Week

6
Cost-Volume-Profit
Relationships

Prepared by: Jayson T. Tasarra

 6-2

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Explain how changes in activity affect
contribution margin.
2. Compute the contribution margin ratio (CM)
ratio and use it to compute changes in
contribution margin and net income.
3. Show the effects on contribution margin of
changes in variable costs, fixed costs, selling
price and volume.
4. Compute the break-even point by both the
equation method and the contribution margin
method.
© McGraw-Hill Ryerson Limited., 2001
 6-3

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
5. Prepare a cost-volume-profit (CVP) graph and
explain the significance of each of its
components.
6. Use the CVP formulas to determine the
activity level needed to achieve a desired
target profit.
7. Compute the margin of safety and explain
its significance.

© McGraw-Hill Ryerson Limited., 2001

 6-4

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
8. Compute the degree of operating leverage at
a particular level of sales and explain how
the degree of operating leverage can be
used to predict changes to net income.
9. Compute the break-even point for a multiple
product company and explain the effects of
shifts in the sales mix on contribution margin
and the break-even point.
10.(Appendix 6A) Understand cost-volume-profit
with uncertainty.

© McGraw-Hill Ryerson Limited., 2001

 6-5

The Basics of Cost-Volume-Profit

(CVP) Analysis
WIND BICYCLE CO.
Contribution Income
Statement For the Month of
June
Per Unit
$ 500
Total 300
Less: fixed expenses $ 200
Sales
80,000(500 bikes) $250,000
Less: variable expenses 150,000
Net income $ 20,000
Contribution margin 100,000
Contribution Margin (CM) is the amount remaining
from sales revenue after variable expenses have
© McGraw-Hill been
Ryerson Limited., 2001

deducted.
 6-6

The Basics of Cost-Volume-Profit

(CVP) Analysis
WIND BICYCLE CO.
Contribution Income
Statement For the Month of
June
Per Unit
$ 500
Total 300
$
Sales (500 bikes) $250,000 200
Less:
NCMn variable
i etico s umseexpenses 150,000
ed to cover fixe $

d20ex0
,00penses.
Contribution margin 100,000
Less: fixed expenses 80,000
© McGraw-Hill Ryerson Limited., 2001

CM is used to cover fixed expenses.

 6-7

The Basics of Cost-Volume-Profit

(CVP) Analysis
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
Per Unit
$ 500
Total 300
$ 200
Sales (500 bikes) $250,000
Less: variable expenses 150,000

Contribution margin 100,000

Less: fixed expenses 80,000
Net
income $ 20,000 © McGraw-Hill Ryerson Limited., 2001
 6-8

The Contribution Approach

For each additional unit Wind sells, $200

more in contribution margin will help to
cover fixed expenses and profit.
Total Per Unit
Sales (500 bikes) $250,000 $ 500
Less: variable expenses 150,000 300
Contribution margin $100,000 $ 200
Less: fixed expenses 80,000
Net income $ 20,000

© McGraw-Hill Ryerson Limited., 2001

 6-9

The Contribution Approach

Each month Wind must generate at least

$80,000 in total CM to break even.

Total Per Unit

Sales (500 bikes) $250,000 $ 500
Less: variable expenses 150,000 300
Contribution margin $100,000 $ 200
Less: fixed expenses 80,000
Net income $ 20,000

© McGraw-Hill Ryerson Limited., 2001

 6-10

The Contribution Approach

If Wind sells 400 units in a month, it will be

operating at the break-even point.
WIND BICYCLE CO.
Contribution Income
Statement For the Month of
June Total Per Unit
Sales (400 bikes) $200,000 $ 500
Less: variable expenses 120,000 300
Contribution margin 80,000 $ 200
Less: fixed expenses 80,000
Net income $ 0

© McGraw-Hill Ryerson Limited., 2001

 6-11

The Contribution Approach

If Wind sells one additional unit (401

bikes), net income will increase by $200.
WIND BICYCLE CO.
Contribution Income
Statement
For the Month of June
Total Per Unit
Sales (401 bikes) $ 200,500 $ 500
Less: variable expenses 120,300 300

Contribution margin 80,200 $ 200

Less: fixed expenses 80,000
Net income $ 200

© McGraw-Hill Ryerson Limited., 2001

 6-12

The Contribution Approach

The break-even point can be defined either as:
➊The point where total sales revenue equals total
expenses (variable and fixed).
➋The point where total contribution margin equals
total fixed expenses.

© McGraw-Hill Ryerson Limited., 2001

 6-13

Contribution Margin Ratio

The contribution margin ratio is:

CM Ratio =
Contribution margin
Sales

For Wind Bicycle Co. the ratio is:

$200 = 40%
$500

© McGraw-Hill Ryerson Limited., 2001

 6-14

Contribution Margin Ratio

At Wind, each $1.00 increase in sales

revenue results in a total contribution
margin increase of 40¢.

If sales increase by $50,000, what will be

the increase in total contribution margin?

© McGraw-Hill Ryerson Limited., 2001

 6-15

Contribution Margin Ratio

400 Bikes 500 Bikes
Sales $200,000 $250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net income $ - $ 20,000

A $50,000 increase in sales revenue

© McGraw-Hill Ryerson Limited., 2001

 6-16

Contribution Margin Ratio

400 Bikes 500 Bikes
Sales $200,000 $250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net income $ - $ 20,000

A $50,000 increase in sales revenue

results in a $20,000 increase in CM
or ($50,000 × 40% = $20,000)

© McGraw-Hill Ryerson Limited., 2001

 6-17

Changes in Fixed Costs and Sales

Volume
Wind is currently selling 500 bikes per month.
The company’s sales manager believes that
an increase of $10,000 in the monthly
advertising budget would increase bike sales
to 540 units.

Should we authorize the requested increase

in the advertising budget?

© McGraw-Hill Ryerson Limited., 2001

 6-18

Changes in Fixed Costs and Sales

Volume
$80,000
$80,000 ++ $10,000
$10,000 advertising
advertising== $90,000
$90,000
Current Sales Projected Sales
(500 bikes) (540 bikes)
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 income $ 20,000 $ 18,000
Sales
Salesincreased
increased by
by $20,000,
$20,000,but
but
net
netincome
incomedecreased
decreased by
by$2,000.
$2,000.

© McGraw-Hill Ryerson Limited., 2001

 6-19

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 income $

(2,000)

© McGraw-Hill Ryerson Limited., 2001

 6-20

APPLICATIONS OF CVP

Consider the following basic data:

Per unit Percent
Sales Price $250 100
Less: Variable cost 150 60
Contribution margin 100 40
Fixed costs total $35,000

© McGraw-Hill Ryerson Limited., 2001

 6-21

APPLICATIONS
 Current sales are $100,000. Sales
manager feels $10,000 increase in sales
budget will provide $30,000 increase in
sales. Should the budget be changed?
YES
Incremental CM approach:
$30,000 x 40% CM ratio 12,000
Additional advertising expense 10,000
Increase in net income 2,000

© McGraw-Hill Ryerson Limited., 2001

 6-22

APPLICATIONS
 Management is considering increasing
quality of speakers at an additional cost of
$10 per speaker. Plan to sell 80 more units.
Should management increase quality?
YES
Expected total CM
= (480 speakers x$90) $43,200
Present total CM
= (400 speakers 40,000
x$100) 3,200
Increase in total contribution margin
(and net income)
© McGraw-Hill Ryerson Limited., 2001
 6-23

APPLICATIONS
 Management advises that if selling price
dropped $20 per speaker and
advertising increased by $15,000/month,
sales would increase 50%. Good idea?
Expected total CM NO
= (400x150%x$80) $48,000
Present total CM (400x$100) 40,000
Incremental CM 8,000
Additional advertising cost 15,000
Reduction in net income (7,000)
© McGraw-Hill Ryerson Limited., 2001
 6-24

APPLICATIONS
 A plan to switch sales people from flat
salary ($6,000 per month) to a sales
commission of $15 per speaker could
increase sales by 15%. Good idea? YES
Expected total CM (400x115%x$85) $39,100
Current total CM (400x$100)
40,000 Decrease in total CM (900)
Salaries avoided if commission paid 6,000
Increase in net income
$5,100 © McGraw-Hill Ryerson Limited., 2001
 6-25

APPLICATIONS

 A wholesaler is willing to buy 150 speakers

if we will give him a discount off our price.
The sale will not disturb regular sales and
will not change fixed costs. We want to
make $3,000 on this sale. What price
should we quote?
Variable cost per speaker
$150 Desired profit on order
(3,000/150)
20
© McGraw-Hill Ryerson Limited., 2001
Quoted price per speaker $170
 6-26

Break-Even Analysis

Break-even analysis can be approached in

two ways:
Equation method
Contribution margin method.

© McGraw-Hill Ryerson Limited., 2001

 6-27

Equation Method

Profits = Sales – (Variable expenses + Fixed expenses)

OR

Sales = Variable expenses + Fixed expenses + Profits

At the break-even point

profits equal zero.

© McGraw-Hill Ryerson Limited., 2001

 6-28

Equation Method

Here is the information from Wind Bicycle Co.:

Total Per Unit Percent

Sales (500 bikes) $250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000

© McGraw-Hill Ryerson Limited., 2001

 6-29

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 sales price
$300 = Unit variable expenses
$80,000 = Total fixed expenses

© McGraw-Hill Ryerson Limited., 2001

 6-30

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 = 400 bikes

© McGraw-Hill Ryerson Limited., 2001

 6-31

Equation Method
We can also use the following equation to
compute 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
percentage of sales
$80,000 = Total fixed expenses

© McGraw-Hill Ryerson Limited., 2001

 6-32

Equation Method
We can also use the following equation to
compute the break-even point in sales
dollars.
Sales = Variable expenses + Fixed expenses + Profits

X = 0.60X + $80,000 +

$0 0.40X = $80,000

X = $200,000

© McGraw-Hill Ryerson Limited., 2001

 6-33

Contribution Margin Method

The contribution margin method is a

variation of the equation method.

Break-even point Fixed expenses

=
in units sold Unit contribution margin

Break-even point in Fixed expenses

total sales dollars = CM ratio

© McGraw-Hill Ryerson Limited., 2001

 6-34

CVP Relationships in Graphic Form

Viewing CVP relationships in a graph gives managers a
perspective that can be obtained in no other way.
Consider the following information for Wind Co.:

Income Income Income

300 units 400 units 500
units
Sales $ 150,000 $ 200,000 $250,000
Less: variable expenses 90,000 120,000 150,000
Contribution margin $ 60,000 $ 80,000 $100,000
Less: fixed expenses 80,000 80,000 80,000
Net income (loss) $ (20,000) $ - $ 20,000

© McGraw-Hill Ryerson Limited., 2001

 6-35

CVP Graph
400,00
0

350,00
0

300,00
250,00 Total Expenses
0
Dollars

200,00
0
150,00 Fixed expenses
0
100,00
0

50,000

-
100

200

300

400

500

600

700

800
-

Units

© McGraw-Hill Ryerson Limited., 2001

 6-36

CVP Graph
400,000

350,000

300,000
Total Sales
250,000
Dollars

200,000

150,000

100,000

50,000

-
100

200

300

400

500

600

700

800
-

Units
© McGraw-Hill Ryerson Limited., 2001
 6-37

CVP Graph
400,00
0

350,00 rea
fitA
0 o
Pr
300,00
0
Dollars

250,00 Break-even point

150,00
0
0
100,00
200,00
r ea
0 A
o ss
L
50,000

-
100

200

300

400

500

600

700

800
-

Units

© McGraw-Hill Ryerson Limited., 2001

 6-38

Target Profit Analysis

Suppose Wind Co. wants to know how

many bikes must be sold to earn a profit
of $100,000.

We can use our CVP formula to determine

the sales volume needed to achieve a
target net profit figure.

© McGraw-Hill Ryerson Limited., 2001

 6-39

The CVP Equation

Sales = Variable expenses + Fixed expenses + Profits

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

$80,000
$200Q = $180,000

Q = 900 bikes

© McGraw-Hill Ryerson Limited., 2001

 6-40

The Contribution Margin Approach

We can determine the number of bikes that

must be sold to earn a profit of $100,000
using the contribution margin approach.
Units sold to attain Fixed expenses + Target
=
the target profit profit Unit contribution
margin
$80,000 + $100,000 = 900 bikes
$200

© McGraw-Hill Ryerson Limited., 2001

 6-41

The Margin of Safety

Excess of budgeted (or actual) sales over

the break-even volume of sales. The
amount by which sales can drop before
losses begin to be incurred.

Margin of safety = Total sales - Break-even

sales

Let’s calculate the margin of safety for Wind.

© McGraw-Hill Ryerson Limited., 2001

 6-42

The Margin of Safety

Wind has a break-even point of $200,000.

If actual sales are $250,000, the margin
of
safety is $50,000 or 100 bikes.
Break-even
sales Actual
400 units sales 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 income $ - $ 20,000

© McGraw-Hill Ryerson Limited., 2001

 6-43

The Margin of Safety

The margin of safety can be expressed as

20 percent of sales.
($50,000 ÷
$250,000) Break-even
sales Actual
400 units sales 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 income $ - $ 20,000

© McGraw-Hill Ryerson Limited., 2001

 6-44

Operating Leverage
 A measure of how sensitive net income is to
percentage changes in sales.
 With high leverage, a small percentage
increase in sales can produce a much
larger percentage increase in net income.
Degree of Contribution
operating leverage = margin Net
income

© McGraw-Hill Ryerson Limited., 2001

 6-45

Operating Leverage
Actual sales
500 Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income $ 20,000

$100,000 = 5
$20,000

© McGraw-Hill Ryerson Limited., 2001

 6-46

Operating Leverage

With a measure of operating leverage of 5,

if Wind increases its sales by 10%, net
income would increase by 50%.
Percent increase in sales 10%
Degree of operating × 5
leverage Percent increase 50%
in profits
Here’s the proof!

© McGraw-Hill Ryerson Limited., 2001

 6-47

Operating Leverage
Actual sales Increased
sales (550)

(500) $ 275,000

Sales $ 250,000
Less variable expenses 150,000 165,000
Contribution margin 100,000 110,000
Less fixed expenses 80,000 80,000
Net 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.
© McGraw-Hill Ryerson Limited., 2001
 6-48

The Concept of Sales Mix

 Sales mix is the relative proportions in
which a company’s products are
sold.
 Different products have different selling
prices, cost structures, and
contribution margins.

Let’s assume Wind sells bikes and carts and

see how we deal with break-even analysis.

© McGraw-Hill Ryerson Limited., 2001

 6-49

The Concept of Sales Mix

Wind Bicycle Co. provides us with the

following information:
Bikes Carts
Sales Total
$ 250,000 100% $ 300,000 100% $ 550,000 100%
Var. exp. 150,000 60% 135,000 45% 285,000 52%
Contrib. margin $ 100,000 40% $ 165,000 55% 265,000 48%
Fixed exp. 170,000
Net income $265,000 = 48% $ 95,000
$550,000
(rounded)
Break-even point in sales dollars:
$170,000 = $354,167 (rounded)
0.48
© McGraw-Hill Ryerson Limited., 2001
 6-50

Assumptions of CVP Analysis

Selling price is constant throughout

the entire relevant range.
Costs are linear throughout
the entire relevant range.
ŒIn multi-product companies,
the sales mix is constant.
In manufacturing companies,
inventories do not change (units
produced = units sold).

© McGraw-Hill Ryerson Limited., 2001

 Appendix

6A
Cost-Volume-Profit
with uncertainty
 6-52

CVP with uncertainty

 Use a decision tree to simplify
calculations
 The decision tree is used to calculate
profits under various alternatives
 A second decision tree can be used to
calculate the probabilities of the various
scenarios to further determine a
reasonable estimate of profit
 A computer can be used to save time

© McGraw-Hill Ryerson Limited., 2001

 6-53

End of Chapter 6
We made
it!

© McGraw-Hill Ryerson Limited., 2001