cost $45,000

3. Contribution margin income statement based on

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Indeed, sales equal to $240,000 does yield a zero profit.

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Many cities and counties encourage residents to recycle

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Cities had actually been making money from the sale of

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The downside is that many residents also add non

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